What Is The Difference Between Direct and Indirect Overhead?

A business entity is incurring different expenses, direct and indirect, to keep the cycle running. Some expenses are direct to the core product or service of the business.

While other expenses are incurred for selling the products and are not directly part of the production process. Material and labor are included in the direct costs of any manufacturing concern. These are essentials to make finished or semi-finished goods.

The indirect costs or expenses of the business entity are not tied to a specific activity level, unit production, etc. These are wholesome expenses incurred for a whole business. A portion of indirect costs is attributed to production, administration, marketing, etc., by using different methods. These indirect costs are often called overhead costs.

The segregation of direct and indirect costs is important from a budgeting point of view, calculating unit product cost and, therefore, the selling price. The differentiation of these expenses also helps in major internal tasks like hiring, outsourcing, procurement, etc. In this article, we are going to differentiate between direct and indirect overhead. Let’s get into it without a further ado.

What Is Overhead?

Overhead costs are the indirect business expenses not directly attributable to a specific product or service offered by the company.

Overhead expenses are ongoing expenses, and these expenses are important for a company to determine the selling price of a product or service. There can be several categories of overhead expenses based on different metrics: variable & fixed, operational & selling, and direct & indirect.

For accounting purposes, the overhead costs are charged to the profit and loss account as the company’s expenses. The overhead costs of any business entity can be variable, fixed, or hybrid.

What Is Included In Overhead Costs?

It’s important to understand what is included in the overhead costs of a business entity. A more general representation of overhead costs in the accounting statements is made variable and fixed overhead. Therefore, we can say that overhead costs include variable, fixed, and hybrid costs

Variable Overhead

The variable overhead costs are the business entity’s expenses that change or fluctuate with time, level of production, etc. For instance, the shipping costs will vary from time to time and the size of the order.

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Fixed Overhead

The fixed overhead costs of the business entity are the expenses that a company incurs irrespective of production level, products sold, services, etc. For instance, the depreciation of the fixed assets owned by a company will be due in every accounting period irrespective of production.

Hybrid Costs

A business entity’s hybrid overhead or semi-variable costs are fixed and variable overhead expenses. Utilities can be regarded as hybrid or semi-variable overhead.

Similar to the segregation of variable, fixed, and semi-variable overhead expenses, direct and indirect overhead costs also exist.

Although, the inherent characteristic of overhead costs is that they are not attributed to a specific product or service. But they can be differentiated based on the area where expenses are incurred. Let’s discuss direct and indirect overhead before we compare the two.

What is Direct Overhead?

Direct overhead costs of a business entity are the expenses that are related to direct business operations. Although incurred during the production process, these overhead costs are irrespective of the production level or units sold. Simply put, the overhead costs incurred in the production process are regarded as the direct overhead of a company.

Explanation

We can call the direct overhead costs of a company the manufacturing overhead. This explains that direct overhead has been used for the production process. You should not confuse direct overhead with a company’s direct costs (direct labor or direct material).

Direct labor and direct material are variable costs that change with every additional unit produced. However, the direct overhead is fixed for a certain level of output.

For instance, a company has a manufacturing plant having a production capacity of 10,000 units. However, currently, the company is manufacturing 7,000 units.

It implies that until the companies make 10,000 or fewer units, the depreciation expense of the manufacturing plant will be fixed. The direct overhead will change when the company intends to upgrade the production facility by having another plant. 

Example

The common examples of the direct overhead costs are as follows:

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Depreciation of plant and machinery

Depreciation of the plant and machinery will be treated as the direct overhead as the machinery is used in the production process. However, we can attribute it to a certain batch, product, or service.

Factory rent

Similarly, the rent of the manufacturing plant remains fixed until a certain level of production. Therefore, it is also attributed as the direct overhead expense of the company.

It is important to understand that the rent of the factory or manufacturing unit will be considered direct overhead only. If the rent of the office or administration space is concerned, it will be accounted for as the indirect overhead.

Utility bills of the manufacturing plant

Utilities like electricity, gas, water, phone service, internet, etc., are indispensable for any business entity now. Therefore, the utility bills of the manufacturing plant will be treated as the direct overhead expense for the company.

Other Relevant Expenses

Other expenses like insurance of the plant, machinery, and factory against the natural calamities, fire, theft, etc., are also treated as the direct overhead expense for the company.

Accounting Treatment

When the accounting treatment for the direct overhead expenses is concerned, the normal double-entry system is followed for recording the expenses. Since the direct overhead expenses are related to the production process, they are added to other production costs to reach a per unit product cost.

When accounting for direct overhead, the expenses related to overhead costs accounted must follow the following guidelines:

  1. Add to the overall production costs to calculate per unit product price and total production cost
  2. Add to work-in-process inventory, finished goods, and cost of sales.
  3. An estimated overhead rate is applied to check the actual and estimated overhead difference.
  4. Under-applied or over-applied overhead costs are added or subtracted, respectively, from the total production cost

What is Indirect Overhead?

Indirect overhead, part of the overhead expenses, covers the expenses incurred by a company that `-are not related to the production or manufacturing process. In other words, the indirect overhead costs are not immediately associated with the product or services of the manufacturer or company.

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Explanation

We can call the indirect overhead costs of a company the operational or non-manufacturing overhead. This explains that indirect overhead has not been used for the production process.

Instead, it is used for other business operations that are necessary for profit-making. The indirect overhead also remains fixed irrespective of the company’s production level. These expenses are treated as fixed costs and do not add substantial value to the company’s production process.

For instance, a company has a front office where the administrative staff works. Besides, the marketing staff is hired to craft the marketing strategy. This staff is not directly associated with the production process. Therefore, such costs are the indirect

Example

The common expenses of the company treated as indirect overhead costs are as follow:

  • Accounting, auditing, and legal expenses
  • Selling and marketing expenses
  • Administrative expenses
  • Research and development
  • Office supplies, postage, and printing
  • Information technology

Journal Entries

When the accounting treatment for the indirect overhead expenses is concerned, the normal double-entry system is followed for recording the expenses.

When accounting for indirect overhead, the expenses related to overhead costs accounted must follow the following guidelines:

  1. Add to the overall production costs to calculate per unit product price and total production cost
  2. Add to work-in-process inventory, finished goods, and cost of sales.
  3. An estimated overhead rate is applied to check the actual and estimated overhead difference.
  4. Under-applied or over-applied overhead costs are added or subtracted, respectively, from the total production cost

Difference Between Direct and Indirect Overhead

Direct OverheadIndirect Overhead
Direct overhead are expenses associated with the production process.Indirect overhead is expenses associated with the production process.
Direct overhead expenses are fixed up to a specific level. However, when the level exceeds, the direct overhead expenses are variable.The indirect overhead expenses of the company are treated as the company’s fixed costs.
Direct overhead expenses are added to the production costs for the appropriation of the per-unit product cost.Indirect overhead expenses are not added to the production cost for the calculation of per-unit product cost.
Examples of direct overhead costs are depreciation of plant, utilities, etc.Examples of indirect overhead costs are selling and administrative expenses, legal expenses, etc.

Final Words

Overhead costs are the expenses of a company associated with the company’s indirect expenses. The company’s overhead expenses can be categorized as variable or fixed, direct or indirect, operational and selling, etc. In this article, we discussed the company’s direct and indirect overhead expenses.

The direct overhead costs are the manufacturing overhead, and indirect overhead is the non-manufacturing overhead. We hope that you are able to differentiate the two and go for the appropriate accounting treatment for each.