Overhead refers to ongoing business expenses that are necessary for operations but cannot be directly tied to producing goods or services. Overhead costs are sometimes referred to as “operating expenses” and are essential costs of doing business that cannot be immediately attributable to a specific product or service.
Common Examples of Overhead
Some of the most common examples of overhead expenses include:
- Rent
- Utilities like electricity and water
- Insurance
- Office supplies
- Internet and phone service
- Accounting and legal fees
- Repairs and maintenance
- Depreciation of equipment and property
- Taxes
- Management and administrative salaries
These ongoing expenses cannot be directly attributed to producing individual products or services, but they are necessary costs for keeping the business running on a day-to-day basis.
How Overhead Differs from Direct Costs
Overhead costs differ from direct costs, which can be traced directly to producing a specific product or service. Examples of direct costs include:
- Raw materials used in manufacturing
- Commissions paid to salespeople
- Wages of production workers
- Costs of shipping a specific order
While overhead expenses are more general in nature, direct costs are directly tied to generating revenue. However, both overhead and direct costs need to be controlled and optimized for a business to maximize profits.
Categorizing Overhead Expenses
Overhead costs are usually categorized into the following types:
Fixed Overhead
Fixed overhead expenses remain constant, regardless of the production output or sales volume. For example, rent for a factory or office space is considered a fixed overhead cost because it remains static on a monthly basis.
Variable Overhead
Variable overhead costs fluctuate based on production or sales volume. For example, shipping costs fall under variable overhead because they go up as more orders are shipped out. Other variable costs include utilities, supplies, and hourly wages.
Semi-Variable Overhead
Semi-variable overhead costs contain both fixed and variable components. For instance, a telephone service contract may include a fixed monthly fee plus per-minute usage charges. Maintenance contracts can also be semi-variable overhead expenses.
Overhead Rate
Businesses calculate their overhead rate to determine the total overhead costs relative to direct costs over a period of time. This helps them understand how much overhead expense is required for each dollar of direct cost incurred.
The formula for overhead rate is:
Overhead Rate = Total Overhead Costs / Total Direct Costs
For example, if a business has $200,000 in overhead costs and $1,000,000 in direct costs over a year, its overhead rate is 20% ($200,000 / $1,000,000). This indicates that for every $1 of direct costs, the business incurs $0.20 in overhead expenses.
Importance of Tracking Overhead
There are several important reasons why businesses need to track their overhead costs, including:
- Budgeting – Having an accurate estimate of overhead costs allows businesses to properly budget for total expenses and allocate resources effectively.
- Pricing – Understanding overhead costs enables businesses to factor them into pricing models to determine profitable price points.
- Cost Reduction – Monitoring overhead helps identify opportunities to cut unnecessary spending and optimize operations.
- Benchmarking – Comparing overhead rates year-over-year or against competitors highlights spending efficiency.
- Decision Making – Analyzing overhead costs informs strategic decisions like make vs. buy, investing in automation, etc.
Methods to Reduce Overhead
Managing overhead expenses is crucial for boosting profit margins. Here are some ways businesses can optimize their overhead spending:
- Renegotiate fixed costs like rent and insurance when contracts are up for renewal.
- Institute energy efficiency measures to reduce utility bills.
- Cut unnecessary costs like subscriptions or maintenance contracts not utilized fully.
- Invest in new tools and equipment to improve productivity and decrease variable labor.
- Automate processes to lower administrative and accounting expenses.
- Rightsize equipment and office space to support true business needs.
- Outsource specialized functions like IT and HR to reduce headcount costs.
Conclusion
Overhead represents the ongoing business expenses not directly tied to producing goods or services. Proper overhead management is key for controlling costs, setting prices, budgeting effectively, and making profitable decisions. By categorizing overhead costs, calculating overhead rates, and finding ways to optimize spending, businesses can maximize their profitability and gain a competitive advantage in the market.