Overheads are the costs in business not directly related to the production of goods or services (indirect costs). If a cost is incurred to create a product or deliver a service, it is classed as a direct cost, not an overhead.
Common overhead cost examples might include your rent, insurance, and admin costs.
There are three main types of overheads: fixed, variable, and semi-variable.
Overheads can be confusing as each business determines what overheads are in a different way. It is often assumed that fixed costs are indirect (and an overhead) because you have to pay them whether you produce anything or not. Similarly, variable costs are often assumed to be direct – as the costs of production tend to go up and down depending on how much is being produced – and therefore not an overhead. However, it isn’t always that clear cut.
For instance, an overhead expense can be affected by how you classify production costs. Some businesses might count rent as a cost of production – e.g. rent for a factory – which would make it a fixed direct cost and, therefore, not an overhead. However, others might say their rent is a fixed indirect cost that the business has to pay whether or not they’re open – such as an office building – which makes it a fixed overhead.
How you classify your overhead costs for your small business will depend on what type of business you are and how your business is structured. Grouping your costs into categories during your accounting can help to streamline this process, e.g. manufacturing/production, admin, and development costs. You’ll then be able to calculate how much you’re spending on overhead costs versus production more easily. When determining if a cost is an overhead, the key thing to remember is that overheads are an indirect cost, which means they’re a cost not related to the production of your goods or services, and can be fixed, variable, or semi-variable.
Overhead expenses are just one category of business costs. To avoid confusion, use the following in the correct contexts:
1. Cost of Goods Sold (COGS): these are direct costs tied to producing goods/services.
2. Sales and General Administration (SG&A): these are operational costs not directly linked to production.
3. Depreciation and Amortization: this accounts for the decrease in value of assets over time.
4. Interest: the costs associated with borrowing funds.
5. Income Taxes: the taxes on your business earnings.
6. Miscellaneous: small, irregular expenses that don’t fit into other categories.
Typically, overheads relate to your business operations as a whole. However, to get a true cost analysis of your products you may want to allocate overhead costs to specific areas. For instance, you could use activity-based costing to allocate specific overhead expenses to your service or product. You’ll then be able to determine how much a particular product or service is costing you in both overhead expenditure and direct labor costs.
To calculate your overhead rate, you’ll need to identify all of your overhead expenses – including fixed, variable, and semi-variable – that relate to the same product or service. Then use this formula:
Overhead rate = indirect costs / allocation measure
The indirect costs are the lump sum of your overhead expenses, and the allocation measure is any type of measurement that’s necessary to make the product or service. This could be the lump sum of any direct costs involved in production like your direct labour, machine or material costs, or it could be the direct labor or machine hours it takes to create your product.