Overhead (business)

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In business, overhead or overhead expense refers to an ongoing expense of operating a business. Overheads are the expenditure which cannot be conveniently traced to or identified with any particular revenue unit, unlike operating expenses such as raw material and labor. Therefore, overheads cannot be immediately associated with the products or services being offered, thus do not directly generate profits. [1] However, overheads are still vital to business operations as they provide critical support for the business to carry out profit making activities. [2] For example, overhead costs such as the rent for a factory allows workers to manufacture products which can then be sold for a profit. Such expenses are incurred for output generally and not for particular work order; e.g., wages paid to watch and ward staff, heating and lighting expenses of factory, etc. Overheads are also a very important cost element along with direct materials and direct labor. [2]

Contents

Overheads are often related to accounting concepts such as fixed costs and indirect costs.

Overhead expenses are all costs on the income statement except for direct labor, direct materials, and direct expenses. Overhead expenses include accounting fees, advertising, insurance, interest, legal fees, labor burden, rent, repairs, supplies, taxes, telephone bills, travel expenditures, and utilities. [3]

There are essentially two types of business overheads: administrative overheads and manufacturing overheads. [4]

Administrative overheads

Administrative overheads include items such as utilities, strategic planning, and various supporting functions. These costs are treated as overheads due to the fact that they are not directly related to any particular function of the organization, nor do they directly result in generating any profits. Instead, these costs simply take on the role of supporting all of the business's other functions. [5]

Charities may refer to their administrative overheads as "core costs". [6]

Universities regularly charge administrative overhead rates on research. In the U.S. the average overhead rate is 52%, which is spent on building operation, administrative salaries and other areas not directly tied to research. [7] Academics have argued against these charges. For example, Benjamin Ginsberg showed how overhead rates are primarily used to subsidize ballooning administrative salaries and building depreciation, neither of which directly benefit research; although it does benefit the administrators that determine university policy in his book The Fall of Faculty. An article written by Joshua Pearce in Science argued that overhead accounting practices hurt science by removing funds from research and discouraging the use of less-expensive open source hardware. [8] He went into detail on the accounting showing how millions were wasted each year on overhead cash grabs by university administrators in ZME Science. [9]

Examples

Employee salaries

This includes mainly monthly and annual salaries that are agreed upon. They are considered overheads as these costs must be paid regardless of sales and profits of the company. In addition, salary differs from wage as salary is not affected by working hours and time, therefore will remain constant. [10] In particular, this would more commonly apply to more senior staff members as they are typically signed to longer tenure contracts, meaning that their salaries are more commonly predetermined. [11]

Office equipment and supplies

This includes office equipment such as printer, fax machine, computers, refrigerator, etc. They are equipment that do not directly result in sales and profits as they are only used for supporting functions that they can provide to business operations. [12] However, equipment can vary between administrative overheads and manufacturing overheads based on the purpose of which they are using the equipment. For example, for a printing company a printer would be considered a manufacturing overhead. [13]

This includes the cost of hiring external law and audit firms on behalf of the company. This would not apply if company has own internal lawyers and audit plans. Due to regulations and necessary annual audits to ensure a satisfactory work place environment, these costs often cannot be avoided. Also, since these costs do not necessarily contribute directly to sales, they are considered as indirect overheads. Although in most cases necessary, these costs can sometimes be avoided and reduced. [14]

Company cars

Many companies provide usage of company cars as a perk for their employees. Since these cars do not contribute directly to sales and profits, they are considered an overhead. Similar company perks that are a one-off or constant payment such as partner contract fees with a gym will also fall under administrative overheads. [15]

Travel and entertainment costs

This will include company-paid business travels and arrangements. As well as refreshments, meals, and entertainment fees during company gatherings. Although one might argue that these costs motivate workers to become more productive and efficient, the majority of economists agree that these costs do not directly contribute to sales and profits, therefore shall be categorized as an administrative overhead. [16] Despite these costs occurring periodically and sometimes without prior preparation, they are usually one-off payments and are expected to be within the company's budget for travel and entertainment. [17]

