Examples of overhead costs and how to calculate them
Updated 7 October 2022
In business, it's crucial to monitor the expenses incurred by the company at all times. Overhead costs are a critical part of a company's expenses that management can include in the budget. Understanding examples of overhead costs and their importance can help you make well-informed financial decisions that can ensure the company progresses. In this article, we define what an overhead cost is, provide examples and types of overhead costs, explain how to calculate them, outline their importance and answer some FAQs.
What is an overhead cost?
An overhead cost is a combination of all the indirect costs that a business incurs to keep the company running. Such costs may not include the cost of producing a product or service. For instance, if a restaurant uses water to cook food, it may not be an overhead cost. If employees use water to clean the floors, then the company may consider the cost of water to be an overhead.
Examples of overhead costs
Here are some common examples of overhead costs:
A company may choose to lease office space where rent may be payable every month. Or, if the budget allows, it may choose to purchase or build office space that fits the company's brand. For instance, a plant company may construct a greenhouse that also offers space for offices. Companies can usually only acquire such a business-specific property type if they build it themselves.
Depending on the business type, a company may require insurance to protect its properties and holdings from liability and damage. This can include basic property insurance to protect the company's physical assets from fire, flood or theft, professional liability insurance, health insurance for employees and car insurance for company vehicles. It's best to consult insurance professionals to get advice on the most appropriate insurance policy for the type of business.
Many larger companies offer a range of benefits to their employees, such as stocking their offices with coffee and snacks, providing gym discounts, hosting company retreats and providing employee cars. A company can consider these expenses overheads, as they may have a minimal direct impact on the company's goods or services. These may instead be an important component of the company's culture that can boost morale among the employees.
Employees use water when making drinks, flushing toilets and washing their hands. Some businesses can also use water in production processes, such as for cooling down machinery in manufacturing. It's a good idea to educate employees in responsible water usage and encourage this behaviour to reduce the cost of water.
Businesses often use electricity to power machinery, light their facilities or maintain a comfortable room temperature for employees during the summer and winter months. Electricity costs can vary from month to month depending on usage and power providers' rates in an area. If the company also uses electricity for production, such as in welding, it may no longer be an overhead cost but a production cost.
Some facilities may use gas for warming rooms in cold weather, and some types of manufacturing industries use gas to power machines. Facilities can limit this cost, whether it is an overhead or a production cost, by using a more sustainable energy source such as solar power. A company can also use sustainable energy because it's better for the environment.
Some parts of a production process may require regular maintenance, and some may suddenly require repairs after a breakdown. The cost of this may depend on the complexity of a particular repair and the value of the affected item. Repairs may also lead to new purchases if the product experiences damage beyond repair or breaks further during the repair process.
Related: What is net pay?
Types of overhead costs
Here are some types of overhead costs a business may encounter:
Fixed overheads can involve any costs a company pays on a recurring basis. Examples of fixed overhead costs include workplace expenses, such as supplies and equipment, and supervisory salaries. Fixed overheads may also include administrative salaries and the insurance paid for production equipment, facilities and inventory.
Variable overhead costs can change depending on the season or period. For instance, the cost of postage and packaging can increase during a busy season and decrease during the off-season. Other examples of variable overheads may include supplies for production, utilities for the facility and machinery, salaries for handling and shipping of the product, raw materials and sales commissions for employees.
A business cost can be variable, for instance, when a business pays a certain sum regardless of activity, while the rest of the sum depends on usage level or activity. For example, utility costs, such as water, can be semi-variable since a company can pay them monthly based on how much the staff use them.
Additional types of overhead costs
Whether they are constant, variable or semi-variable, a company can divide overhead expenses into two categories: administrative and manufacturing. Administrative costs are overheads that allow the company to keep running while manufacturing costs are overheads that support the production process. For instance, a company may consider insurance to be an administrative cost, while the cost of water used to clean machinery can be a manufacturing cost.
How to calculate overhead costs
To calculate overhead expenses, follow these five steps:
1. List expenses
It's useful to start by making a comprehensive list of indirect business expenses such as rent, taxes, office equipment, factory maintenance and utilities. These expenses may have a minimal direct effect on the production process, but they add to a company's overall expenses. Creating a list can provide a clear and organised view of all the relevant items and helps ensure the company includes all its expenses.
2. Determine the cost of each item
A company can learn the cost of utilities, such as water and electricity, from its leasing agent or directly from its suppliers. It can keep track of the cost of listed items by ensuring the responsible employees always note prices when purchasing items, such as toilet paper or soap, for company bathrooms. It may also be useful to keep receipts that the company can refer to in the future.
3. Subtract the production cost from the total cost
Once a company calculates the total value of all its expenses, it can subtract the production costs from this figure to determine the overhead costs. Since the expense list may be long, it's useful to use a spreadsheet to make calculations easier. After working out the overhead cost, the following additional calculations can provide a more detailed result.
4. Calculate the overhead rate
The overhead rate or the overhead percentage is the fraction of revenue that the organisation uses to manufacture a product or provide a service. To calculate the overhead rate, divide the indirect costs by the direct costs and multiply by 100. If the overhead is more than 20, it can mean the business spends 20 of its revenue on producing a product or providing a service. Here's the formula you can use:
Overhead rate = (indirect costs/direct costs) x 100
Importance of calculating overhead costs
Here are some reasons why overhead costs can be important in business:
Determine prices: Overhead costs may influence how the company prices its products to ensure profit. For instance, if overhead costs are high, the company's product or service may also have a high price.
Control spending ability: These costs may play a key part in the company's ability to spend on other items. For instance, if a company has a limited budget, a high cost for electricity may reduce the amount of money available for production, which may cause a decline in output.
Determine overhead rates: A business can only determine the overhead rate after calculating the overhead cost. The overhead rate can then help to quickly determine the percentage of revenue that the company is spending on indirect costs.
Frequently asked questions about overhead costs
Here are some common questions regarding overhead costs:
How can a company calculate overhead per hour?
A company can easily work out the overhead per hour by calculating the overhead allocation rate. This is a value found by dividing the total overhead by the number of direct work hours. Here is a breakdown of the formula:
Overhead allocation rate = total overhead/total work hours
Example: The total overhead for creating cherry cookies is £500 and the figure for total work hours is 150. Calculate the overhead allocation rate by using these figures in the formula.
Overhead allocation rate = £500/150 hours
Overhead allocation rate = £3.33
This means that for every hour that employees spend making cherry cookies, the company can allocate £3.33 worth of overhead.
Do overhead costs contribute to income?
No. Overhead costs can only support the processes and employees in a company. If the company doesn't monitor these costs, they may take up a significant part of the revenue.
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