What are overhead costs?
“Overhead” is money you spend running a business that isn’t directly related to the product or service that you’re producing. Let’s say, for example, you run a restaurant. The money you spend on buying food or paying cooks is a direct cost while what you spend on rent, utilities, and health inspections is your overhead.
What is the difference between overhead costs and regular expenses?
Regular expenses are necessary for the production of a business’ wares while overhead costs are merely incidental. Let’s return to our restaurant example. You need to buy food or you won’t have anything to sell. You also need to pay salaries to your cooks and servers. Therefore, food and labor costs are necessary operating expenses.
But you don’t need to pay rent in an expensive neighborhood to run a restaurant. You could just as easily operate one from a food truck. Or you could convert one room in your house into a restaurant. Maybe put some chairs and tables on your lawn for that outdoor dining experience.
Any of the above approaches will cut down your rent bill to zero but people still pay a lot of money to rent dedicated restaurant space in shopping districts. Why? Because it makes business sense.
A shopping district will have far more foot traffic compared to your house. That means greater visibility, more walk-ins, and more money. Not to mention that zoning regulations and health codes might prevent you from converting your house into a restaurant. You could also charge more money for your food if you’re serving it in a sit-down restaurant in a fancy part of town compared to serving it in your backyard or from a food truck.
You may hate overhead as a business owner but isn’t always evil. Rent may be an unnecessary expense but if it puts your restaurant in a more visible location with more foot traffic and a more affluent customer base, it makes sense to spend that money.
Examples of overhead costs
- Administrative costs
- Utility costs
- Insurance premiums
- Legal fees
- Accounting fees
- Business licenses
- Office supplies
- Travel expenses
- Maintenance and repair of premises and equipment
- Technology and news subscriptions
- Sales commissions
- Property taxes
Types of overhead costs
Fixed overhead costs
Fixed overhead costs stay the same day in and day out. If we return to our restaurant example, rent, insurance, and business permits are fixed costs because you’re paying the same amount every time.
Variable Overhead costs
Variable costs change. Returning to our restaurant example, the most volatile cost would be delivery. The cost of each delivery will vary due to factors like distance, weather, and traffic. Equipment maintenance and repair is also a variable cost.
Hybrid overhead costs/Semi-variable costs
Semi-variable costs have a fixed and a variable component. Take utility bills, for example. There’s a fixed cost you have to pay no matter what and a variable fee that is dependent on usage.
The cost of goods sold (COGS) is another form of semi-variable overhead. If you run a clothing, factory, for example, your COGS will factor in three things:
- The cost of raw materials (fabric, thread, dye, etc)
- Direct labor hours spent on each item of clothing
- Overhead costs (factory rent, sewing machine maintenance, and the cost of transporting clothing from the factory to the customer).
Is asset depreciation an overhead cost?
While it is unavoidable, depreciation is an indirect cost of business activity and all indirect costs are part of overhead.
Can you eliminate overhead costs?
A total overhead cost of zero is impossible because those costs are unavoidable to a certain extent. Government regulations mean you can’t operate a business without a license, for example. You could also be sued for any number of reasons, so legal expenses aren’t always avoidable. The same goes for manufacturing overhead and renting business facilities.
The goal shouldn’t be to eliminate overhead completely but rather to decrease costs as much as possible without negatively impacting the business.
The key to eliminating unnecessary overhead is asking yourself whether the cost is worth the returns. The analysis part is where people make the mistake of lying to themselves.
They waste money on expensive office space for a two-person business that they could run from home. They hire an assistant they don’t need for appearances or pay for a country club membership because of the “networking opportunities” when all they ever do is drink margaritas in the clubhouse.
These are all status-seeking behaviors but most of the people engaging in them wouldn’t admit it, even to themselves. They deceive themselves to protect their positive self-image.
If they can reasonably argue that unnecessary expenditures which only exist to make them feel important are actually sensible business expenses, they don’t have to confront the ugly truth: they’re shallow and overly concerned about what other people think of them.
Don’t fall into that trap. Just ask the golden question: “If I cut this expense, what will suffer more? My ego or my business?” The answer to that will tell you everything you need to know about the necessity of your overhead costs.
How to reduce overhead costs
Do the following to decrease overhead costs and boost your profit margins:
- Reevaluate employee perks. While you cannot take an axe to your payroll without impacting motivation and productivity, there are still a lot of business resources being wasted on non-salary perks which contribute nothing to the bottom line. Cut those.
- Cut down on meetings and travel unless you specifically need to impress a client.
- Outsource anything that isn’t a core function of the business.
- Consolidate subscriptions and any other services from third-party vendors. You can get a better deal that way.
- Review your inventory to ensure you’re not overstocked.
- Embrace coworking spaces and remote working to cut down on office rent and utilities.
- Cut down on paper usage.
- Automate as much as possible.
Overhead costs are unavoidable and every business owner ends up with a tab for them. Reducing overhead requires deep introspection and radical self-honesty.
- Investopedia. How to Treat Overhead Expenses in Cost Accounting.
- The Wall Street Journal. The Case for Lying to Yourself.