Manufacturing overheads

Manufacturing overheads are all costs endured by a business that is within the physical platform in which the product or service is created. Difference between manufacturing overheads and administrative overheads is that manufacturing overheads are categorized within a factory or office in which the sale takes place. [18] Whilst administrative overheads is typically categorized within some sort of back-office or supporting office. Although there are cases when the two physical buildings may overlap, it is the usage of the overheads that separates them. [19]

Examples

Employee salaries

Although the general concept is identical to the example under administrative overheads, the key difference is the role of the employee. In the case of manufacturing overheads, employees would have roles such as maintenance personnel, manufacturing managers, materials management staff, and quality control staff. It would also include the set wages for janitorial staff members. Once again, the key difference lies in the nature of their respective jobs and the physical location in which their jobs are carried out. [20]

Depreciation of assets and equipment

This refers to the reduction in value of equipments as it becomes older and more obsolete. For example, if a printer has a potential useful life span of 5 years, the amount that it can be sold for will decrease each year. [21] Therefore, this value in depreciation is calculated as a manufacturing overhead. Moreover, this also applies to vehicles as they tend to depreciate significantly after the first year. When calculating manufacturing overheads, accountants mainly use two methods: straight-line method and declining balance method. [22]

Property taxes on production facilities

Every single property unless government owned is subject to some form of property tax. [23] Therefore, the taxes on production factories are categorized as manufacturing overheads as they are costs which cannot be avoided nor cancelled. In addition, property taxes do not change in relation to the business's profits or sales and will likely remain the same unless a change by the government administration. [24]

The rent for factory buildings is considered a manufacturing overhead The central gate factory <<OCM>>.JPG
The rent for factory buildings is considered a manufacturing overhead

Rent of factory building

Unless the business decides to purchase land and build its own factory, it will be subject to some sort of rent due to the amount of capital required to build a privately owned factory. Therefore, this rent must be paid to the landlord on a regular basis regardless of the performance of the business. Although the rent for the building provides the physical platform for the company to produce its products and services, it is not a direct contributor. [25]

Utilities for factory

This would vary depending on how the utility bill is structured. In the case of it being an overhead, the utility bill is pre-negotiated meaning that the monthly utility bill will be the same regardless of the amount in which the factory actually consumes. [26] This will only be relevant in various countries where there is an option for standardized utility bills. However, due to the vast consumption of electricity, gas, and water in most factories, most companies tend to not have standardized utility bills as it tends to be more expensive. [27] Standardized utility bills are also oftentimes discouraged by governments as it leads to wastage of resources and negative externalities of production. [28]

Application of business overheads

For most businesses, business overheads are calculated by accountants for budgeting purposes but also often so the business has an idea of how much they must charge consumers in order to make a profit. The following are common accounting tools which take account of business overheads. [29]

A standard break-even analysis chart CVP-FC-Contrib-PL-BEP.svg
A standard break-even analysis chart

Break-even analysis

The break-even analysis determines the point which the business's revenue is equivalent to the costs required to receive that revenue. It first calculates a margin of safety (the point which the revenue exceeds the break-even point) as that is the "safe" amount which the revenue can fall whilst still remaining to be above the break-even point. [30] The graph on the right shows a typical break-even chart. Contribution refers to sales of the product or service, it can also be interpreted as the business's revenue stream. Fixed costs in this case serves the same purpose as business overheads, it will simply be shown as a straight horizontal line on the graph as shown. [31]

Shut-down graph

In economics, revenue curves are often illustrated to show whether or not a business should stay in business, or shut down. In theory, if a business is able cover variable operational costs but unable to cover business overheads in the short run, the business should remain in business. On the other hand, if the business is not even able to cover operational costs, it should shut down. [32] Although this rule largely differs depending on the size of the business, the business's cash-flow, and the competitive nature of the business, it serves as a model rule for most small competitive businesses to operate on. [33]

