Overhead - Explained
What is Overhead?
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Table of ContentsWhat is Overhead?How is Overhead Used?Types of Overhead CostHow Overheads WorksTypes of Overhead ExpensesOverhead ReportingAcademic Research on Overhead
What is Overhead?
In business and economics, overhead or burden costs refers to the day-to-day expenses of running a business. Unlike raw materials and labor, which directly affect the product costs, overhead expenses do not directly affect the prices of a particular service or product.
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How is Overhead Used?
Overhead refers to any expenses the business incurs, to support the production of a product. Companies need to keep paying overhead costs, even if the company is not making any profits at the moment. Overhead costs are critical in supporting the business to generate profits. They help in the budgeting process and also aid the company to determine a products final price. Businesses often break down overhead costs into three categories; fixed, variable, and semi-variable expenses. Fixed overhead expenses remain the same month-in, month-out. A type of fixed overhead is the rent of the business facility, government fees, insurance premiums, and depreciation rate of assets. They can invest the money set aside for rent, and grow the business first before renting an office. A business can also negotiate the cost of utilities with its suppliers to reduce the overhead expenses. Laying off employees, hiring on contract, and excluding entertainment are ways of reducing expenses in the company. In general, businesses need to monitor overhead costs because they can drain the money in a business unnecessarily. A start-up company, for example, does not need to rent an expensive office space if the business activities can take place in a small room at home.
Types of Overhead Cost
- Variable overhead cost - They are expenses that increase or reduce depending on the levels of business activities over time. For example, shipping and mailing costs, legal costs, consulting services, and salaries of various employees in the business are variable costs.
- Semi-variable costs - They include costs a business incurs regardless of the daily activities, but they may increase as activities also increase. For example, a US accountant always needs a printer toner but might need more during the first quarter of the year when printing tax forms for customers.
How Overheads Works
For example, a potter needs clay and the potters wheel to mold items, so the business cannot classify those as overhead costs as they directly affect the final product. However, the rent of the space of molding activities is an overhead as they potter needs it anyway to run the business. Apart from rent, other examples of overheads include:
- Insurance payments
- Government fees and business license fee
- Property taxes
- Legal expenses
- Utilities like water, electricity, internet, or phone service
- Accounting expenses
- Asset depreciation
- Administrative salaries
Types of Overhead Expenses
Businesses have different operational categories like administration, sales and marketing, research, logistics, and production. All of these categories have their overhead expenses:
- Administrative overhead costs include basic administrative duties like the hiring of accountants and receptionists in the office
- Sales and marketing overhead costs involve payments of television commercials that market the business
- Maintenance overhead costs may include repair of various equipment like bulbs, chairs, cabinets, printers, and doors in the office
- Transportation and logistics overhead costs include the costs of delivering goods to clients and various distribution points in the market
- Companies use research overhead costs when they want to introduce a new product or business process in the market.
The company must include all the overhead expenses in its income statement, as they play a role in the profits of a business. Every expense the company incurs contributes to its net profit and overall worth. Removing all unnecessary expenses in daily operations ensures the company increases the net worth of its business. Net profit = Gross profit expenses (inclusive of overhead) An overhead rate is an amount per dollar that the business spends on overhead costs. Overhead rate = total overhead costs / total sales A higher overhead rate means the business has a low net income, while a lower overhead rate means the business has a high net income.