What are overheads? | Learn more
Most of the costs incurred by a company in doing business come down to its ability to provide a product or service to customers. But not all. Businesses must also consider overhead costs. These are indirect expenses related to the whole business or operation, which do not directly contribute to the end product or service. As a result, they are not traceable to a specific production unit.
The easiest way to identify overhead is to look at known expenses. These are costs for which the company is responsible, regardless of its turnover. No matter how many Widgets you sell, the rent is still $ 10,000. Likewise, business insurance always costs the same regardless of how high (or low) your sales numbers are. There’s just no getting around overhead – it’s something every business has.
Types of overheads
There is usually three types of overheads most companies should consider: fixed, variable and semi-variable.
- Fixed costs. These are costs that remain the same from month to month, regardless of external factors. The best examples include rent, insurance, and interest payments. Other examples of fixed overhead costs include services such as website hosting, janitorial contracts, property taxes, phone plans, and PO box rentals.
- Variable costs. Variable costs are those that fluctuate, but are still incurred on a regular basis and are not dependent on sales. Utility bills are the best example, as they fluctuate with the amount of water, electricity or gas used. Other examples of variable overhead costs include equipment repairs, seasonal staff salaries, and vehicle maintenance.
- Semi-variable costs. Semi-variable costs are a type of recurring overhead that the business can control. Telephone plans are a good example. For example, you could pay $ 200 / month. for a standard phone plan, but incur additional charges when you exceed a data cap. Other examples include staff bonuses, bookkeeping fees, and professional services.
Overheads are also not a single category on an income statement. These costs are divided into different categories depending on the cost center to which they are associated. For example, bookkeeping costs would be general administrative costs, while reimbursement for mileage could be general transport costs. Businesses need to be diligent in how they categorize and report overhead costs.
Overhead vs. Operating Expenses
There is usually some confusion when it comes to distinguish between overheads and operating expenses. While the two can rub shoulders with each other on the income statement, there are important factors that set them apart.
- Overheads relate to the management of the business itself. They are not tied to the cost of production, which means management can assess and adjust them with relative ease.
- Operating Expenses are directly linked to the production of a good or a service. They are more difficult to control. Management must balance them.
The easiest way to tell these costs apart is to look at what they allow. Operating expenses are the cost of doing business, while the overheads are the cost of running the business.
General expenses and their impact on net profit
Overhead is one of the key variables in determining the bottom line of a business for an accounting period. The net profit equation is:
Net Profit = Total Income – Total Expenses
Overheads 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 more a business is able to maintain its total expenses by controlling overheads, the higher its bottom line (regardless of income).
How to reduce overhead
Reducing overhead costs is usually one of the first levers a business will use to improve its bottom line. There are different degrees of ease with which it can reduce or eliminate overheads.
- Cut unnecessary or luxury spending is an easy way to get money back. For example, instead of chartering private jets for regional business meetings, business executives could fly commercial jets, saving thousands of dollars.
- Negotiate better rates or choose smarter service options can reduce overhead. For example, a business may be looking for better insurance rates. It might be possible to find similar coverage for a 10-15% lower rate.
- Changing the business model may result in reduced overhead costs. For example, outsourcing marketing to a PR firm removes this cost from the budget and could allow the firm to move to a more profitable facility.
- Develop or identify efficiency gains could allow a company to reduce its overhead costs without changing its operations. For example, taking advantage of automation to reduce the number of administrative hours spent on a task.
It’s important to look beyond the cost of overhead. All of the above are viable options for saving money, but they only make sense if they do it without harming the business. Getting a better insurance rate at the expense of inadequate coverage or downsizing of the marketing department and loss of brand identity in the process will both create long-term damage that will cost more. to repair than what the company could save.
The cost of running the business
Overhead costs are inevitable when it comes to running a business. Fortunately, they are also controllable. Smart businesses will strive to keep overhead costs as low as possible and in doing so achieve higher bottom-line profits. In addition, companies concerned with controlling their overheads demonstrate a responsible approach to operations, which encourages investors to exercise good tax management.
To learn more about financial reporting while deepening your investment knowledge, join the U investment e-letter below. The ability to run a healthy business with the lowest possible external costs is a virtue that is often rewarded with shareholder confidence, which in turn enables continued growth.