A start-up has to sustain and manage various expenses in the process of its creation and post-incorporation to run a business. Though such costs may vary depending on the type of business structure, nature of products/or services offered, and the scale of business operations or business models. For instance, online businesses need bricks and mortars, coffee shops may have more requirements than just furnishings and spaces than bookstores.
Especially in the early stages of a business, there is an immense need for careful planning and meticulous accounting. Some start-ups, though neglect the process of managing costs & fail to consider the importance of accounting operations and rely on a flood of customers instead to keep the operation afloat usually end -up with abysmal results. Since the list of such expenses could be long and confusing at the same time, it seems only logical to classify them into different categories of business operation for their better management & function.
All such business expenses could be further divided into – overhead or operating costs and the difference between the two relies on the nature of the business being run. While operating expenses are expended as a result of normal business operations, overhead expenses are the costs required to run the business.
Thus, Overhead costs are a fundamental constituent of operating a business and reflect expenses start-ups need to expend for running their day-to-day operations. As they are impossible to be avoided, it becomes necessary for us to understand them and the manner of their calculation to manage them effectively and make a business profitable. In this article, we’ll take a look at the meaning of overhead costs, their importance, and how to calculate them.
Overhead Costs-Meaning & Definition
Thus, Overhead Costs refer to the running costs of a business that cannot be directly attributed to the manufacture of a product or procurement of a service. These expenses are incurred to stay in the business irrespective of its level of growth or success and usually vary depending upon the nature of the business. Some typical examples of Overhead costs include-
Rent
Utilities
Taxes & Insurance
Salaries that aren’t a job- or product-specific
Office equipment & supplies
Features of Overhead Costs
Overhead costs represent costs that are fixed in nature and are related to general business functions such as payment of salaries to accounting personnel and facility costs. Likewise, a start-up incurs other business expenses such as insurance payments and salaries of administrative staff and management personnel, which are fixed in nature but may change slightly over the period. Similarly, the costs of utilities may change depending on usage. For example, if a manufacturing company increases production, it may be required to pay more electricity charges.
Overhead expenses also include expenses incurred by a start-up to advertise or promote their products or services in the market. For instance, for a soap manufacturing company, overhead costs may include commercial ads, signage in retail aisles, or any other promotional costs. And, these costs are still incurred even if the production is shut down temporarily for a short period.
Overhead costs are expenses of continuing nature but do not directly contribute to the generation of business profits. Still, businesses are obligated to meet overhead expenditures on an ongoing basis, regardless of the percentage of sales or sales turnover attained for the period. For instance, a service-based business having an office would incur overhead expenses such as rent, utilities, insurances, etc. in addition to its direct costs such as labor and supplies.
Overhead costs can either make or break a start-up. These costs though are unavoidable but are needed to be incurred carefully to maintain liquidity in the business Therefore, businesses should try to keep them as low as possible while building a business.
Expenses related to business overheads appear under the income statement of the company, which in turn affect the Net profits of the business. The company must assess overhead expenses to determine its net income which is also known as the bottom line.
Why is it necessary to understand overhead Costs?
Having a deeper understanding of overhead costs has the following benefits-
Planning & forecasting costs-Knowing the overhead costs can assist a business in its crucial business functions such as pricing goods or services offered in a way that could make a business profitable. By factoring overhead costs into the total cost to operate your business, a start-up could easily forecast the number of funds required to cover overhead expenses required to lead a successful business.
Assessing Business Net Profits-Accurate assessment of overhead costs could help a business to calculate the position of its net profits by using overhead costs and gross profit and subtracting all expenses to find out your net profit. This net profit will also help a business to understand whether it is earning revenues over and above its expenses or expenses are more than the revenues.
Cost-reduction-Finding out the total amount of funds required to meet overhead expenses will help the management to find the right ways to reduce them or set sales targets for a profitable business. Additionally, it could also help to save money by estimating any large expenses generated over time and to come up with solutions to reduce such costs.
Budgeting-Preparation and implementation of budgets is an important business function. Since most of the overhead costs are fixed or semi-variable in nature, it becomes easier to forecast them and manage the business functions effectively.
