Overhead Costs: What Are They and How Do You Calculate Them?

Overhead costs are ongoing business expenses that are not directly attributed to creating a product or service. Calculating and keeping track of overhead is important for any business. Not only does it make budgeting easier, but it’s also used to determine how much they should charge for their products in order to turn a profit.

To quickly summarize, overhead is any expense incurred to support a business while not being directly related to a specific product or service. Overhead costs often include employee perks, health benefits, rent, and technology such as computers, printers, or photocopiers. Almost every business has some form of overhead associated with their ongoing operations.

Overhead Explained

Companies pay overhead on an ongoing basis, regardless of how much money they earns in a particular month or quarter. Overhead costs are usually fairly fixed. That means they remain mostly constant from month-to-month.

A service-based business with a physical office usually has monthly overhead costs like rent, utilities, and insurance. They have to pay those costs in addition to the direct costs of providing their service. Those costs could include materials, supplies, and manpower expenses.

Some types of overhead expenses can be variable. That means the expense might increase or decrease depending on the business’s activity level. For example, a business’s rent payment is likely to be fixed. However, its shipping and mailing costs may vary from month-to-month.

How Overhead Is Calculated

Expenses related to overhead appear on a company’s income statement. They directly affect the overall profitability of the business. The company must account for overhead expenses to determine its net income, also referred to as its “bottom line.”

Net income is calculated by subtracting all production-related and overhead expenses from the company’s net revenue. (Also referred to as its top line revenue.) In some cases, overhead expenses can be known as “semi-variable.”

Semi-variable means that a company incurs some portion of the expense no matter what.  The other portion depends on the level of business activity. Utility costs can vary depending on the amount of power used in a certain time frame, for example.

Calculation Formula

There are a number of different ways of calculating overhead. The general rule is: Overhead rate = Indirect costs/ allocation measure. The indirect costs are the overhead costs. Meanwhile the allocation measure would include labor hours or direct machine costs, which is how the company measures its production.

Overhead expenses can be found on a company’s income statement. Then they are subtracted from its income to arrive at a net income figure. Analyzing overhead is critical to showing the profitability of a company. It’s required on most quarterly and annual financial statements.

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Types of Overhead

As mentioned, there are many different types of overhead that a company must manage and pay for. Some common examples of overhead costs include rent, utilities, administrative costs, insurance, and employee payments and perks.

Let’s take a deeper dive into various types of overhead expenses. We’ll discuss how they can impact a business, in both the short- and long-term. While all businesses have some type of overhead, not all businesses incur the same overhead expenses.

Rent and Utilities

Rent is the cost associated with maintaining an office or manufacturing space. Most companies still require some sort of physical location. (And even if the company buys the space instead of renting it, mortgage costs would replace the rent expense.) Another expense of maintaining a physical location is utilities. Gas, water, power, internet, and phone services are all classified as overhead costs.

Additional costs associated with rent and utility might include items such as a subscription to virtual meeting platforms such as Zoom or Microsoft Teams. It could also include subscriptions to industry magazines, newspapers, and other publications.

Administrative Costs

Companies that have more than one employee (or are not sole proprietorships) tend to have administrative costs. These costs are frequently one of the most expensive types of overhead.

Administrative costs include expenses such as stocking the office with supplies, salaries for office associates, and external legal and accounting fees. Administrative costs can range from buying toilet paper for the washroom to hiring an external accounting firm to audit the company’s finances.

Insurance

Depending on the type of business, a company might be required to hold many different types of insurance. Insurance can include basic property insurance to protect an organization’s property and physical assets from fire, flood, or theft. It could also include professional liability insurance, health insurance for employees, and even car insurance for any company-owned vehicles.

While none of these costs are directly related to generating revenue for the company (by providing a good or service), businesses are often legally required to purchase different types of insurance, depending on their local laws and regulations.

Employee Perks

In addition to salaries, many companies offer a range of benefits and perks to their employees. It helps retain their talent and keeps them engaged and motivated. These types of perks include everything from keeping offices stocked with coffee and snacks, to paying for gym memberships or happy hour outings.

Other types of employee perks include hosting company retreats, providing access to a corporate vehicle, and subsidizing health and wellness treatments like massages. All perks and benefits are considered overhead, as they have no direct impact on the goods or services being produced.

Other Types of Overhead

Other types of overhead expenses include the need for human resources staff and office receptionists. Selling overhead relates to activities involved in marketing, like billboards, online advertisements, or television commercials.

Depending on the nature of the business, other types of overhead might also be incurred. This could include research, maintenance, manufacturing, and transportation costs. Overhead expenses can grow or retract over time, depending on the operational pace of a business.

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Special Considerations

Overhead is viewed as a “general expense.” That means it applies directly to a company’s operations. It’s commonly accumulated as a lump sum, at which point it may then be allocated to a specific project or department.

For example, using activity-based costing, a service-based business may allocate overhead expenses based on the activities completed within each department, such as printing or office supplies. Most businesses spread overhead costs around between various departments.

The Bottom Line

Overhead costs are an essential component of most business operations. As a rule, overhead includes all expenses related to the operation of a business that are not directly attributed to creating a product or service. It would be rare for a company to not have any overhead expenses at all.

Tracking and calculating overhead is important, since it allows businesses to assess their expenses and determine their profitability. Most publicly traded companies are required to track and report their overhead expenses as part of their quarterly financial obligations.