Overhead: understanding overhead

All business owners can attest to the fact that it takes money to make money. The costs associated with the creation of products and services are called “direct costs”. Expenses that are not directly associated with the creation of a service or product are called “overhead” or “indirect costs”.

If you’re not careful as a business owner, your overhead could eat into your income. Take the time to understand how to calculate overhead. Knowing these numbers can also help you reduce your expenses.

Overheads are all costs you incur while running your business that are not directly attributable to the following categories:

  • Product
  • Service
  • Part of the company’s income
  • Commercial activities

In other words, overheads are indirect costs such as:

  • Insurance
  • Administrative costs
  • Property taxes
  • Licenses and permits
  • Office supplies/equipment
  • Utilities
  • Depreciation

Operating expenses are also called manufacturing expenses. These are the costs incurred in manufacturing a product or providing a service. For example, if you are making fragrances for humidifiers, you may need to use essential oils as an ingredient. The more perfumes you make, the more essential oils you will need to buy. The expenses associated with purchasing essential oils may change, but the number of machines you use will remain the same for at least a while.

Total overhead is related to running a small business and selling a product or service. Think of it this way: If you go on vacation, you’ll still have to pay your office rent or mortgage payments, liability insurance, and internet bill, among other bills. These costs make up the business expenses that often appear on your balance sheet covering business operations.

Overhead costs are indirectly related to profit generation. These are costs that keep your business afloat full time, including operating costs, labor costs, and product costs such as raw materials.

Here are some examples of overhead costs:

  • Lease
  • Insurance
  • Utilities
  • Travel
  • Office supplies
  • advertising marketing
  • Salaries and treatments
  • Property taxes
  • Accounting fees
  • Legal fees
  • Employee salaries

There are three types of overhead:

  • Fixed overhead
  • Variable overhead
  • Semi-variable overhead

1. Fixed overhead

Most business overhead costs fall into this category. These costs remain the same every month, regardless of how much profit you make or how active your business is. Here are some examples of fixed overhead:

  • Property taxes
  • Business insurance
  • Personnel costs
  • Software subscription
  • Loan interest rates

2. Variable overheads

Variable expenses vary from month to month and may also be considered direct expenses on your financial statements. It should also be noted that not all companies incur variable overhead. Rather, it depends on the nature of your business.

Here are some general examples of variable overhead:

  • Office supplies
  • Administrative costs
  • Shipping costs
  • Over time
  • Advertising and marketing costs
  • Legal fees
  • Consulting fees

Variable costs are difficult to predict. Sometimes they can get out of control, as we’ve seen with the COVID-19 pandemic, where companies have had to purchase safety clothing and equipment for their employees.

3. Semi-variable overhead

Utilities are semi-variable costs, meaning they occur monthly, although the rate or cost may vary. A good example of a semi-variable expense is the cost of electricity. During the months when your office is warm and air conditioning is essential, the electricity bill will be more expensive than during the cold months.

Here are general examples of semi-variable overhead:

  • Utilities
  • Trip costs
  • company car
  • Hourly wages

What are fixed overheads?

The term “fixed overhead” refers to a group of expenses that remain the same regardless of the level of activity. These expenses must be incurred for a business to remain operational. Your administrative overhead and manufacturing overhead both fall into this category.

Always be aware of the total fixed costs incurred by a business. This is necessary so that management can budget for a sufficient amount of contribution margin on the sale of products and services to be able to at least offset the amount of fixed overhead.

Here are some examples of fixed overhead:

  • Inventory
  • Lease
  • Utilities
  • Insurance for product equipment

What is variable overhead?

The term “variable overhead” refers to manufacturing expenses that move roughly in proportion to the amount of goods produced. This idea is to model the future amounts of expenses that will be incurred by your business, as well as to determine the minimum price at which a product should be offered for sale.

The variable overhead costs borne by a company can be:

  • Equipment utilities
  • crafting supplies
  • Handling wages

What is semi-variable overhead?

Some of the characteristics of fixed costs and variable costs are present in semi-variable overhead. These features include the ability for a business to incur such costs at any time, despite the fact that the precise cost will change depending on the level of business activity.

A semi-variable overhead may have a base cost that the business is required to pay regardless of the degree of activity, in addition to a variable cost that is determined by the level of consumption of the resource.

What is Charged Overhead?

The cost of making a product can be increased by hidden expenses called “loading costs”. These expenses can be related to labor or inventory. The production of a good is not directly related to overhead costs.

Labor charges are expenses incurred by your business that go beyond paying regular wages, including:

  • Health insurance
  • Education (certifications, training, etc.)
  • Social charges
  • workers compensation
  • Travel
  • PTO

The inventory charge is calculated separately from other costs. In this case, you have opened a business and purchased all the necessary equipment. Inventory expense focuses on the costs incurred to operate the machinery on a daily basis for the purpose of producing the product. The sum of what it costs will then be added to the cost of producing the product to give you the inventory charge.

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

Overhead rate formula

To get the company’s overhead rate, divide the total amount of overhead costs incurred by the company in a given month by the company’s monthly sales. This figure should be multiplied by 100 to determine your overhead rate.

Important Takeaways

Ultimately, overhead can be used in a number of different operational categories. General and administrative costs such as the hiring of accountants, human resources and receptionists are generally included in general and administrative expenses. Marketing and selling the product or service are examples of selling overhead. This can include television advertisements, printed materials and commissions for salespeople.

Nav helps you access capital for your business so you can finance all necessary costs without breaking the bank. Our platform makes it easy and instant to find your best small business loan and business credit card options. To improve your financing options, learn how to establish business credit and explore our website for more resources specific to the nature of the business you run.

This article was originally written on June 27, 2022.

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