Overhead refers to the ongoing, day-to-day expenses of operating a business that aren’t directly attributed to the level of output or specific business activity. It remains constant regardless of revenue and can have a direct impact on the sustainability, the breakeven, and the profitability of a business.
Overhead is directly related to the operating leverage of the business. This refers to how low the activity level can go before the business is in the red, and how high the activity level needs to go before the business can break even and start to produce a profit. It also determines how much economies of scale would help the business.
Because overhead plays a pivotal role in your business’s finances, it’s important to learn what it exactly is, what constitutes an overhead cost, how to calculate it, and the key types involved.
Definition and Examples of Overhead
Companies must pay overheads, also known as operating expenses, in order to support profit-making activities and “keep the lights on.” Overhead costs can be fixed, variable, or semi-variable. Fixed overhead costs, such as rent and insurance, remain constant regardless of the level of business activity, while variable costs, such as transportation, fluctuate based on output. Semi-variable costs, meanwhile, start at a baseline number and increase proportionally to output. Utilities are a good example of semi-variable costs. For instance, the cost of running a manufacturing plant starts at a certain level and increases as more goods are produced.
Expenses related to overhead appear in a company’s income statement and directly affect the overall profitability of a business. A small overhead allows businesses to increase their profit margins, which boosts their bottom line.
Seeing as overhead costs remain constant regardless of whether a business earns revenue, they can be draining if not properly controlled. In fact, calculating overhead costs is crucial in order to set prices for products and services because you’ll be able to know whether you’re setting your prices too low (which can impact profit) or too high (which can impact inventory and bottom line).
Direct costs required to create products and services, such as labor and materials, are excluded from overhead costs.
Other examples of overhead costs include:
- Office supplies
- Property taxes
- Advertising expenses
- Permits and licenses
- Accounting and legal fees
- Depreciation on fixed assets
How Does Overhead Work?
Since overhead is considered a general expense, it is accumulated as a lump sum. However, for accounting purposes, it is useful to allocate overhead costs to a specific product or service. For example, while you might have total overhead costs for a manufacturing facility, you may wish to calculate overhead for a specific product category.
To calculate overall overhead costs, divide the total overhead costs of the business in a month by its monthly sales. Multiply this number by 100 to get your overhead rate.
Overhead Rate = Overhead Costs/Sales x 100
If the overhead rate is 30%, it means the business spends 30% of its operating expenses on producing a good or providing a service.
You can also calculate overhead costs relative to other reasonable measures, such as machine hours or labor (wages). For example:
$100,000 overhead costs/10,000 machine hours
The result is an overhead allocation rate of $10 per machine hour.
Types of Overhead
While overhead is initially calculated as a lump sum, it can fall under a number of categories. Depending on the nature of the business, other types of overhead may apply, such as research overhead (pharmaceuticals), maintenance overhead (airlines), or transportation overhead (logistics).
For most businesses, however, administrative overhead and manufacturing overhead are two of the most common types of operating expenses.
While administrative overhead costs tend to remain constant, manufacturing overheads can vary widely, which is why it is a good practice to separate the two when determining your overall overhead costs.
Here is a closer look at how these two overhead costs differ.
Administrative overhead costs are expenses unrelated to production, marketing, or research. These costs include those related to accounting, legal services, and office-related business costs Some administrative overhead costs examples are rent, utilities, property tax, insurance, and office supplies.
Manufacturing overhead costs are expenses incurred in a manufacturing facility other than the costs of direct materials and direct labor. Examples include rent and property taxes on the manufacturing facility, depreciation on manufacturing equipment, repairs and maintenance, employees, utilities, and indirect factory supplies. For accounting purposes, manufacturing overhead costs must be allocated to the units manufactured, although this can be hard to do for items like property taxes and insurance.
- Overheads are operating expenses that remain constant, regardless of business revenue.
- Overheads tend to fall into two categories: administrative (eg: rent, utilities, insurance) and manufacturing (eg: depreciation of machinery, maintenance, factory supplies).
- A small overhead allows businesses to increase their profit margins, which can boost their bottom lines.