Overhead refers to the bills your business has to pay even if no sales are being made. The monthly rent on an office is one example of an overhead cost. Calculating overhead provides key information for setting prices. Accurate overhead information allows you to allocate these costs to each product or service so you charge customers appropriately
Direct and Indirect Costs
Businesses incur some costs specifically to manufacture a product or provide a service to clients. These are categorized as direct costs. Examples include raw materials, wages for production workers and freight charges. Direct costs are closely tied to the firm’s business volume. Suppose a shoe company makes twice as many shoes this year compared to last year. The firm must spend the money to acquire additional raw materials directly needed to make the shoes.
Expenditures not directly tied to a particular product or service can be classified as overhead, or as indirect costs. Most overhead costs tend to be fixed, meaning they do not vary with the level of business activity. For example, the shoe company still pays the same monthly rent on factory space regardless of how many shoes it makes.
Sample Overhead Expenses
Calculating overhead is a matter of identifying indirect costs and adding up how much is spent during a month, year or other accounting period. Some overhead expenses are primarily administrative in nature. Administrative overhead includes:
- Compensation for non-production management
- Salaries for office and sales staff
- Office eases and utility bills
- Office supplies
- Government licenses, fees and property taxes
- Telephones, Internet fees and travel expenses
- Accounting and legal fees
Firms typically have other overhead costs as well. A retail business must pay rent and utilities for retail outlets. Manufacturers may lease factory space and pay indirect costs like production utilities, production management salaries and janitorial services.
Fixed and Variable Overhead
Rent, taxes and insurance are examples of fixed overhead costs. These usually remain stable for extended periods of time. A business may also incur variable overhead costs, which are defined as expenditures that don’t contribute directly to making products or providing services, but vary with the level of business activity.
Suppose a manufacturing firm experiences a significant growth in sales. Wages for non-production factory staff may grow because the workload has increased. Expenditures for office supplies used for billing customers increase as well. A case also can be made that some of these expenses are actually direct costs, so firms categorize such expenses in the way that best fits their business situations.
Service Business Overhead
Firms that provide services need to calculate overhead costs just like any other business. For example, suppose you are a freelance graphic designer. You bill clients for your direct costs, including your time plus materials like paper and production supplies. You’ll also have fixed overhead expenses. You may pay rent on an office and workshop as well as insurance, utilities and fees for accounting services. You also will have some variable overhead. For example, graphic design requires the use of tools and supplies that aren’t directly billable because they are used for multiple clients.
To properly price your design services, you need to add together all of your overhead costs. Allocate a percentage based on the size of a client’s order and incorporate this amount into the price you charge.