Do you want to know what overhead is in business? You may be quite familiar with this business terminology but don’t have an in-depth understanding of all it entails. Not to worry, this article will rectify this situation.
It shares in-depth knowledge of what overhead expenses are in business.
It also goes further to discuss the types and how to calculate and reduce them in your business.
Keep reading to learn more.
Meaning of Overhead in Business – What is Overhead in Business
Business overhead is the money a company uses to carry out its daily processes.
It is a business’s ongoing expenses that are not directly used to create the business services or products.
The money a company spends to support itself does not relate to the product or/and service the company offers.
A company’s overhead can’t be linked to a particular business activity or cost.
Also, it usually doesn’t matter whether a business is making sales; the business would still need to pay all its overhead costs whenever they are due regardless.
This is why keeping track of these expenses is very important.
If you leave things to chance, you may end up running your business without making enough profit.
Types of Overhead – What is Overhead in Business
Overheads can be classified into 3 main groups; fixed, variable, and semi-variable.
The kind of overhead a company incurs is often based on the type of business it is, as well as its industry.
Apart from the 3 main types of overhead, businesses can incur other types of overhead according to the nature of the business.
Therefore, we’ll look at the three main types of overhead and under the “others” subsection, we’ll discuss other overheads that do not fit into the main groups.
That said, here are the different types of business overheads a company can incur.
This kind of overhead, as the name implies, is fixed.
That is, they stay constant in every billing cycle or month regardless of how much work the business does.
A business could go slow or grow, but its fixed overheads won’t be affected by these changes.
Examples are rent, insurance premiums, depreciation, employees’ salaries, government licenses, property taxes, and so on.
This kind of overhead is the exact opposite of fixed overheads.
This means that they often change depending on how much work or activities the business engages in.
Also, they may increase or reduce depending on the business activities.
When activity levels increase, variable overheads will also increase.
Likewise, when activity levels reduce, the variable overheads will also decrease.
Examples are legal expenses, office supplies, repair and maintenance of equipment, marketing and advertising expenses, mailing and shipping costs, and so on.
These overheads are a mixture of both variable and fixed overheads.
They share certain characteristics of variable overheads and some characteristics of fixed overheads.
A semi-variable overhead, like a fixed overhead, would be incurred despite the business activity.
Yet at the same time, like a variable overhead, it may increase if the levels of activity increase and vice versa.
So, while the expense is constant, the price of the expense may fluctuate based on the company’s activity levels.
Examples are vehicle usage and utilities with a fixed cost but attract additional costs depending on use, like water and power costs, sales commission, etc.
These other types of overheads are often incurred based on the type of business.
For instance, a company may have some overheads that can be classified under several operational categories.
A company may also need to pay certain administrative and general expenses necessary for the business’s administration and general management.
These could include the need for human resources, receptionists, accountants, and so on.
Also, there’s selling overhead; this refers to the costs for selling and marketing activities.
These typically include television commercials, printed materials, sales personnel commissions, etc.
Lastly, other overheads can include research, maintenance, transportation, manufacturing, etc.
Overhead Vs Direct Costs – What is Overhead in Business
Direct cost is another type of business expense.
This type of business expense is typically the exact opposite of overhead costs.
This is because, unlike overheads, direct costs are directly related to the production of the business’s goods or services.
Let’s use a shoe manufacturing company as an illustration to help you better understand the difference between overheads and direct costs.
So, let’s say to manufacture shoes; the company will need raw materials.
Whatever money the company uses to make the shoes, i.e. buy raw materials and every other expense directly made to make the shoe, are the direct costs.
But other expenses that do not directly relate to making the shoe, such as transportation, rent for the factory, money used in advertising, and so on, are the overhead costs.
Importance of Tracking Overhead Costs – What is Overhead in Business
Every business, regardless of its nature, has its overhead costs and these costs often eat into how much profit a business makes.
