Overheads, also known as indirect costs or burden, are those costs that are not involved in generating profit, but they ensure your company’s day-to-day operations. Overheads include, for example, accounting and legal expenses, rent and utilities and are divided into fixed and variable overheads — depending on whether they are stable or not.
The sphere of the company’s operations may also be a factor to divide overheads into groups — for example, manufacturing or administrative overheads.
The contrary to the overheads is direct costs — or the expenses required to create products and services, e.g. direct materials and direct labour. Together with overheads, direct costs make all of the expenses incurred by your company. Accounting and bookkeeping services (which will also be part of your overheads, by the way) are provided to take the burden of counting off you and help you find the ways to reduce the indirect costs.
Fixed costs are those you have to pay for a certain period of time, no matter how big your sales volume is and how much profit your company makes. Fixed overheads include:
- Rent or mortgage payments
- Depreciation on fixed assets (such as cars or office equipment like computers)
- Salaries or any associated payroll costs
- Liability and other insurance
- Utilities (such as electricity or water)
- Legal and accounting costs
Even fixed costs may change with the course of time. For example, if you have a great increase in sales, you hire more employees and pay more salaries. The same situation might affect the renting costs — if your company’s staff grows, you might need to rent a new office space.
Variable costs are those that are dependent on some factors: for instance, the change of season or a fluctuation in the prices of supplies and services. Variable overheads include:
- Telephone expenses
- Office supplies (the more the business grows, the more you need of these)
Some costs may also be characterized as semi-variable, meaning that some part of the payment must be paid no matter what, while there might be some additional expenses for you depending on how active your business is. For example, you spendings on utilities may be semi-variable if there is a base charge and further extra charges if you exceed a certain threshold.
Overheads types based on business departments
Overheads can also be divided based on the type of activity of your company that they are connected to. They can be split into the following groups:
- Material overheads (costs related to purchasing, handling, storing and delivering materials used in the production process; for example, a warehouse rental)
- Production overheads (costs involved in producing a good or delivering a service; for example, rent or other facilities costs, stationery or utilities)
- Sales overheads (for example, sales and marketing department salaries)
- Administrative overheads (for example, office supplies or HR/accounting department salaries)
The overhead rate is a cost that you allocate to the production of a certain product/service. The allocation measure here might be any type of measurement that is necessary for the production (for example, direct labour hours or machine hours). The overhead rate may show you how much of overheads costs you have for every pound in your direct labour expenses, or how much of overheads costs you have for every hour the machine is in production.
The basic formula to calculate the overhead rate is indirect costs divided by a certain allocation measure.
Let’s have a look at several overhead rate calculation examples.
Counting an overhead rate in pounds: this counting will give you the figure of how much it costs your company in overheads expenses for every pound you spend on direct labour.
Total overhead expenses (for a certain period) — £15,000,000
Direct labour expenses — £5,000,000
Applying the formula: £15,000,000/£5,000,000=£3 and that is the overhead rate, meaning that it costs you £3 of overheads expenses for every pound you spend in your direct labour costs.
Counting an overhead rate per hour: this counting will give you the figure of how much it costs your company in overhead expenses for every hour a manufacturing machine is in production. By analyzing this, you can properly price the product to make sure there is enough profit margin to compensate for the figure you make per hour in your indirect costs.
Total overhead expenses (for a certain period) — £300,000
Machine hours — £30,000
Applying the formula: £300,000/£30,000=£10, and that is the overhead rate, defining in this case that it costs your company £10 in overhead expenses for every hour the machine was in production.
Ways to reduce your overhead costs
Either fixed or variable, overhead costs can be reduced to save you money — so, it is efficient to have a look at your indirect costs from now and then and check out where you can spend less. Here are a few ways to cut down your overheads.
- Go paperless. Many businesses are switching their accounting and archives to a paperless system — online. This can not only help you to avoid some mistakes, but it can also help you to reduce or even eliminate some overheads. For example, you might not need to spend money on paper or ink. Or, you can hugely save on storage costs, if you move your archives online.
- Rent. Depending on the type of business you have, you might think about moving your office from the city centre to the suburbs (where it is usually less expensive) — if you do not need it so much, for example, to meet the clients there. Or, you can even get rid of the office renting fees, if it is possible to make all your staff work remotely.
- Salaries. Talk to your employees and negotiate the working schedule with them — by ensuring they are working most efficiently in whether it is a part-time job or full-one, you can save money on paying just equally to everyone. And, with a proper calculation, you might even find a possibility to hire another person to boost your business productivity in a sphere you have long planned to develop.