Overhead costs: Definition, Classifications, Examples, and How to calculate it

Overhead costs: Definition, Classifications, Examples, and How to calculate it

Priyanka Tiku Tripathi
Priyanka Tiku Tripathi
Table of Contents
Table of Contents



Index

  • Overhead costs definition
  • Overhead costs examples
  • Types of overhead costs
  • Should a business cut down overhead costs?
  • How to calculate overhead costs

Overhead Costs Definition


Overhead costs are the continuous business expenses that are not directly related to manufacturing a product or creating a service. It is an important part of the budgeting process and also determines how much a company will charge for a product or service for profit.

Simply put, an overhead meaning can be any expense a company incurs to support the core business activities, while not being directly related to the business’ products and services.


Overhead Costs Examples


An organization has to pay overhead on various fronts on a regular basis, irrespective of the company’s sales.

For example, a business that offers services with an office has overhead costs, like rent, insurance, utilities, office supplies, etc. These are in addition to the direct costs of providing its services.

Some other overhead costs’ examples are:

  1. Employee travel
  2. Advertising expenses
  3. Accounting and legal expenses
  4. Salaries and wages
  5. Depreciation
  6. Government fees and licenses
  7. Property taxes

Here is a format that is used to represent the overhead costs of an organization.

Source: Cliff Notes | Total overhead costs


The expenses that are related to overhead appear on an organization's income statement. Overhead costs directly affect the growth of the business. Organizations must take overhead costs into account for determining whether they are earning a profit or incurring a loss.


Overhead costs for one organization may be a direct production cost for another organization. For example, an advertising agency will likely list the expenses of a massage session for its employees as an overhead cost, while the spa at which the said massage session is happening will likely list it as a direct cost for providing the service.



Types Of Overhead Costs

Source: Wall Street Mojo | Types of overhead costs
Source: Wall Street Mojo | Types of overhead costs





Classification of Overhead

Source: Slide Player|Classification of overheads
Source: Slide Player|Classification of overheads


Overhead costs can be classified in terms of functions, behavior, and elements.

When it comes to functions, overhead costs are categorized into the following types:



1. General and administrative overhead costs:

These generally include costs related to the overall management and administration of an organization, like the need for accountants, human resources, receptionists, errand runners, and other administrative staff.


2. Selling overhead costs:

These are related to activities that are a part of marketing and are fundamental to the sales of the goods or services. It may include printed material and television advertisements, as well as the commissions/incentives offered to the sales team. Depending on the nature of the business, there can be other categories as well, like research overhead, manufacturing overhead, maintenance overhead, warehousing overhead, sales point overhead, or transportation overhead.


3. Production overheads:

These are incurred for production activities. Some examples would be electricity bills, raw materials packaging, repair costs for machinery and, spare parts.


4. Distribution overheads:

These are required to deliver and transport products and services to customers. Some examples of distribution overhead costs would be rent for godowns, packaging charges, delivery vehicle fuel costs, etc.

Source: The Balance Small Business| Fixed vs variable costs
Source: The Balance Small Business| Fixed vs variable costs


When it comes to behavior, overhead costs are categorized into the following types:


1. Fixed Overhead Costs:

These are those that remain the same amount every month. Fixed overhead costs do not change with business activity. Fixed overhead costs can include rent, mortgage, utilities, depreciation of assets, insurance, property taxes, annual salaries, and government fees.


2. Variable Overhead Costs:

These fluctuate according to business activity. When there is an increase in business activity, variable overhead costs are likely to increase, too. Similarly, when there is a decrease in business activity, variable overhead costs are likely to decrease. Variable overhead costs may include shipping charges, legal expenses, office supplies, equipment maintenance, materials, advertising,



Overhead costs are also classified in terms of the elements that are generating the cost. ie. labor, materials or expenses.


1. Indirect Materials:

These lead to overhead costs because these materials are used in the production process, but cannot be linked to a specific product or service. They are consumed as part of the production process but are not integrated into major amounts into a product or service. Some examples of the same would be fittings, cleaning supplies, oil.


2. Indirect Labor:

This is an overhead cost that is not directly related to the production of goods and the delivery services, but adds to the production cost nonetheless. Some examples of indirect labor costs would be the wages paid to executives for the transport of raw materials from one warehouse to another.


3. Indirect Expenses:

These are those overhead costs that do not add any value to the production of goods, and services, but are miscellaneous costs that aid the day-to-day activities of an organization. Some examples of this would be postage, printing, research and, development.

How to Calculate Overhead Costs

To calculate overhead costs, you can follow these steps:

1. List Expenses

The first step in decreasing overhead costs would be to make a comprehensive list of indirect business expenses (items like rent, taxes, office equipment, factory maintenance, utilities. etc.) These expenses do not affect the production process directly but add to the overall expenses of production.
While categorizing the direct and indirect costs, we need to remember that some items will not be attributed to a specific category.

2.  Add The Overhead Costs

Add the monthly overhead costs to calculate the aggregate overhead cost projections for your organization on quarterly, half-yearly and, annual basis. This is the amount of money that your company will need for running the business.

3. Calculate What The Overhead Rate Would Be

The overhead rate or the overhead percentage is the amount your organization spends on manufacturing a product or providing services to their customers. To calculate the overhead rate, we divide the indirect costs by the direct costs and multiply by 100.

For example: If the overhead rate is 20%, it means that the business spends 20% of the revenue on manufacturing a good or providing its services. A lower overhead rate indicates business efficiency and higher profits.

4. Compare To The Organization’s Sales

While setting prices and making the organization’s budgets, we need to know the percentage of a dollar that is allocated to overhead costs. To calculate the percentage of overhead costs in comparison to sales, we divide the monthly overhead cost by monthly sales and multiply it by 100.


For example, if a business has a monthly sales of $150,000 and overhead costs are $45,000, then overhead costs will be $45,000/ ($150,000) x 100 = 30%


5.Comparing To Labor Costs

If we want to measure the efficiency with which business resources are being used, we calculate overhead costs as a percentage of the labor cost. The lower the percentage, the more efficiently the business is utilizing its resources.

We divide the total overhead cost by the total labor cost for the month and multiply by 100 to express it as a percentage.

Example: Let us say that the overhead cost of a company is $1200 and the total labor cost is $10,000. The labor cost percentage will be $1200/$10,000 x 100 = 12%


We hope this article cleared your doubts about overhead costs. If you want to simplify the accounting process for your organization, Deskera is here to help. By using Deskera, you will be able to automate accounting and inventory processes and keep your organization’s health and processes in check. Not only that, you will be able to track your company’s expenses and costs in real time, which will let you have more control over the decision-making process.









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