What is Overhead? A Guide to Not Get in Over Your Head

Imagine this: You are preparing for an annual board meeting, you know you will be asked to explain how the company will navigate shifting market conditions next year. The first step in shifting your strategy requires getting a firm grasp on your budget, so you can see what spending can be changed and what costs are non negotiable. 

This is where overhead comes into play. Optimizing your overhead spending can guide your decisions about resource allocation and help you operate efficiently. 

What Is Overhead?

Overhead costs are expenses required to sustain daily operations. They play a vital role in determining an organization's profitability and overall financial health.

In order to understand how overhead costs impact profitability, it is important to understand how they differentiate them from direct costs. Direct costs are those associated with producing specific products or services, like raw materials and labor. Overhead, on the other hand, includes expenses such as rent, utilities, salaries of non-production staff, office supplies, and maintenance costs.

The primary components of overhead can vary across industries and businesses but commonly include rent or lease payments for facilities, administrative salaries, insurance, and depreciation of equipment, and utilities like electricity and water.

Overhead costs have a profound impact on an organization’s bottom line. Mismanagement can erode profitability, making it imperative for business leaders to closely monitor and control these costs. Understanding overhead enables leaders to make informed decisions and streamline operations, ultimately optimizing organizational efficiency and financial performance. 

Why Overhead Cost Matters

Effectively managing overhead costs is fundamental for the financial wellbeing and prosperity of any organization. It holds substantial implications for strategic decision-makers as they strive to maximize profitability. Here's a closer look at the impacts of overhead.

Cost Reduction Strategies

Identifying and implementing overhead reduction strategies can yield significant cost savings. Streamlining operational processes and renegotiating vendor contracts can help you trim these costs. It also helps to adopt cost-efficient technologies that reduce overhead without compromising quality.

Impact on Pricing

Overhead costs directly shape the pricing strategies for products or services. Elevated overheads necessitate higher prices, potentially compromising a company's competitiveness in the market. Effective overhead management enables companies to offer more attractive pricing. This can entice a larger customer base and enhance market share.

Enhanced Profitability

Excessive overhead can erode profitability, posing a substantial risk to an organization's financial health. Prudent overhead management, conversely, contributes to heightened profitability. This empowers companies to reinvest in growth initiatives, innovation, and employee development.

Overhead costs are not mere financial details but key components of a strong business strategy. They influence everything from pricing to profitability and competitiveness. That is why it’s important to regularly evaluate and adjust spending. This leads to a healthy bottom line and long-term sustainability.

Types of Overhead Costs

There are various kinds of overhead costs, and each serves a distinct purpose within a company's financial framework. These categories include fixed, variable, semi-variable, and other less common types of overhead. Understanding the various types of overhead costs is essential for effective financial management, as it allows organizations to allocate resources carefully and make informed decisions regarding cost control and optimization. Here are the details about each type of overhead cost.

Fixed Overhead Costs

Fixed overhead costs are constant and do not vary with changes in production or sales levels. Examples include rent or lease payments for facilities, insurance premiums, and salaries of permanent staff members. These expenses remain stable over time, regardless of business fluctuations.

Variable Overhead Costs

Variable overhead costs fluctuate in direct proportion to changes in production or activity levels. Examples include raw materials, direct labor, and utilities like electricity and water. As production increases, so does the expense, and vice versa, making these costs directly tied to the volume of goods or services produced.

Semi-Variable Overhead Costs

Semi-variable overhead costs possess characteristics of both fixed and variable costs. A portion of these expenses remains constant, while another portion fluctuates with production or activity levels. An example is sales commissions — whereas a base salary is fixed, additional commissions vary based on sales performance.

Other Less Common Types of Overhead

Less common overhead types include step-variable costs, which change in increments as production reaches specific thresholds, and discretionary costs, which can be adjusted or eliminated at management's discretion to meet budgetary goals.

Calculating Overhead

Quantifying your overhead is an important step in understanding and managing a company's financial health. To determine overhead accurately, businesses follow a systematic methodology, specifically: 

1. Identifying Overhead Costs: This first step involves identifying all the indirect costs associated with running the business. Gather information on every expense, from utilities and office supplies to administrative salaries and maintenance costs. (These costs should be clearly distinguished from direct costs, which are directly tied to the production of goods or services.)
2. Determining the Overhead Rate: Once you've identified overhead costs, you can calculate an overhead rate. This is typically expressed as a percentage and is used to allocate overhead to specific products, projects, or departments. To calculate it, divide the total overhead costs by a relevant allocation base, such as labor hours, machine hours, or total production units. 
3. Allocating Overhead Costs: With the overhead rate in hand, you can allocate overhead costs to specific cost centers, products, or projects. Multiply the overhead rate by the actual amount of the allocation base used by each cost center or project. This process ensures that overhead costs are distributed appropriately and that each activity bears its fair share of indirect expenses.

Accurate overhead cost calculations enable businesses to price products effectively and maintain profitability. It's a critical aspect of financial management that helps organizations optimize their operations and achieve their financial goals.

Leveraging Overhead for Success

Overhead cost data can be a strategic tool for business success. By closely examining overhead expenses, organizations gain valuable insights into their financial health and operational efficiency. This data empowers decision-makers to make better, more informed choices that can lead to improved profitability and competitiveness. Upper management can also utilize overhead information to allocate resources more effectively, identifying areas where cost reduction is possible and where investments may be needed. 

Overhead also plays a pivotal role in optimizing organizational efficiency. Understanding the composition of overhead costs allows leaders to assess the cost-effectiveness of various departments, projects, or product lines. By identifying high-overhead areas and evaluating their contributions to overall performance, companies can make targeted improvements and reallocate resources to more profitable endeavors. 

Reduce Your Company’s Overhead

Overhead costs are a fundamental aspect of business operations that include indirect expenses. These expenses can significantly influence an organization's financial health and efficiency. 

Taking proactive steps to find ways to save can help you manage overhead more effectively. Increasing efficiency in your employee benefits spending is an area of overhead costs that can have a substantial impact. For example, investing in wellness programs can yield more engaged employees, as well as long-term cost savings. In a study of more than 19,000 employees, Wellhub clients saw their healthcare costs reduced by up to 35%. 

Talk to a Wellhub wellbeing specialist about how you can reduce your overhead through employee wellbeing!