The Overhead Costs in Business - Essay Example

Introduction The of overhead costs is one of the most topical areas in conventional accounting. Inseveral instances, the overhead costs of a business largely determine the survival of that business on the basis of expenses versus revenues. In construction projects, the most important expenses are normally the overhead costs which largely determine the feasibility of such projects. However, it is indeed much difficult to trace overhead costs in the final products or construction projects (Kam, 2003). On the other hand, labour and material costs are easily traceable and can therefore easily be associated with the final product (Hartley, 2009). The allocation and measurement of overhead costs is therefore a very important factor in accounting given that it makes no sense to engage in production if the business experiences much overhead cost that cannot balance the revenues (Hilton, 2012). The overhead costs in business are basically the costs the ongoing expenses realized in the operations. They include electricity, rent wages and gas. The name overhead arises out of the fact that these costs cannot be easily associated with the final products but are nevertheless imperative for the continued functioning of the business (Kieso & Weygandt, 2001). In any case, most of the overhead costs are not directly related to the business. For instance full rent for the premises has to be paid whether the business operates for fewer hours or not. In the income statement, the overhead costs include all the costs except direct materials, direct labour and direct expenses (Horngren, 2002). Overhead allocation In most cases, the overhead costs are normally much higher than the direct costs. In this regard, accountants must effectively allocate overhead costs to the inventory. Overhead costs normally fall into two categories. Administrative overheads include all the costs realized in production and development of goods such as front office and sales. Manufacturing overheads include all the costs incurred by the business other than direct costs (Innes & Mitchell, 2005). It is imperative to allocate the manufacturing overheads to the inventory items classified as finished goods or work in progress. However, the overheads should not be allocated to the raw materials. In one procedure, all the manufacturing costs are accumulated into cost pools and then an activity formula is applied in apportioning the overheads in the cost pools to the inventory in the business. As such, the allocation formula becomes: Cost pool/Total activity measure= Overhead allocation per Unit Absorption costing In some cases, the overhead costs are ignored from the general expenses realized by a business. In this case, absorption costing is an important way of ensuring that such omissions are well addressed. Unlike variable costing where the fixed costs are not actually absorbed by the product, absorption costing ensures that all the direct costs realized in the production of goods are factored within the cost base. In this case, absorption costing is important given that the fixed cost normally provide future benefits to the business. Through the use of absorption costing, the overhead costs are easily included in the total production costs and can therefore be attributed to any unit production. Tax advantages Manufacturing overhead costs are normally tax deductible. It is therefore very important for the business to effectively track all these cost to the overall manufacturing expenses. In this case, the taxable income can greatly be reduced and subsequently lower the tax burden for the business (Khalik, 2008). Most of the overhead costs are normally deductible in the very year they are incurred which actually works to the advantage of the business. Nevertheless, equipment is depreciated over a period of years. Disadvantages Rising prices Considering the inflationary environment realized in the present business environment, the rising overhead costs are normally a challenge to businesses. Most businesses resort to increasing the prices of the products in order to balance the overheads even in the event that material and labour cost do not rise. For instance, inflation makes it important to increase the wages paid to the workers ad this translates to increasing the overall expenses realized by the business (Fields, 2002). The failure to control overhead costs can be very detrimental to the business and can therefore drive the business out of the market Cash flow challenges One major challenges realized in businesses is the continuation of overhead costs even in the absence of production. During machine outrages and manufacturing downtimes, overheads are normally realized. In this case, a business will end up spending cash while it might not be realizing any revenues. It is therefore important for all business in production to keep an emergency fund which can cover the overhead costs in cases where the business in non-manufacturing. This is greatly important as it can salvage the business from winding up due to the burden of overhead costs (Drury, 2005). Managing overhead costs Presently nearly 40% to 50% of the total costs realized by most companies are overheads. Overhead cost management has therefore become one of the major issues in business management given that a failure to manage these costs can be very detrimental to the business. Organizations that effectively manage their overheads are very profitable. In order to effectively manage the overheads, it is imperative to understand the dynamics of business expenses and understand what