Overhead Costs

What is overhead cost?

Overhead costs are ongoing expenses that a business pays regardless of how much or how little it sells. Unlike the direct costs associated with creating and delivering the company’s products or services (such as materials and labor), overhead costs are indirect expenses.

This means that while overhead costs are a necessary part of bookkeeping in order to stay in business, these costs don’t have direct influence over what a company produces.

Examples of overhead costs are:

Property tax or rent
Website building software
External accounting fees
Liability insurance

Businesses incur overhead costs even if they are going through a slow period, and because of this it’s extremely important to keep close tabs on them.

Types of overhead costs

There are three main types of overhead costs to consider when starting a business:

Fixed overhead

Fixed expenses are ones that will stay the same amount over time, whether it’s monthly, quarterly or annually.

For example, rent for an office or factory space will cost the same month-to-month. The only change you might experience with these expenses is if the cost of rent or services increases over time.

Variable overhead

Variable overhead costs are those that change over time. These are often affected by factors related to the level of business activity.

For example, the cost of driving to and from the office might change depending on the price of gas, or the number of outside client meetings and professional conferences you attend.

Hybrid overhead

Hybrid overhead expenses have a fixed cost with a variable fee applied to them. The cost of utilities in your office or factory is a good example of a hybrid overhead cost.

While the base cost of the services remains relatively the same over time, fees will change during busier office hours when employees consume more resources. During slower seasons, like the December holiday period, fees will likely go down.

Examples of overhead costs

Fixed, variable and hybrid overhead costs can be further broken down into categories. Let’s take a look at the most common examples of overhead below.

Organizational overhead

In order to do business, companies need certain documentation and permits in place.

For instance:

Government-issued licenses
Zoning permits
Liability insurance

This kind of organizational overhead needs to be in place from the start, and businesses can’t afford to lapse on payments for these fixed fees.

Manufacturing overhead

Manufacturing overhead expenses are the costs associated with running and maintaining a place of work.

For example:

Rent or mortgage payments
Utility fees
Property taxes

A business doesn’t need to have a manufacturing plant or factory for this kind of overhead to apply. These fees are relevant for all types of work spaces, whether it's an office, shop or factory.

Unless the facility closes down, manufacturing fees always need to be paid and are a basic part of running a business, although some months may be higher than others.

Administrative overhead

These types of overhead are in-house costs pertaining to anything a business needs to run their back office. For example:

Office furniture
Equipment (including computers and phones)
Payroll system
Business software

These are in-house costs, so businesses using an in-house accountant, for example, wouldn’t count this as administrative overhead. Rather, using automated accounting software like QuickBooks or FreshBooks are fees that would apply here.

When businesses need to cut down on expenses, administrative costs are a good place to start. While many of these expenses will be necessary, there are always ways to scale back resources or digitize previously manual processes to reduce costs.

Personnel overhead

For businesses that outsource work to external vendors or organizations, related fees will count towards overhead costs. For instance:

Accounting services
Legal fees
Seasonal staff wages
Contractor wages

The salaries and wages that paid employees who directly provide your services do not count as overhead, since those are part of your cost of goods.

Sales overhead

This category is pretty cut-and-dried. It includes all the things businesses do to build brand awareness, drive traffic and convert prospects into paying users. For example:

Web hosting and domain name fees
Website design fees
Email marketing software fees
Online ads
TV, radio, or print ads
Billboards and signage

This is one of the more flexible categories of overhead costs. While business’s marketing and sales spendings are usually steady, there are ways to cut back on some of these costs during ebbs in business, and times when they’ll want to increase their efforts.

How is overhead calculated?

Overhead costs need to be separated from total operating costs. Operating costs include both overhead costs and the cost of goods and services. So, the first calculation needed to determine overhead is:

Monthly Operating Costs - Monthly Cost of Goods/Services = Monthly Overhead Costs

In addition to calculating overhead costs, it’s important for businesses to know what their overhead rate is. This will show what percentage of revenue is going towards expenses.

Overhead rate can be calculated using the following formula:

Monthly Overhead Costs / Monthly Sales = Monthly Overhead Rate