What are Overhead Costs: Definition, Types, and Examples

Costs are always a concern for anyone involved in business: owners, executive managers, accountants, and investors. If done correctly, costs could be a gateway to business growth. If not, loss of revenue, unhappy customers, bad quarterly performance, and even going out of business are some consequences.

The primary differentiator between profit-making and losing companies is managing costs efficiently to optimize expenditure across all operations, processes, departments, and roles. Indeed, budgets can become out of control in real-world scenarios. Costs could exceed projected expenses, usually called overhead costs, overheads, or overruns.

To maintain cost-effectiveness, companies must manage costs to keep profiting, if not to avoid loss. But to manage overhead costs effectively - and, for that matter, compliantly - business owners and executive managers need to understand overhead costs meaning, get overhead costs examples, and more.

Learn how to manage your overhead costs, why overhead costs are important in accounting, how to reduce overhead costs, and how Enerpize can help.

Overhead Cost Definition

Overhead costs are business expenses indirectly related to a company’s direct expenses but are essential to keep a business operating. That is, an overhead cost is a cost that is not used to produce goods or provide services. Having overhead costs is common in any business, regardless of activity, niche, or geography.

For example, a company selling outdoor gear with a large warehouse in a hurricane-prone area will likely pay hefty insurance premiums. This is an overhead cost that, if not kept in check, could lead to runaway costs.

As companies continue to operate, direct and indirect expenses continue to rise. The right balance between direct and indirect costs should be maintained to ensure running expenses are in check.

Read Also: How to Track Your Business Expenses

As explained in a bit, overhead costs come in many forms and could be of varying risk degrees to a business depending on that company’s overall financial situation. Indeed, overhead costs can be a make-or-break for many companies. That is why letting overhead costs run out of control should not be acceptable if a company wants to continue to make profits and avoid loss if not bankruptcy.

In short, overall costs must be considered.

Importance of Overhead Costs in Accounting

Here are some practical examples of why overhead costs are indispensable:

Accurate Product Pricing

Intuitively, companies can only set accurate product prices or even plan for pricing if overhead costs are accounted for. The indirect costs a company incurs, although not accounted for in production costs, directly affect any company’s ability to generate revenue. The great variability of overhead expenses, particularly for bigger companies, makes managing, let alone predicting, overheads elusive. This has profound implications for product pricing, where products with fluctuating prices could be inadequately priced, resulting in loss.

Profitability Analysis

Calculating overhead costs is part of cost accounting and is indispensable to performing profitability analysis.

In calculating overhead costs, part of cost accounting calculations, financial planners, controllers, and auditors need to identify gaps in processes and activities that result in inefficiencies and drive costs up. For example, if a specific product line is not performing as planned or is shown to be increasingly unfavorable in a given market (and hence generating less revenue if not reporting losses), responsible managers may opt to discontinue that product to minimize that product’s impact on the company’s profitability bottom line. The overhead costs indirectly incurred to produce such a product are expenses better disposed of.

Budgeting and Forecasting

This follows as a no-brainer from accurate product pricing and profitability analysis. Financial planners and controllers can only budget or forecast for existing or future products or other operating expenses if overhead costs are accounted for accurately and against a solid profitability analysis.

Cost Control and Efficiency

Control and efficiency reign supreme for companies operating in industries where input materials consume significant COGS expenses.

Consider mining companies. Typically, mining companies operate in relatively remote areas where special staff accommodation arrangements, lighting, travel expenses, and more constitute relatively high overheads such companies must incur to continue to operate. Unless cost control and efficiency measures are set to ensure overheads stay manageable, mining companies will likely report slim profit margins, if not long-term losses.

Break-even Analysis

This analysis calculates costs against unit sell price to determine when a company will break even or start making profits. High overheads will likely delay breaking even, with considerable financial stability, profitability, and growth implications.

Decision Making

Business owners and managers can only make sound decisions with accurate financial data and analysis. Sound accounting practices that account for all business expenses are apt to lead to just as accurate decision-making processes.

Tax Planning

Compliance is unquestionable, or should be, for any business. In all jurisdictions where tax laws and regulations are strict or lax, compliant reporting practices lead to more confidence in a company’s performance and are a great way to build a brand and reputation.

However, to comply, companies need to report financial statements accurately, and to do so, all costs, including overheads, must be accounted for promptly and accurately.

Financial Reporting

This, again, follows as a no-brainer in tax planning. Tax planning done correctly, timely, and compliantly - while accounting for all overheads - leads, intuitively, to sound financial reporting practices where all records are entered, adjusted, and audited as planned and according to best-in-industry standards.

Overhead cost calculation and reporting are cyclical processes in which accurate product pricing, profitability analysis, budgeting and forecasting, cost control and efficiency, break-even analysis, decision-making, tax planning, and financial reporting are all connected and point to how indispensable accounting—accurately, timely, and compliantly—for overhead costs is.