Difference between Overhead Costs and Operating Expenses
Points of Difference Operating Expenses Overhead Costs
i. Definition Operating expenses are the costs incurred as a result of the normal business operations such as materials, labor, and machinery to complete the process of production. Overhead expenses are the expenses incurred to run a business such as insurance and utilities such as electricity and water charges.
ii. Avoidable or unavoidable? Operating expenses are required to run the business and cannot be avoided at any cost. Overhead expenses should be reviewed regularly to reduce wastage and increase the profitability of the business.
iii. Examples Payroll, travel, repair & maintenance, interest & taxes, office supplies, depreciation, and advertising, etc. are some common examples of operating costs. Accounting Fees, advertising & promotion, employee benefits, travel expenditures, and utilities, etc. are examples of overhead expenses.
iv. Expenses included Operating expenses include both overhead and Cost of Goods Sold(COGS)/Cost of Sales(COS) Overhead expenses cover all the expenses necessary to stay in business.
v. Superiority Operating expenses are a wider concept covering everything required to be spent in the course of running a business Overhead is a sub-type of operating expenses.
Types of Overhead Costs
There are three types of overheads namely- fixed overheads, Variable overheads, and Semi-variable overheads.
i. Fixed overheads
Fixed overheads are the costs that remain fixed every month and do not change with the level of business activity. They are fairly predictable and are necessary to ensure the smooth running of business operations. However, profit margins should be reflected in the costs of fixed overheads.
Some of the examples of fixed overhead costs include-
Rent of the factory, warehouse, or corporate office
Salaries of plant managers and supervisors
Depreciation of fixed assets
Taxes and insurance
ii. Variable overhead
Variable overhead costs are costs that change with the volume of production. In other words, variable costs tend to increase or decrease with the level of production output. However, the direct labor involved in the production would not be variable overhead unless the number of workers increases or decrease with the volume of production. Likewise, in case there is no production output available, there would be no variable overhead costs included. Some of the examples of variable overhead are as follows-
Some of the examples of variable overhead include-
Supplies
Raw materials or Labor for production purposes
Sales commissions
iii. Semi-variable overhead
Semi-variable overheads possess characteristics of both fixed and variable costs. For instance, a business may have a limited quantity of staff but may require to hire more staff during busy seasons depending upon the level of business activity.
Though, variable overheads could be incurred at any time, even though the exact cost will fluctuate dependent upon the level of business functions. Semi-variable overhead costs may come with a base rate that a business must pay at any activity level including a variable cost that is determined by the level of usage.
Examples of semi-variable expenses include-
Payment of Bonus-Awarded to the employees at different times during the year;
Janitorial services- During the busy season, an event management company may need extra staff for cleaning or maintenance services for the extra mess.
Sales Commissions
Cost of Utilities such as electricity charges and water costs that includes a fixed charge and additional costs based on usage.
Process of Calculation of Overhead Costs
Since overhead costs cannot be directly attributed to any specific cost, they are regarded as a general expense and are accumulated as a lump sum which is then allocated to a specific product or service. There are several ways of calculating overhead, the general rule is –
Overhead rate = Indirect costs/ Allocation measure. Here, the indirect costs are the overhead costs while the term allocation measure includes labor hours, or direct machine costs, through which a company measures its costs of production. The process of calculation of overhead costs has been explained in the steps provided below-
i. List all of the expenses
In the first step, prepare a complete list of all of the business overhead costs. Such a list should be thorough and should include expenses such as rent, utilities, taxes, and repairs & maintenance except costs including and related to stock, materials, and labor.
ii. Categorize each expense
The process of calculation of overhead costs becomes easier and straightforward with an organized list of expenses. Start by categorizing each item on the list of the expenses incurred in the manufacture of goods or procurement of services by your business. For instance, labor costs and the cost of materials for a construction business are direct costs. However, there is a necessity for caution while organizing costs as some items don’t fall easily into one category or the other. For example, usually, businesses classify legal costs as overheads. But, for a legal services firm and the lawyer’s cost of services are direct costs as these are directly related to the business services.
iii. Add the overhead costs
Now, after categorizing costs in separate categories of direct costs and overheads, collect all these overhead costs month-wise to calculate the total overhead expense. Typically, this is the sum required by a start-up for running its business.
iv. Determine Overhead Rate
Next, you need to figure out the overhead rate for absorption of overhead expenses. By definition, an overhead rate is a cost apportioned for the indirect costs incurred in the manufacture of any goods or services. Since overhead costs are not tied up with any direct costs, they are collected in a lump-sum amount and then should be apportioned by employing an overhead rate based on specific measures. For example, overhead costs may be apportioned at a prescribed rate on the number of machine-hours or labor hours required to manufacture a product.
