Overhead Expense: Meaning, Types, Examples & Calculation

What is Overhead?

Overhead refers to continuing company costs that are not directly related to the creation of a product or service. It is vital not just for budgeting but also for deciding how much a firm should charge for its products or services in order to earn a profit. Overhead is any expenditure required to sustain the business that is not directly tied to a certain product or service. Overhead expenses appear on a company’s income statement and have a direct impact on its overall profitability. To calculate net income, the corporation must take into account overhead expenditures.

Geeky Takeaways:

• Overhead refers to the continuing expenditures of running a firm but does not include the direct costs connected with developing a product or service.
• Overhead expenses might be fixed, variable, or a combination of the two.
• There are several types of overhead, such as administrative overhead, which comprises expenditures associated with running a firm.
• The income statement discloses overhead charges.

Types of Overhead

Overhead expenditures can be fixed, meaning they always cost the same amount, or variable, meaning they fluctuate based on the degree of business activity. Overhead expenditures can also be semi-variable, which means that the firm incurs some of the expense regardless, while the remainder is determined by the degree of business activity.

1. Fixed Overhead: Fixed overhead refers to overhead expenditures that stay constant throughout time and do not fluctuate with business activity. Fixed overhead stays constant regardless of whether the firm grows or slows. Rent, depreciation, insurance payments, office worker wages, and license fees are some examples.

2. Variable Overhead: Variable overhead refers to overhead expenditures that change with business activity. These are variable overhead charges. As corporate activity grows, so does variable overhead. As economic activity slows, variable overhead lowers. Examples include office equipment, shipping and mailing charges, marketing, legal fees, and upkeep.

3. Semi-Variable Overhead: Semi-variable overhead is a hybrid of fixed and variable overhead, in which some costs are incurred regardless of company activity but may rise as business activity increases. Semi-variable overhead includes commissions and utility bills. Utilities are charged a base fee, with the balance dependent on use.

4. Other Types: Other types of overhead may be suitable, depending on the business. For example, overhead charges might apply to a wide range of operational areas. General and administrative overhead generally covers expenditures associated with a company’s general management and administration, such as the hiring of accountants, human resources, and receptionists.

Examples of Overhead

1. Rent and Utilities: Overhead includes the expenditures of maintaining the office or industrial space that businesses require in order to operate. This covers both rent and utilities, including water, gas, electricity, internet, and phone service. Additional expenses, such as a subscription to virtual meeting platforms like Zoom, must be included in a company’s overhead.

2. Administrative Costs: Administrative expenses are sometimes one of the most expensive components of a company’s overhead. This might include the expense of supplying the office with supplies, employee salaries, and external legal and audit costs.

3. Insurance: Businesses, depending on the industry, are obliged to carry a variety of insurance policies in order to function efficiently. These can include basic property insurance to safeguard the company’s physical assets from fire, flood, or theft, as well as professional liability insurance, employee health insurance, and auto insurance for company-owned vehicles.

4. Employee Perks: Many bigger organizations provide a variety of advantages to their employees, like keeping their offices stocked with coffee and food, offering gym discounts, conducting corporate retreats, and supplying company automobiles. All of these expenditures are considered overhead since they have no direct influence on the company’s products or services.

Why is Overhead Cost Important?

1. An understanding of the overhead costs makes it easier to evaluate how much a company’s product or service must cost to achieve adequate profits.

2. Overhead is often a broad expenditure, which means it affects the entire company’s activities.

3. It is often amassed as a lump payment, which may subsequently be assigned to a specific project or department depending on cost drivers. For example, utilizing activity-based costing, a service-based organization might distribute overhead expenditures depending on the activities accomplished within each department, such as printing or office supplies.

4. Overhead costs are essential because they represent the expense of running a firm.

5. Understanding and managing the overheads of a company, particularly how it relates to the companies production, can help management keep the firm successful and maximize the sales margins.

6. Overhead expenses are essential and inevitable. However, if you fail to keep track of your overheads, they can eat away at your earnings and destabilize your firm.

How is Overhead Calculated?

Overhead is frequently considered a general expenditure, so it is accrued in one single payment. This is then applied to a particular product or service. There are a variety of different techniques to calculate overhead. Knowing your overhead cost will allow you to calculate the overhead rate based on the price of your product or service. The net income will increase as the overhead rate decreases. For example, suppose a firm has ₹10,000 in overhead expenditures and ₹50,000 in sales per year. The following calculation can be used to establish the rate:

Formula of Overhead

[Tex]Overhead~Rate=\frac{Overhead~Expenditures}{Sales}[/Tex]

I.e., the company has used ₹1 in overhead to generate a sale of ₹5.

How to Allocate Overhead Costs?

The overhead rate is a cost associated with the production of a product or service. Overhead expenditures are expenses that are not directly related to production, such as the cost of the corporate office. To distribute overhead expenses, an overhead rate is used to direct production costs by spreading or distributing them according to particular metrics.

For example, overhead expenses may be imposed at a fixed rate depending on the number of machine or human hours necessary for the product.

Let’s assume a company has overhead expenses that total ₹20 lakhs for the period. The company wants to know how much overhead relates to direct labor costs. The company has direct labor expenses totaling ₹5 lakhs for the same period.

Overhead Rate = ₹4, meaning that it costs the company ₹4 in overhead costs for every rupee in direct labor expenses.

How to Reduce Overhead Cost?

1. Negotiate Contracts: Renegotiate your vendor contracts on a regular basis to guarantee you obtain the best available costs. Consider multi-year contracts to increase your savings.

2. Utilize Group Purchasing Organizations (GPOs): Joining a GPO allows you to utilize group purchasing power to get discounts on goods and services.

3. Use Lean-Startup Strategies: You may decrease waste and overhead expenses by identifying and eliminating unproductive processes utilizing a lean startup methodology.

4. Optimize Software Subscriptions: Regularly examine your software requirements and terminate any superfluous subscriptions. Consider employing open-source solutions whenever feasible.

5. Go Paperless: Switch to a digital-first strategy for administrative chores. This can help lower the cost of paper, printing, and storage.

6. Outsource Jobs: Consider outsourcing jobs that aren’t critical to your firm, like accounting or human resources, to eliminate the need for full-time employees and related costs.

7. Implement Energy-Saving Techniques: Invest in energy-efficient appliances and encourage staff to use less energy to save money on power costs over time.

Overhead – FAQs

What are overheads?

Overhead refers to continuing company costs that are not directly related to the creation of a product or service.

What are the types of overheads?

There are three main types of overhead costs: administrative costs, selling costs, and manufacturing costs.

How can training reduce overhead costs?

Investing in training can boost staff productivity while reducing the need for pricey external consultants.

What are the examples of variable overhead cost?

• Electricity
• Equipment repairs and maintenance
• Office supplies
• Overtime wages
• Legal expenses