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 that supports the making or selling of a product or service.
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.
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 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.
Overhead can also be general, referred to as company overhead, meaning it applies to the company's operations as a whole. A company can allocate overhead to a specific project or department, as well. For example, a service-based business may allocate overhead expenses based on the activities completed within each department, such as printing or office supplies.
- 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.
Types of Overhead
Overhead expenses may apply to a variety of operational categories. Administrative overhead traditionally includes costs related to basic administration and general business operations, such as the need for accountants or receptionists. Selling overhead relates to activities involved in marketing. This can include printed materials and television commercials, as well as the salaries of administrative-support professionals.
Depending on the nature of the business, other categories may be appropriate, such as research overhead, maintenance overhead, manufacturing overhead, or transportation overhead.
Expenses related to overhead typically appear on a company's income statement, as they directly play into the overall profitability of the business. The company must account for overhead expenses to determine its net profit, also referred to as the bottom line. Removing the associated expenses from the gross revenues, referred to as the top line, along with other production-related expenses, accomplishes this purpose. Also important is knowing the overhead rate, which is the amount spent on overhead per dollar earned. It is calculated by dividing overhead costs by sales. Overhead rates are inversely related to net income; therefore, large overhead rates result in a smaller net income and vice versa.