What are overhead costs

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One of the popular phrases in the business world is “You have to use money, to make money”. Quite a convoluted statement to start a post with isn’t it? But it is true to an extend. I say this because, while it is true that you have to spend money to generate some more, it also critical that the money is spent in the right areas and not just spending for the sake of it.

Overheads are a sensitive area in any business, and if not carefully managed it can easily become a thorn in a company’s revenue stream. Below is all the information you need to know about overhead costs and how to calculate them.

So, what are overhead costs?

Overhead costs or indirect costs are operating expenses that are not directly related to the cost of producing or creating a product or service. They are necessary expenditures that businesses have to spend for them to remain in business, irrespective of their success levels. They are categorized into three that is; fixed costs, variable costs, and semi-variable cost.

Cost of goods sold + Overhead Cost =Operating Cost

Overhead cost is one of the elements of a business’s total operating cost. As earlier mentioned, overhead costs are expenditures that are not closely related to what the business is selling or offering. If you take an example of a hotel business, the overhead cost would include things like; costs for maintaining common areas, bathrooms, lights, sanitation, and other utilities.

Calculation of overhead costs is essential in establishing how much should a business charge for its service, or product. It is also one of the things that are considered when developing a business or a company’s budget.

To reduce overhead costs, you’ll have to consider cost reduction measures such as; minimizing utility bills, renting equipment, and renegotiating rent contracts.

Examples of overhead costs

Overhead costs depend on the type of business a company is involved in. For instance, the overhead cost of a company dealing with travel and tourism will have some difference with say, a car manufacturing company. Some examples of common overhead costs include; Rent, office supplies, insurance, utilities, salaries (that aren’t a product or job-specific), office equipment among others.

Types of overhead cost

As noted above, overhead costs are classified into three categories i.e. fixed, variable, and semi-variable.

Fixed costs, as the name suggests, are similar each month. For example rent, salaries, insurance, taxes, among others. Variable costs, on the other hand, decreases or increases depending on how demanding the business is. Examples are; wages, some utility costs, among others.

Semi-variable costs are the ones that are incurred irrespective of the activity level but can increase as the business increases. An example is a secretary working in an office, who uses a toner, but might require more toners at the end of each quarter due to the end of quarter report writing and presentations which requires printing.

Some companies also classify these overheads into categories such as; sells overhead and administrative overheads. For sales overheads, these are the costs that are associated with sales and marketing of certain goods or services. Examples of sales overheads include;

  • legal expenses and after-sale service costs
  • Showrooms expenses, advertisements, and cost for printed materials
  • travel expenses, commission and sales agents salaries

As for administrative overhead expenses, this are cost incurred in relation to administrative and general management functions of the business or company. Some examples include;

  • bookkeeping
  • Human resource
  • Payroll
  • Outside legal and office fees
  • Office supplies

Since overhead expenses have no direct impact on the generated revenue, it is easy to forget about them, and therefore, it is prudent that these expenses are frequently monitored. Also note that, though it doesn’t have a direct relation to revenue, it can have a negative impact on a business’s financial performance if it is not properly managed.

A good example of unnecessary overhead cost is a businessman with a start-up business, who decides to open up an office in a posh neighborhood for an activity or operation that he could have done at home, at least until the business grows and demands more office space, equipment, and workers. The money paid he paid for rent, could have been used to pay for the advertisement and promotion of his new business.

How to minimize overhead cost

One way of increasing profits and improving cash flow is by minimizing overhead costs. Here are some tips on how to minimize overhead costs

  1. Evaluate your overhead cost; the first step in minimizing overhead cost is to assess your overhead expenses and mark those that are unnecessary, too expensive, and lastly, those that are open to efficiencies. After you have identified the ones that you can reduce or do without, it is prudent that you remove them from your expenditures.
  2. Get rid of all unproductive marketing expenditures. Marketing has nowadays gone digital with social media (Facebook twitter WhatsApp) dominating the marketing space. This has made marketing to be more targeted and more cost-effective.
  3. Cut down on the travel expenditures. Travelling can be pretty expensive and reducing these trips can save you a lot of money.
  4. Re-assess your business needs and identify and eliminate unnecessary expenditures. Additionally, you can negotiate with your suppliers and vendors for a better price than what they are currently offering.
  5. Think of outsourcing tasks; Instead of hiring new staff to perform certain duties such as accounting, cleaning, website maintenance or tax deduction, why don’t you outsource them to third-parties. This will help in cutting -off employee-related costs such as pension and health benefits.
  6. Reevaluate software upgrade: Software upgrades are expensive and not all upgrades are mandatory. There is very minimal resale value for software and computers. So, even though your staff are pressuring you for software upgrades, consider scaling down. Instead of purchasing the rather costly software for your entire team, why don’t you instead purchase licenses for employees who truly need them?

How to calculate overhead Cost

To calculate the overhead costs, you will first need to identify all the overhead expenses that were incurred over a certain period of time (preferably this should be done per month). Even though most indirect costs are overheads, you need to be careful when categorizing these expenses.

For instance, the majority of businesses out there classify legal fees as an overhead cost. However, for a legal firm, legal fees fall under direct cost.

After you’ve classified all the expenses, the next thing is, to sum up, all the over head cost for that specific accounting period.

You can then calculate the percentage by dividing the overall overhead cost with the total sales then multiplying it by 100. This percentage informs you or stakeholders of how much your business has spent on direct costs, and how much on overhead costs.

Calculating overhead rate

To determine the overhead rate, you will need to divide the total monthly overhead costs with the total monthly sales and then multiply it by 100. For example, if business X total monthly overhead cost is $20000 and its total monthly sales is $100,000, the overhead rate will be:

Since,

Overhead rate = Total overhead cost/Total sales

The overhead rate will, therefore, be, 20000/100000 = 0.2 which is equivalent to 20%

This, therefore, means that the business used 20% of the total generated revenue on overhead expenses.

Conclusion

Overhead costs are pretty much all the expenses listed on a business income statement, except those that are directly associated with the manufacture, production, or those directly related to service delivery. Overheads are important during the development of the budget, and when determining how much money a company should charge for its service or product. Lastly, for any business to succeed, it has to have a manageable overhead cost and this should be continuously monitored so that it does not spill out of control.

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