What is overhead?
Overhead refers to ongoing business costs that are not directly related to the creation of a product or service. This is important not only for budgeting purposes, but also for determining how much a company should charge for a product or service to make a profit. In other words, overhead costs are costs that are not directly related to a specific product or service, but are incurred to support your business.
- Overhead costs refer to the ongoing costs of running a business, but do not include the direct costs associated with creating a product or service.
- Indirect costs can be fixed costs, variable costs, or a hybrid of both.
- There are different categories of overhead, such as administrative overhead, which includes costs associated with managing a business.
- The income statement reports overhead expenses.
Companies must continue to pay miscellaneous expenses regardless of sales volume. For example, a service-based business with an office has overhead costs such as rent, utilities, and insurance in addition to the direct costs of providing the service (such as labor and supplies).
Expenses related to overhead are reported on a company's income statement and have a direct impact on the overall profitability of the business. Businesses must consider overhead costs to determine net profit, also known as bottom line. Net profit is calculated by subtracting all production-related costs and overheads from a company's net revenue (also known as the top line).
Type of overhead
Overheads can be fixed costs (meaning they are the same amount each time) or variable costs (meaning they increase or decrease depending on the level of business activity). Overhead costs may be semi-variable. This means that a company will incur some expenses no matter what, and the rest will depend on the level of business activity.
Fixed overhead costs are overhead costs that are fixed over time and do not change with the ebb and flow of business activity. Fixed overhead costs remain the same whether your business is growing or slowing down. Examples include rent, depreciation, insurance premiums, and office staff salaries. and licensing costs.
Variable overhead costs consist of indirect costs that change depending on business activities. These are non-static overhead costs. As business activity increases, variable overhead costs also increase. When business activity slows down, variable costs decrease. Examples include office equipment, shipping, mailing costs, marketing, legal costs, maintenance, etc.
Semi-variable overhead costs are a combination of fixed and variable overhead costs, where some costs are incurred regardless of business activity, but costs can also increase as business activity expands. Examples of semi-variable overhead expenses include fees and utilities. For utilities, you will be charged a base rate and the rest will be billed based on usage.
Depending on your business, other categories of overhead may be appropriate. For example, overhead costs may apply to different operational categories. General and administrative expenses have traditionally included costs associated with the general management of a company, such as accountants, human resources personnel, and receptionist costs.
Sales expenses relate to activities involved in marketing and selling products and services. This includes print and television commercials, as well as sales rep commissions. Other categories such as research overhead, maintenance overhead, manufacturing overhead, and transportation overhead also apply.
Common examples of overhead costs that businesses must anticipate include rent, utilities, management fees, insurance, and employee benefits.
rent and utilities
The costs associated with maintaining the office and manufacturing space that a company needs to conduct its business are an example of indirect costs. This includes rent as well as utilities such as water, gas, electricity, internet, and telephone. Additional costs, such as subscriptions to virtual meeting platforms such as Zoom (ZM), must also be factored into a company's overhead costs.
Administrative costs are often one of the most expensive aspects of a company's overhead. This may include the cost of furnishing the office, salaries of office employees, and outside legal and audit fees. Administrative costs can range from supplying toilet paper in office bathrooms to hiring an external auditing firm to ensure a company complies with industry-specific regulations.
Some businesses require different types of insurance to operate properly. These include basic property insurance to protect a company's physical assets from fire, flood, and theft, as well as professional liability insurance, employee health insurance, and auto insurance for company-owned vehicles. . Although none of these costs are directly related to a business generating revenue by providing a product or service, businesses are required to purchase these different types of insurance if they wish to operate within most jurisdictions. Participation is often legally required.
Many large companies offer a variety of benefits to their employees, such as keeping coffee and snacks in the office, offering gym discounts, and hosting company retreats and company cars. . All of these costs are considered overhead expenses because they do not directly impact the business' products or services.
Overhead costs are typically general expenses, meaning they apply to the entire operation of your company. It is typically accumulated as a lump sum, at which point it may be allocated to specific projects or departments based on specific cost factors. For example, a service-based company can use activity-based costing to allocate overhead costs based on activities completed within each department, such as printing or office supplies.
Why are indirect costs important?
Overhead costs are important because they are the costs of running a business. Understanding and managing your overhead costs, especially how it relates to business results, will help you ensure your business is profitable and get the most from your sales. .
What are the different types of overhead?
Broadly speaking, overhead can be categorized into three main types. Fixed overhead costs include expenses that remain the same over time. These may include rent and depreciation of fixed assets. Variable overhead costs include costs that can change over time, such as shipping charges. Semi-variable costs are a combination of the two. Utilities are an example of a semi-variable cost.
How is overhead calculated?
Miscellaneous expenses are often considered general expenses and are therefore set aside as a lump sum. This is assigned to a specific product or service. There are many ways to calculate overhead costs, but the general rule is: Overhead Rate = Overhead Costs / Allocation Measure. Overhead costs are indirect costs, but the allocation basis includes labor hours and direct machine costs. This is how companies measure production.
Indirect costs refer to the costs of running a business that are not directly related to the production of goods or services. These costs include fixed costs such as rent, and variable costs such as transportation costs. It can also be something semi-variable, such as utility bills. Effectively managing overhead allows you to keep costs low, set competitive prices, and maximize revenue.