Overhead Costs

What are Overhead Costs?

Overhead costs are the indirect recurring costs of running a business such as administration, selling, and premises expenses.

They are all the support costs of a business which are not directly attributable to the goods or services that the business is producing.

Overhead costs continue to be incurred whether goods or services are produced and sold or not, this is in contrast to variable costs which only occur when goods or services are produced and sold.

Overhead costs are sometimes referred to as Fixed costs although they are not always actually fixed. Being fixed simply refers to the fact that the overhead costs do not vary directly in relation to the level of goods or services the business is producing. Overhead costs do not remain constant they tend to increase in steps as a business grows.

For example, a business producing widgets rents a manufacturing premises, the rent is an overhead cost and will not vary in relation to how many widgets are produced, the rent will still be payable whether widgets are produced or not. However, the rent is not fixed, over time it will change in stepped increases in accordance with the rental agreement the business has with the owner of the premises.

Why are the Level of Overhead Costs Important?

In order to break even a business must ensure that it has sufficient gross profit to cover its overheads.

In the example below, operating at its current level of sales, the business will start to lose money when the overhead costs go above 50,000.

Income statement
Revenue 100,000
Cost of sales 50,000
Gross profit 50,000
Overheads 30,000
Net income 20,000

For a given level of overheads, the level of revenue needed to break even can be determined by using the formula

Break Even Revenue = Overhead Costs / Gross Margin Percentage

.

In the example above the break even revenue at overhead costs of 30,000 is 30,000/50% = 60,000.

If the overhead increases by 5,000 the break even revenue rises to 35,000/50% = 70,000, an increase of 10,000, double the overhead increase.

It can be seen from this that as overhead costs rise the level of revenue needed to break even will rise. It is therefore important to keep the level of overheads as low as possible in relation to the size of the business.

Overhead Costs November 6th, 2016Team

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