What are Overhead Costs?
Many of the costs a business incurs doing business come down to its ability to deliver a product or service to customers. But not all of them. Companies need to consider overhead costs as well. These are indirect expenses related to the whole company or operation, which don’t directly contribute to the end-product or service. As a result, they’re not traceable to a specific unit of output.
The simplest way to identify overhead costs is to look at known expenses. These are costs the business is responsible for regardless of its sales revenue. It doesn’t matter how many Widgets you sell, the rent is still $10,000. Likewise, business insurance still costs the same, regardless of how high (or low) your sales figures are. There’s just no getting around overhead: it’s something every business has.
Types of Overhead Costs
There are generally three types of overhead costs most businesses need to consider: fixed, variable and semi-variable.
- Fixed costs. These are costs that stay the same month-over-month, regardless of external factors. The best examples include rent, insurance and interest payments. Other examples of fixed overhead include services such as website hosting, janitorial contracts, property taxes, phone plans and PO box rental.
- Variable costs. Variable costs are those that fluctuate, but still incur on a regular basis and aren’t contingent on sales. Utility bills are the best example, since they fluctuate depending on how much water, electricity or gas used. Other examples of variable overhead include equipment repairs, seasonal staff salaries and vehicle maintenance.
- Semi-variable costs. Semi-variable costs are a recurring type of overhead that the business can control. Phone plans are a great example of this. For example, you might pay $200/mo. for a standard phone plan, but incur additional costs when you go over a data cap. Other examples include staff bonuses, bookkeeping charges and professional services.
Overhead isn’t just one category on an income statement, either. These costs split out into different categories depending on the cost center they’re associated with. For example, bookkeeping expenses would be administrative overhead, while mileage reimbursement might fall under transportation overhead. Companies need to be diligent in how they categorize and report overhead costs.
Overhead vs. Operating Expenses
There tends to be some confusion when it comes to distinguishing overhead costs and operating expenses. While the two might rub up against each other on the income statement, there are important factors that differentiate them.
- Overhead costs pertain to running the business itself. They’re not tied to the cost of production, which means management can assess and adjust them with relative ease.
- Operating expenses are directly tied to the production of a good or service. They’re more difficult to exercise control over. Management needs to balance them.
The simplest way to tell these costs apart is by looking at what they enable. Operating expenses are the cost of doing business, while overhead expenses are the cost to run the business.
Overhead Costs and Their Impact on Net Profit
Overhead costs are one of the key variables in determining a company’s net profit for an accounting period. The equation for net profit is:
Net Profit = Total Revenue – Total Expenses
Overhead costs are part of total expenses. And, because companies can exercise control over overhead more easily than COGS or operating expenses, overhead becomes a focal point for efficiency. The lower a company is able to keep total expenses via overhead control, the higher its net profit (independent of revenue).
How to Cut Back on Overhead
Cutting back on overhead expenses is usually one of the first levers a business will pull as it seeks to improve net profit. There are varying degrees of ease by which it can reduce or eliminate overhead.
- Cutting superfluous or luxury expenses is an easy way to recoup cash. For example, instead of chartering private jets to regional business meetings, company executives might fly commercial, saving thousands.
- Negotiating better rates or choosing smarter service options can reduce overhead. For example, a company might shop around for better insurance rates. It might be possible to find similar coverage for a rate that’s 10-15% lower.
- Changing the business model can result in lower overhead. For example, outsourcing marketing to a PR firm eliminates this cost from the budget and might enable the business to move into more cost-efficient facilities.
- Developing or identifying efficiencies might enable a business to decrease overhead without changing operations. For example, leveraging automation to reduce the number of administrative man hours spent on a task.
It’s important to see beyond the cost attached to overhead. All of the above are viable options for conserving dollars, but they only make sense if they do so without harming the business. Getting a better insurance rate at the expense of inadequate coverage or downsizing the marketing department and losing brand identity in the process will both create long-term damage that costs more to fix than the company might save.
The Cost to Run the Business
Overhead costs are unavoidable when it comes to running a business. Thankfully, they’re also controllable. Smart companies will strive to keep overhead as low as possible—and in doing so, will see higher net profits. Moreover, companies with the forethought to control overhead show a responsible approach to operations, which keys investors into good fiscal management.
To learn more about financial reporting while expanding your investment knowledge in the process, sign up for the Investment U e-letter below. The ability to run a healthy business with as few extraneous costs as possible is a virtue that’s often rewarded by shareholder confidence—which in turn enables continued growth.