The New Palgrave Dictionary of Economics

2018 Edition
| Editors: Macmillan Publishers Ltd

Overhead Costs

  • Basil S. Yamey
Reference work entry
DOI: https://doi.org/10.1057/978-1-349-95189-5_1586

Abstract

John Maurice Clark wrote in 1923 that the term overhead costs is ‘variously used’, although there is the central underlying concept that these costs are ‘costs that cannot be traced home and attributed to particular units of business in the same direct and obvious way in which, for example, leather can be traced to the shoes that are made from it’. ‘Most of the real problems’ stem from the fact ‘that an increase or decrease in output does not involve a proportionate increase or decrease in cost’ (1923, p. 1). The notion of overhead costs is similar to that of Alfred Marshall’s ‘supplementary costs’, that is, charges or expenditures that, unlike ‘prime’ or ‘direct’ costs, ‘cannot generally be adapted quickly to changes in the amount of work there is for them to do’ (1920, p. 360). Thus overhead costs, a term used infrequently in economic theory or analysis nowadays, are akin to the more familiar ‘fixed costs’ (as in the variable costs/fixed costs dichotomy). However, the feature that they cannot be traced directly to particular units of output or activities gives overhead costs some of the flavour of common or joint costs.

John Maurice Clark wrote in 1923 that the term overhead costs is ‘variously used’, although there is the central underlying concept that these costs are ‘costs that cannot be traced home and attributed to particular units of business in the same direct and obvious way in which, for example, leather can be traced to the shoes that are made from it’. ‘Most of the real problems’ stem from the fact ‘that an increase or decrease in output does not involve a proportionate increase or decrease in cost’ (1923, p. 1). The notion of overhead costs is similar to that of Alfred Marshall’s ‘supplementary costs’, that is, charges or expenditures that, unlike ‘prime’ or ‘direct’ costs, ‘cannot generally be adapted quickly to changes in the amount of work there is for them to do’ (1920, p. 360). Thus overhead costs, a term used infrequently in economic theory or analysis nowadays, are akin to the more familiar ‘fixed costs’ (as in the variable costs/fixed costs dichotomy). However, the feature that they cannot be traced directly to particular units of output or activities gives overhead costs some of the flavour of common or joint costs.

Overhead costs do not raise special questions for economic theory that do not arise in connection with fixed costs or common costs generally. They are evidently important for many issues in applied economics. Two well-known books with ‘overhead costs’ in their titles consist largely of studies on subjects such as transport, public utilities, two-part tariffs and competition in retailing (Clark 1923; Lewis 1949).

This essay concentrates on the treatment of overhead costs in modern cost accounting, which dates from the second half of the 19th century. It became standard practice in cost accounting for overheads or oncost to be allocated to units or batches of production or to departments or divisions within the firm. Thus the total cost of, say, a batch of production is ascertained by accumulating the direct costs of that batch and adding an ‘allocation’ of overheads. Allocation of overheads has been made on a variety of bases. In a surviving 15th century set of cost calculations, the costs common to a number of products were allocated according to the weights of those products. In 1890 Marshall observed two allocation bases. He wrote that in ‘some branches of manufacture it is customary to make a first approximation to the total cost of producing any class of goods, by assuming that their share of the general expenses of the business is proportionate either to their prime cost, or to the special labour bill that is incurred in making them’ (1920, p. 195). Several other bases have been advocated and used. Further elaboration has been achieved by subdividing overheads into categories (e.g., manufacturing and distribution overheads) and sub-categories, and by using different bases for different categories. Yet more elaboration has been introduced by calculating overhead allocations on the basis either of a ‘standard’ output or of the expected output in the period in question. There has been much discussion about which bases of allocation are ‘fair’, ‘reasonable’ or ‘appropriate’, and whether, for example, interest on capital is an element of overhead that should be allocated in the cost accounts, now generally called management accounts.

Economists have criticized the accounting treatment and have argued that the allocation of overheads costs necessarily is arbitrary; that these costs do not form part of short-run marginal costs; that costs in cost accounting refer to past costs; and that for all these reasons accounting figures purporting to measure ‘total costs’ are at best irrelevant for output, pricing and investment decisions, and at worst may mislead the decision-maker who is not aware of their make-up (e.g., Solomons 1952, esp. articles by R.S. Edwards, R.H. Coase, W.T. Baxter and D Solomons). The accounting treatment of these costs can be especially misleading when the efficiency or performance of a manager of a department (or division or product group) in a firm is judged on the basis of his department’s recorded profit; this profit will in part depend upon allocated costs for which he has no responsibility and over which he has no control.

Recognition of the implications of the conventional treatment has caused many accountants and firms to abandon or disregard the allocation of overheads in management accounting. Instead, emphasis in the accounts is placed on the determination of the ‘contribution’ to fixed overheads and profits made by the particular product, division or department, namely the difference between the revenues generated and the sum of the variable costs incurred. In the same spirit, in compiling accounting information bearing on the performance of a manager, his account is not charged with allocations of those overheads over which he has no control. The various categories of overhead costs are budgeted and monitored directly, a distinction being made between those that are fixed for the period in question and those that are to some extent variable. Concentration of attention on the contributions made by (or budgeted for) particular products and activities is found in some firms in which, nevertheless, overhead costs are allocated in the traditional way in accordance with selected allocation formulae.

