Overhead Costs in Service Businesses vs. Product – Based Businesses

Introduction

The difference between a service-based business and a product-based business can be seen in the way overhead costs are set up and allocated. Product-based businesses need to account for raw materials, production, and other expenses, while service-based businesses completely rely on human expertise and skills.

For budgeting, profitability, and pricing strategies it is significant to understand the impact of overhead cost. In this article, we will try to figure out the various overhead costs in product and service-based businesses.

Most importantly overhead costs are always considered essential in running any business which usually covers all day-to-day operations and other indirect expenses. These costs may be variable in some cases but generally remain constant regardless of the production or service levels.

To understand the actual financial health of the business it is crucial to have an idea about overhead expenses and strategic decision making. These costs typically include rent, utilities, office supplies, employee wages,  and others.

Overhead Costs in Service Businesses

In-service business overhead costs refer to ongoing expenses that occur in day-to-day operations and are not directly related to the delivery of a particular service. Managing overhead costs efficiently is important for service businesses to maintain profitability while maintaining a high level of service quality and customer satisfaction. Reducing overhead without affecting service quality is a key challenge.

Service Business Overheads and Their Examples

In service-based businesses, overhead costs are generally associated with the personnel required to deliver the service, as well as the technology infrastructure that supports the business. Service businesses focus more on sustaining a skilled workforce and maintaining the resources needed to support client services.

Examples of Service Business Overheads:

• Salaries and Wages: As salaries and wages of labor cover a significant portion of overhead, therefore it is important to overlook each amount spent on a particular skill set as laborers are the core asset of the company.
• Rent: A very basic and predictable overhead cost is “rent” and it generally varies depending on the size or location of the business. Services businesses, those working with physical offices must need a planned budget for utilities and rent.
• Office Supplies and Utilities: Service businesses require office supplies such as computers, printers, software, stationery, and internet access. Utilities, including electricity, water, and heating, also factor into overhead costs.
• Software Subscriptions: Often service business uses specialized software for managing their activities which range from project management tools to customer relationship management (CRM) systems. This software ensures efficient service delivery. However, the cost related to these software subscriptions must be included in the calculation of overhead costs.

Service Business has a Heavy Focus on Labor and Employee Benefits

The workforce serves as the core basis for service operations and internally the largest portion of expenses comes from employee-related expenses. Apart from paying wages and salaries, businesses must handle costs for employee benefits, insurance, and training programs. Offering customized service requires constant workforce investments and adds complexity to managing overhead expenses.

Examples:

• Training and Development: Companies spend significant resources on employee training because specialized skills are essential in consulting, healthcare, and technology industries. Companies need to account for these long-term training expenses when managing their overhead expenses. A consulting firm invests large sums in leadership training and technical certifications to maintain staff excellence.
• Employee Insurance and Benefits: Service businesses must pay for health insurance plus employee benefits such as retirement plans and time-off packages. Employee benefits support staff loyalty yet represent substantial ongoing expenses that require proper financial control.

Unique Challenges for Service Businesses

Service organizations experience specific obstacles that start from delivering intangible services to customers. Effective human resource management helps service businesses run smoothly and stay profitable because people provide most of their value through their skills and experience. Service businesses find it challenging to create set procedures and forecast demand because their operations depend heavily on tailored service delivery.

• Reliance on Skilled Workers: A service business succeeds when it keeps qualified professionals both in the workforce and motivated to stay. Professional service providers like law firms and medical groups need skilled workers who deserve to earn high wages because of their specialized knowledge. High demands for qualified professionals drive up hiring costs and make it difficult to keep talented employees in competitive job markets.
• Balancing Labor Costs with Client Expectations: Service businesses must find the right way to control employee expenses while making sure they deliver the expected customer service. A company facing low customer demand must decide if keeping excess staff will create unnecessary expense burdens. Your business loses opportunities and disappoints clients when you do not provide enough support to your team during peak periods.

Overhead Costs in Product-Based Businesses

In contrast, product-based businesses focus on the production, storage, and distribution of tangible goods. The nature of these goods requires significant investment in materials, facilities, and machinery, making overhead costs more capital-intensive compared to service businesses.

Product Business Overheads and Their Examples

Product-based businesses need to track all expenses related to making and moving their physical products, from raw materials to production costs and supply chain handling to shipping fees. They also need significant resources to maintain their production equipment while managing product supply and delivery operations.

Examples of Product Business Overheads:

• Manufacturing Facility Costs: Product companies require physical spaces to manufacture their products. The buildings used for storage and production require financial support for rental fees combined with power bills and maintenance needs.
• Machinery and Equipment: Businesses operating in manufacturing or large industry sectors must purchase and support their manufacturing tools and production facilities. The costs of maintaining and updating equipment and handling their wear and tear make a big part of overhead expenses.
• Inventory Storage: Businesses face substantial financial costs from providing enough physical space and facilities to handle their inventory needs including raw materials and completed products. Having extensive product quantities in stock requires businesses to spend more on storing and maintaining that inventory.
• Shipping and Distribution: After manufacturers complete their products they need to ship them to customers. All costs for transporting merchandise and supply management need to go into the overhead budget. The expenses change based on where the product is located, how fast we need to deliver it, and how complex our supply chain operations are.

Product Business Emphasis on Materials and Production Infrastructure

Product-based companies must spend a lot of their overhead costs on purchasing raw materials needed to produce finished products. Product businesses struggle to get raw materials while service businesses only need experienced workers to succeed.