Impact of Overhead Costs

To put overhead costs into a proper context of significance, predicting costs has always been a subject of study in academia and business. For one, Petr Novák et al., in a comprehensive study, “Analysis of Overhead Cost Behavior: Case Study on Decision-Making Approach,” shows that predicting overhead cost behavior and subsequent decision-making process using regression models requires optimization of the manufacturing process total time to production volume ratio.

The above findings are informed by broader structural changes that enterprise activities have undergone due to growing customer demands for product modification, intensifying R&D investments, and innovation activities. These changes have resulted in substantial changes in the cost structure of overhead costs up to around 35-40% as of the 2007/2008 financial crisis.  

The importance of overhead costs cannot be overestimated. Indeed, businesses stand to lose big if overhead expenses are not accounted for manually or automatically. 

Types of Overhead Costs

Overhead costs are classified as variable, fixed, or semi-variable based on variability. As businesses continue to operate, different types of overheads emerge. What counts as fixed, variable, or semi-variable may change over time.

For example, small companies with fixed rent overhead may need to adjust their overhead structure when splitting up workspace to serve different business functions, each with a different lease and management commitment. This applies to almost every overhead type where variability evolves.

To understand how overhead costs work, here are more details about each type:

Fixed Overhead

By definition, fixed overhead remains constant over extended periods, regardless of business activity or market conditions. 

Examples include rent, salaries, and insurance.

Consider rent. Choosing to rent a place is an additional, fixed overhead cost that companies must manage well. Specifically, while rent fees, however premium, may not represent a substantial fixed cost (and should not), they could be fixed for an agreed-on period or paid month-to-month. This is a critical consideration because rent fees could change in response to various externalities, such as currency exchange, regulatory developments, etc.

Variable Overhead 

Also, by definition, variable overhead refers to variable costs responsive to business activity and market conditions.

Examples include advertising, legal costs, and travel costs.

Consider legal costs. Legal costs could drag on long, costing companies overheads well beyond revenue in any reporting period. That is why legal costs should always be accounted for carefully. Costly as they are in some cases, legal overheads may be a make-or-break for companies, as has been reported in a range of antitrust cases against major U.S. Big Tech companies.

Semi-Variable Overhead 

This is an overhead type combining fixed and variable costs where only a portion of costs remains fixed and another portion varies. 

Examples include commissions and manufacturing overhead costs.

In industrial settings, for example, manufacturing overhead costs are generally a combination of fixed and variable costs. Manufacturers pay a fixed overhead set for all industrial companies and usage-dependent variable overhead. Soaring utility prices for manufacturers have a cascading effect across all economic activities. That is why optimizing utility overheads—and energy costs at large—to produce goods is necessary so companies remain competitive.

Examples of Overhead Costs

As noted, overhead costs come in four main types: fixed, variable, and semi-variable. Examples are numerous of each type, including:

Rent

Rent is a classic example of fixed overhead costs. Leasing a space to perform various business activities, including having an HQ for business, is too familiar. Indeed, many companies prefer to lease out a place instead of buying one. 

Salaries

Salaries, or labor costs, are a second classic example of fixed overheads. All companies have a payroll to pay employees weekly, monthly, or quarterly. Understandably, companies vary substantially in how and when employees are paid. For example, a company operating in different countries might have a combination of full-time, part-time, and project-based jobs. Paying all employees—each in a different job role, pay scale, and jurisdiction—could be a headache for such a company if labor cost is not optimized to maximize labor ROI. 

Insurance

Companies operating in specific industries, such as freight, have insurance as an unquestionable fixed overhead cost to buffer against existing and emerging risks. The insurance premium could also be mandated under law, and, as such, companies operating in a jurisdiction where insurance is mandatory must always ensure a recurring insurance premium is earmarked to cover all required payments.

That being said, companies are generally advised to have some form of insurance coverage, particularly under current dynamic and often uncertain operating ecosystems. For example, global companies operating in jurisdictions where social unrest or natural disasters are highly probable have every reason to obtain insurance coverage.  

Advertising

Many companies need advertising for different reasons, such as branding, product marketing, customer engagement, etc. The advertising overhead is generally variable and subject to many factors, such as internal business needs, changing customer behaviors, regulatory developments, etc. Choosing when and how to advertise is left to every business’s financial prudence.

That said, some big names in major industries, such as Google, only invest a little, if at all, in advertising to promote business activities. There is no one-size-fits-all approach to advertising, and like it or not, advertising is one of the first victims companies shed when experiencing liquidity or profitability pressures.

Legal Costs 

Legal costs are always cost-structure elastic. That is, while companies may have in-house legal counselors or advisors to perform a range of routine legal matters, a special power of attorney—external or internal—may be brought abroad on a permanent or temporary basis to handle emerging legal issues, such as mergers, patenting efforts, lawsuits, etc.

