An overhead is essentially one of the many ongoing business expenses that are not directly related to producing goods or delivering services. Unlike operating expenses, which include costs explicitly related to production, overhead costs are indirect costs necessary to keep a business up and running.
You’ll want to understand overhead expenses to put yourself in the best position to stay profitable and financially viable for years.
Overhead (definition)
Overhead costs are administrative expenses that stay constant year-round – regardless of how much you are actually producing in your business. In other words, an overhead cost won’t fluctuate with the amount of goods sold or services delivered, but they are indeed extremely necessary for your daily business operations. Each business expense could have a variable or fixed cost, generally including administrative costs, rent, utilities, business insurance, legal fees and more.
3 different types of overhead costs
While it differs from sector to sector, for the most part, there are three main categories of business overheads: fixed, variable and semi-variable.
1. Fixed overhead costs
Fixed costs will stay constant no matter whether your business is in a state of high production or experiencing a lull. These expenses must be paid regularly, whether or not your company is generating revenue. Some common examples include:
- Rent or lease payments
- Salaries for administrative staff
- Professional liability insurance
- Property taxes
- Audit fees
2. Variable overhead costs
Next up, variable overheads can fluctuate depending on how active or inactive your business is, as they will increase or decrease with production or sales. Examples include:
- Marketing costs (advertising, promotions, etc.)
- Shipping costs
- Utility bills (electricity, gas, water, phone service)
- Company cars (petrol, maintenance)
3. Semi-variable overhead costs
Finally, semi-variable overheads have both fixed and variable components. Think of it as a portion of the cost that stays constant, while the rest fluctuates based on usage. For example:
- Office supplies (paper, ink, software subscriptions)
- Staff bonuses
- Entertainment costs (business meetings)
How to calculate overhead costs
To better get to grips with how your overhead rate can impact your daily operations, use this simple formula:
Overhead rate = (Total indirect costs) / (Total direct costs)
Let’s say your total overhead expenses (indirect) are $10,000 and your direct costs (e.g. raw materials, labour) are $50,000. In this scenario, your overhead rate would be:
$10,000 / $50,000 = 0.20 or 20%
This means 20% of your total business costs are overheads.
Overhead costs vs operating expenses
While they can be – and often are – used interchangeably, overhead costs and operating expenses are actually different. An indirect cost is something you pay to keep your business running but it’s not directly tied to your product manufacturing or service delivery.
On the other hand, operating expenses include direct production costs, such as raw materials, salaries for your production employees and manufacturing overhead.
Here are some examples of overhead expenses:
Administrative overhead
- Office rent
- Administrative salaries
- Office equipment maintenance
- Phone and internet services
- Legal expenses and professional fees
Manufacturing overhead
- Factory equipment
- Depreciation (of your equipment)
- Indirect labour costs
- Safety compliance costs
Marketing and sales overhead
- Advertising campaigns
- Sponsorships and brand promotions
- Website (and ongoing maintenance for it)
- Customer service support
The impact of overhead on your net profit
A high overhead rate can really have an impact on your net profit. The more overhead your business incurs, the lower your profitability. That’s why it’s crucial to stay on top of all your overhead costs, so you can spot areas to improve and boost your business’s financial health – all while keeping your pricing competitive.
Controlling these expenses will help your financial stability over the long term, whether fixed, variable or semi-variable. Mark it in your calendar to review your business’s overhead costs every month or quarter and find ways to reduce them where possible.
See related terms
What is a liability?
What is fixed cost?
What is an operating expense?