For instance, if a shoe company spends about 15 dollars to make a pair of shoes and then sells the shoes at 30 dollars each, the company’s profit won’t be 15 dollars on each pair.
The real profit margin can only be gotten after the company deducts its direct costs and overhead costs per unit from the amount they sell the shoes.
So, let’s say the company spends 15 dollars to make the shoes, and its overhead cost per unit is 5 dollars.
Its profit per unit would be 10 dollars.
This is why companies need to keep track of their overhead costs, as they directly impact a company’s revenue.
A company needs to track its overhead costs and ensure the price it sells its products reflects these costs.
Furthermore, the company’s pricing should cover direct costs and overheads and ensure enough profit left.
Overheads are also vital in calculating a company’s net profit.
When the company subtracts all its expenses (overheads and direct costs) from its gross profit, that is the only way to reach its net profit.
Therefore, a company that does not keep track of its overhead cost may end up with a small profit margin or even not get any profit.
In summary, you need to calculate and track your overhead costs to keep your business profitable.
Examples of Overhead Costs – What is Overhead in Business
A business needs to take its overhead costs as a priority.
But it may not be easy to do this when you do not even know for sure what you are supposed to track.
So far, this article has discussed the various types of overheads that a company can incur.
But you also need to know the overheads that fall under those categories.
Luckily, this section of this article will discuss some of the common overheads that a business can incur.
This way, you can know what to look out for and track in your business.
Although this list is limited, it will give you an idea of what overheads look like in business.
This is the money your business pays to use its premises for its operations.
This could include your office space, warehouses, and any other property your business uses for its operations.
You won’t have to pay rent if your business owns the building it uses.
Notwithstanding, you’d still need to book depreciation expenses.
The rent billing cycle could be yearly, quarterly, or monthly.
Rent is a fixed overhead, so it often stays the same whether or not the business is growing or moving slowly.
However, if your business isn’t doing well and the rent is eating deep into revenue, you can renegotiate your rental charges and see if you can get a better deal.
Alternatively, you could move your business to cheaper premises.
These costs cover the daily running of your business.
It typically covers costs used in paying the salaries of your administrative staff, such as your receptionists, cleaner, receptionists, and so on.
These are considered overhead costs because they aren’t directly related to any business function and don’t generate profit.
They simply support the normal processes of the business.
Other examples include employee salaries, legal fees, audit fees, entertainment expenses, etc.
Sales and Marketing
Marketing is an essential aspect of business and often comes at a cost.
Since marketing does not directly relate to producing goods and services, every expense spent on marketing is considered overheads.
These overheads include promotional materials, paid advertisements, sales staff commissions, salespersons’ wages, trade shows, and so on.
As a business owner, the last thing you want to do is run your business without certain insurance in place.
There are different types of insurance, and the type you use for your company is based on the company you operate.
But one thing is sure, insurance is very important and will protect your business against certain financial losses.
The money a company pays for its insurance premiums is overhead insurance costs.
So, if you have property insurance, whatever amount you pay for this insurance premium is an overhead cost that your business incurs.
Insurance cost is fixed overhead.
Regardless of whether your business is moving well, your insurance cost will stay the same, and you will still have to pay it.
These are essential services that your company needs to carry out its functions and processes.
Examples include electricity, gas, water, sewer, internet, phone services, etc.
These are semi-variable overheads; you still need to pay them whenever they are due, but the amount could increase depending on how much your company uses the utility.
Equipment Maintenance and Repairs
This overhead is incurred by companies that use equipment and machinery for their basic functions.
These include businesses like landscaping, distributors, equipment leasing, transport services, and so on.
Businesses incur this overhead because they have to repair and maintain their equipment constantly.
Employee Perks and Incentives
Some large companies provide certain perks and incentives for their employees.
These perks could be anything from keeping snacks and coffee in the office to gym discounts, company cars, company retreats, and more.
The costs of these perks are overheads because they do not directly impact the company’s goods and services.