Activity-based costing

Activity-based costing (ABC) aims to reduce the proportion of costs treated as overheads by allocating costs to each activity involved in the production of a product or delivery of a service. [34]

Balance sheet

Balance sheet is a financial statement which outlines a company's financial assets, liabilities, and shareholder's equity at a specific time. Both assets and liabilities are separated into two categories depending on their time frame; current and long-term. Business overheads in particular fall under current liabilities as they are costs for which the company must pay on a relatively short-term/immediate basis. Although the balance sheet by itself does not offer much information, it is a useful piece of financial information when combined with other documents such as the income statement or ratio analysis as it offers a diverse and well-rounded description of the company's financial position. [35]

See also

Related Research Articles

<span class="mw-page-title-main">Cost accounting</span> Procedures to optimize practices in cost efficient ways

Cost accounting is defined by the Institute of Management Accountants as "a systematic set of procedures for recording and reporting measurements of the cost of manufacturing goods and performing services in the aggregate and in detail. It includes methods for recognizing, classifying, allocating, aggregating and reporting such costs and comparing them with standard costs". Often considered a subset of managerial accounting, its end goal is to advise the management on how to optimize business practices and processes based on cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future.

In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone where, given limited resources, a choice needs to be made between several mutually exclusive alternatives. Assuming the best choice is made, it is the "cost" incurred by not enjoying the benefit that would have been had by taking the second best available choice. The New Oxford American Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is chosen". As a representation of the relationship between scarcity and choice, the objective of opportunity cost is to ensure efficient use of scarce resources. It incorporates all associated costs of a decision, both explicit and implicit. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure, or any other benefit that provides utility should also be considered an opportunity cost.

<span class="mw-page-title-main">Cost</span> Money spent to produce or procure goods or services

Cost is the value of money that has been used up to produce something or deliver a service, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this case, money is the input that is gone in order to acquire the thing. This acquisition cost may be the sum of the cost of production as incurred by the original producer, and further costs of transaction as incurred by the acquirer over and above the price paid to the producer. Usually, the price also includes a mark-up for profit over the cost of production.

<span class="mw-page-title-main">Cost of goods sold</span> Carrying value of goods sold during a particular period

Cost of goods sold (COGS) is the carrying value of goods sold during a particular period.

<span class="mw-page-title-main">Income statement</span> Type of financial statement

An income statement or profit and loss account is one of the financial statements of a company and shows the company's revenues and expenses during a particular period.

<span class="mw-page-title-main">Fixed cost</span> Business expenses not dependant on output

In accounting and economics, fixed costs, also known as indirect costs or overhead costs, are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be recurring, such as interest or rents being paid per month. These costs also tend to be capital costs. This is in contrast to variable costs, which are volume-related and unknown at the beginning of the accounting year. Fixed costs have an effect on the nature of certain variable costs.

<span class="mw-page-title-main">Throughput accounting</span> Principle of management accounting

Throughput accounting (TA) is a principle-based and simplified management accounting approach that provides managers with decision support information for enterprise profitability improvement. TA is relatively new in management accounting. It is an approach that identifies factors that limit an organization from reaching its goal, and then focuses on simple measures that drive behavior in key areas towards reaching organizational goals. TA was proposed by Eliyahu M. Goldratt as an alternative to traditional cost accounting. As such, Throughput Accounting is neither cost accounting nor costing because it is cash focused and does not allocate all costs to products and services sold or provided by an enterprise. Considering the laws of variation, only costs that vary totally with units of output e.g. raw materials, are allocated to products and services which are deducted from sales to determine Throughput. Throughput Accounting is a management accounting technique used as the performance measure in the Theory of Constraints (TOC). It is the business intelligence used for maximizing profits, however, unlike cost accounting that primarily focuses on 'cutting costs' and reducing expenses to make a profit, Throughput Accounting primarily focuses on generating more throughput. Conceptually, Throughput Accounting seeks to increase the speed or rate at which throughput is generated by products and services with respect to an organization's constraint, whether the constraint is internal or external to the organization. Throughput Accounting is the only management accounting methodology that considers constraints as factors limiting the performance of organizations.

