Updated March 16, 2023

Every company should monitor its overhead to ensure that it's operating within its means. Reviewing overhead costs compared to other expenses and profits can help a business determine if it needs to downsize or increase production to remain profitable. Learning about the types of overhead and their importance for a business can help you make well-informed financial suggestions for the company you work for.

In this article, we define overhead and explain how to calculate it, go over the three main types of overhead costs and their importance to a business and review how accountants analyze overhead for pricing.

Related: How Much Money Does It Take To Start a Business?

Overhead, also known as burden or indirect costs, refers to the recurrent expenses of a business that are not directly used for the creation of a service or product. It's an expense that helps to support the organization without directly relating to the product or service offered.

For example, paying rent on a workspace is overhead because it's necessary for the success of a company but doesn't directly involve the costs related to producing a product. A company will always have overhead expenses it pays on an ongoing basis, regardless of its profits.

Related: Operating Ratio: Definition, Formula and Calculation

A company will always have overhead expenses it pays on an ongoing basis, regardless of its profits. Businesses can list overhead on their income statements. Things that a company can list as overhead costs on an income statement include:

• Labor

• Accounting fees

• Travel expenses

• Legal fees

• Interest

• Rent

• Repairs

• Supplies

• Taxes

• Utilities

Overhead expenses are included on an income statement because they directly affect how profitable a company is. A business owner should know the total sum of overhead expenses to determine a net income, also known as the bottom line. To get the net income, you must subtract all of the overhead and production-related expenses from the net revenue, which is also known as the top line.

Related: What Is Applied Overhead? (Definition, Formula and Example)

Knowing what your overhead cost is will help you determine the overhead rate on the price of your product or service. The smaller the overhead rate, the bigger the net income will be. For example, a company has \$10,000 in overhead costs annually and its sales are \$50,000 per year.

The owner can use this formula to determine the rate:

\$10,000 / \$50,000 = 0.2 or 2%

Or, the company spends two cents on overhead for every dollar it makes.

Besides setting price levels, knowing your overhead expenses is also important to help you set a budget when analyzing its sum together with other expenses, such as direct materials and direct labor.

There are three main types of overhead:

Fixed overhead involves any costs you pay on a recurring basis. Examples include workplace expenses like supplies, equipment and tools; production supervisory salaries; administrative salaries; depreciation on production equipment; and insurance on production equipment, facilities and inventory.

Variable overhead can change depending on the season. Examples include supplies for production, utilities for the facility and machinery, salaries for handling and shipping of the product, raw materials and sales commissions for employees.

Some overhead costs can be semi-variable. This happens when a business pays a certain sum regardless of activity, then the rest of the sum depends on the activity level. For instance, utility costs are usually semi-variable since a company pays them monthly, but the amount varies.

Related: FAQ: What Is Manufacturing Overhead?

Overhead is important because it helps determine the right price levels for products or services. It's a way for businesses to monitor their income and earn a profit on a long-term basis.

Knowing what your overhead expenses are can also help you reduce these expenses whenever possible. If there is one expense that is substantially high, you might be able to remove it or reduce it to increase profit. For example, if an organization is renting a workspace in an expensive area or that's too large for its needs, it can reduce its overhead costs by moving to a new, smaller location.

Related: What Is Underapplied Overhead? (Definition and Importance)

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Accountants use programs and software that help them take account of overheads so they can suggest a good price for the product or service being offered. Such tools include:

### Break-even analysis

This is a technique that accountants use to categorize production costs between the variable costs that change depending on production and the fixed costs that remain the same regardless of production. Break-even analysis will first calculate the margin of safety. The margin of safety determines how the amount of production or sales needed to reach a break-even point.

Related: How To Calculate Predetermined Overhead Rate (With Examples)

### Shut-down graph

This is a revenue curve that helps accountants determine if a business should continue operating. A business that can cover variable operational costs but not business overheads for a temporary time can remain in business.

However, if a business can't cover operational costs, then accountants would advise the owner to shut down. The shut-down graph helps accountants see if there's a possibility to keep the business operating or not.

### Activity-based costing

This technique assigns manufacturing overhead costs to the company's products logically rather than using the traditional approach of allocating costs depending on machine hours. For example, a company's utility bill per year is \$10,000 and the direct labor hours for using utilities is 5,000 hours. This means the overhead application rate is \$2:

\$10,000/5000 hours = \$2

Related: 7 Factory Overhead Components (Plus How To Calculate Them)

### Balance sheet

The balance sheet is where you can find a company's liabilities, financial assets and shareholder's equity. You would find the business overheads under current liabilities. Together with the other accounting tools, the balance sheet can help you understand the financial condition of your business.

Related: 10 Examples of Operating Costs in Running a Business

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