It is a well-known proposition, to quote Marshall again, that ‘it is of course just as essential in the long run that the price obtained should cover general or supplementary costs as that it should cover prime costs’ (1920, p. 420). Economists and many accountants say, in effect, that the allocation of overheads to products or activities cannot contribute rationally to the long-run ‘recovery’ of overheads in pricing and output decisions.

However, an economic and business rationale for overhead cost allocations has been considered occasionally (recently again in Zimmerman 1979). The rationale concerns firms in which authority to make certain decisions is assigned by the central management to otherwise subordinate managers, such as managers of particular product groups or of geographically dispersed sales offices.

In varying degrees, managers make use of the assets owned by the firm and of services supplied by other divisions or departments within the firm. Managers compete for internallysupplied resources and services. If a manager’s performance is judged wholly or in part on the basis of the accounting profits he achieves, and a fortiori if his remuneration is related to his profits, he has an incentive to use internally supplied inputs as if they were free goods unless his account is in some way charged for them. This gives rise to waste in the use of resources and services. Demands by one manager on the services provided by the firm’s assets and by other parts of the organization may deflect these services from more profitable uses within the firm.

Overhead allocations may serve, it is argued, as a set of internal prices to be ‘paid’ by a manager for the use of inputs supplied to him within the organization. Provided that the prices (the overhead allocation rate or amount) for the various inputs appropriately reflect opportunity costs, the internal price system within the firm together with profit-maximizing behaviour of managers will (ex ante) maximize the profits for the firm as a whole from its available resources, and will dispense with the need for administrative controls and rationing.

To reflect opportunity costs properly, the amount of overhead to be allocated to users would have to be adjusted in the light of the changing level (and expected level) of internal demand for the services of the resources in question. The appropriate amount to be allocated will almost invariably not be the actual outlays incurred by the firm, nor be related in any way to those outlays. For example, the amount should be zero if the cost is fixed and the underlying resources are not expected to be used fully in the relevant period; and it should exceed actual outlays when there is excess demand. Further, the overheads allocated to a particular user department should closely reflect that department’s consumption of the services in question, and should ceteris paribus be smaller when the usage is lower.

Systems or schemes used in practice for the allocation of overheads do not generate accounting charges that are sensitive to changes in internal and external market conditions or to variations in the rate of consumption of services. For overhead cost allocations to perform an efficient rationing function would require a different approach from that generally adopted in management accounting systems.

What is required is a set of shadow prices, revised whenever there has been (or is expected to be) a material change within the firm in the supply and demand conditions for the services in question. Methods for estimating the shadow prices might range from the exercise of judgement by experienced managers to the use of mathematical programming techniques.

It may seem that the inclusion of allocations of overhead costs in cost data would help decision-makers in a firm to assess the level of prices for its products at which new competitors might be attracted to enter the market. However, the calculation of the established firm’s own average costs (variable and fixed costs, including sunk costs) can serve as no more than a rough guide for this purpose, since allowance has to be made, for instance, for new methods available to new entrants and for learning costs.

Allocations of overhead costs to particular products or transactions come into their own when prices are determined by formula and not by the market (as in some defence contracts), or where a government agency engages in control of maximum prices for whatever reason. Again, allocations may be crucial when a regulatory agency has to ensure that a regulated enterprise does not engage in cross-subsidizing its unprotected activities from the profits of its protected activities. They may also be critical when a regulatory agency seeks to determine whether a multiproduct firm has been charging monopoly prices for one of its several products, or whether a firm has discriminated in the prices for its products sold to different customers. In the past, also, cooperative schemes designed to reduce the intensity of price competition have included the adoption by members of an industry of a uniform costing system. Such systems have involved the use of standard methods for the allocation of overheads to products (Solomons 1950). In all these cases, the arbitrary nature of the allocations cannot be escaped; and the bases of allocation to be adopted provide much scope for ingenuity in argument.

See Also

Bibliography

  1. Clark, J.M. 1923. Studies in the economics of overhead costs. Chicago: University of Chicago Press.Google Scholar
  2. Lewis, W.A. 1949. Overhead costs. London: George Allen & Unwin.Google Scholar
  3. Marshall, A. [1890] 1920. Principles of economics, 8th edn. London: Macmillan.Google Scholar
  4. Solomons, D. 1950. Uniform cost accountancy – A survey. Economica 17: 237–253, 386–400.Google Scholar
  5. Solomons, D. (ed.). 1952. Studies in costing. London: Sweet & Maxwell.Google Scholar
  6. Zimmerman, J.L. 1979. The costs and benefits of cost allocations. Accounting Review 54: 504–521.Google Scholar

Copyright information

© Macmillan Publishers Ltd. 2018

Authors and Affiliations

  • Basil S. Yamey
    • 1
  1. 1.