Overhead cost and opportunity cost

Overhead cost

Overhead cost (indirect cost) is the total of indirect material, indirect labour and indirect expenses. It cannot be traced to a single product or job, so it is distributed over products using an allocation base (labour hours, machine hours, % of direct labour).

• Types: factory overhead (factory rent, power, supervisor wages, machine depreciation), administration overhead (office salaries, stationery), and selling and distribution overhead (advertising, delivery).
• By behaviour: fixed, variable or semi-variable.
• Overhead absorption rate = budgeted overhead / budgeted base (e.g. Rs 600,000 / 20,000 labour hours = Rs 30 per hour).

Opportunity cost

Opportunity cost is the benefit lost by giving up the best alternative when a resource is used for one purpose. It is not a cash payment, but it is a real economic cost and must be included in decisions.

Example: A company owns a plot it could rent out for Rs 200,000 per year. If it builds a factory on it, the Rs 200,000 rent forgone is the opportunity cost of the land, even though no cash is paid. Similarly, if Rs 1 million is invested in a machine instead of a bank deposit earning 8%, the lost interest of Rs 80,000 per year is an opportunity cost.

This is also why the minimum attractive rate of return (MARR) is set at the return of the best investment opportunity forgone.