What Is Overhead?
Overhead refers to the ongoing business expenses not directly attributed to creating a product or service. It is important for budgeting purposes but also for determining how much a company must charge for its products or services to make a profit. In short, overhead is any expense incurred to support the business while not being directly related to a specific product or service.
- Overhead refers to the ongoing costs to operate a business but excludes the direct costs associated with creating a product or service.
- Overhead costs can be fixed, variable, or a hybrid of both.
- There exist different categories of overhead, such as administrative overhead, which includes costs related to managing a business.
- The income statement reports overhead expenses.
A company must pay overhead on an ongoing basis, regardless of how much or how little the company sells. For example, a service-based business with an office has overhead expenses, such as rent, utilities, and insurance that are in addition to direct costs (such as labor and supplies) of providing its service.
Expenses related to overhead appear on a company's income statement, and they directly affect the overall profitability of the business. The company must account for overhead expenses to determine its net income, also referred to as the bottom line. Net income is calculated by subtracting all production-related and overhead expenses from the company's net revenue, also referred to as the top line.
Types of Overhead
Overhead expenses can be fixed, meaning they are the same amount every time, or variable, meaning they increase or decrease depending on the business's activity level. Overhead expenses can also be semi-variable, meaning the company incurs some portion of the expense no matter what, and the other portion depends on the level of business activity.
Fixed overhead is overhead costs that remain static for a long period of time and do not change as business activity ebbs and flows. Regardless of if business is growing or slowing, fixed overhead remains the same. Examples include rent, depreciation, insurance premiums, office personnel salaries. and the cost of licenses.
Variable overhead consists of the overhead costs that fluctuate with business activity. These are overhead costs that are not static. As business activity increases, so does variable overhead. As business activity slows, variable overhead decreases. Examples include office equipment, shipping and mailing costs, marketing, legal expenses, and maintenance.
Semi-variable overhead is a combination of fixed and variable overhead where some costs are incurred regardless of business activity but may also increase if business activity grows. Examples of semi-variable overhead include commissions and utility costs. For utilities, a base amount is charged and the remainder of the charges are based on usage.
Other categories of overhead may be appropriate depending on the business. For example, overhead expenses may apply to a variety of operational categories. General and administrative overhead traditionally includes costs related to the general management and administration of a company, such as the need for accountants, human resources, and receptionists.
Selling overhead relates to activities involved in marketing and selling the good or service. This can include printed materials and television commercials, as well as the commissions of sales personnel. Other categories such as research overhead, maintenance overhead, manufacturing overhead, or transportation overhead also apply.
Examples of Overhead
Some common examples of overhead costs companies must assume are rent, utilities, administrative costs, insurance, and employee perks.
Rent and Utilities
The costs associated with maintaining the office or manufacturing space companies must have in order to perform their business is an example of overhead. This includes rent as well as utilities such as water, gas, electricity, internet, and phone service. Additional costs such as a subscription to virtual meeting platforms like Zoom (ZM) also must be factored into a company's overhead.
Administrative costs are often one of the most expensive facets of a company's overhead. This can include the cost of stocking the office with the necessary supplies, the salaries of office associates, and external legal and audit fees. Administrative costs can range from the supply of toilet paper in the office restroom to hiring an external audit firm to ensure the company complies with industry-specific regulations.
Depending on the company, businesses are required to hold many different types of insurance in order to operate properly. These can include basic property insurance to protect the company's physical assets from fire, flood, or theft as well as professional liability insurance, health insurance for its employees, and car insurance for any company-owned vehicles. While none of these costs are directly related to generating revenue for the company by providing a good or service, the business is often legally mandated to purchase these various types of insurance if it wishes to operate within most jurisdictions.
Many larger companies offer a range of benefits to their employees such as keeping their offices stocked with coffee and snacks, providing gym discounts, hosting company retreats, and company cars. All of these expenses are considered overhead as they have no direct impact on the business's goods or services.
Overhead is typically a general expense, meaning it applies to the company's operations as a whole. It is commonly accumulated as a lump sum, at which point it may then be allocated to a specific project or department based on certain cost drivers. For example, using activity-based costing, a service-based business may allocate overhead expenses based on the activities completed within each department, such as printing or office supplies.
Why Is Overhead Cost Important?
Overhead cost is important because it is the cost to run your business. Understanding and managing your overhead well, particularly how it relates to your business output, will help ensure your business is profitable and to obtain the best margins you can on your sales.
What Are Different Types of Overhead?
Broadly speaking, overhead can be organized into three main types. Fixed overhead includes expenses that are the same amount consistently over time. These can include rent and depreciation on fixed assets. Variable overhead expenses include costs that may fluctuate over time such as shipping costs. Semi-variable costs are a blend of the two. Utilities are an example of a semi-variable cost.
How Is Overhead Calculated?
Since overhead is often considered a general expense, it is accumulated as a lump sum. This is then allocated to a specific product or service. There are a number of different ways of calculating overhead, however, the general rule is the following: Overhead rate = Indirect costs/ Allocation measure. The indirect costs are the overhead costs, while the allocation measure would include labor hours, or direct machine costs, which is how the company measures its production.
The Bottom Line
Overhead refers to the costs of running a business that are not directly related to producing a good or service. These costs can be fixed, such as rent, or variable, such as transport costs. They can also be semi-variable, such as utilities. Effectively managing your overhead allows you to keep costs low, set competitive prices, and maximize the most of your revenues.