Administrative Overhead

Administrative overheads are those expenses of the business that are not directly linked to the production & distribution of goods & services but are the expenses that are indirect, such as expenses incurred in the policy formulation, employee costs, legal and audit fees, telephone and electricity expenses, etc.

Administrative overheads are not directly linked to the production and selling of goods & services. These overheads are indirect expenses such as rent, insurance, salary paid to office staff, printing & stationery expenses, consultancy & legal charges, audit fees, etc. These are incidental to the main business activity and are also important to conducting the company's affairs.

Administrative overheads are mostly related to the office expenses of the business. These expenses are not the manufacturing overheads as they are not directly related to producing goods & services. The administrative expenses are the expenses for conducting the business's operations, formulation of policies, and other expenses not related to the production and research & development of the business.

The administrative overhead includes all the expenses that are not linked to the specific business function. The administrative expenses include wages & salaries to the office staff, audit and legal expenses, consultancy fees, rent, insurance premiums paid, utility expenses, rates & taxes, subscriptions, transport and conveyance charges, bank charges, repairs & maintenance expenses, printing & stationery expenses, etc. These expenses are necessary for conducting the operations of the business.

The administrative overhead list below reflects some of the types in which these costs exist. Let us have a look at them:

• The first type of administrative overhead is the indirect materials. These are materials that are associated with the manufacturing of goods, but not incorporated in the final finished product. Some of the examples of such items are office stationery and printing equipment, expenses related to cleaning items, etc.
• The next on the list is indirect labor. Which includes costs related to keeping human resources that perform operations and activities beyond production of goods and services.
• The third one is the indirect expense, which firms incur while carrying out daily business operations.

Let us consider the following instances to understand how administrative overhead costs affect a business and help in sound decision-making:

Example 1

Let us take the example of a company named Clothes incorporation which deals with clothes manufacturing. The expenses incurred by the company during the financial year 2019-20 are as follows:

Solution:

Calculation of Administrative Overheads:

The direct material purchased and the salary paid to the factory staff are directly linked to the production, which is not included in the administrative cost as they are production overhead. Moreover, the sales & marketing costs are part of the selling & distribution cost, and research & development expenses are part of the research & development cost, so they are also not included. Therefore, the total administrative overhead is $870,000.

Example 2

In October 2022, National Institutes of Health (NIH) confirmed how using authorized cloud-based tools reduces administrative overhead. This is because the use of FedRAMP-authorized TeamMate+ helped the institute gain security confidence and automate updating every audit management data regularly.

As a result, the IT resource required to manage database reduces, thereby minimizing the administrative overhead expenses.

It is important to keep these expenses controlled to ensure the business doesn’t lose much money in something it can do without. In an attempt to achieve this, the firms adopt certain measures, which are as follows:

1. Preparing Budgets: Separate budgets for allocating administrative overheads must be prepared just like the production & sales budget. By preparing the budgets, the maximum limit for the expenses related to administration overhead is decided to control the amount of expenditure on administration work.
2. Cutting Traveling Cost: The business should reduce the traveling and conveyance costs by doing the possible amount of work through video calls, phone calls, and emails. The visits should be tried to be done with the inexpensive means of transport.
3. Use of Packages: If the travel work is done regularly, then the rewards given by the airlines on bulk purchases should be utilized, and even all other traveling benefits given by the agencies should be opted-out to reduce the traveling costs.
4. Limit Entertainment Expenses: The face-to-face meeting, followed by the expensive dinner, can be switched to virtual meetings, which could help in reducing the cost of administrative overheads. Even an employee's stay and unnecessary office events should be limited so that the organization's overall cost can be reduced.
5. Keeping a Check on Staff: The business owners should check the staff expenses and even see that the organization's employees are not misusing the cash limit provided to them for doing day-to-day business expenditures.
6. Eliminate Cost of Papers: In this era of technology, the files and documents should be kept electronically on the computer systems. Preparing and keeping the documents on the computer system reduces the cost of paper, and even the time is saved if documents are maintained electronically.
7. Decentralizing Business Functions: The organizations working at large scales have centralized management that has high administrative expenses. Therefore, delegating some work to the subsidiaries can help lower the administrative cost.

The following methods can account for the administrative costs of the company:

• The first method is booking the cost as an expense in the company's income statement by assuming that all the expenses are not directly linked to the production, manufacturing & selling of goods & services.
• The second method of the accounting treatment is based on the assumption that the business has two main activities, i.e., production activity and selling & distribution activity. So by following this assumption, the administrative overhead is apportioned between these two main activities.
• Now in this third method of accounting for administrative overhead, this expense is separately included in the work cost to measure the cost of production because an owner thinks that the administrative costs are as important as the production and selling & distribution costs.

Though there are many reasons behind computing and recording administrative overhead as it helps firms keep track of the costs incurred and control costs:

• The administrative overhead includes the cost of administration, like staff salary, rent, etc. These costs are fixed costs that must be paid whether there is profit in the business. For example, if the business is shut down for the month due to unavoidable circumstances, then the factory's rent is also to be paid.
• Also, these administrative costs being fixed in nature have the limited ability to get reduced. Companies that have centralized management generally have high administrative overheads.

This has been a guide to Administrative Overhead. Here, we explain the concept along with its examples, types, allocation methods, and limitations. You may learn more about financing from the following articles –

• Applied Overhead
• SG&A Expenses
• Factory Cost
• Absorbed Overhead
• Manufacturing Overhead