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Overheads

Business costs that are related to the day-to-day running of the business

What are Overheads?

Overheads are business costs that are related to the day-to-day running of the business. Unlike operating expenses, overheads cannot be traced to a specific cost unit or business activity. Instead, they support the revenue-generating activities of the business.

 

Overheads

 

For example, a vehicle retail company pays a premium rent for business space in an area with adequate space to accommodate a showroom. The premium rent is one of the overhead costs of the business. A business must pay its overhead costs on an ongoing basis, regardless of whether the products are selling or not.

 

Types of Overheads

There are three main types of overheads that businesses incur. The overhead expenses vary depending on the nature of the business and the industry it operates in.

 

1. Fixed overheads

Fixed overheads are costs that remain constant every month and do not change even with the changes in business activity levels. Examples of fixed overheads include salaries, rent, property taxes, depreciation of assets, and government licenses.

 

2. Variable overheads

Variable overheads are expenses that vary with business activity levels, and they can increase or decrease with different levels of business activity. It means that during high levels of business activity, the expenses will increase, but with reduced business activities, the overheads will substantially decline or will even be eliminated.

Examples of variable overheads include shipping costs, office supplies, advertising and marketing costs, consultancy service charges, legal expenses, as well as maintenance and repair of equipment.

 

3. Semi-variable overheads

Semi-variable overheads possess the characteristics of both fixed and variable costs. A business will incur such costs at any given time, even though the exact cost will fluctuate depending on the business activity levels. A semi-variable overhead may come with a base rate that the company must pay at any activity level plus a variable cost that is determined by the level of usage.

Examples of semi-variable overheads include sales commissions, vehicle usage, and some utilities such as power and water costs that have a fixed charge plus an additional cost based on the usage.

 

Examples of Overhead Costs

Overhead costs are important in determining how much a company will charge its products or services in order to generate a profit. The most common overhead costs that any business will incur include:

 

1. Rent

Rent is the cost that a business pays as a lease for using its business premises. If the property is purchased, the rent will be equal to the payments that the business makes as mortgage installments.

Rent is payable monthly, quarterly or annually, as agreed in the tenant agreement with the landlord. When the business is experiencing slow sales, it can reduce its cost by negotiating the rental charges or moving to less-expensive premises.

 

2. Administrative costs

Administrative costs are costs related to the normal running of the business and may include costs incurred in paying salaries to the receptionist, accountant, cleaner, etc. Such costs are treated as overhead costs since they are not directly tied to a particular function of the business and they do not directly result in profit generation. Rather, administrative costs support other functions of the business.

Examples of administrative costs may include audit fees, legal fees, employee salaries, and entertainment costs. A business can reduce administrative expenses by laying off some of its employees, switching employees from full-time to part-time, hiring employees on a contract basis, and eliminating certain expenses such as entertainment and office supplies.

 

3. Utilities

Utilities are the basic services that the business requires to support its main functions. Examples of utilities include water, gas, electricity, internet, sewer, and phone service. A business can reduce its expenditure by reducing the costs incurred on utilities.

For example, a business can cut electricity expenses by using alternative sources of energy such as solar energy and wind, which are also friendly to the planet. Internet and phone service costs can be reduced by switching to low-cost plans that are still sufficient for the company.

 

4. Insurance

Insurance is a cost incurred by a business to protect itself from financial loss. There are various types of insurance covers depending on the risk that is likely to cause loss to the business. For example, a business may purchase property insurance to protect its property or business premises from certain risks such as flood, damage, or theft.

Another type of insurance is professional liability insurance that protects the business (such as an accounting firm or law firm) from liability arising from malpractice. Other types of insurance include health insurance, home insurance, renter’s insurance, flood insurance, life insurance, disability insurance, etc.

 

5. Sales and marketing

Sales and marketing overheads are costs incurred in the marketing of the company’s products or services to potential customers. Examples of sales and marketing overheads include promotional materials, trade shows, paid advertisements, wages of salespeople, and commissions for sales staff. The activities are geared towards making the products and services popular among customers and compete with similar products in the market.

 

6. Repair and maintenance of motor vehicles and machinery

Rent and maintenance overheads are incurred in businesses that rely on motor vehicles and equipment in their normal functions. Such businesses include distributors, parcel delivery services, landscaping, transport services, and equipment leasing.

Motor vehicles and machinery need to be maintained on a continuous basis and repaired whenever they break down. Related overheads can be minimized by switching to hybrid vehicles or fuel-efficient vehicles/machines.

 

More Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Inventoriable Costs
  • Non Cash Expenses
  • Operating Lease
  • Remuneration

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