<span class="mw-page-title-main">Variable cost</span> Sum of marginal costs over all units produced

Variable costs are costs that change as the quantity of the good or service that a business produces changes. Variable costs are the sum of marginal costs over all units produced. They can also be considered normal costs. Fixed costs and variable costs make up the two components of total cost. Direct costs are costs that can easily be associated with a particular cost object. However, not all variable costs are direct costs. For example, variable manufacturing overhead costs are variable costs that are indirect costs, not direct costs. Variable costs are sometimes called unit-level costs as they vary with the number of units produced.

<span class="mw-page-title-main">Net income</span> Measure of the profitability of a business venture

In business and accounting, net income is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, and taxes for an accounting period.

Profit margin is a financial ratio that measures the percentage of profit earned by a company in relation to its revenue. Expressed as a percentage, it indicates how much profit the company makes for every dollar of revenue generated. Profit margin is important because this percentage provides a comprehensive picture of the operating efficiency of a business or an industry. All margin changes provide useful indicators for assessing growth potential, investment viability and the financial stability of a company relative to its competitors. Maintaining a healthy profit margin will help to ensure the financial success of a business, which will improve its ability to obtain loans.

In business, operating margin—also known as operating income margin, operating profit margin, EBIT margin and return on sales (ROS)—is the ratio of operating income to net sales, usually expressed in percent.

<span class="mw-page-title-main">Matching principle</span> Accounting method

In accrual accounting, the matching principle instructs that an expense should be reported in the same period in which the corresponding revenue is earned and is associated with accrual accounting and the revenue recognition principle states that revenues should be recorded during the period in which they are earned, regardless of when the transfer of cash occurs. By recognizing costs in the period incurred, a business can see how much money was spent to generate revenue, reducing "noise" from the mismatch between when costs are incurred and when revenue is realized. Conversely, cash basis accounting calls for recognizing an expense when the cash is paid, regardless of when the expense was incurred.

<span class="mw-page-title-main">SG&A</span> Accounting term representing operating costs

SG&A is an initialism used in accounting to refer to Selling, General and Administrative Expenses, which is a major non-production cost presented in an income statement.

Operating costs or operational costs, are the expenses which are related to the operation of a business, or to the operation of a device, component, piece of equipment or facility. They are the cost of resources used by an organization just to maintain its existence.

Profit, in accounting, is an income distributed to the owner in a profitable market production process (business). Profit is a measure of profitability which is the owner's major interest in the income-formation process of market production. There are several profit measures in common use.

Manufacturing overhead costs are all manufacturing costs that are related to the cost object but cannot be traced to that cost object in an economically feasible way.

Cost pools is an accounting term that refers to groups of accounts serving to express the cost of goods and service allocatable within a business or manufacturing organization. The principle behind the pool is to correlate direct and indirect costs with a specified cost driver, so to find out the total sum of expenses related to the manufacture of a product.

Utility ratemaking is the formal regulatory process in the United States by which public utilities set the prices they will charge consumers. Ratemaking, typically carried out through "rate cases" before a public utilities commission, serves as one of the primary instruments of government regulation of public utilities.

<span class="mw-page-title-main">Emile Garcke</span> English industrialist

Emile Oscar Garcke was a naturalised British electrical engineer, industrial, commercial and political entrepreneur managing director of the British Electric Traction Company (BET), and early author on accounting. who is noted for writing the earliest standard text on cost accounting in 1887.

<span class="mw-page-title-main">J. Lee Nicholson</span> American economist

Jerome Lee Nicholson was an American accountant, industrial consultant, author and educator at the New York University and Columbia University, known as pioneer in cost accounting. He is considered in the United States to be the "father of cost accounting."

References

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