Overhead costs are ongoing expenses involved in operating a business. A company must pay overhead on an ongoing basis, regardless of how much or how little the company is selling. There are two types of overhead costs: fixed and variable.
- Companies need to spend money on producing, marketing, and selling its goods or services - a cost known as overhead.
- Fixed overhead costs are constant, and do not vary as a function of a productive output, including items like rent or a mortgage and fixed salaries of employees.
- Variable overhead varies with productive output, such as energy bills, raw materials, or commissioned employees' pay.
Fixed Overhead Costs
Fixed overhead costs are costs that do not change even while the volume of production activity changes. Fixed costs are fairly predictable and fixed overhead costs are necessary to keep a company operating smoothly. However, profit margins should reflect the costs of fixed overhead.
Examples of fixed overhead costs include:
- Rent of the production facility or corporate office,
- Salaries of plant managers and supervisors,
- Depreciation expense of fixed assets,
- Taxes and insurance.
For example, suppose company ABC rents office space for $5,000 a month; this is a fixed overhead cost that must be paid. Also, the property taxes for the building would be a fixed cost since it does not increase or decrease with changes in sales volume.
Typically fixed overhead costs are stable and should not change from the budgeted amounts allocated for those costs. However, if sales increase well beyond what a company budgeted for, fixed overhead costs could increase as employees are added, and new managers and administrative staff are hired. Also, if a building must be expanded or the rental of a new production facility is needed to meet increased sales, fixed overhead costs would need to increase to keep the company running smoothly.
Variable Overhead Costs
Variable overhead costs are costs that change as the volume of production changes or the number of services provided changes. Variable overhead costs decrease as production output decreases and increase when production output increases. If there is no production output, then there would be no variable overhead costs.
Examples of variable overhead costs include:
- Raw materials used in production,
- Direct materials,
- Sales commissions.
The labor involved in production, or direct labor, might not be variable cost unless the number of workers increase or decrease with production volumes.
For example, DEF Toy is a toy manufacturer and has total variable overhead costs of $15,000 when the company produces 10,000 units per month. The variable cost per unit would be $1.50 ($15,000/10,000 units). In the following month, the company receives a large order whereby it must produce 20,000 toys. At $1.50 per unit, the total variable overhead costs increased to $30,000 for the month.
The Bottom Line
Unlike fixed costs, variable costs vary with the level of production. Typically, variable overhead costs tend to be small in relation to the amount of fixed overhead costs. Variable overhead costs can change over time, while fixed costs typically do not.
Companies with larger amounts of fixed costs relative to variable costs might find it more challenging to weather economic downturns since they can not easily eliminate their fixed costs without hurting their overall business.
Conversely, companies with more variable costs than fixed might have an easier time reducing costs during a recession since the variable costs would decline with any decline in production due to lower demand.