There are many costs associated with running a business. However, those costs don't all fall into the same bucket. One type is overhead costs, which are all of the expenses not tied directly to the production of a product or service. These are costs that a business incurs whether it makes anything or not – rent, utilities and insurance fall into this group.
It is important to have a clear understanding of both your overhead costs and the expenses directly related to production, because it helps to establish the breakeven point for your business (how much it needs to produce and sell in order to cover all its costs). It can also be a key strategy to identify efficiencies for cost savings.
What is overhead?
A business's overhead is its fixed expenses of operations that aren't directly related to production and therefore don't vary with output. In other words, if your business stopped producing anything tomorrow, you would still have to pay overhead costs to keep the business open, such as rent, utilities, insurance, and back-office costs like salaries for administrative personnel.
Overhead is a significant aspect of solid accounting for several reasons. First, it reflects costs that a business can't avoid simply by slowing or stopping production. Second, determining overhead costs is necessary to establish the breakeven point of your business. Specifically, you can factor those overhead costs into the prices you set for your goods and services to ensure you aren't selling your items at a price point where you are losing money.
Understanding your overhead expenses is also important because it is one of the biggest sources of cost savings for companies looking to streamline operations. You should be regularly reviewing your bills for services like electricity and internet to see if better deals are available to reduce your overhead expenses.
What is fixed and variable overhead?
When people talk about overhead, they're typically referring to fixed overhead. This includes things like business insurance and rent – expenses that remain constant regardless of your production or sales.
However, there are also some expenses that are considered variable overhead. These are costs directly related to production – such as raw materials for production and utility costs for running equipment.
The biggest difference is that fixed overhead costs have to be paid whether the company produces and sells anything or not. This is the area where you can find ways to be more efficient and increase profits. However, both of these types of costs are necessary for your business to produce and sell products, and you need to calculate both of them in order to determine your business's profitability point.
Types of overhead costs
|Item||Why it matters|
|Rent or mortgage||It has to be paid whether your business is open or not.|
|Utilities||You have to pay a certain amount whether or not your business opens its doors on any given day. Some of these are fixed monthly costs, while others may fluctuate. For example, natural gas bills tend to be higher in the winter than in the summer.|
|Insurance||Coverage has to remain in place even when you're closed.|
|Administrative costs||These costs include salaries of employees who don't have anything to do with production – people whose pay does not fluctuate with production or sales.|
|Sales and marketing||Marketing costs aren't tied to production – they have to be paid either way.|
Office supplies, property taxes, and professional services like accounting and legal advice are also overhead costs. These can vary by industry, company size and other factors.
You must also be aware of what is excluded from overhead costs – not just variable production costs, but also expenses for investment in assets, such as the cost of renovating your business facilities. These aren't fixed costs; they are one-time expenses that help to increase the value of your business.
How to calculate overhead costs
To calculate overhead expenses, you first need to identify all of your fixed costs that aren't directly related to production. Once you've identified all relevant costs, you total them.
Fixed Facilities Cost + Utilities + Licensing + Insurance + Sales and Marketing Costs + Administrative Fees = Overhead
Be sure to note the things that aren't included in the formula above – especially things like labor for production, which is a direct cost tied to production and not included in company overhead.
Of course, this is typically a lot easier to do with accounting software, which can help you identify relevant expenses and total them automatically over various periods.
Calculating overhead is also critical for planning your budget. Without understanding your total fixed costs, it's difficult to accurately forecast company revenue and expenses or make key decisions about investing in the future growth of your business.
How do you allocate overhead costs?
Allocating overhead costs is when a business owner or manager breaks down their total overhead cost into a per-hour or per-unit basis. In other words, you divide up your total overhead cost so you can see exactly how much cost is tied to each individual unit of time or production.
(Fixed Facilities Cost + Utilities + Licensing + Insurance + Sales and Marketing Costs + Administrative Fees) ÷ Hours or Units of Production = Overhead per Unit
Like calculating total overhead, the process of allocating overhead is easier with the right tools – it is a common feature of accounting software.
Why allocating overhead is important
By allocating your overhead costs, you can see how much profit (above and beyond your variable production cost) has to be produced per unit or per hour to cover fixed costs.
This process also breaks down your company's overhead into a more tangible number – tying those costs to something that isn't so abstract, such as an hour of labor. Once overhead is laid out this way, its importance is easier to recognize, as it shows exactly how much your business needs to make per unit just to cover fixed costs.
Most importantly, allocating overhead will help you keep costs in line. It also clearly demonstrates the importance of identifying efficiencies – finding ways to cut costs and increase profits.