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 overall revenue-generating activities of the business.
For example, a vehicle retail company pays a premium rent for business space in an area with additional 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 its products are selling or not.
- Overheads are business costs that are related to the day-to-day running of the business.
- Overhead expenses vary depending on the nature of the business and the industry it operates in.
- Overhead costs are important in determining how much a company must charge for its products or services in order to generate a profit.
Types of Overheads
There are three main types of overhead 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 with 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. During high levels of business activity, the expenses will increase, but with reduced business activities, the overheads will substantially decline or 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 some of the characteristics of both fixed and variable costs. A business may incur such costs at any time, even though the exact cost will fluctuate depending on the business activity level. 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 must charge for its products or services in order to generate a profit. The most common overhead costs that any business incur include:
Rent is the cost that a business pays for using its business premises. If the property is purchased, then the business will book depreciation expense.
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 this cost by negotiating the rental charges or by 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 a 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 the general running 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, or by eliminating certain expenses, such as entertainment and office supplies.
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 may be able to reduce utility expenses by negotiating for lower rates from suppliers.
Insurance is a cost incurred by a business to protect itself from financial loss. There are various types of insurance coverage, depending on the risk that may 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 a 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 toward making the company’s products and services popular among customers and to 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.
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 CFI resources below will be useful: