Overhead Costs Explained + Examples
Business owners have plenty of expenses to keep track of, from the costs of raw materials to the software they use to wages they pay and more.
Not all costs are the same, though. Some directly apply to the product or service you provide — your direct costs, like cost of goods sold (COGS). If you manufacture products, you have to pay directly for the raw materials.
But you also have costs in the background — costs you deal with regardless of production. Many of these are your overhead costs.
Below, we’ll explain what overhead costs are, then show you how to calculate them to get a better financial picture of your company.
What Are Overhead Costs?
Before defining overhead costs, let’s define the broader category they’re a part of: indirect costs.
Indirect costs are any costs not directly traceable to your product. These are critical to cost accounting, which works together with financial accounting to create your business’s financial picture.
For example, accounting software is an indirect cost if you aren’t an accounting firm.
However, if you are an accounting firm, accounting software may no longer be an indirect cost if you provide some proprietary software to your clients. It becomes a direct cost.
Overhead costs are all the indirect costs involved in running your business. It ends up on the income statement since it’s money you’re spending.
Types of Overhead Costs
Fixed
Fixed overhead costs remain the same every month. For example, your rent doesn’t change, making it a fixed overhead cost.
Same with something like inventory storage. Inventory itself isn’t overhead, but the cost of the building you house it in might be.
Another example might be insurance costs. Your insurance premium remains the same month-to-month, meaning it falls under the fixed overhead cost category.
Salaries can be a bit confusing. Although they can change every year due to raises, they are still considered fixed because they remain the same month-to-month. As for hourly wages, any you pay for regular work hours are considered fixed costs.
Variable
Variable overhead costs can change depending on your firm’s activity level.
For instance, say you’re a manufacturer. Shipping costs or the cost of repairing machinery would be variable costs.
Back to salaries and wages again: any money you pay to employees (working on products or services) outside their regular hours is a variable cost since it’s less predictable. For example, an hourly employee’s overtime pay is variable. Sales commissions are also a variable overhead cost.
Semi-Variable
Semi-variable costs — also called semi-fixed costs and mixed costs — contain components of fixed and variable costs.
Utilities may be considered semi-variable costs since you pay a minimum amount regardless of your activity. For example, you might pay $1,000 a month just to power the lights and computers, which is the fixed component. Any electricity beyond that depends on your production activity, the variable component.
Calculating Overall Overhead Per Product
Knowing how much overhead you spent per product or service sold is a helpful figure. It informs decision-making regarding increasing efficiencies and cutting costs, helping you boost your net income.
You can’t attribute overhead costs directly to products or services without doing a little math, though.
First, add up all of your overhead costs. This will tell you what portion of your total revenue you spend on these overhead costs.
After that, you divide the total overhead costs by your revenue to see how much overhead you’re spending per product. Multiply by 100 to arrive at a percentage — that’s your overhead rate.
For example, say you’re a manufacturer that did $100,000 in sales and spent $30,000 on overhead. Here’s the math:
$30,000/$100,000 = 0.3
0.3 x 100 = 30%
In other words, you spent $0.30 on overhead for every dollar of revenue you bring in on all your products or services.
Allocating Overhead Costs
Since overhead isn’t directly traceable to the products or services you provide, you must allocate it to specific parts of the company based on cost drivers — certain things that influence business activities.
An example of a cost driver in manufacturing would be machine hours. These are the hours your machines spend making products on the factory floor.
By allocating based on cost drivers, you can get as accurate a picture as possible of which parts of your company are most reliant on your overhead spending. From there, you can estimate future costs for making more products or selling more services.
To do this, you’ll calculate your overhead allocation rate for each cost driver.
Let’s say you’re a manufacturer again. Perhaps you spent that same $30,000 on overhead from above, and you spent 2,000 machine hours to make all those sales.
Here’s the math:
$30,000/2,000 machine hours = $15/machine hour
This means you spent $15 per hour that the machine was doing work.
Now that you know this information, you can factor it into future budgeting and financial decision-making.
For example, maybe it takes five machine hours to make a product. You’d multiply your $15/machine hour rate by five to arrive at a total overhead cost of $75/product.
It works the same way for service firms. If you’re a marketing agency, one of your cost drivers for a project might be market research time. You could figure out how many dollars you spend per hour of market research and factor that number into each proposal with your clients.
Demystifying Overhead Costs
Knowing your overhead costs is vital to profitable pricing if you’re a product business and accurate quoting if you’re a service business. After all, you have to cover more than the direct costs of creating the product or providing the service.
Accounting software like ZarMoney helps track your overhead costs and separate them from other costs for more accurate cost allocation. It also offers advanced inventory features, quite helpful when it comes to cost accounting.
