O
Overhead Costs
Basil S. Yamey
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 attrib-
uted 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 ‘supplemen-
tary 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 eco-
nomic theory or analysis nowadays, are akin to the
more familiar ‘fixed costs’ (as in the variable
costs/fixed costs dichotomy). However, the fea-
ture that they cannot be traced directly to particu-
lar units of output or activities gives overhead
This chapter was originally published in The New
Palgrave: A Dictionary of Economics, 1st edition, 1987.
Edited by John Eatwell, Murray Milgate and Peter
Newman
# The Author(s) 1987
Palgrave Macmillan (ed.), The New Palgrave Dictionary of Economics,
DOI 10.1057/978-1-349-95121-5_1586-1
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 connec-
tion 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 utili-
ties, 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 accu-
mulating the direct costs of that batch and adding
an ‘allocation’ of overheads. Allocation of over-
heads 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 allo-
cated 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
2 Overhead Costs
other bases have been advocated and used. Fur-
ther 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 cal-
culating overhead allocations on the basis either
of a ‘standard’ output or of the expected output in
the period in question. There has been much dis-
cussion about which bases of allocation are ‘fair’,
‘reasonable’ or ‘appropriate’, and whether, for
example, interest on capital is an element of over-
head 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 deci-
sions, 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 effi-
ciency or performance of a manager of a depart-
ment (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 allo-
cated costs for which he has no responsibility and
over which he has no control.
Recognition of the implications of the conven-
tional 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 deter-
mination of the ‘contribution’ to fixed overheads
and profits made by the particular product, divi-
sion 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 Mar-
shall 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 con-
tribute 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 perfor-
mance 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 pro-
vided 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 over-
head allocation rate or amount) for the various
Overhead Costs
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 chang-
ing 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 account-
ing charges that are sensitive to changes in inter-
nal and external market conditions or to variations
in the rate of consumption of services. For over-
head cost allocations to perform an efficient
rationing function would require a different
approach from that generally adopted in manage-
ment 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 mathemat-
ical 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 calcu-
lation 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
3
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, allo-
cations may be crucial when a regulatory agency
has to ensure that a regulated enterprise does not
engage in cross-subsidizing its unprotected activ-
ities 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 discrim-
inated in the prices for its products sold to differ-
ent customers. In the past, also, cooperative
schemes designed to reduce the intensity of price
competition have included the adoption by mem-
bers of an industry of a uniform costing system.
Such systems have involved the use of standard
methods for the allocation of overheads to prod-
ucts (Solomons 1950). In all these cases, the arbi-
trary nature of the allocations cannot be escaped;
and the bases of allocation to be adopted provide
much scope for ingenuity in argument.
See Also
▶ Accounting and Economics
▶ Fixed Factors
Bibliography
Clark, J.M. 1923. Studies in the economics of overhead
costs. Chicago: University of Chicago Press.
Lewis, W.A. 1949. Overhead costs. London: George Allen
& Unwin.
Marshall, A. [1890] 1920. Principles of economics,
8th edn. London: Macmillan.
Solomons, D. 1950. Uniform cost accountancy – A survey.
Economica 17: 237–253, 386–400.
Solomons, D. (ed.). 1952. Studies in costing. London:
Sweet & Maxwell.
Zimmerman, J.L. 1979. The costs and benefits of cost
allocations. Accounting Review 54: 504–521.