Definition of overheads: A business cost which is not directly linked to production or the provision of a service.
What are overheads?
Overhead is a name given to the collection of costs which are not directly incurred to produce an additional unit of revenue. For this reason, they’re often known as indirect expenses. In reality, some overheads are variable and will increase with revenue, but not as proportionately as cost of goods sold.
Examples of overheads include:
- Office costs, such as rent
- Factory facility costs, such as the depreciation of equipment
- Human resources department
- Accounting & finance department
- Legal department
- Sales & marketing
- Training and education
These will be the costs presented beneath gross profit, and above operating profit or profit before tax. Different financial accounting textbooks may have slightly different income statement layouts, but this relative position should always hold true.
Overheads is a widely used term which refers to a group of costs, but it doesn’t often feature in the income statement, because each expense category is given a more descriptive label which explains its nature.
How is the word overheads used in a sentence?
“Gross margin rose last quarter, but the rise in overheads meant that net income was down overall.”
“The charge for bad debt expense and onerous contracts is presented within overheads.”
What else you should know about overheads
Overheads might be only loosely connected to each unit of production, but managers still need to take them into account when deciding how to price their products. After all, the revenue from each sale needs to cover both the direct and indirect costs to generate a net profit.
Therefore, management accountants will use an absorption costing method to allocate a fair proportion of total overheads to each product line, or individual item, to give visibility on the ‘total cost’ of producing that item.
A real example would be a restaurant costing up the price of ingredients and cost of the chef/waitress labour for a particular dish, but then also adding additional cost to represent the fixed overhead of the restaurant such as cleaning staff, management, rent, utilities and marketing.
If the total overhead spend per year is £160,000 and the restaurant serves 13,000 tables per year, then it can quickly estimate that the price of each dish needs to include £160,000/13,000 = £12 of margin just to cover the overheads per table.
How does the definition of overheads relate to investing?
Investing courses will explain that business models can vary greatly between industries, and looking at the proportion of revenue spent on overheads is one useful way to get an insight into how capital intensive a business really is.
Some businesses operate on a ‘low overhead’ basis, meaning that they can generate a lot of revenue without extensive support from non-customer-facing departments. An example of a low-overhead business model would be a business where employees work at customer sites, carry a laptop and are responsible for many back-office business processes such as raising bills and so on.
This is a decentralised way to run an organisation but removes the need for large offices full of administrative staff who aren’t generating any revenue.
Companies with low overheads can scale quite efficiently. Expanding to another location may just require a few more recruited employees.
High overhead businesses may be those which have large capital expenditure on assets such as tools and machinery. Such businesses will tend to have plenty of support teams, such as engineers, cleaners, data analysts and managers, but don’t actually need much labour to produce each unit of their product. Utility companies are an excellent example.
Their gross margin will be high, but it will be balanced by a higher overhead.