Travel Costs 

Travel is a variable cost that many companies may not be willing to pay but are forced to pay because of necessary business needs. Bigger companies generally have more travel needs and costs than smaller ones.

For example, a global company operating in multiple jurisdictions may need to set aside a separate travel budget for country managers who may need to negotiate deals, approach local government officials, perform on-site business audits, etc.

Semi-Variable Overheads 

Companies with a sizeable number of salespeople must account for a combination of variable and fixed, aka semi-variable, overheads. Specifically, such companies that pay salespeople based on a basic/commission salary structure need to manage sales commissions properly, particularly if such companies are operating in multiple jurisdictions where pay scale and salary structure may vary widely.

How to Reduce Overhead Costs? 

So far, you may have fully grasped how overheads, although apparently marginal, could have broad knock-on effects on your business. To optimize your overhead costs, here are some best practices:

Have a Second Look at Your Workspace Design and Use

Your workplace design and use are not sacred and should be used to adapt to your evolving needs. To optimize workspace costs, consider remodeling, moving to a new workspace, or even subleasing your unused space to reduce your rent overhead.

Optimize How You Work

This applies to all your processes, workflows, and operations. Identify and close any gaps in all. Automate if and when necessary so your staff can focus on more strategic matters. 

Always Negotiate Prices

Do not simply accept set prices from your business partners, suppliers, vendors, etc., as are. Instead, look around and identify your best-fit deals. 

Go Wholesale

If wholesale compared to retail prices save you money, go ahead and buy in bulk. Under ever-fluctuating supply prices, buying in bulk in advance may save you small fortunes later when supply prices hit the roof.

Revisit Your Subscription

Typically, subscriptions roll on and on, and you may continue to pay for them almost indefinitely. Revisit all your subscriptions in all areas (business education and knowledge [e.g., newspapers, magazines, etc.], product development, workflow management, etc.) to drop what you do not need and look for added-value subscriptions.

Be Energy Efficient 

This is an age where energy costs are soaring. As a business owner or executive manager, you want your utility overheads to stay manageable. So, ensure you acquire energy-efficient lighting and heating equipment and encourage your employees to adopt energy-friendly habits.

Go Green 

Reduce your dependence on paper and go digital as much as possible. This is good for the environment and reduces operating costs, including overheads.

Develop a Cost-Conscious Culture—Education Matters 

Educate your staff on best practices to optimize costs everywhere at your company - and reward cost-saving champions. 

In short, as a business owner or executive manager, you have everything to gain when you learn how to optimize your overhead costs - and everything to lose if you do not.

Read Also: How to Calculate Overhead Costs: Formula & Example

Streamlining Overhead Costs Accounting With Enerpize 

Getting your overhead costs in order is a business mandate. Managing overhead costs is shown to be a business saver, particularly for companies operating in high-risk environments.

At Enerpize, our online accounting software enables businesses of all sizes to optimize accounting operations, including overhead cost management. 

If you are a business owner or executive manager who wishes to optimize your overheads, here is how Enerpize can help:

• Auto-adding expenses from any device or platform, any time. 
• Auto-tracking all your spend from a centralized, easy-to-use dashboard.
• Custom-displaying your overall revenue and expenses to generate custom invoices and expense reports.
• Monitoring all your operation expenses to control all costs, including overheads, and calculate profits per product, department, or salesperson.
• Maintaining an accurate record of all financial transactions to prepare reporting-ready statements, annually or automatically.
• Auto-setting recurring expenses daily, weekly, monthly, or within whatever reporting period you wish per business activity or customer.
• Categorizing expenses, vendors, and customers to get organized, printable, shareable invoices and receipts.
• Adjusting currency and tax payments and compliance as per customer, jurisdiction, or business activity to get multicurrency customer invoices and tax reports.

Try us out for 14 days for free and enjoy our overhead cost management magic spell over your accounting operations at large.

Final Thoughts

Overhead costs can be a make-or-break for businesses. Unless managed efficiently, overhead costs could run out of control, putting your whole business at risk.

As indirect costs to business, overhead costs come in four main types: variable, fixed, and semi-variable (general, administrative, etc.). 

To optimize overhead costs, eight best-in-industry practices can be adopted, including:

• Reconsidering workspace design and use.
• Optimizing workflows and processes.
• Negotiating prices. 
• Buying wholesale.
• Managing subscriptions.
• Optimizing energy use.
• Going green.
• Developing a cost-conscious culture.

Going solo and managing your overhead costs is fine, but you need to know when, how, and where to optimize.

Better still, opt for leading accounting software to automate your overhead cost management and make it a routine, not a drain on you, your staff, and your overall business.