Overhead Costs Explained – Everything You Need to Know

(Last Updated On: March 18, 2022)

Businesses incur overhead costs during everyday operations, and it’s important for business owners to understand how these costs affect their bottom line, or how they can reduce them. In this article, we shall talk about the types of overhead costs, how to calculate them, and the differences between overhead costs and operating expenses.

What Are Overhead Costs?

Overhead costs are fixed indirect costs incurred by businesses. They aren’t directly linked to the creation or manufacture of a product or service. These are the costs a company occurs to stay in business and generally support all revenue-generating activities.

Overhead costs generally include fixed costs, including mortgage or rent, insurance fee, employee payroll, utilities, legal costs, and administration costs. These can be further broken down into two categories: fixed and variable costs.

What Are Fixed Overhead Costs?

Fixed overhead costs do not fluctuate based on a business’ varying levels of activity. They tend to remain constant on a month-to-month basis. For instance, rent is a common example of a fixed overhead cost. Another common examples include mortgage payments, property taxes, business licenses, and more. 

 

What Are Variable Overhead Costs?

Conversely, variable overhead costs are business expenses that are linked to a business’ activity levels, and tend to fluctuate accordingly. As business activity levels increase, so do variable overheads, and vice versa. Common examples of variable overheads, include shipping costs or maintenance expenses.

Also see: What is the predetermined overhead rate

How Do You Calculate the Overhead Rate?

The overhead rate refers to the percentage of overhead costs that a business incurs in providing services or manufacturing products. To allocate overhead costs to a product or service, businesses apply the overhead rate to the direct costs incurred during production.

To calculate the overhead rate, you first need to determine an allocation measure or an activity driver. Businesses generally allocate overhead costs based on the number of direct labor hours or machine hours worked.

The formula to calculate the overhead rate is as follows:

Overhead rate = Indirect costs / Overhead Rate Measure

For instance, if total overhead indirect costs were $500,000 in 2021, and total machine hours (the overhead rate measure in this manufacturing example) worked were 40,000 to produce goods.

By dividing $500,000 by 40,000, the overhead rate will come out to $12.5. This implies that a company spends $12.5 in overhead expenditure for each machine hour worked during production. This can help with accurately pricing the product.

Examples of Overhead Costs

There are several examples of overhead costs, some of which are discussed below:

Administrative Expenditure

Administrative expenses generally constitute the bulk of overhead costs and mainly include costs associated with handling the day-to-day operations of the business. Administrative expenditure costs are related to purchasing office supplies, paying office associates, including any auditing or legal costs.

Rental Expense and Utilities

Both the rental expense incurred by the company as well as the amount paid for utilities such as gas, electricity, telephone service, or internet costs each month are attributed to overhead costs. In some cases, subscription costs for software might also be included in overhead.

Insurance Costs

The insurance premium paid by the company to protect itself from fiscal loss is also an overhead cost. This includes business liability insurance, health insurance, property insurance, and other types of insurance coverage that the business uses.

Repairs and Maintenance of Plant and Machinery

Plant and machinery often need to undergo routine maintenance, Apart from this, costs associated with the repairs and maintenance of vehicles and other equipment owned by the business are also attributed to overhead costs.

Why Is It Important to Calculate Overhead Costs?

Calculating overhead costs is very important for businesses as it directly impacts a company’s financial statements. Overheads are incurred regardless of a company’s activity levels, so they’re a constant presence on your income statement and balance sheet.

While it’s easy to calculate the cost of inventory, raw materials, or the labor that goes into the final product, it would be a mistake to just look at those costs and add markup as every business as many other costs that need to be accounted for.  

This can help finance leaders make better decisions that can affect a company’s performance. For instance, if a product is priced based solely on direct costs, it can reduce profits. By factoring in normal overhead costs, companies can sell goods without hurting their bottom line.

There are also strict accounting requirements where businesses must allocate costs to the goods or services they produce, which is why calculating and accounting for overhead costs is so important.

What Are the Differences Between Overhead Costs and Operating Expenses?

There are numerous differences between overhead costs and operating expenses. The latter refers to expenses incurred by the company during its normal course of business. They’re generally unavoidable expenses and appear on the income statement. Common examples include direct labor costs or materials required to manufacture a product.

Overhead costs, on the other hand, are costs that don’t directly relate to labor or materials. These are costs that relate to core business functions, including administration expenses, costs of maintenance, or rent. Unlike operating expenses, overhead costs are incurred even if a company does not partake in any revenue-generating activity.

How Often Should You Calculate Overhead Rate?

The overhead rate is used to allocate overhead costs, which is essential for determining the costs of manufacturing a product or offering a service.

Ideally, businesses should calculate their overhead rate after every financial year. They can get relevant figures from the financial statements and use those to determine overhead expenses for the previous year.

Smaller businesses can also calculate the overhead rate each quarter and allocate costs more efficiently. Calculating the overhead rate more frequently allows companies to quickly make key adjustments that prevent indirect expenditure from negatively affecting their product pricing and profit margins.