What is Overhead Cost?
Overhead cost is the cost that is incurred when running a business and cannot be linked to the production or manufacture of goods or services. These costs include rent, utility bills, salaries for administrative personnel, and insurance costs, among others. There are three types of overhead costs: fixed, variable, and semi-variable.
Overhead Costs are not just expenses; they are strategic elements in the business. They may not directly contribute to the cost of making the actual product, but they are crucial for running the business. Controlling and analyzing these costs is not just important; it’s a strategic necessity for understanding the global strategy of any company and its budgeting method.
Importance of Understanding Overhead Cost
Understanding overhead costs is crucial for a business due to the following reasons:
- Accurate Pricing: Overhead costs have to be incorporated into the product or service cost to ensure that each expense is accounted for. This precision in pricing empowers you to set the right prices, thereby directly influencing your business’s profitability.
- Budgeting and Financial Planning: Such understanding is important in planning the business because it makes it possible to develop better budgets, produce better forecasts about future expenses, and use available resources more efficiently.
- Profitability Analysis: Overall, the =recording of overhead costs allows for evaluating the company’s profit level, which indicates specific points in need of cost reduction in order to increase its revenues.
- Cost Control: It is always helpful to shed light on overhead costs as it allows for the development of measures that would help eliminate avoidable costs, therefore leading to the effectiveness and profitability of the business.
- Competitive Advantage: Any company that is able to manage its overhead expenses effectively can price its products competitively and still maintain its profitability, thus the advantage in the market.
- Informed Decision-Making: Knowledge of the components and behavior of overhead costs assists the management in decisions on investments, Cost reduction or cost control, and changes to the business.
Types of Overhead Cost
1. Fixed Overheads
It is costs that do not change with the level of activity or output, commonly known as the overhead costs. These costs remain constant irrespective of business activity and have to be paid for all the time, even if no revenues are coming in. This entails costs such as rent for the office space, permanent employees’ salaries, and insurance expenses. For instance, the rent that a manufacturing firm pays for their factory will always remain constant whether they produce 1000 units or 10000 units of a product, and therefore, rent such cost is referred to as fixed overhead.
2. Variable Overheads
On the other hand, variable overhead costs vary in proportion to the volume of products that are produced or the number of sales made. These costs rise with increased production and decrease with a decrease in production levels. Some of these are energy bills, the supply of raw materials, and the cost of transportation, among others. For instance, the electricity cost in a bakery may go high as more ovens are used for baking more products; thus, it is considered variable overhead related to activity volume.
3. Semi-Variable Overheads
The other type of overhead costs is the semi-variable overhead costs, which are also referred to as mixed costs since they contain both fixed and variable elements. These costs are incurred directly up to a particular level of production or levels of usage and are known as fixed costs after that level. An example is a company’s maintenance expenses: Some level of maintenance is compulsory (fixed); more maintenance is needed as the frequency and usage of machinery rise (variable). For example, a delivery company may have fixed monthly costs to maintain the vehicles. Still, the variable costs are contained in the service contract and will also depend on the mileage or how often the vehicle has been used. It then qualifies to be a semi-variable overhead.
Formula and Calculations
The formula for calculating overhead cost is as follows:
Overhead Cost = Fixed + Variable + Semi-variable Overhead Costs
To calculate the overhead cost per unit, use the following formula:
Overhead Cost per Unit= Total Units Produced / Total Overhead Costs
Solved Example
Scenario: A company has the following costs:
Fixed Overheads = $ 10,000
Variable Overheads = $ 12,000
Semi-variable Overheads = $ 8,000
Total Units Produced: 5,000 units
Therefore, the solution is:
Total Overhead Cost = 10,000 +12,000 + 8,000 = $ 30,000
Overhead Cost per Unit= 30,000 / 5,000
Overhead Cost per Unit=$6
Result: The overhead cost per unit is $6. This means that for each unit produced, the company incurs $6 in overhead costs.
Reasons for High Overhead Cost
High Overhead costs can result from several factors:
- Inefficient Operations: inefficiencies mean that operational costs increase because of ineffective technologies ir manual processes in business operations. For instance, a firm that processes a high level of inventory may end up with high warehousing and administrative costs.
- Excessive Administrative Staff: Having excess people in the administration makes the overhead costs very high. If, for example, a company hires any administrative staff above the optimum level needed, then the salary and additional benefits to be paid can elevate overhead costs.
- High Facility Costs: Hiked overhead is also associated with higher office or manufacturing space costs, such as high rent or electricity use. For example, an organization operating from a posh business building may experience overly high rent and utilities costs.
- Inadequate Cost Control: Some of the causes of high overhead include, and could be as follows: poor cost control, expenses not being regulated, or lack of proper approval from management. For instance, overindulgence in office supplies cost or service costs that are not periodically revisited results in high overhead costs.
- Regulatory Compliance Costs: Other expenses incurred due to compliance with industrial regulations and standards contribute to overhead. For example, an enterprise may have to spend a lot of money on health and safety requirements, environmental laws, or quality standards.
- High Insurance Premiums: Some forms of insurance, such as high coverage limits or industry risk, may increase overheads because it is costly. Companies that are in the high-risk sectors may end up paying high insurance costs, which are reflected in overhead charges.
By managing and making the right changes in these aspects, it is possible to minimize and keep the overhead costs under check.
How to Reduce Overhead Cost
There are usually several overhead costs involved, and cutting or minimizing them can have a profound effect on the profitability and resource utilization of a business.
Here are several strategies to achieve this:
- Streamline Operations: Increase efficiency and effectiveness of operations through a systematic approach based on lean tools, elimination of wasteful activities, and use of technology solutions for common tasks. For instance, when designing an integrated software system, less work is done manually, such as typing data, hence improving overhead costs.
- Negotiate Suppliers Contracts: It is advisable to have a contract review and negotiate with vendors and service providers to obtain a better rate or condition. For Example, additional negotiations of some office supplies or searching for more attractive prices can lead to a reduction of expenses on procurement.
- Reduce Utility Expenses: Ensure that efficient ways of energy usage are put in place, for instance, by changing to energy-efficient lighting or procuring energy officiant equipment such as smart thermostats. Schemes that help to curb the use of utilities can bring down superior costs of power considerably.
- Outsource Non-Core Functions: Look at outsourcing some activities that do not directly relate to the business, for example, payroll services, internal IT support, or cleaning services from companies that can offer such services more cheaply. Such an approach can help save costs normally accrued in terms of hiring in-house staff and related overhead expenses.
- Optimize Space Utilization: Review and improve the efficiency of the office or manufacturing area in relation to the organization’s functions. Reducing the space, moving to a less expensive area, or changing the structure of the space also leads to a reduction in rent and energy bills.
- Implement Remote Work: Redesign organizational structures to allow for work from home or flexible working that can eliminate the necessity of acquiring a physical workplace and related expenses. This also helps to reduce overall expenses that are involved in operating the office, such as expenditures on consumables and power costs.
Therefore, implementing the above strategies will enable businesses to minimize their overhead costs and positively impact their financial position and operational performance.
Conclusion
Managing overhead is critical because it impacts the financial health and day-to-day functioning of any enterprise. Since these costs consist of fixed, variable, and semi-variable costs, control of indirect expenses enables firms to make appropriate decisions, increase efficiency, and improve performance. Measures such as rationalizing processes, bargaining some contracts, and efficient and effective space management are typical ways of reducing overheads to a large extent, and this leads to improved organizational financials and competitive advantage.
