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.

Key Takeaways

  • Overhead refers to the ongoing costs to operate a business but excludes the direct costs associated with creating a product or service.
  • Overhead 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.
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Overhead

Understanding Overhead

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 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.

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. For example, a business’s rent payment may be fixed, while shipping and mailing costs may be variable. Other examples of fixed costs include depreciation on fixed assets, insurance premiums, and office personnel salaries.

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. For example, many utility costs are semi-variable with a base charge and the remainder of the charges being based on usage.

Allocating Overhead

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.

Types of Overhead

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.

Depending on the nature of the business, other categories may be appropriate, such as research overhead, maintenance overhead, manufacturing overhead, or transportation overhead.