In contrast, indirect costs include overhead expenses such as rent, payroll, advertising, and other expenses that are not directly related to the product creation process.
Regardless of whether the expenses are direct or indirect, they contribute to the overall revenue generated by the business. The net profit is determined by deducting all the overhead costs involved. Understanding overhead costs and their impact on business operations can be challenging for new business owners. In this article, we have simplified overhead cost calculation and its effect on business operations.
What is an Overhead Cost?
Overhead costs are mostly costs that are not directly associated with profit generation. However, they perform a critical support function for adequately running the business. Overhead costs also differ from company to firm. For example, the overhead costs for a freelancer will include utility bills and seat occupancy costs, and contrarily, for a retailer, it will consist of space rent, insurance, and wages. Below is a list of expenses included in the overhead cost
- Office space rent
- Utility bills
- Office Supplies such as computers, stationery & other equipment
- Insurance & mortgages (if any)
- Travel & logistics expenses
- Advertising and marketing expenses
- Taxes, depreciation, and government licenses
Categorizing Overhead Costs
Some organizations further break down overhead costs into various categories for easy calculation and prioritizing costs.
- Manufacturing overheads: Any cost arising from your product’s manufacturing facility is considered a manufacturing overhead. Overhead is apart from direct labor & raw material costs.
- Selling overheads: Costs such as logistics, advertising, and all other areas that aid in selling products fall under the category of selling overheads.
- Administrative overheads: these are office operational costs and include rent, mortgages, utilities, payroll, taxes, and depreciation.
Why is it Essential for Businesses to Consider Overhead Costs?
It’s important for businesses to consider their entire overhead cost. Inexperienced business owners often only calculate the direct cost of creating their product or providing their service and then set their prices based on those calculations. However, to be truly profitable, it’s crucial also to consider the overhead cost when determining pricing. This allows for the selection of an excellent long-term strategy and helps keep the budget in check.
How to Calculate Overhead Costs?
Calculating the overhead cost for your business is crucial, especially when deciding the pricing for your product or service. A profitable product promises profit even after deducting the indirect/overhead costs incurred.
- Step 1: To calculate the overhead costs, you must first bind every cost incurred to a period. Any quarterly, annual, or weekly expenses should be broken down or accumulated in a month. Once you have categorized quarterly incurred and weekly expenses as the total monthly overhead costs, bear in mind that for different industries, overhead costs differ. A graphic designer is the critical service provider for a web design company and includes the direct prices. In contrast, a designer design company’s sign support services for a web design company are included in overhead expenses. With your monthly overhead cost calculated, estimate the overhead rate by dividing the overhead cost by the total sales amount.
- Overhead rate (%) = Monthly overhead cost / monthly sale amount
- Step 2: Next, calculate the overhead allocation rate. Allocation is the amount of money allocated in overheads for every hour utilized in making the product.
- Overhead allocation rate ($) = Total overhead /bor hours
- Step 3: Lastly, calculate the overhead per unit. To calculate, you will multiply the overhead allocation rate per hour by the number of hours required to manufacture the product you are selling. This equation gives you the final overhead price per product, allowing you to decide your product’s pricing quickly
- Overhead price per unit ($) = Overhead Per Hour X Total Number of Hours Required for Manufacturer
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