Overhead

What Is Overhead?

Overhead refers to the ongoing business expenses not directly attributed to creating a product or service. It is important for budgeting purposes but also for determining how much a company must charge for its products or services to make a profit. In short, overhead is any expense incurred to support the business while not being directly related to a specific product or service.

Key Takeaways

  • Overhead refers to the ongoing costs to operate a business but excludes the direct costs associated with creating a product or service.
  • Overhead costs can be fixed, variable, or a hybrid of both.
  • There exist different categories of overhead, such as administrative overhead, which includes costs related to managing a business.
  • The income statement reports overhead expenses.
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Overhead

Understanding Overhead

A company must pay overhead on an ongoing basis, regardless of how much or how little the company sells. For example, a service-based business with an office has overhead expenses, such as rent, utilities, and insurance that are in addition to direct costs (such as labor and supplies) of providing its service.

Expenses related to overhead appear on a company's income statement, and they directly affect the overall profitability of the business. The company must account for overhead expenses to determine its net income, also referred to as the bottom line. Net income is calculated by subtracting all production-related and overhead expenses from the company's net revenue, also referred to as the top line.

Overhead expenses can be fixed, meaning they are the same amount every time, or variable, meaning they increase or decrease depending on the business's activity level. For example, a business’s rent payment may be fixed, while shipping and mailing costs may be variable. Other examples of fixed costs include depreciation on fixed assets, insurance premiums, and office personnel salaries.

Overhead expenses can also be 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. For example, many utility costs are semi-variable with a base charge and the remainder of the charges being based on usage.

Examples of Overhead

Some common examples of overhead costs companies must assume are rent, utilities, administrative costs, insurance, and employee perks.

Rent and Utilities

The costs associated with maintaining the office or manufacturing space companies must have in order to perform their business is an example of overhead. This includes rent as well as utilities such as water, gas, electricity, internet, and phone service. Additional costs such as a subscription to virtual meeting platforms like Zoom (ZM) also must be factored into a company's overhead.

Administrative Costs

Administrative costs are often one of the most expensive facets of a company's overhead. This can include the cost of stocking the office with the necessary supplies, the salaries of office associates, and external legal and audit fees. Administrative costs can range from the supply of toilet paper in the office restroom to hiring an external audit firm to ensure the company complies with industry-specific regulations.

Insurance

Depending on the company, businesses are required to hold many different types of insurance in order to operate properly. These can include basic property insurance to protect the company's physical assets from fire, flood, or theft as well professional liability insurance, health insurance for its employees, and car insurance for any company-owned vehicles. While none of these costs are directly related to generating revenue for the company by providing a good or service, the business is often legally mandated to purchase these various types of insurance if it wishes to operate within most jurisdictions.

Employee Perks

Many larger companies offer a range of benefits to their employees such as keeping their offices stocked with coffee and snacks, providing gym discounts, hosting company retreats, and company cars. All of these expenses are considered overhead as they have no direct impact on the business' good or service.

Types of Overhead

Overhead expenses may apply to a variety of operational categories. General and administrative overhead traditionally includes costs related to the general management and administration of a company, such as the need for accountants, human resources, and receptionists. Selling overhead relates to activities involved in marketing and selling the good or service. This can include printed materials and television commercials, as well as the commissions of sales personnel.

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

Special Considerations

Overhead is typically a general expense, meaning it applies to the company's operations as a whole. It is commonly accumulated as a lump sum, at which point it may then be allocated to a specific project or department based on certain cost drivers. For example, using activity-based costing, a service-based business may allocate overhead expenses based on the activities completed within each department, such as printing or office supplies.

What Is Overhead?

Overhead includes the fixed, variable, or semi-variable expenses that are not directly involved with a company's product or service. Examples of overhead include rent, administrative costs, or employee salaries. Overhead expenses can be found on a company’s income statement, where they are subtracted from its income to arrive at the net income figure. Analyzing overhead is critical to showing the profitability of a company. 

What Are Different Types of Overhead?

Broadly speaking, overhead can be organized into three main types. Fixed overhead includes expenses that are the same amount consistently over time. These can include rent and depreciation on fixed assets. Variable overhead expenses include costs that may fluctuate over time such as shipping costs. Semi-variable costs are a blend of the two. Utilities are an example of a semi-variable cost. 

How Is Overhead Calculated?

Since overhead is often considered a general expense, it is accumulated as a lump sum. This is then allocated to a specific product or service. There are a number of different ways of calculating overhead, however, the general rule is the following: Overhead rate = Indirect costs/ Allocation measure. The indirect costs are the overhead costs, while the allocation measure would include labor hours, or direct machine costs, which is how the company measures its production.