Therefore, an overhead rate could be calculated by dividing the indirect costs by the direct costs and multiplying the same by 100. If the overhead rate is 50%, it means that the enterprise spends 50% of its income on the manufacture of a good or providing a service. Similarly, a lower overhead rate represents efficiency and higher profits.
v. Compare to sales
While setting costs and creating budgets, it is necessary to understand the percentage of sales dedicated to overheads. For calculating the overhead costs compared to sales, divide the month-wise overhead cost by month-to-month deals and multiply by 100.
For example, an organization has monthly sales of Rs. 200,000 and overhead costs totalling Rs. 50,000 has (50,000/ (200,000) x 100 = 50% overheads.
vi. Compare to labor cost
To figure out the efficiency of a business with the resources applied, calculate the overhead cost as a percentage of labor cost. And, if the percentage is lower, it means that the business is using its resources effectively. Now, divide the whole overhead cost by the total labor cost for the month and multiply by 100 to denote it as a percentage.
Calculation of Overhead Absorption Rate
The amount of indirect costs allocated to goods and services is known as Overhead absorption. The overhead absorption rate is calculated to include indirect costs in the total cost of production and to determine the amount required to cover costs for indirect labor, material, and other indirect expenses from the stage of production to the work in progress.
Hence, such overhead costs are attributed to each unit of goods produced or each service procured based on direct labor hours, machine hours, direct labor cost, etc.
There are several methods for calculating the absorption rate such as-
i. Percentage of Direct Material Method
The direct material cost is one of the primary constituents of the cost of production. Under this method, the absorption rate is established based on the cost of direct material. For which, the overheads must be divided with either the estimated or actual direct material costs.
% on Direct Material Cost = Overhead x 100
Direct Material Costs
ii. Direct Labour Cost Method
The estimated or actual cost of labor could be calculated by dividing overhead by direct wages which are then expressed as a percentage.
Direct Labor Percentage = Overhead x 100
Direct Wages
iii. Prime Cost Percentage Method
The prime cost is the sum of direct labor and direct material costs related to a business. The prime cost percentage could be calculated by dividing factory overhead by prime cost.
Prime Cost Percentage = Overheads x 100
Prime Cost
iv. Labour Hours Method
The labor hour rate is arrived at by dividing factory overheads by the total direct labor hours.
Labor Hour Rate = Overhead
Labor Hours
v. Machine Hour Rate
Machine hour rate could find out by dividing the factory overhead by machine hours.
Machine Hour Rate = Overheads
Machine Hours
vi. Sale Price Method
Under this method, budgeted overheads could be calculated by dividing overheads by the sale price of units of production.
Sale Price = Overheads
Sale Price of Production Units
Therefore, overhead costs are the indirect costs that cannot be tied up to any direct cost of production, still are crucial to keep a business running long-term and help a business to price their goods or services that may help them to cover all those expenses plus a suitable profit margin. For understanding and reviewing overhead costs, it is also necessary to keep an up-to-date record of all overhead expenses of the business that will help every start-up to establish the best price for your product or service. Not only is this an obligation for large-scale businesses, but is also relevant for smaller businesses and start-ups.
However, start-ups should monitor overheads costs and where possible, should recuse themselves from overspending on such expenses. Since they aren’t directly related to business revenues, they could drain a business unreasonably when not properly controlled. An example of unnecessary overhead is when a start-up rents office space in a trendy location for a business operation that could be easily home-based until reaching a significant growth level where more room is required for the staff and equipment. The money spent on rent payments might be better invested in any other business functions such as advertising or promotional activities, etc.
