Unfortunately, most businesses are seasonal. This means there are times where revenue drops dramatically but you still have necessary business expenses. The scope of this article today is to answer the question "what are overhead costs" so you can identify yours and reduce them when times are lean.
What Are Overhead Costs?
So what are overhead costs? In short, overhead costs are expenses you must incur to operate your business but they do not generate any revenue for you.
Businesses large and small, across all industries, have overhead costs. There is no avoiding them, but there are ways to reduce them. The three types of overhead costs your business incurs are fixed, semi-variable and variable.
What Are Fixed Overhead Costs?
To learn what are overhead costs, you must first understand fixed overhead costs. Fixed overhead costs are the same amount every month. These will never fluctuate regardless of business activity. For example, the rent or mortgage payment you make every month is fixed. Your phone bill is probably about the same every month and your internet bill will never change. You may even have a fixed water or power payment depending on the lease you signed for your building.
Other examples of fixed overhead costs include:
Variable Overhead Costs
As the name suggests, variable overhead costs change. Specifically, these increase or decrease with the level of business activity. The more business you have, the more variable overhead costs you will incur. Similarly, the less business you have, the less variable overhead costs you will incur. These costs may even be eliminated.
Examples of variable overhead costs include advertising, consulting services, equipment maintenance and repairs, legal expenses, materials, office supplies and shipping.
Semi-Variable Overhead Costs
Semi-variable overhead costs will be incurred no matter how much business you have. However, the cost incurred will fluctuate slightly. These overhead costs usually have a base rate that must always be paid and a variable rate based on usage. The most notable semi-variable overhead cost is your power bill. Even if you do not make a single sale this month, you will still have to pay for gas and electricity.
However, your power bill will be higher if you manufacture more goods this month than last month. You also have to heat and cool the building no matter how much revenue you bring in, but you may have to use more or less depending on what's happening in the building or the way temperatures vary from year to yea.
Other semi-variable overhead expenses include hourly wages with overtime, salespeople's commissions and vehicle usage. Keep in mind, an overhead cost for a company in one industry may be a direct production cost for a company in a different industry. For example, rent may be a direct cost for a production facility. However, a marketing agency would consider rent to be an overhead cost.
Furthermore, certain expense types can be direct or indirect depending on the situation. For example, the salary you pay your accountant is an overhead cost. However, the salary you pay your mechanic is a direct cost, because his work directly increases your business's revenue.
The Importance of Knowing Your Overhead Costs
To maximize profits, it is critical that you can answer what are overhead costs for your business. When you know how much you incur in overhead costs, you can set your prices such that your sales can be profitable. Once you factor overhead costs into the total cost of running your business, you only need a simple formula to determine how much your business needs to bring in every month.
Once you know your overhead costs, you can calculate your net income. This is sometimes called net profit or the bottom line because it is the last line on your profit and loss (P&L) statement. To calculate your net income, subtract all expenses, including overhead, from your gross profit. This will tell you if your business is making money or losing money.
Let's say the entirety of your business is selling shirts. Based on your past 10 years of operation, you know you will sell 40,000 shirts in August. You also know you need to profit $200,000 a month to reach your earning goals. This means, you need to price your shirts so you will bring in a profit of $5 per shirt.
Improving Your Bottom Line
The goal of every business is to make money. Once you identify your overhead expenses, you can look for ways to reduce them. For example, if your rent has been increasing at a rate of 15% annually, it may be time to find a new place to operate out of when your current lease is up.
Create a P&L that shows you each general ledger line item side-by-side for the past five years. Depending on your ERP software, you may be able to generate a report that shows you percentage differences from year-to-year, too. Analyze each line to see if there are any expense accounts that seem far too large or may not seem too significant but have been steadily increasing year-over-year.
Then, dig into the general ledger to find out why these expenses are so high. It may be that an incompetent accountant was mis-coding an asset as an expense or using a "throwaway" account to hide expenses he did not know how to code. However, if all expenses were charged to the right account, you now know where you can start saving money on overhead expenses.
How to Calculate Overhead Costs
The first step you need to take to calculate overhead is determining each overhead cost for a specific time period. This is usually done by the month. Once you have identified all your overhead expenses for the given time period, sum them together. Now that you know the total overhead costs, you can calculate your overhead rate.
To do this, all you have to do is divide the total overhead costs you calculated for the time period by the sales revenue you generated during the same time period. For simplicity, we will assume that you did not offer any discounts or promotions or give customers any cash for returns. Let's say you had overhead costs of $18,000 one month and brough in sales revenue of $180,000. Dividing $18,000 by $180,000, we get an overhead rate of 0.1, or 10%. In other words, you spend $0.10 on overhead for every dollar you make.
Calculate Overhead Costs for Different Products
Every business faces the same constraints. Time and money are finite resources, and you want to make the most of what you have. To do this, you can calculate overhead costs for different products. You can see which products are the most profitable during which times of the year. For example, you may be better off producing sweatpants in August to prepare for a drastic influx in your sweatpants sales in the autumn and winter.
Similarly, you may want to dedicate more employees, fabric and machines to manufacturing t-shirts in February to prepare for the sales you will receive when the weather warms. If you cannot set the price of a product high enough to break even or generate an adequate profit, you must consider discontinuing that product.
How to Calculate Break-Even Point
Like the calculations for overhead costs and overhead rates, calculating the break-even point for a given product is simple. The break-even quantity of products you need to sell is equal to your fixed costs divided by the difference between the sales price per unit and the variable cost per unit.
Fixed costs are all costs incurred that do not change based on output, such as rent, salaries excluding bonuses and machinery. The sales price per unit is how much you sell a single unit for and variable cost per unit is all variable costs, including overheat, incurred to create a unit.
If your fixed costs are $2.4 million, you sell a shirt for $20 and it costs you $10 dollars to make a shirt, your break-even quantity will look like this:
$2,400,000/($20 - $10) = $2,400,000/$10 = 240,000.
With a profit of $10 per shirt, you will need to sell 240,000 shirts to cover all your fixed costs for the year.
The Bottom Line
Now that you understand what are overhead costs, you can take steps to reduce them. Overhead costs are expenses you must incur to keep your business running but they do not make you any money directly. Fixed overhead costs are the same amount every month. Variable overhead costs change every month, and semi-variable overhead costs will always be incurred, by they will fluctuate slightly based on business activity.
To calculate your overhead rate, add up all your overhead costs for a given time period. Then, divide that total by the total amount of sales you made for the same time period. Knowing your overhead rate is essential for every business, because it allows you to calculate your break-even point accurately. From there, you can perform other statistical analysis to determine your break-even point and profit selling a number of units at different price-points. The bottom line of all of this is use your understanding of overhead costs to discover where you can save money and become profitable or increase your net profit this year.