Overhead costs are costs that relate to the ongoing business expenses which are not directly linked to creating a product or service. Overhead costs are not only important for budgeting purposes, but also for determining how much a company is to charge for its products or services in a bid to make a profit.
Types of Overhead Costs
There are three main types of overhead costs, they include fixed costs, variable costs, or semi-variable costs.
Fixed overhead is the fixed amount of business expenses, for example, rent. These costs remain constant every month and do not change as regards changes in business activity levels.
Examples of fixed overhead includes:
- Web hosting
- PO Box rental
- Phone plan
- Property tax
- Business insurance
- Interest on mortgage payments
- Regular janitorial services
- Bookkeeping services.
- Depreciation of taxes
- Government licenses
Variable overhead costs are those costs that are incurred on a regular basis with costs that fluctuate. These costs vary with business activity levels and can increase or decrease with different levels of business activity. Variable overhead expenses increase during high levels of business activity, but with reduced business activities, the overheads will substantially decline or even be eliminated.
Examples of variable overhead include:
- Hiring seasonal support staff
- Vehicle maintenance
- Staff events
- Building or equipment repairs.
- Shipping costs
- Office supplies
- Advertising and marketing costs
- Consultancy service charges, legal expenses
- Maintenance and repair of equipment
These are costs that fall somewhere between variable and fixed overhead. This type of overhead possesses some of the characteristics of both the fixed and variable costs. Note that a business may incur such costs at any time, although the exact cost will fluctuate based on the business activity level. Also, a semi-variable overhead may come with a base rate that the company is required to pay at any activity level, plus a variable cost that is determined by the level of usage.
- Janitorial services
- Traditional bookkeepers
- Staff bonuses
- Sales commissions
- Vehicle usage
- Water costs
- Power costs
Understanding Overhead Costs
Overhead must be paid by companies on an ongoing basis no matter how much or how little the company makes. Expenses linked to overhead can be seen on a company’s income statement, and they affect the overall profitability of the business.
The company is expected to account for overhead expenses to determine its net income, also known as the bottom line. Net income is calculated by deducting all production-related overhead expenses from the company’s net revenue, also known as the top line.
As discussed earlier on, overhead expenses can be fixed, variable, or semi-variable. Now note that it is very important to pay close attention to overhead costs, because they are not directly linked to revenues and can take a toll on business unnecessarily if not properly handled.
How to Calculate Overhead Rate
Overhead rate simply means how much money you spend on overhead as compared to how much revenue you generate.
Why Should You Calculate Overhead Rate?
It is important to calculate the overhead rate to really ascertain the actual profit your business is making. It helps you factor in all your overhead costs, to help you know whether your profit is lower than your profit projections.
The formula for Overhead Rate
It is very easy to calculate the overhead rate. Here is the formula:
Now note that for the formula to work, you need to use numbers from a single period, say one month.
To calculate, divide the total overhead costs of the business in a month by its monthly sales. Then multiply this number by 100 to get your overhead rate.
Departmental overhead rate = Estimated overhead for the department / Estimated activity for the department
The applied overhead for each department = Departmental overhead rate x Actual activity (using the same driver used to calculate the rate)