What is Overhead?
Overhead refers to ongoing business expenses that are not directly tied to creating a product or service. These costs are crucial for budgeting and determining how much a company must charge for its products or services to ensure profitability. Thus, overhead encompasses any expense incurred to support the business that is not directly related to a specific product or service.
Key Takeaways
- Overhead costs are necessary for running a business but exclude direct costs related to production or services.
- Overhead can be fixed, variable, or hybrid in nature.
- Administrative overhead costs are part of overhead that involves managing the business.
- These expenses are reported in the income statement.
Unraveling Overhead
Regardless of sales volume, businesses must pay overhead costs consistently. For example, a service-based business operating from an office has additional overhead expenses such as rent, utilities, and insurance, besides the direct costs for labor and supplies.
Overhead expenses are reflected in a company’s income statement, impacting its overall profitability. Net income or the bottom line is calculated by subtracting production-related and overhead expenses from the net revenue or the top line.
Types of Overhead
Overhead expenses come in different forms: fixed, variable, and semi-variable. Each type has distinct attributes.
Fixed Overhead
Fixed overhead remains constant over a long period, regardless of business activity. These costs include rent, depreciation, insurance premiums, office staff salaries, and license costs.
Variable Overhead
Variable overhead adjusts in accordance with business activity levels. If business booms, variable overhead costs rise, and they fall when business slows. Examples include office equipment, shipping expenses, marketing, legal fees, and maintenance costs.
Semi-Variable Overhead
Semi-variable overhead is a blend of fixed and variable costs. Part of these expenses remains constant, while some increase with business activity. Utility bills and commissions are typical examples of semi-variable overhead.
Other Categories of Overhead
Businesses can identify additional overhead categories tailored to their specific operations:
- Administrative Overhead: costs related to general management tasks like accounting, human resource salaries, and reception.
- Selling Overhead: expenses related to marketing and sales activities such as ads and sales commissions.
- Research, Maintenance, Manufacturing, or Transportation Overhead: varies by sector and includes specific overhead tied to respective operations.
Real-World Examples of Overhead Costs
Below are common overhead costs businesses need to manage:
Rent and Utilities
Essential costs for maintaining office or manufacturing spaces include rent and utilities like water, electricity, internet, and phone service. Virtual meeting platform subscriptions are also part of these costs.
Administrative Costs
Administrative costs cover office supplies, salaries for office staff, legal and audit fees. These can range from basic supplies like toilet paper toexternal auditing services to ensure regulatory compliance.
Insurance
Insurance is crucial for operational security, covering property, professional liability, employee health, and company-owned vehicles. These mandatory costs do not generate revenue but are necessary under legal obligations.
Employee Perks
Larger companies often provide benefits like stocked break rooms, gym discounts, retreats, and company cars. These perks enhance morale but do not directly tie to product or service creation.
Special Considerations for Overhead Allocation
Typically considered general expenses, overhead costs are collected as a lump sum and may be allocated to specific departments or projects based on cost drivers. For example, printing and office supplies may be allocated using activity-based costing.
The Importance of Overhead Cost Management
Understanding and managing overhead costs are crucial for business profitability. By keeping overhead low and optimizing its impact relative to business output, companies can achieve better profit margins.
FAQs about Overhead
Why is Overhead Cost Important?
Managing overhead costs ensures business operational efficiency and profitability. Clear knowledge of these expenses enables better pricing strategies and margin improvement.
What are the Different Types of Overhead?
Overhead can be categorized into fixed, variable, and semi-variable expenses. Rent and depreciation are fixed, shipping is variable, and utilities represent semi-variable costs.
How is Overhead Calculated?
Overhead is usually accumulated as a lump sum and then allocated to specific products or services. Overhead rate calculation follows this formula: Overhead rate = Indirect costs / Allocation measure.
Conclusion
Managing overhead is central to maintaining business profitability. Recognizing and categorizing overhead costs helps set competitive prices, optimize resource allocation, and ultimately maximize revenues.
Related Terms: fixed costs, variable costs, semi-variable costs, profit margin, income statement.
