All business owners can attest to the fact that it takes money to make money. Costs associated with product and service creation are known as “direct costs”. Expenses that are not directly associated with creating a service or product are called “overhead costs” or “indirect costs.”
If you are not careful as a business owner, your overhead costs could drain your revenues. Take the time to understand how to calculate overhead costs. Knowing these numbers can also help you cut back on your expenses.
What Are Overhead Costs?
Overhead costs are any costs you incur when running your business that isn’t directly attributable to the following categories:
- A portion of the company’s income
- Business activity
In other words, overhead costs are indirect costs such as:
- Administration costs
- Property taxes
- Licenses and permits
- Office supplies/equipment
How Do Overhead Expenses Differ From Operating Expenses?
Operating expenses are also known as manufacturing expenses. These are costs incurred when making a product or providing a service. For example, if you make fragrances for humidifiers, you may need to use essential oils as one of the ingredients. The more fragrances you make, the more essential oils you will need to buy. The expenses associated with buying essential oils may change, but the number of machines you use will remain the same for at least some time.
Total overhead costs have to do with running a small business and selling a product or service. Think of it this way: if you went on vacation, you would still have to pay your office rent or mortgage payments, liability insurance, and internet bill, among other bills. These costs are what make up the business expenses that are often shown on your balance sheet covering business operations.
Examples of Overhead Costs
Overhead costs are indirectly linked 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.
Examples of overhead costs are:
- Office supplies
- Salaries and wages
- Property taxes
- Accounting expenses
- Legal expenses
- Employee salaries
Types of Overhead Expenses
There are three types of overhead costs:
- Fixed overhead expense
- Variable overhead expenses
- Semi-variable overhead expenses
1. Fixed Overhead Costs
Most business overhead costs fall under this category. These costs remain the same every month, no matter how much profit you make or what your business activity level is. Some examples of fixed overhead expenses are:
- Property taxes
- Business insurance
- Payroll costs
- Software subscription
- Loan interest rates
2. Variable Overhead Costs
Variable expenses vary from month to month and can also be considered direct expenses on your financial statements. It should also be noted that not every business incurs variable overheads—instead, it depends on the nature of your business.
Some general examples of variable overhead costs include:
- Office supplies
- Administrative costs
- Shipping expenses
- Advertising and marketing expenses
- Legal fees
- Consultation fees
Variable costs are hard to predict. At times, they might get out of hand, as we saw with the COVID-19 pandemic, where businesses had to buy safety clothing and gear for their employees.
3. Semi-Variable Overhead Costs
Utilities are semi-variable costs, meaning they occur every month, although the rate or cost may vary. A good example of a semi-variable expense is the electricity cost. During months when your office is hot and air conditioning is a must, the power bill will be more expensive than it is in cold-weather months.
General examples of semi-variable overhead expenses include:
- Travel expenses
- Company car
- Hourly wages
What is Fixed Overhead?
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 in order for a business to remain operational. Your administrative overhead and manufacturing overhead both fit into this bucket.
Always be aware of the total fixed costs that a business incurs. This is necessary in order for management to plan for a sufficient amount of contribution margin from the sale of products and services so they can at least offset the amount of fixed overhead.
Examples of fixed overhead include:
- Insurance for product equipment
What is Variable Overhead?
The term “variable overhead” refers to the manufacturing expenses that shift roughly in proportion to the amount of goods being produced. This idea is to model the future amounts of spending that will be incurred by your business, as well as determine the minimum price at which a product should be offered for sale.
Variable overhead costs incurred by a business can be:
- Equipment utilities
- Production supplies
- Materials handling wages
What is Semi-Variable Overhead?
Some of the features of both fixed costs and variable costs are present in semi-variable overheads. These characteristics include the possibility for a company to incur such costs at any point in time, despite the fact that the precise cost will change depending on the activity level of the company.
A semi-variable overhead may have a base fee 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 Burdened Overhead?
The cost of manufacturing a product can be driven higher by hidden expenses known as “burden costs.” These expenses might be related to labor or inventories. The production of a good is not directly tied to overhead costs.
Labor burdens are expenses your business incurs that extend beyond the payout of regular salaries, including:
- Health Insurance
- Education (certifications, training, etc.)
- Payroll Taxes
- Workers’ Compensation
The inventory burden is calculated separately from other costs. In this instance, you’ve opened a business and purchased all the necessary equipment. Inventory burden focuses on the costs incurred to keep the machinery running daily for the purpose of product output. The sum of what it costs will then be added to the cost of producing the product to give you the inventory burden.
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 overhead rate of the company, divide the entire amount of overhead costs incurred by the company in a given month by the company’s monthly sales. This figure has to be multiplied by 100 to determine your overhead rate.
Overhead Rate = Overhead Costs / Sales
Ultimately, overhead costs can be used in a number of different operational categories. General and administrative costs like hiring accountants, human resources, and receptionists are usually included in general and administrative overhead. Marketing and selling the product or service are examples of selling overhead. This can include commercials on TV, printed materials, and commissions for salespersons.
Nav helps you access business capital so you can fund all necessary costs without breaking the bank. Our platform makes it easy to instantly find your best options for small business loans and business credit cards. To improve your funding options, learn how to establish business credit, as well as explore our website for more resources specific to the nature of the business you’re running.
This article was originally written on June 27, 2022.