Everything You Want to Know About Overhead Expenses
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Successful businesses often track their expenses to determine whether they're profitable and make adjustments to save money. Overhead refers to regular expenses that nearly every business can consider when deciding their budget. Learning what ongoing expenses are and how to calculate them can make you a more effective manager and help you identify inefficiencies within a business. In this article, we explain what ongoing expenses are, discuss the different categories and kinds of expenses, state why they're important, provide the formula for calculating ongoing expense rate, and share tips for reducing expenses.
What is overhead?
Overhead is any expense that a business incurs that doesn't involve creating a product or delivering a service. It's sometimes referred to as indirect costs or burdens. It doesn't include the cost of materials or the cost of production of a product. You can think of indirect costs as all the extra expenses involved with running a business outside of the actual work that the business does. For example, consider a company that manufactures sneakers. The costs for insurance or taxes are indirect costs, while materials used to make the shoes and the cost of employee labour are direct costs.
Understanding ongoing expenses allows a company to determine how profitable they are. Profit is the total remaining after you subtract total expenses from total revenue. Being successful as a business involves more than achieving high sales numbers, it also involves controlling indirect costs to help ensure a high profit.
3 types of overhead
There are three distinct types of indirect costs and several forms that these expenses can take. You can consider all of them to help ensure the business is working to control costs and increase profits. Here are the three types of ongoing expenses:
Fixed indirect costs are those that are paid on a regular basis and typically remain consistent. They can include monthly obligations like rent, payroll, equipment, and insurance. The consistency of fixed costs can make it easier to budget and plan for them.
Variable indirect costs are those that may change according to the time of year. Examples of variable costs include shipping rates, utilities, and sales commissions for employees. Because variable costs may change from month to month, they can be more difficult to plan for and may affect businesses more significantly.
Semi-variable costs are those that are incurred on a regular schedule, but can vary according to company activity level. For example, utilities like electricity and water are semi-variable expenses. You can account for these costs on a monthly basis, like fixed costs.
Kinds of ongoing expenses
Indirect costs can take many forms depending on the business. Here are some of the most common types of these expenses:
Rent and utilities
Nearly every business pays some form of rent or utility costs. Businesses with a physical location pay rent to a landlord or property taxes to a municipality. If a business has a physical location, they can account for the cost of electricity, water, natural gas, and other utilities. Even if a business operates completely online, they might pay rent in the form of subscriptions to software or server space. Most rent expenses stay the same for a set duration, while utilities are a semi-variable cost.
Administrative costs refer to expenses incurred in the process of running a company. They can include external expenses like a tax firm hired to file on behalf of the company, or the supplies used in the company office. The administration of a company often involves specialized employees working in an office environment, so this can cause many hidden expenses. Administrative costs can also include accounting software or computers.
Insurance rates vary across different industries, but almost every business needs protection against unexpected events. Companies might insure their property against damage or theft, or insure their employees in case of an accident. Many jurisdictions require that companies carry insurance in order to operate. Insurance rates can change from year to year, so this is an indirect cost that can be significant.
Selling expenses refer to the money spent on marketing a product and engaging with customers. This can include the cost of an advertising agency, printing flyers, television commercials, or telephone marketing. You can track selling expenses and measure them against sales to help ensure that advertising campaigns provide a good return on investment.
Offering employees extra benefits for employment is an excellent way to attract talent to a company, but it can also lead to increased indirect costs. Employee perks might include free meals in a cafeteria, lounge areas for employees, transportation, or other benefits like retirement plans or expense accounts. Anything that a company provides to employees outside their regular salary is an indirect cost.
Why are ongoing expenses important?
A strong understanding of indirect costs allows a business to increase profitability and make effective plans for the future. First time business owners often underestimate the indirect costs involved in operating a company. Successful managers stay aware of these costs and actively work to reduce them without sacrificing productivity. If you remain aware of all indirect costs involved in running the business and recognize that they can constantly change, you can prepare for unexpected expenses.
Calculating indirect costs allows a business to price their products appropriately. If they know how many extra costs they may incur by creating a product and bringing it to market, they can set a price that results in the desired level of profit. Accountants include indirect costs in calculations that can reveal the health of a business, the possibility of expanding a company, or an appropriate price for a product.
Calculating ongoing expense rate
This rate describes the relationship between a company's indirect costs and its direct costs or hours of production. Calculating it requires knowledge of the company's allocation period, which refers to any unit of measurement that tracks the production of a product, including a dollar value or unit of time representing labour hours or machine hours. Here's the formula for ongoing expense rate:
Overhead rate = indirect costs / allocation period
A low rate suggests that a company is managing expenses efficiently, while a high rate might be the result of the unique challenges of a specific industry or expense management issues. For example, consider a company that has 20 million dollars of indirect expenses in a month, and 10 million dollars of direct labour costs. Using the formula, you can calculate the indirect costs:
Overhead rate = 20,000,000 / 10,000,000 = $2 in indirect costs for each dollar spent on labour
Tips for reducing ongoing expenses
Every business can benefit from reducing ongoing expenses. Here are some tips you can use to decrease indirect costs:
Focus on expenses
The first step towards reducing ongoing expenses is staying aware of additional costs. Try to develop metrics to track expenses across every area of the business. Specialized equipment can help you track and reduce energy use. Consider making a habit of examining the company's monthly expenses. Focus on the details and note any unexpected increases in indirect costs. You can encourage staff to conserve supplies and be conscious of needless expenses. Businesses that create a culture of frugality and sustainability develop the resiliency to survive unexpected expense increases.
Staying aware of indirect costs and taking measures to reduce them is important, but consider the consequences of any change you make to the business carefully. Remember that a high level of indirect costs doesn't mean a business isn't healthy financially. Devoting significant resources to costs like employee benefits and office improvements can improve morale and increase productivity. Reducing these costs might seem beneficial in the short term but have an adverse effect on a business in the future. You can analyze the relationships between costs and productivity to make informed decisions about reducing spending.
You might be able to achieve a significant reduction in indirect expenses with a single creative idea. Restructuring a department, finding a new supplier, or rethinking operations can massively reduce costs. You may attempt to promote a company culture of innovation in which managers listen to employees' ideas and suggestions. Unexpected suggestions can lead to new methods that you may not have otherwise considered. A specialized efficiency consultant can also offer ideas on how to reduce costs. Using all available resources can help increase your chances of discovering new ways to reduce expenses.
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