What is Overhead?
Overhead costs are ongoing business expenses that keep the business running beyond the direct costs of a product or service.
Overhead refers to the materials and services that keep a business running each month. It’s the cost to operate and support the business. These expenses don’t directly generate revenue, but you need to pay for them whether or not your business makes any money. Calculating overhead is essential for budgeting. A company’s revenue must be higher than its direct and overhead costs combined if it wants to make a profit. So, businesses must consider their overhead expenses when making important decisions like pricing for their products and services.
A company’s overhead varies depending on the type of business. A clothing retailer’s overhead may include rent, utilities, insurance, taxes, office equipment (like computers and telephones), and any repairs and maintenance. Salaries that don’t contribute to making a product or delivering a service, such as human resources, also count as overhead.
Overhead is like the engine in a car…
Your car needs an engine to run. The engine doesn’t physically drive you from one place to another, but it’s necessary to get where you want to go. Similarly, overhead doesn’t directly contribute to revenue. Instead, these costs pay for all the support equipment, materials, and services needed for your business to run.
Overhead expenses may be fixed, variable, or semi-variable.
Fixed overhead costs are the same every time. For instance, rent and insurance premiums are fixed expenses — changes in production volumes don’t affect them. Variable overhead expenses typically shift alongside changes in the company’s activity level. Think of increased advertising and marketing costs during the busy holiday season.
The last type is semi-variable overhead — a hybrid of fixed and variable. For example, utilities (like your electricity bill) generally have both a fixed and variable portion, such as a set base fee and then a variable charge that’s calculated based on your usage.
Depending on the nature of the business, there are four main types of overhead costs. Let’s take a look at each one.
These indirect costs cover the daily general operations of a business, such as a company’s corporate headquarters. They’re not directly tied to the production of a product but still impact the entire business as a whole.
Office supplies, insurance, rent, mortgage payments, and utilities for the office building, as well as legal expenses, are examples of general and administrative overhead.
Specific employee payroll is also included in general and administrative expenses. These are generally salaries for receptionists, secretaries, and support staff. However, payment for direct labor doesn’t count as overhead.
Selling overhead is the amount spent to promote a company's products or services. Its purpose is to stimulate demand and secure orders. Examples include advertising and marketing costs, discounts, rebates, sales commissions, and payroll for sales personnel.
Advertising and marketing expenses are usually variable, while salaries for salespeople may be fixed or semi-variable, depending on the commission structure.
Distribution overhead covers things like transporting products to and from the warehouse and delivering products to the consumer. For example, if a business offers “free shipping” to customers who place an order over $100, the company typically absorbs the shipping cost into its distribution overhead.
Other distribution overhead may include payroll for employees that handle packaging and the cost to rent and maintain the warehouse.
Some businesses may have a department that pursues research and development. This department tests new products and aims to improve existing products to expand a company’s offerings or product line.
Research overhead includes the expenses required to support this research. The cost of raw materials for a research project, subscriptions to books and journals, and patent applications fall under research and development overhead.
Manufacturing and production overhead expenses are the costs of production not directly related to a product. Lighting, heating, cleaning materials, and machinery maintenance of a production facility are variable or semi-variable costs that fall under manufacturing overhead. Salaries of managers, supervisors, as well as repair and maintenance employees also fall into this bucket.
Overhead costs directly affect the profitability of your business. These are generally unavoidable costs that are critical to your business operations yet don’t directly result in sales or increased revenues.
Because overhead costs tend to be fixed or semi-variable, they can be difficult to change and don’t typically scale up and down with production. If your overhead costs are high, it could be more difficult to survive lean times.
For instance, if your property taxes are above average for your industry, it could mean that you’ve invested in more property, plants, and equipment than the competition, or you’re located in an area with higher tax rates. This may not be a bad move if you’re expecting your company to grow. But, if demand suddenly decreases, you may find yourself stuck with a high property tax bill you can’t afford, especially since relocating your operations costs both time and money. The higher your overhead costs, the more risk you have of running into financial problems if sales decline.
Generally, when your overhead costs are lower, your business is more agile with a greater potential for profit as sales grow. If your business has a lower overhead than the competition, you can sell products at the same price yet pocket more profit at the end of the day. You also have a greater ability to undercut the competition on price if you need to.
When calculating a business’s overhead, look at every expense and categorize each one as either an overhead or a direct cost. Direct costs are typically the direct labor costs (like hourly wages for people working on the assembly line) and direct material expenses (like the raw materials used to make your product). Almost everything else is overhead.
Your overhead costs will likely change from one period to the next as some of these costs are variable (think marketing fees) or semi-variable (think utilities). So, to better budget for overhead costs, consider averaging your expenses over the last 12 months, or estimate them based on what your costs were during the same period last year.
The overhead rate helps you compare your overhead costs to production and total direct costs. You can use the overhead rate to figure out product pricing or to allocate manufacturing overhead to the costs of goods sold on your income statement. Calculating overhead rates can also determine your company’s efficiency and budget the costs of overhead for an upcoming project.
The overhead rate is the total overhead costs divided by an allocation measure (such as direct labor hours or machine hours) in a specific reporting period.
Let’s say that a fictitious company, Carrie’s Candles, has a total overhead cost of $10,000 a month and direct production costs of $20,000 (aka the allocation measure). By dividing its overhead costs by direct costs, you can see how much revenue goes to overhead. $10,000 divided by $20,000 equals $0.50.
So, the company incurs $0.50 worth of overhead for every $1.00 spent on the direct costs of production.If Carrie’s Candles can lower its overhead costs, it can improve its bottom line — aka profitability.
You can also calculate the overhead rate compared to hours of direct labor. For example, let’s say the business has 700 hours of direct labor every month. Total overhead divided by total direct labor hours gives us an overhead allocation rate of about $14.29 ($10,000 / 700 hours = $14.29 per hour). In other words, Carrie’s Candles incurs $14.29 worth of overhead for every hour of direct labor making candles.
If the company wants to estimate the overhead for a special order of 100 holiday candles, Carrie’s Candles can determine the cost of overhead for this specific order based on how many hours it will take to complete. If it takes the factory workers 5 hours to fulfill this order, the overhead will amount to $71.45 (5 hours x $14.29 = $71.45).
To determine the overhead rate per unit for the company, divide the total overhead cost of $10,000 by the number of units sold. So if Carrie’s Candles sells 1,250 candles in a month, the overhead rate per unit would be $8 per unit ($10,000 / 1,250 units = $8).
There are many applications for overhead rates. These rates are particularly important so that a business can adequately price its product to make sure there’s enough profit margin to cover all costs — both direct and indirect.
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