written by | May 3, 2022

What Is Overhead Cost and How You Can Calculate It?

Today, let's clarify a big question - "what is an overhead cost," and understand the accurate techniques to calculate the same. There are numerous costs associated with running a business. But, they do not all belong in the same category. One example is overhead expenses, including all the costs not directly related to manufacturing services or products.

These are the costs an organisation has to pay regardless of whether or not it makes anything. Rent uses, insurance, and utility costs belong to this category.

It is essential to understand your overhead costs and the costs directly linked to production. This assists in determining the break-even point of your company (how much it will need to produce and sell to pay all its expenses). It is also an important strategy for identifying ways to reduce costs.

Did you know?

Overhead expenses include interest, legal fees, accounting fees, advertising, insurance, labour burden, rent, taxes, utilities, telephone bills, repairs, supplies, and travel expenditures. There are two sorts of business overheads: manufacturing overheads and administrative overheads.

Also Read: What are the different types of Job Costing Concepts

Overhead Costs

Overhead costs, also known as overhead expenses, are indirect expenses associated with the day-to-day operations of a company. Although they're not directly connected to the product or service, they are non-labour expenses, important to managing an enterprise.

They can be categorised as fixed costs like mortgage and rent and recurring expenses like marketing and administrative costs. If you're not paying attention to your overhead expenses, you'll be ignoring them, which can be harmful in the long run.

The overhead expenses could sneak up on you when you're juggling other major business expenses, like manufacturing, starting expenses, raw materials, and inventory. Since they're not directly connected to earning revenue, they're one of the first expenses to scrutinise when trying to reduce your expenses.

Different Types of Overhead Costs

Overhead expenses can be divided into three categories, which are as follows:

Fixed Overhead Costs

Fixed overhead costs do not alter based on the amount of production. They include rent (office/factory space) and monthly/annual repairs, and various other constant or "fixed" costs that generally are the same. For instance, you will have to pay the same amount to rent factory space or office space, even if the organisation decides to cut production during this period.

Variable Overhead Costs

The quantity of output directly influences variable overhead costs. Therefore, the more products you create, the greater your costs. The variable overheads include:

  • The cost of shipping.
  • Charges for the use of machinery marketing campaigns.
  • The size of production directly influences various other expenses.

Semi-variable Overhead Costs

Some costs stay the same in time, but the exact amount varies depending on the production. In short, businesses have to pay for electricity every month. However, how much they must pay is contingent on the amount of production. For example, during times characterised by high production, the bill will go higher, while the cost decreases in the off-season.

One thing to note is that By analysing both, you may be able to identify opportunities to improve profits for small businesses.

Overhead Cost Examples

An organisation must cover overhead costs in several areas regularly regardless of revenue.

For instance, a company offering services through an office will incur overhead costs, including rent, utility bills, office supplies and insurance. These are not part of the direct costs associated with offering its services. 

Other overhead cost examples include:

  1. Travel for employees
  2. Advertising costs
  3. Accounting and legal costs
  4. Pay and salaries
  5. Depreciation
  6. Licences and fees from the government
  7. Taxes on property

Calculate Your Profit and Overhead

While adopting an industry-standard method for profit, the overhead calculation gets simpler. There are three good reasons why calculating these figures yourself is vital for the success of your construction company.

1. Management of Business

Knowing the actual overhead and profit expense (O&P) enables you to run your construction company confidently. You know how to estimate the cost of projects, the amount of work required to do, and the fundamental requirements your business requires to run.

2. Growth in Business

The most accurate O&P figures help you understand where you can spend money on different resources. These may include marketing, hiring, or acquiring new tools.

3. Protection of Business

An accurate review of your expenses and profit will help you keep your position positive. You'll know areas where you're wasting cash and stop yourself from underquoting work.

Also Read: Why is Maintaining Administrative Expenses Important?

How Can I Calculate Overhead Costs?

To calculate the overhead cost, take these steps:

1). The list of expenses: The first step to decreasing the overhead cost is to compile a detailed list of business indirect expenses (items like tax, factory equipment, rent, office equipment, utilities, etc.). The costs do not affect the process of production directly. However, they add to the overall cost of production.

In determining the indirect and direct costs, it is important to remember that certain items cannot be assigned to a particular class.

2). Add the overhead costs: Involve the overhead expenses to determine the total overhead cost for your company annually, half-yearly and quarterly. It is the sum your business will require to operate the business.

3). Calculate what the overhead cost is: The overhead rate, also known as the overhead percentage, is the sum of money your business spends on producing products or offering services to customers. To calculate your overhead percentage, divide indirect costs by direct costs and multiply them by 100.

4). Compare the sales of the organisation: When setting prices and preparing budgets for the company, it is important to determine the proportion of money allocated to overhead expenses. To determine the number of overhead expenses relative to sales, we will divide the overhead costs per month by the monthly sales, then multiply by 100.

5). Comparing labour costs: We determine the effectiveness of how the resources of a business are being used by calculating overhead costs as a percentage of labour costs. The lesser the percentage, the more effectively the company uses its resources.

We divide the entire overhead cost by the entire labour cost for the whole month and then multiply by 100 to fetch a percentage. 

Overhead Rate vs Direct Costs

In order to measure the overhead rate, you must separate indirect expenses from direct costs, and various estimates of the overhead rate are ratios of one in contrast to the other.

To understand the concept of overhead rate, you need to first be aware of the definition of direct costs and how they function. Direct costs are the expenses paid by a business associated with the business's production activities. The cost of providing the service or operating a specific manufacturing line are good examples.

When you determine your business's overhead rates, it is first necessary to deduct all of these costs tied to specific products. After that, you're left with your overall costs that don't have to be related to specific tasks. They are the total indirect costs (the cost of being in business), including office utilities, equipment rental, administrative staff salaries, etc.

Conclusion

The reduction in overhead expenses often results in greater flexibility. The flexibility in your budget allows you to make strategic business decisions, for example, pricing your products economically or launching new products that could boost your growth.
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FAQs

Q: How to calculate overhead expenses?

Ans:

The overhead rate, also known as the overhead percentage, represents the amount your company spends to create products or offer services to its clients. To determine the overhead rate, divide the indirect costs by direct costs and multiply the result by 100.

Q: What are 3 sorts of overhead costs?

Ans:

The three types of overhead are variable costs, fixed costs and semi-variable costs.

Q: What are overhead cost examples?

Ans:

Following are the examples:

  • Rent
  • Administrative costs
  • Utilities
  • Insurance
  • Sales and marketing
  • Repair and maintenance of machinery and motor vehicles

Q: What are overhead costs in accounting?

Ans:

Overhead cost is very simple to understand. Overhead means the ongoing costs of running a business, but it excludes the direct expenses of creating a service/product. Also, overhead costs can be variable, fixed, or a mix of both.

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