is variable and not variable. It is often realized that while direct labour contributes only about 10% of the total costs realized by a business, much effort is always directed towards managing direct labour costs (Cropper, 2006). In this case, companies lay off workers which translate into series of problems with unions and the government. On the contrary, while overheads form the largest proportion of the total costs realized by a business, there is always less effort on the part of the management to manage these costs (Wolk, 2009). In managing overhead costs in the business, cost accountability emerges as an important aspect in consideration. In this case, every individual within the organization should have the responsibility to ensure that costs are kept as low as possible. Through the use of Cost Center Accounting, costs can easily be assigned to different departments and /or managers responsible for different functional areas within the organization (Burton & Bragg, 2000). For instance, costs center can be formed in the functional areas of purchasing, marketing, human resources and administration. Those in charge of the cost centers are therefore responsible for good performance standards and cost planning. Actual performance has to be measured through a comparison of the actual cost realized against an expenditure plan. This can effectively improve performance and keep most of the costs down (Weygandt, Kieso & Kell, 2004). In the same way, by greatly understanding the Cost Base in the business, a manger can encourage improvement in most of the areas of expenditure. New technology in energy saving and capital feasibility studies can be experimented in the organization as a way of keeping down costs. In the same way, the businesses should evaluate the possibility of engaging third party production instead of in-house production. Most organizations are today outsourcing most of their services and this greatly helps to reduce much of the overhead costs realized (Meigs & Meigs, 2000). In a world where technology has become a solution in most areas, it is important for an organization to capitalize on the use of technology on reducing overhead costs. Technology comes in various forms and every business has the opportunity to adopt efficient ways and means of enhancing its operations. Organizations must clearly monitor and keep all the costs under control (Bragg, 2005). Activity based costing As a costing methodology, Activity Based Costing involves the identification of all the activities in the organization and assigning cost to them on the basis of resources consumed (Khalik, 2008). In this case, more overhead costs are assigned into direct costs as compared to the other methods of costing. The aim of ABC is therefore to get rid of products that are unprofitable for the organization and reduce the prices of overcharged products. In the same way, through ABC, services and processes that are ineffective and easily identified and eliminated in order to realize better yield for the organization. The importance of ABC has grown tremendously in the recent past as a result of the increase in the manufacturing overheads of most businesses. In the same way, the lack of correlation between manufacturing overheads and the productive machine hours creates the need for ABC. However, the use of ABC requires large sums of money to implement within an organization since there is so much data to be collected and tracked. In the same way, the data can easily be misinterpreted in decision making (Hilton, 2012). Decision making For a manager, making the best decisions is one of the core tasks. Decisions are normally made between two or more alternatives and it is important that the best alternative is selected. The costs and benefits of all the decision have to be determined and analyzed before the decisions are made (Belkaoui, 2009). A managerial accountant is must therefore analyze the impact of predicted cost in the future versus the revenues and also factor in aspects of inflation before making a decision in the business. In this case, a clear understanding of the nature of overhead costs is very important. Such decisions will inform the managers on whether to make or buy and how effectively to utilize the scarce resources in the bossiness (Atrill, 2001). By clearly understanding the nature of overhead costs managers will be well position in seeking for alternative ways of production in which such costs can be kept down. The present competitive business environment presents managers with various alternatives in entirely all sectors. In this case, it is seen that a clear understanding of overheads cost is very important not only for managerial accountants but for every manager in charge of a functional unit within an organization (2013). It is therefore seen that despite the less focus normally placed on the need to manage overhead costs in a business, they actually form the greatest proportion of all the total costs and hence the need to greatly focus on their management. Through absorption costing, it is much possible to allocate the overhead costs to the final production of a business which ultimately enables the business to limit some of the challenges realized in variable costing. In sum, an understanding of overhead costs in the organization is a proper way of ensuring that proper decisions are made within the business and limiting some of the challenges often realized. References Allocation of Oveheads. (2013). Journal of Accounting, Auditing & Finance, 5(6), 23. Atrill, P., Harvey. (2001). 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