4. Overhead Expenses

Another tricky situation can arise because of so-called overhead expenses. These are expenses the firm incurs to run the business that cannot be directly linked to a specific project or cost unit. Overhead expenses could include accounting and legal fees, the CEO's salary, travel expenditures, the corporate headquarters, utilities, general advertising, etc.

  

Especially in larger corporations, the question is how high the charge should be for overhead.

 

Theoretically, the answer is clear: If the firm incurs these expenses regardless of the investment decision at hand, they are not incremental and we should ignore them.

 

Example

Suppose a firm can produce a new product X in a building that needs to be heated in wintertime and cooled during the summer months. The firm already uses the same building to produce another good Y, and therefore already incurs annual energy costs of EUR 50'000 for the building. How should the costs be allocated to the two products?

  

The initial reaction could be to spread the costs over the two projects X and Y and charge them EUR 25'000 each. On second thought, however, this does not make much sense. If the production of X does not cause any additional energy costs in the building, they are not incremental and should therefore be ignored in the valuation of project X!