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Understanding Direct and Indirect Overhead Expenses

Welcome to our comprehensive guide on direct and indirect overhead expenses – a must-read for business owners and managers looking to understand and optimize their company's expenses. In this article, we'll walk you through the definitions and examples of direct and indirect overhead costs, explore the differences between them, and discuss how to record and manage them in the financial statements. Moreover, we'll dive into the impact of these costs on various industries and examine their effects on business performance, from profitability to strategic decision-making. By the end of this article, you'll have a solid understanding of direct and indirect overhead expenses, empowering you to better manage your company's finances and drive growth.

Understanding Direct and Indirect Overhead Expenses

Overhead expenses are costs that are not directly tied to the production on construction sites or service you offer but are necessary to maintain business operations. These expenses are classified into two categories: direct overhead and indirect overhead expenses. Understanding the differences between these two categories is essential for businesses to better allocate their resources, manage their expenditures and income statements, and plan future budgets.

Definition of Direct Overhead Expenses

Direct overhead expenses are fixed or variable costs that can be directly linked with the production process of a company. These expenses are necessary to run the business and are incurred in a way that they can be traced directly to the production of a particular project or service. They are allocated proportionately with the volume of production or the level of activity within a business.

Direct overhead expenses are regarded as an essential part of the cost of goods manufactured and are incurred either on project sites or in the office building that you run your construction company from. Since these costs are directly tied to the production of goods, they are a part of a business's cost of goods sold (COGS), affecting the profit calculation.

Definition of Indirect Overhead Expenses

Indirect overhead expenses, also known as general overheads, or administrative overheads, are costs that cannot be traced directly to a specific product or service. These expenses are essential for maintaining the overall operation of a company, but they cannot be linked easily to an individual unit of production or service nor be easily allocated among different production departments.

Indirect overhead expenses are usually related to general management and support functions, not necessarily associated with the production process or any specific department within the company. They are distributed across the entire company rather than being attributed to a particular department or function. Indirect overheads are taken as operating expenses that influence overall profits.

Examples of Direct Overhead Expenses

Some examples of direct overhead expenses include:

  1. Depreciation of production equipment: Depreciation of machines and tools used for manufacturing goods directly influences the cost of production.

  2. Office utilities: Expenses related to electricity, water, gas, and other utilities used directly in an administrative office or shop directly impact the cost of manufacturing.

  3. Direct labor costs: Salaries and wages paid to production workers who are directly involved with the manufacturing of goods or the completion of construction projects.

  4. Equipment maintenance costs: Costs related to maintaining, repairing, and servicing production equipment directly contribute to the construction process.

  5. Office rent: The cost of renting a production facility like a shop or office is a direct expense associated with the manufacturing process.

Examples of Indirect Overhead Expenses

Some examples of indirect overhead expenses include:

  1. Depreciation of office equipment: Depreciation costs related to non-production equipment such as computers, office furniture, and vehicles used for general administrative purposes.

  2. Administrative salaries: Wages and salaries of employees who are not directly involved with manufacturing, such as managers, executives, accountants, and human resource personnel.

  3. Office supplies: Expenses related to stationery, printing, photocopying, and other supplies used for organizational support functions.

  4. Insurance: Insurance premiums covering the company's general liability, property, and worker's compensation are considered indirect overhead expenses.

  5. Advertising and marketing costs: Expenses for promoting a company’s products and services are indirect overheads, as they are not directly associated with the production process.

By understanding the differences between direct and indirect overhead expenses, businesses can better manage their budgets, allocate resources efficiently, and improve profitability. Direct overhead expenses directly impact the cost of goods sold, while indirect overhead expenses affect overall operating costs. Direct expenses are the pieces you pull together to build your estimate. Indirect costs impact the overhead and markup you have to account for on every project. This distinction in allocation helps businesses to understand the distribution of costs throughout the organization and improve decision-making processes.