Overhead

Foot the Bill

What is overhead?

Overhead is the total expenses that a business must pay just to stay open.

Overhead costs typically do not change month-to-month or have limited variability. They are not directly associated with the production of items for sale.

Common overhead costs:

  • Rent
  • Electricity, water, and other utilities
  • Property taxes
  • Insurance
  • Wages for administrative staff
  • Licensing fees
  • Accounting expenses
  • Legal expenses
  • Office supplies

What’s not included

Another term for overhead is “indirect costs.” The opposite of overhead costs are “direct costs,” which are caused directly by the production of items for sale. If an expense disappears when the company stops creating products for sale, it is a direct cost, not overhead.

  • Raw materials
  • Wages for factory workers
  • Shipping costs
  • Storage costs

Why important

Overhead costs must be paid by a business even if they aren’t making any money.

If the business stops production or pauses operations for any length of time, it must still be able to pay its overhead to stay afloat. If poor planning means the business can’t cover its overhead without sales revenue—even temporarily—it will fail.

The lower a business’s overhead costs, the easier it is for it to weather hard times.

Overhead and sales price

Businesses also closely track their overhead costs to determine how much they need to sell their products for to turn a profit.

The sales price of any item is specifically calculated to cover:

  • A portion of company overhead
  • Direct costs attributed to producing that item
  • Profit

Overhead costs and direct costs together equal all the expenses of a business, so the products a company sells must generate enough revenue to cover those costs. The lower the overhead costs, the more of its revenue a business gets to keep as profit.

Fixed vs. Semi-variable costs

Most overhead costs are “fixed costs,” which means they do not go up or down depending on how well the business is doing or how much it produces.

  • Rent
  • Insurance
  • Licensing fees
  • Property taxes

While most truly “variable” costs are direct costs—for example, a company could spend nothing at all on raw materials if they stopped production—some overhead costs can be “semi-variable,” which means there is a minimum expense, but it can go higher depending on how the business is doing. The more active the business, the more it will spend on such things as:

  • Phone bills
  • Utility bills
  • Administrative wages if new employees are needed to handle the workload
  • Office supplies

Fun facts

  • Overhead costs are different for every business. A professional bodybuilder, for example, might consider body oils and a gym membership to be necessary overhead.
  • Many nonprofit organizations have surprisingly high overhead costs. The Law Enforcement Legal Defense Fund, for example, spends more than 82% of the money it raises on overhead costs, including the cost of hosting more fund-raisers, meaning less than 18% goes toward law enforcement defense costs.

References

  1. http://www.investopedia.com/terms/o/overhead.asp
  2. http://www.accountingtools.com/questions-and-answers/what-is-overhead.html
  3. http://www.accountingtools.com/overhead-definition
  4. https://www.entrepreneur.com/encyclopedia/overhead
  5. https://www.shopify.com/encyclopedia/overhead-costs
  6. http://www.investinganswers.com/financial-dictionary/businesses-corporations/overhead-799
  7. http://www.wisebread.com/20-amazing-outrageous-and-just-plain-weird-tax-deductions
  8. https://www.thestreet.com/story/12878005/1/you-wont-believe-the-overhead-costs-at-these-10-nonprofits.html
  9. https://www.solereview.com/wp-content/uploads/2016/05/Cost_split_Nike_shoe.jpg
  10. http://1.bp.blogspot.com/-2F59ygurZ6M/UgpApCN7xnI/AAAAAAAAEHQ/RAzGdcj_ov8/s1600/Chart.jpg
  11. https://image.slidesharecdn.com/costs1-141206124000-conversion-gate01/95/microeconomics-costs-2-638.jpg?cb=1417869654

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