What is overhead?
Overhead costs refer to current commercial expenses that are not directly attributable to the creation of a product or service. It is important for budgetary purposes but also for determining how much a business must charge for its products or services to make a profit. In short, overhead costs are expenses incurred to support the business without being directly related to a specific product or service.
Key points to remember
- Overhead costs refer to the ongoing costs of operating a business, but exclude the direct costs associated with creating a product or service.
- Overhead costs can be fixed, variable, or a hybrid of the two.
- There are different categories of overheads, such as administrative overheads, which include the costs of running a business.
- The profit and loss account reports overhead costs.
Understanding overhead costs
A business has to pay overhead on an ongoing basis no matter how much or how little it sells. For example, a service business with an office has overhead costs, such as rent, utilities and insurance, which add to the direct costs of providing its services.
Expenses related to overheads appear in the income statement of a business and directly affect the overall profitability of the business. The company must take into account overhead costs to determine its net profit, also called net profit. Net income is calculated by subtracting all production and overhead expenses from the company’s net income, also called the “top line”.
Overheads can be fixed, which means that they are the same amount each time, or variable, which means that they increase or decrease according to the level of activity of the company. For example, the payment of rent for a business may be fixed, while the cost of shipping and delivery may be variable. Other examples of fixed costs include depreciation of capital assets, insurance premiums and office staff salaries.
Overhead costs can also be semi-variable, which means that the company incurs part of the expenses, no matter what, and the other part depends on the level of commercial activity. For example, many public service costs are semi-variable with a basic charge and the rest of the charges are usage-based.
Allocation of general expenses
Overhead costs are generally overhead costs, which means that they apply to the operations of the business as a whole. It is generally accumulated as a lump sum, in which case it can then be allocated to a specific project or service depending on certain cost drivers. For example, using activity costing, a service-based business can allocate overhead costs based on activities performed in each service, such as printing or office supplies.
Types of overhead
Overhead costs can apply to various operational categories. General and administrative costs have traditionally included costs related to the general management and administration of a business, such as the need for accountants, human resources and receptionists. General selling costs relate to activities related to the marketing and sale of the good or service. This can include print materials and television commercials, as well as sales staff commissions.
Depending on the nature of the business, other categories may be appropriate, such as general research costs, general maintenance costs, general manufacturing costs or general transport costs.