Along with direct materials and direct labor, overheads are also a very important cost element to determine directly to your business’s profitability. In this guide, we’ve covered:
Overhead definition
Examples of overhead
Types of overhead
Overhead calculation
What is overhead?
Overhead, also known as an overhead cost, refers to an ongoing expense of operating a business. Overhead costs are not directly attributed to creating a product or service to lead to the generation of profits. However, overheads are still necessary to business operations as it provides critical support for the generation of profit-making activities. Unlike operating expenses such as raw material and labor, overheads can not be conveniently traced with any particular revenue unit.
For example, you must pay a substantial overhead cost such as rent for allocating a store in an adequate facility that allows you to reach out to your customers, sell goods and make profits.
The most common overheads include accounting and legal expenses, administrative salaries, depreciation, insurance, licenses, government fees, property taxes, rent, utilities, telephone bills, travel expenditures, etc.
Overhead costs fall into two categories: administrative overheads and manufacturing overheads
Other concepts of overheads in accounting are fixed costs and indirect costs. They are allocated in the indirect expense section of the income statement and then are accounted for on the balance sheet and cash flow statements. You must calculate overhead expenses to determine its net income, also referred to as the bottom line. To calculate it, you subtract all production-related and overhead expenses from your company’s net value, also referred to as the top line.
Types of Overheads
There are three types of overhead costs: fixed, variable, and semi-variable.
Fixed overheads
Fixed overheads are expenses associated with the basic operation and do not change with the business activity level. Fixed costs include rent and mortgage payments, property tax, website hosting, depreciation of assets, annual salaries, government fees, etc.
Variable overheads
Variable overheads change in the proportion of the volume of production output or business activity. They increase when the production level increases. Conversely, when business activities slow down, the variable overheads associated with production will consequently decrease. Examples of variable costs include shipping, legal expenses, materials, office supplies, equipment maintenance, advertising, consulting services, etc.
Semi-variable overheads
Some overhead expenses are considered 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. Semi-variable overhead expenses include some utilities, vehicle usage, hourly wages with overtime, and salespeople’s salaries and commissions.
How Do You Calculate Overhead Cost?
Overheads are often considered a business’s general expense as it is accumulated as a lump sum. This is then allocated to a specific product or service in a specific period of time. There are a number of different ways of calculating overhead depending on what types of your company, however, the general rule is as follows:
Overhead rate = Indirect costs/ Allocation measure |
The smaller your overhead rate is, the bigger your net income is generated.
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