How to Calculate Your Company’s Overhead Costs – What is Overhead in Business
Keeping track of your company’s overhead costs is very important to determine your company’s pricing and to ensure your business remains profitable.
The good thing about overhead costs is you can easily calculate them and keep track of them.
This section of the article will teach you how to properly calculate your company’s overhead costs yearly, per unit, and per employee.
How to Calculate your Yearly Overhead
To calculate your overhead yearly, list every expense your business incurs in a year.
When you have made a list, look at all the items on it and rule out the expenses that fall or increase according to the production of services and goods.
These are your direct costs.
The remaining costs are your overheads.
Now, you need to total them to get your yearly overhead costs.
You can also get an average monthly overhead by dividing your yearly overhead cost by 12.
How to Calculate your Overhead Per Unit
A lot of businesses prefer to calculate their overheads per unit.
This is because it would be easier to determine their pricing this way.
To calculate your overhead per unit, divide your total overhead cost by the total number of units you produce.
So, let us say your company’s total annual overhead cost is 30,000 dollars; in that year, you produced about 10,000 products.
Your overhead cost is 30,000 dollars (total overhead cost) divided by 10,000 (number of units produced).
This means that the overhead per unit would be 3 dollars.
How to Calculate your Overhead Per Employee
Depending on the nature of the business, some companies would find it better to calculate their overhead per employee.
For instance, a service business may find this method more effective.
To calculate your overhead costs per employee, you would total your overhead and labour costs (including salary, holiday pay, health benefits, pension, and so on) and divide the total by your number of workers.
So, assuming your company’s overhead cost is 30,000 dollars and you have about 10 employees.
The overhead costs per employee will then be 30,000 divided by 10.
This would make your overheads per employee 3,000 dollars.
How to Reduce Overhead Costs – What is Overhead in Business
Overheads can eat deep into your company’s revenue and affect your company’s profitability if you leave them unchecked.
This is why a lot of companies often adopt several strategies to keep their overhead costs to a minimum.
Since they cannot cut down on direct costs, which would affect the quality of their services or products, they would rather cut down on overheads to save costs.
The following are some ways you can reduce your company’s overhead costs and increase your profit margin.
Find an Ideal Space
One major overhead that can cost thousands of dollars and affect your profits is rent.
It may be time to reconsider your office space.
Does it make financial sense?
Are you operating your business in an expensive area when you can still operate it optimally from a less centralized area?
Or, you can run your business from a home office, but you are currently paying for office space?
Is the office space you currently occupy much bigger than what you need?
If you notice that your current space does not make sense financially or logically, it may be better to find an ideal space.
This will help you save a lot of overhead costs.
You can also decide to sublet a part of your office space if you occupy a space bigger than what you need.
Automate Your Operations
Every business person knows that time is money.
So, whatever helps you save time by extension helps you save money.
Luckily, in today’s world, saving time is whole easier.
There is so much software available for automating several business processes.
Automating your operations removes the need to hire certain personnel in your company, which would help save costs.
Not only will automating your operations help you save costs, but it will also improve the quality of your services and increase efficiency.
Be Smarter When Hiring
When it comes to cutting costs, a lot of businesses often jump straight to laying off some of their employees.
While this would significantly reduce costs, it often has certain downsides.
So, instead of laying off staff, consider making better hiring decisions.
When you want to hire someone, look for someone with the skill set to carry out more than one business need.
Also, you should consider outsourcing some of your company’s tasks rather than employing full-time employees.
Finally, invest in your company’s culture to reduce your company’s employee turnover rate.
It may not seem like much, but the hiring process incurs expenses.
When you retain your workers, you are cutting down the hiring expenses.
Conclusion on What is Overhead in Business
Business overhead is ongoing expenses that are not directly used in creating business services or products.
Calculating and keeping track of your business overhead is vital to determine your business’ net profit and to ensure your business stays profitable.
Hopefully, this post has shown you how to calculate overheads and some strategies you can use to reduce overhead costs.
All you have to do now is practice and help your business grow financially.