Is Depreciation Considered Overhead in Cost Accounting?
Understand how depreciation is classified in cost accounting and when it is considered an overhead expense based on different allocation methods.
Depreciation is a key concept in cost accounting, affecting how businesses allocate expenses over time. It represents the gradual reduction in value of assets such as machinery, buildings, and equipment. How depreciation is categorized—whether as overhead or another type of expense—impacts financial reporting and decision-making.
Understanding when depreciation is considered overhead depends on factors such as an asset’s function and role in production. This distinction is crucial for accurate cost allocation and pricing strategies.
The Nature of Overhead in Cost Accounting
Overhead costs are necessary for business operations but are not directly tied to production. Unlike direct materials and labor, which can be traced to specific products, overhead supports the overall production process. Examples include utilities, rent, and administrative salaries.
Manufacturing businesses divide overhead into fixed and variable costs. Fixed overhead remains constant regardless of production levels, while variable overhead fluctuates based on output. For instance, factory rent is a fixed overhead cost, while electricity used for machinery may be variable if consumption increases with production.
Proper classification of overhead ensures accurate cost allocation and pricing. Businesses use predetermined overhead rates to assign these costs to products, often based on direct labor or machine hours. This helps distribute indirect costs fairly, preventing inaccurate pricing.
Depreciation as a Fixed Expense
Depreciation is a fixed expense because it does not vary with production levels. Whether a factory operates at full capacity or remains idle, depreciation for machinery, buildings, or vehicles remains the same. It is based on an asset’s useful life and allocation method rather than actual usage.
Common depreciation methods include straight-line, declining balance, and units of production. The straight-line method spreads an asset’s cost evenly over its useful life, creating a fixed annual expense. For example, if equipment costs $100,000 with a 10-year lifespan and no salvage value, the company records $10,000 in depreciation each year. This predictability aids in budgeting and financial planning.
Depreciation also affects financial metrics such as operating income and asset turnover ratios. Since it is recorded as an expense, it reduces taxable income. Under U.S. tax law, businesses can use accelerated depreciation methods like the Modified Accelerated Cost Recovery System (MACRS) to take larger deductions in an asset’s early years, lowering taxable income during that period.
When Depreciation Is Treated as Overhead
Depreciation is categorized as overhead when it applies to assets that support overall business operations rather than a specific product or service. In manufacturing, this often includes depreciation on factory buildings, general-use equipment, or shared production tools. Since these assets contribute to multiple production processes, their depreciation is considered an indirect cost.
For example, if a company owns a production facility housing multiple assembly lines, the building’s depreciation expense is distributed across all manufactured products. This differs from depreciation on a machine dedicated to a single product line, which may be assigned directly to that product’s cost. Similarly, depreciation on office computers, corporate headquarters, and administrative software is classified as overhead since these assets support business functions rather than production.
Accounting standards require businesses to allocate these indirect costs appropriately. Under U.S. Generally Accepted Accounting Principles (GAAP), depreciation of assets used in general business operations is typically recorded as part of selling, general, and administrative (SG&A) expenses. International Financial Reporting Standards (IFRS) follow a similar approach but also emphasize component depreciation, where different parts of an asset may have distinct depreciation schedules.
Cost Allocation Approaches
Determining how depreciation is allocated requires selecting an approach that accurately reflects cost distribution while adhering to accounting standards. One widely used method is activity-based costing (ABC), which assigns depreciation based on an asset’s usage across various cost drivers. If a factory machine services multiple product lines, ABC ensures each product absorbs depreciation according to machine hours used, offering a more precise allocation than traditional averaging methods.
Another approach is cost center allocation, where depreciation is assigned to specific departments rather than individual products. A company may allocate IT infrastructure depreciation to the technology department, which then distributes costs internally based on system usage. This method is common in service-based industries, where shared assets like software platforms and office space require strategic cost distribution.
Government regulations also influence allocation strategies. Under IRS guidelines, businesses depreciating assets for tax purposes must follow prescribed recovery periods, such as five years for computers and seven years for office furniture. Compliance ensures tax benefits are maximized while adhering to legal requirements.