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Overhead

What Is Overhead?

Overhead refers to the ongoing business expenses that are not directly attributed while creating a product or delivering a service. Overhead, generally speaking, is important for budgeting purposes and it is also taken into account while determining how much a company must charge for its products or services to earn a profit. In short, overhead is any expense incurred to support the business while not being directly related to a specific product or a service.

Before we move ahead, let’s summarise-

  • Overhead refers to the ongoing costs to operate a business. This 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.

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 and work. 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, which 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 goods or services. This can include printed materials and television commercials, as well as the commissions of sales personnel and other benefits.

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

There are three main types of overhead that businesses incur. The overhead expenses vary depending on the nature of the business and the industry it operates in.

1. Fixed overheads

Fixed overheads are costs that remain constant every month and do not change with changes in business activity levels. Examples of fixed overheads include salaries, rent, property taxes, depreciation of assets, government licenses and other investments that you make on your employees. 

2. Variable overheads

Variable overheads are expenses that vary with business activity levels, and they can increase or decrease with different levels of business activity. During high levels of business activity, the expenses will increase, but with reduced business activities, the overheads will substantially decline or even be eliminated.

Examples of variable overheads include shipping costs, office supplies, advertising and marketing costs, consultancy service charges, legal expenses, as well as maintenance and repair of equipment.

3. Semi-variable overheads

Semi-variable overheads possess some of the characteristics of both fixed and variable costs. A business may incur such costs at any time, even though the exact cost will fluctuate depending on the business activity level. A semi-variable overhead may come with a base rate that the company must pay at any activity level, plus a variable cost that is determined by the level of usage.

Examples of semi-variable overheads include sales commissions, vehicle usage, and some utilities such as power and water costs that have a fixed charge plus an additional cost based on the usage.

Examples of Overhead Costs

Overhead costs are important in determining how much a company must charge for its products or services in order to generate a profit. The most common overhead costs that any business incur include:

1. Rent

Rent is the cost that a business pays for using its business premises. If the property is purchased, then the business makes mortgage payments.

Rent is payable monthly, quarterly, or annually, as agreed in the tenant agreement with the landlord. When the business is experiencing slow sales, it can reduce this cost by negotiating the rental charges or by moving to less expensive premises.

2. Administrative costs

Administrative costs are costs related to the normal running of the business and may include costs incurred in paying salaries to a receptionist, accountant, cleaner, etc. Such costs are treated as overhead costs since they are not directly tied to a particular function of the business and they do not directly result in profit generation. Rather, administrative costs support the general running of the business.

Examples of administrative costs may include audit fees, legal fees, employee salaries, and entertainment costs. A business can reduce administrative expenses by laying off some of its employees, switching employees from full-time to part-time, hiring employees on a contract basis, or by eliminating certain expenses, such as entertainment and office supplies.

3. Utilities

Utilities are the basic services that the business requires to support its main functions. Examples of utilities include water, gas, electricity, internet, sewer, and phone service.

A business can often reduce utility expenses by negotiating for lower rates from suppliers.

4. Insurance

Insurance is a cost incurred by a business to protect itself from financial loss. There are various types of insurance coverage, depending on the risk that may cause loss to the business. For example, a business may purchase property insurance to protect its property or business premises from certain risks such as flood, damage, or theft.

Another type of insurance is professional liability insurance that protects the business (such as an accounting firm or law firm) from liability arising from malpractice. Other types of insurance include health insurance, home insurance, renter’s insurance, flood insurance, life insurance, disability insurance, etc.

5. Sales and marketing

Sales and marketing overheads are costs incurred in the marketing of the company’s products or services to potential customers. Examples of sales and marketing overheads include promotional materials, trade shows, paid advertisements, wages of salespeople, and commissions for sales staff. The activities are geared toward making the company’s products and services popular among customers and to compete with similar products in the market.

6. Repair and maintenance of motor vehicles and machinery

Rent and maintenance overheads are incurred in businesses that rely on motor vehicles and equipment in their normal functions. Such businesses include distributors, parcel delivery services, landscaping, transport services, and equipment leasing.

Motor vehicles and machinery need to be maintained on a continuous basis and repaired whenever they break down.

Summary

One way to understand overheads vs operating expenses is that operating expenses are the expenses associated with a specific business, while overheads are the general costs that apply to running any business.

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