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Finance glossary

What are overhead costs?

Bristol James
5 Min

Overhead costs are business expenses related to running operations. These costs are not directly related to creating a product or service, as those costs are known as cost of goods sold or direct expenses. Overhead expenses are the costs associated with general operations, like rent and utilities. They are critical to keeping operations running smoothly.

Overhead costs are important to track because they directly factor into your bottom-line profitability and your pricing structure. Let’s say that your overhead costs are $10,000 a month. This means you need to make enough profitability to cover these costs to break even. If your profitability per unit was $25 after subtracting direct costs, you will need to sell 400 units to cover your overhead costs.

Moreover, overhead costs are relatively easy to account for when it comes to planning and budgeting. Although not always fixed, overhead costs are usually consistent between periods, making it easier for management to plan cash flow and upcoming expenses.

Types of Overhead

There are two main types of overhead expenses: fixed and variable. These costs can be scattered throughout the income statement, such as in cost of goods sold and selling expenses.

Fixed Overhead

Fixed overhead costs are business expenses that don’t change from month to month. Examples of fixed overhead costs include rent, insurance, salaries, property taxes, and depreciation. Each month, these business costs will be the same, helping members of management properly plan.

For example, if your building rent is $5,000 per month, insurance is $1,000, and salaries are $5,000, your business will be paying $11,000 each month regardless of whether there is enough profit to cover the expenses.

Fixed overhead costs are not easily manipulated based on activity levels. Instead, they are set amounts that your business needs to earn revenue to cover. The inability to earn enough income to cover fixed overhead expenses can result in the need to seek outside funding, like lines of credit or investor contributions.

Variable Overhead Costs

Variable overhead costs change between periods and can be based on activity levels. Common examples of variable overhead costs include:

  • utilities
  • commissions
  • office supplies
  • legal fees
  • marketing expenses.

For example, months with higher sales levels might result in more commissions compared to lower sales months. Properly estimating these costs relies on forecasting upcoming demand and operations. Some companies choose to use historical data to compile an average variable cost for the period.

Let’s go through a quick example of creating an average variable cost. You review past financial statements and find that you spend around $0.50 on advertising per unit and $0.25 in commissions. In addition, utilities and office supplies remain consistent between $1,000 and $1,100 each month when you sell 1,000 units.

The average office supply and utility cost of $1,050 results in a per-unit cost of $1.05. Add together the $0.50 in advertising and $0.25 in commissions, and your team can use $1.80 in variable overhead costs to plan upcoming budgets. This makes it easier to forecast profitability and cash flow when you have an average variable cost to apply to sales.

Examples of Overhead Expenses

Overhead expenses are ongoing business expenses that don’t have a direct connection to generating your product or service. Here are some examples:

  • Rent
  • Utilities
  • Property taxes
  • Salaries
  • Advertising
  • Insurance
  • Accounting
  • Maintenance
  • Office supplies
  • Shipping
  • Bank fees
  • Business licenses

Overhead costs can be found in each of the main categories on your income statement, including cost of goods sold, selling, administrative, and occupancy. Remember, some of these costs will be fixed and easy to track each month, while others can vary on your growth strategies and output levels. Knowing how to differentiate between these costs is crucial for accurately calculating overhead.

It’s also important to understand that the industry you operate in will dictate your overhead expenses. For example, if you are a startup software company, you might not be paying rent or salaries yet. However, if you are a distributor or manufacturer, high overhead costs can be common.

Calculating Overhead Costs

Calculating the overhead rate relies on differentiating between your direct and indirect business costs. Direct costs are those that are only incurred when the product or service is produced, such as raw materials to produce finished goods. On the contrary, indirect costs are the expenses that don’t relate to the principal production of your goods or services but are necessary to keep operations running smoothly.

Calculating total overhead cost helps your business plan and earn enough revenue to cover all operating expenses. Let’s go through a monthly overhead cost calculation. Your business sells toys, which cost $2.50 each to make. The $2.50 figure represents all direct costs. Due to market demand, you are able to sell your product for $4.50. Your monthly overhead costs consist of the following:

  • $2000 – Rent
  • $500 – Insurance
  • $1500 – Salaries
  • $1/unit – General

How many products do you need to sell to break even each month? Here are the steps you will need to take:

  1. Add direct costs: $2,000 + $1,000 + $500 = $3,500
  2. Calculate profit per unit: $4.50 – $2.50 – $2.00
  3. Subtract variable costs from profit: $2.00 – $1.00 = $1.00
  4. Divide Direct Costs by Unit Profit: $3,500 / $1.00 = 3,500 Units

Your business will need to sell 3,500 units to break even each month. Now, let’s say that you want to earn $1,000 in profit. You would factor your profit into your direct costs and divide the amount by your profit per unit. This means you will need to sell 4,500 units to earn $1,000 in profit.

The Importance of Overhead Costs

Total overhead costs play a crucial role in a company’s profitability and scalability. Calculating how many units you need to sell gives your sales team a goal to work toward. For example, if it takes 3,000 units to break even, you might set a sales goal of 4,000 units. With this information, your team can plan marketing campaigns and reach out to clients to reach this goal.

Overhead costs are also important if your business is trying to lean out. Fixed overhead costs occur each month, regardless of whether your business is profitable. These costs can also be some of your organization’s highest expenses, like rent. Finding ways to lower your overhead costs helps you increase your profitability and move away from total dependence on unit sales.

Overhead costs also play a crucial role in pricing your products and services. Assigning a cost based on direct costs can result in an overall loss when factoring in overhead costs. As a result, you need to price your goods and services by calculating your ideal net profit. Net profit factors in all costs, including direct and indirect expenses, making it more realistic when determining what price to charge customers.

Summary

  • Overhead costs are business expenses that aren’t directly tied to the production of products or services.
  • Fixed overhead costs are expenses that don’t change each month, while variable overhead costs can vary based on sales levels.
  • Consistently reviewing your overhead costs helps your business increase profitability and better plan for upcoming periods.

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