Generally, overhead costs are a basic aspect of running a business and represent the expenses organizations incur to operate on a daily basis. Due to the impossibility of eliminating overhead costs, it is crucial to comprehend them to minimize expenses and generate a profit. This article examines what overhead costs are, why they are important to know, and how to calculate them.
List of Contents
What Exactly Is an Overhead Cost?
The term overhead cost refers to all indirect business expenses. These recurring costs sustain your firm but are unrelated to the production of a product. Calculating overhead expenses is essential for budgeting and deciding how much a firm should charge for a service or product to generate a profit. For instance, if you run a service-based firm, you would pay indirect expenses such as rent, utilities, and insurance in addition to the direct costs of delivering the service.
The Importance of an Overhead Cost
Knowing your overhead cost can help you set profitable prices for your products and services. By including overhead expenses in the entire cost of operating your firm, you may estimate the total amount of capital necessary for success. Moreover, using your overhead costs, you may calculate your net profit by taking your gross profit and deducting all expenditures. The net profit will reveal whether your firm is profitable or costs exceed revenues.
In addition, understanding your overhead expenses can allow you to identify strategies to cut them. Thus, you may save money by identifying long-term expenses and brainstorming ways to cut overhead and enhance profits.
3 Types of Overhead Costs
1. Variable Overhead
Variable overhead costs are expenses that vary based on sales volume. Variable expenses grow as sales increase and drop as sales decline. Common variable overhead expenditures include shipping, legal fees, some utilities, office supplies, equipment upkeep, marketing, and other comparable charges.
2. Fixed Overhead
Fixed overhead costs do not vary with profit, time, or business activity. Rent, insurance premiums, loan payments, mortgages, property taxes, and government fees are frequent examples of fixed expenditures. You are still responsible for these expenses even if you are not selling your items and earning cash.
3. Semi-Variable Overhead
Semi-variable overhead costs are expenses that must be paid regardless. However, the amount may vary significantly based on the level of company activity. Most utilities, car expenditures, hourly pay, and sales-related salaries and commissions are examples of semi-variable expenses.
How to Calculate Overhead Costs
Keeping an organized and thorough record of your overhead costs can benefit your business and assist you in determining the optimal pricing for your goods. Accurate recordkeeping will allow you to identify areas where you may save money and streamline your company strategy. Here are six straightforward procedures for calculating overhead costs:
1. Detail every expenditure
You should compile a comprehensive list of your business’s expenses. Your list should be exhaustive and include company renting space, utilities, taxes, and building maintenance. These are instances of indirect expenses. Other expenditures, like inventory, materials, and labor, are not overhead charges.
2. Categorize each cost
The organization simplifies the calculation of your overhead expenses. Categorize each line item on your list of costs for the items or services your company delivers. For instance, the labor and materials used to construct a house are direct expenses. The direct costs are associated with the building phase.
Moreover, it is vital to remember that certain goods do not simply fit into one category or the other. Thus, you must use your judgment. For instance, the majority of firms identify legal expenses as overhead. The cost of the law firm and the attorney’s services is a direct cost since it is directly related to the provision of legal help, which is the law firm’s service. Following the rules of the given industry, overhead costs are classified as either direct or overhead charges.
3. Include overhead costs
You should calculate the overall annual overhead costs by adding the monthly overhead charges. Typically, the amount is what you need to operate your firm.
4. Determine the overhead rate
The overhead rate or percentage is the amount your firm spends on producing a product or supplying clients with services. The overhead rate may be determined by dividing indirect expenses by direct costs and multiplying the result by 100. If your overhead rate is 40%, the company spends 40% of its revenue on producing or delivering a product or service. The lower your overhead rate, the more productive and lucrative your business may be.
5. Compare to sales
When establishing expenditures and creating budgets, you should know the proportion of cash allocated to overhead expenses. To calculate the overhead costs compared to sales, divide the monthly overhead expense by the monthly sales and then multiply by 100. For instance, a business has monthly revenues of $200,000 and monthly overhead expenses of $50,000.
($50,000/$200,000) x 100 = 25% overhead
6. Compare to labor cost
To assess a company’s resource utilization efficiency, compute the overhead cost as a % of labor cost. The smaller the proportion, the more efficiently a business uses its resources. You can divide the monthly overhead cost by the monthly labor expense and multiply the result by 100 to obtain the percentage.
Formulation Calculation of Overhead Costs
There are other ways to calculate overhead expenses. However, the following formula is the simplest:
As mentioned before, overhead costs are indirect costs not directly related to producing a product or service. Allocation measure is any estimation required for the production of the product. It may refer to the number of direct labor or machine hours for a certain item or period. The computation of overhead expenses is based on a given period. For instance, if you were to calculate the indirect expenses for a month, you would add up your monthly indirect or overhead charges.
Then, you would analyze what enters into production for the same period. By calculating the overall direct labor costs for the month, the denominator would be the total direct labor costs for that month’s production. Ultimately, you would divide indirect costs by the allocation measure to determine the monthly overhead expenses per direct labor dollar. A corporation that surpasses expectations by monitoring and reducing its overhead expenses might increase its productivity and profitability.
Conclusion
Overhead cost refers to company expenses that are not directly associated with providing a product or service. These expenses might be set, like rent, or variable, like transportation expenditures. They may also be semi-variable, as is the case with utilities. Therefore, effectively controlling your overhead enables you to maintain low expenses, establish competitive prices, and maximize profits.
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Source: Freshbooks