Examples:

• Raw Materials: The price of fundamental materials like metals, plastics, and fabrics moves because of global distribution networks, international politics, and seasonal market growth needs. The price of copper increases dramatically when mining companies and transport systems face supply problems.
• Depreciation of Assets: Manufacturing equipment and vehicles naturally lose their usefulness as production time passes. Businesses need to factor in ongoing equipment depreciation when they check their operations’ long-term survival potential.

Product Business Unique Challenges for Product Businesses

Companies focusing on product sales have to deal with several unique challenges in their product creation and supply management. The main difficulty for product businesses lies in controlling production costs that adapt based on manufacturing quantity and temporal changes.

• Managing Variable Overheads: Product businesses deal with costs that change depending on production volumes but service businesses keep most of their costs consistent. Raw material prices depend on market trends and seasonality affects both their prices and the costs of energy and transportation service.
• Supply Chain Disruptions: Our overhead costs vary due to external conditions that block supply chains, restrict materials, and change business rules. Various product businesses encountered shipping delays and higher material expenses as global supply chains broke apart during the COVID-19 pandemic.

Key Comparisons Between Service and Product Businesses

Both service and product-based businesses have distinct overhead structures, but there are key areas of overlap.

Here, we will compare some of the most critical aspects of overhead costs in each model:

1. Fixed vs. Variable Overheads

• Service: Businesses that offer services maintain the same fixed costs like building rent and employee salary payments despite providing more or less work. The business also deals with costs that fluctuate due to project work assignments and freelance contractor inputs.
• Product: Product businesses experience overhead expenses that vary based on their operations. The costs of raw materials shipping and production utilities vary depending on production schedules and outside influences.

2. Impact on Pricing Models

• Service: Pricing in service businesses is often tied to the expertise provided or the time spent on a project. This can make pricing relatively flexible, but it also means businesses must carefully manage the time invested in each client.
• Product: Pricing in product-based businesses is often based on unit production costs, which include the direct cost of materials, labor, and overheads. The pricing strategy also incorporates factors such as production scale, market demand, and competition.

3. Profit Margins and Scalability

• Service: Profit margins in service businesses depend largely on employee productivity and efficiency. Since labor is a significant overhead, improving utilization rates can directly enhance profitability. However, scalability may be more challenging since expanding a service business often requires hiring additional skilled workers.
• Product: Product businesses benefit from economies of scale. As production volume increases, fixed costs are spread across more units, leading to higher profit margins. Furthermore, product-based businesses can often automate certain aspects of their production processes, improving scalability.

Tips for Managing Overhead Costs in Both Models

Service Businesses

• Embrace Automation: Service businesses can reduce overhead by automating tasks such as scheduling, client communication, and billing. For example, legal or consulting firms might use software to automate time tracking and invoicing.
• Invest in Employee Development: Providing training opportunities helps improve employee productivity and reduces turnover, which can otherwise be costly.

Product Businesses

• Service: Employee performance and work methods directly impact how profitable service businesses become. When companies use their workforce more efficiently they can earn stronger profit levels since labor costs form a big part of their spending. A service business faces difficulty when it needs to grow because we must find more qualified employees.
• Product: Product businesses create better profit margins by scaling up their operations. Production growth reduces the impact of fixed costs on individual items giving better profit margins. Producing products allows businesses to automate their operations and grow their business effectively.

Common Advice

• Track Overhead Allocation: Both service and product businesses benefit from activity-based costing (ABC), which allocates overhead costs to specific activities, helping businesses identify inefficiencies and better understand their true cost structure.
• Conduct Regular Audits: Businesses should regularly review their overhead costs to identify areas for improvement and ensure that unnecessary expenses are eliminated.

Real-Life Examples of Companies

Service Business Example: Deloitte

• Deloitte continues to grow because it needs experienced professionals to serve its global consulting clients. The consulting firm Deloitte spends money on consultant salaries must pay for office space and buys costly analytical software for its work. Deloitte succeeds financially by reducing employee costs and monitoring the time its staff spends working for paying clients.

Product Business Example: Apple

• Apple’s overhead expenses go toward creating its devices requiring aluminum and silicon components. Apple dedicates substantial funds to research and manufacturing practices that enable smooth product development and cost-effective production scale-up. Apple’s massive scale of production and trusted brand name help them minimize business expenses and secure healthy profit margins.

Conclusion

Overhead costs are an integral part of any business model, but the structure and management of these costs vary widely between service-based and product-based businesses. Service businesses face significant overhead related to labor and expertise, while product-based businesses must manage costs tied to production, materials, and infrastructure.

Understanding these differences allows businesses to make more informed decisions about budgeting, pricing, and profitability. By adopting strategic approaches to managing overhead costs whether through automation, lean practices, or efficient supply chain management businesses can improve their bottom lines and remain competitive in their respective industries.

FAQs!

What are overhead costs in the service industry?

All the indirect expenses that are required to run the business and are indirectly related to the specified business activities. The overhead costs in the service industry are utilities, rent, administrative salaries, or office supplies. 

What is the difference between product-based and service-based business?

A product-based business focuses on creating and selling physical goods, while a service-based business offers intangible services, such as consulting, maintenance, or education.

How to allocate overhead costs in a service business?

Overhead costs in a service business can be allocated based on various methods, such as labor hours, service hours, or the number of clients served. The goal is to proportionally assign these indirect costs to different services offered.

What are the overhead costs of a product?

Overhead costs of a product include indirect expenses like manufacturing facility rent, utilities, equipment maintenance, and salaries of employees not directly involved in production.