Overhead

The term “overhead”, in finance and accounting, refers to an expenditure a business incurs, which isn’t directly connected to producing goods or services. Overhead is derived from different sources and there are various types of overhead, but it’s usually presented as one sum, which then might be distributed by different products or projects. 

It’s crucial to measure a company’s overhead, as it represents a sum of money which must be spent anyway to keep the business running, and by knowing its precise amount it’s possible to set up reasonable prices and determine the following way of developing.

Overhead components and examples

Expenses that create overhead occur on an everyday basis in every organization, as they are what provides the very possibility for any business to exist. For example, an organization needs a location or a platform, regardless of its activity. A manufacturer needs a production site, a service-oriented company needs an office, and even a company with a whole working process being organized remotely still needs an online platform for operating. In all these cases, it’s required to pay for using any of the abovementioned things, and it’s just one example of overhead.

Origins of overhead vary for each particular organization. 

The most common ones, similar in most entities, are the following:

• Rent and utility expenses;
• Office supplies, including tea, snacks, toilet paper, stationery, etc.;
• Maintenance and current repair expenses;
• Legal and external fees and taxes;
• Insurance and licenses required for work;
• Advertising and marketing expenses, and some others.

Overhead main types

To get a better understanding of overhead, it’s possible to divide it into three large groups:

• Fixed overhead, which is the same for each period of time (rent payments are a good example);
• Variable overhead, which changes depending on the volume of production or other factors (current repair expenses aren’t usually the same each period of time);
• Semi-variable overhead, which starts from a fixed sum, but might get larger (for example, utility expenses).

It’s also a widely used practice to divide overhead by operational categories. Such a way of allocating and accounting is typical for ABC (activity-based costing), a costing method which takes into account relations between costs, products and procedures, aimed at determining the sources of overhead expenses.

According to this method, overhead expenses might be of these types:

• Administrative overhead, typical for most companies and related to accounting, legal and office issues;
• Manufacturing overhead, which also might be found in most organizations, which specifies in production;
• Maintenance overhead, typical for organizations which use machinery heavily;
• Research overhead, typical for scientific companies, which widely use research, development and innovations;
• Logistics overhead, typical for businesses, which heavily rely on constant transportation of goods and supply.

Overhead reporting and calculating

As overhead is important for accounting and estimating profitability, it must be included in a company’s financial statements. Overhead expenses affect various factors of business cost-efficiency, so it’s critically important to assess and report it correctly.

It’s necessary to remember that direct costs of production (such as cost of resources and labor used specifically to produce a good or a service) aren’t accounted for in the calculation of overhead expenses.

Overhead is often viewed as a general expense and presented as a single sum of money, which is also usually called a lump sum. This sum is often recommended to be divided and the divided parts to be attributed to certain products or services for accounting objectives. There might be various ways of calculating overhead, but in general, it’s usually counted for a period of time (typically a month). All the overhead expenses during a given month are divided by the amount of monthly sales, and then presented as percentage. It’s also possible to calculate overhead expenses in relation to other factors, such as working hours, for example.