What are Overhead Costs?
Overhead costs are the indirect recurring costs of running a business such as administration, selling, and premises expenses.
They are all the support costs of a business which are not directly attributable to the goods or services that the business is producing.
A business incurs overhead cost whether goods or services are produced and sold or not, this is in contrast to variable costs which only occur when goods or services are produced and sold.
Overhead costs are sometimes referred to as fixed costs although they are not always actually fixed. Being fixed simply refers to the fact that the overhead cost does not vary directly in relation to the level of goods or services the business is producing. Overhead costs do not remain constant they tend to increase in steps as a business grows.
For example, a business producing widgets rents a manufacturing premises, the rent is an overhead cost and will not vary in relation to how many widgets are produced, the rent will still be payable whether widgets are produced or not. However, the rent is not fixed, over time it will change in stepped increases in accordance with the rental agreement the business has with the owner of the premises.
Why are the Level of Overhead Costs Important?
In order to break even a business must ensure that it has sufficient gross profit to cover its overheads.
In the example below, operating at its current level of sales, the business will start to lose money when the overhead costs go above 75,000.
|Cost of sales
In the example above the break even revenue at overhead costs of 29,000 is as follows.
Overhead cost = 29,000 Gross margin % = Gross margin / Revenue = 75,000/120,000 = 62.5% Break Even Revenue = Overhead Cost / Gross margin % Break Even Revenue = 29,000/62.5% = 46,400
If the overhead increases by 5,000 to 34,000 then the break even revenue rises to a new level as follows.
Overhead cost = 34,000 Gross margin % = Gross margin / Revenue = 75,000/120,000 = 62.5% Break Even Revenue = Overhead Cost / Gross margin % Break Even Revenue = 34,000/62.5% = 54,400
As a result of the increase in overhead cost of 5,000 the breakeven revenue has increased by 8,000.
In general as the overheads rise the level of revenue needed to break even will also rise by a larger amount. It is therefore important to keep the level of overheads as low as possible in relation to the size of the business.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.