Overhead Costs: What is “Overhead” and How to Reduce Overhead Costs
Updated May 26, 2020
Overhead, otherwise known as overhead costs, refers to the ongoing expenses associated with operating a business. Understanding your overhead costs and keeping them under control is essential to success as a business owner. Learn how with Credibly.
What are Overhead Costs?
Overhead costs represent business expenses that are not directly related to making a product or performing a service. These are expenses such as rent, insurance, and utility, which are generally fixed costs that cannot be attributed to a specific product or service. On the other hand, labor, materials, machinery, and other production costs would not be considered overhead.
Overhead Costs + Cost of Goods Sold = Operating Expenses
Overhead costs are just one component of a businesses’ total operating expenses. As mentioned above, overhead costs are expenses that are unrelated to what the business is selling, while the cost of goods sold are the expenses attributed to a business’s products or services. For example, McDonald’s overhead would include the costs associated with maintaining bathrooms, common areas, and sanitation, lights, and other utilities. Input costs like ingredients, kitchen equipment, cups, and packaging would be examples of expenses related to the cost of goods sold.
Fixed expenses are costs that remain the same every month, regardless of whether there is an increase or decrease in production. The following list includes some common fixed expenses that you may find in your business.
- Real estate and property tax
- Payments to employees (wage and salary, not including overtime or bonuses)
- Some debt expenses
- Insurance and rent
- Some utilities (like phone and internet)
- Interest on mortgage
- Janitorial services
- The costs of setting up machinery and equipment
Variable expenses are the opposite of fixed expenses and represent the costs that increase with production or activity, such as:
- Some utilities, such as water or electricity
- Seasonal staff or events
- Some debt expenses
- Commissions to sales representatives
Semi-variable expenses, also known as mixed costs, contain both fixed and variable costs and typically constitute a fluctuating increase in a fixed expense. Costs are fixed for a certain level of production or consumption but become variable once this production level is exceeded. Examples of semi-variable expenses include raw material costs used in production, direct labor costs (overtime and bonuses), and some utility costs (data packages, mobile phone bills, etc.).
Categories of Overhead Expenses
When it comes to overhead, there are both general overhead expenses and specific categories of overhead expenses. General overhead expenses are those that affect the entire business whereas administrative overhead, selling overhead, and other overhead categories are associated with specific business activities.
Administrative overhead includes the costs related to the general management and administration of a company, such as:
- Human resources
- Office supplies
- Outside legal and office fees
Selling overhead includes costs related to activities involved in marketing and selling a good or service, such as:
- Sales representative’s salaries, commissions, and travel expenses
- Printed materials, advertisements, and showroom expenses
- After-sale service and legal expenses for recovering debt
Other Types of Overhead Costs
There are many other categories of overhead expenses and these categories are usually specific to the type of business. For example, research and development overhead costs represent expenses related to the research and development of a good or service, such as new technology. Manufacturing and distribution overhead represents factory-related expenses that are not directly involved in the manufacturing of a product, such as factory supplies or the electricity needed to power the building. The best way to identify and categorize your overhead costs is to understand all aspects of your business and the activities related to producing your goods or service and maintaining operations in general.
Calculating Overhead Rate
Overhead rate (overhead percentage) is the amount your business spends to provide your customers with your product or service. Understanding the rate of overhead is critical as it prevents you from overstating profits so that you do not pay more income tax than necessary. While there are numerous ways to calculate the overhead rate, below is the basis for any calculation:
Overhead Rate = (Indirect Costs / Allocation Measure)
- Indirect costs include the costs that are not directly tied to the production of a product or service
- The allocation measure is what is necessary to produce the product, service, or time period (direct labor hours, machine hours, etc.)
- Overhead rate is calculated based on a specific period and/or business activity so it’s crucial to understand what you wish to analyze
With a granular understanding of how much it costs in overhead to produce a specific product or service, management can more effectively manage the business’s profit margin. In general, companies that are successful in monitoring and managing their overhead rate are well-positioned to improve their bottom line or profitability.
How to Reduce Overhead Costs
Reducing overhead costs is a great way to increase profitability, ensure ample cash flow, and in turn, protect your business in the event of unexpected expenses or a reduction in sales. Below are some tips that can help you reduce some common overhead costs.
- Cut travel expenses. Travel can be very costly so try to limit unnecessary trips and expenses as much as you can. (ie. share hotel rooms, plan to travel around cheaper flights when possible, etc.)
- Reduce or unproductive marketing expenses. Marketing has become increasingly more targeted with technology, meaning you can spend your marketing dollars more efficiently. Carefully review all of your marketing strategies and replace unproductive channels and campaigns with free alternatives.
- Evaluate your business needs and negotiate with your vendors. If you take a granular look at your business expenses there’s a chance it does not perfectly line up with what you need. Cutting unnecessary expenses and renegotiating with your vendors and suppliers can save you serious monthly costs.
- Hire an accountant to ensure your cash flow is well managed and that you receive all qualified tax deductions.
- Making good hiring decisions.
Make good hiring (and firing) decisions. While most businesses will need to fill hiring gaps from time to time, ensuring that you hire employees who can be a long-term asset is a huge cost saver. After all, studies show that most new employees are not productive until they have been in their role for one to two years. Replacement costs can be high but if a current employee is hurting your business or not being productive, you must fix the dynamic and you cannot be afraid to let them go if the behavior cannot be corrected.
Director, Marketing & Strategic Partnerships at Credibly