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What are Overhead Costs? Definition & Meaning

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Overhead Costs
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A business has to spend money to make money, that’s how it works. In the business landscape, there is a term called overhead costs. It covers all the expenses from renting an office to employing staff. All these expenses are documented from the start of the company. Cracking your overhead costs is vital as it will help determine the product’s pricing more accurately. In this blog, let us learn more about overhead costs deeply.

What is Overhead Cost in Accounting?

Overhead costs meaning is simple, these are the expenses that occur indirectly to the business. These costs are calculated mainly for budgeting purposes and for determining the price of a company’s products and services. This will help a business to make profits. However, these expenses are incurred to support the business and are not directly related to the creation of a product.

Further, a company should pay overhead costs regularly and is not affected by the sales of the company. A service-oriented business operating from an office incurs additional expenses beyond the direct costs associated with providing its services. These overhead expenses include items like rent, utilities, and insurance, in addition to the labour and supplies directly related to the service delivery.

All the overhead expenses are documented in the company’s income statement. Plus, they impact the overall profitability of the business. A company in order to determine its net income must account for its overhead costs. It is also referred to as the bottom line. In addition, the net income is calculated by deducting all production-related and overhead expenses from the company’s net revenue. This is also referred to as the top line.

Examples of Overhead Costs

A business has to pay for overhead costs regardless of the company’s sales. Imagine a company that provides services and has an office. Apart from the money spent directly on services, they also have extra costs like rent, insurance, utilities, and office supplies for running the office.

Here are other examples of overhead costs:

  • Depreciation
  • Employee travel
  • Advertising expenses
  • Government fees and licenses
  • Salaries and wages
  • Property expenses
  • Rent and utilities
  • Accounting and legal expenses

For instance, in a company, overhead costs could include a monthly office rent of Rs 50,000, utility bills totalling Rs 10,000, and insurance expenses at Rs 5,000. These are additional expenses beyond the direct costs of producing goods or services, contributing to the overall operational expenses of the business.

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Types of Overhead Costs

Overhead costs can be divided depending on behaviour, functions and elements. Based on functions overhead costs can be classified into the following types:

1. General and Administrative Overhead Costs

These are expenses linked to running and organizing a company, such as paying for accountants, human resources staff, receptionists, and others who help with day-to-day tasks. It’s the cost of managing and keeping the organization running smoothly.

2. Selling Overhead Costs

Expenses related to activities pertaining to marketing and those that are fundamental to the sale of goods and services come under this type. The expenses include printed material, advertisement expenses in television, and the commissions/incentives offered to the sales team. Based on the type of business, there might be different types of overhead costs, such as research expenses, production costs, maintenance fees, warehouse costs, sales location expenses, or transportation charges. It all depends on the specific activities and needs of the business.

3. Production Overheads

These expenses are incurred due to the production operations. It includes electricity bills, raw materials packaging, repair expenses for machinery and spare parts.

4. Distribution Overheads

These expenses are incurred when the product or services are required to be delivered or transported to the customer. These expenses include packaging charges, rent for godowns, vehicle fuel costs(delivery vehicles) etc.

Depending on the behaviour, overhead costs can be divided into two types:

1. Fixed Overhead Costs

The cost which remains the same every month and which does not change with any business activity is known as fixed overhead costs. Fixed overhead costs include the depreciation of assets, annual salaries, rent, mortgage, insurance, government fees, utilities and property taxes.

2. Variable Overhead Costs

Variable overhead cost fluctuates depending on the business activity. If the business activity is increased, the variable overhead expenses rise. And when the business activity decreases, the variable overhead costs lower. These expenses include shipping charges, legal expenses, office supplies, equipment maintenance, materials etc.

3. Semi-Variable overhead

Semi-variable overhead is the combination of fixed and variable costs. Some costs are incurred regardless of any business activities. But the costs will increase when the business activity increases. Commissions and utility costs are some examples of semi-variable overhead costs.

Overhead costs are also grouped based on what causes the expense, like employee labour, materials used, or general business expenses. It helps businesses understand where their costs are coming from and manage them more effectively.

1. Indirect Materials

Indirect materials are linked to production activities which cannot be linked to a specific product or service. These expenses are added as a part of the production process. However, they are not embraced into the major chunk of the product or service. fitting, oil, supplies, cleaning etc. are some of the examples.

2. Indirect Labour

Indirect labour is overhead cost not directly linked to the production of the goods and services daily. However, it adds up to the production expenses. Some examples of Indirect labour overhead costs are the expenses paid to the executives for the transportation of raw materials from one warehouse to another.

3. Indirect Expenses

These are extra costs that don’t directly contribute to making goods or services better but help with daily operations. For instance, things like postage, printing, and research and development fall into this category. They’re expenses that support the organization’s routine functions.

Also Read : What are Operating Costs?

How to Calculate Overhead Costs?

Given below are some steps to be followed to calculate the overhead costs-

1. List Expenses

In the first step list all the indirect expenses such as rent, taxes, office equipment, factory maintenance, utilities etc. All these expenses do not affect production but are added to the overall production expenses. When sorting direct and indirect costs, it’s important to acknowledge that certain items may not be assigned to a particular category.

2. Add to Overhead Expenses

Combine the monthly overhead costs to estimate the total overhead expenses for your organization on a quarterly, semi-annual, and yearly basis. This represents the funds required to sustain and operate your business.

3. Calculate the Overhead Expense

The overhead rate, or percentage, indicates the portion of your organization’s expenses dedicated to producing goods or offering services. To find this rate, divide indirect costs by direct costs and multiply the result by 100.

4. Compared to the Organization’s Sale

When determining prices and creating budgets for the organization, it’s crucial to understand the percentage of a rupee allocated to overhead costs. To calculate this percentage relative to sales, divide the monthly overhead cost by monthly sales and multiply the result by 100.

5. Compare to Labour Costs

To measure the efficiency of resource utilization in a business, determine overhead costs as a percentage of labour expenses. A lower percentage signifies more efficient resource utilization by the business.

Tips to Reduce Overhead Costs

1. Explore remote work or shared offices to cut down on rent expenses.

2. Streamline processes by automating tasks, reducing excess work hours, and minimizing supply usage. You can use advanced technologies such as ERP software to automate the tasks.

3. Research alternative vendors for better prices on materials, and consider consolidating services for cost savings.

4. Evaluate bulk purchasing to determine potential savings on supplies.

5. Optimize business software to avoid unnecessary monthly subscription costs.

6. Minimize paper use by utilizing free digital services for tasks like emailing invoices and implementing direct deposit for payroll.

Final Takeaway

Overhead Costs are crucial for an organisation. In this blog, you have learned the right way to calculate overhead costs. To ease all your accounting processes, implement an ERP system for efficiency. It is the best solution to all your accounting challenges.

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