What are Overhead Costs?

Definition: Overhead costs are company expenses that tend to happen regardless of production and sales levels. These are all costs not intrinsically linked to the products or services provided by the organization. Therefore, overhead costs are different to direct costs.

What Does Overhead Cost Mean?

Any business must identify and monitor its overhead costs because those expenses are not directly linked to revenues. The company has to pay them when production and sales are at top but also when at minimum. If overhead costs increase too much during good times, profits could be negligible or even negative during low-revenue times. Careful identification is important because classification of costs varies according to the business.

For instance, the accountant’s salary is generally considered an overhead cost, particularly for a manufacturing firm, but this is a direct cost if the company business is precisely accountant services. This term can apply to fixed expenses, such as the outdoor walls maintenance, but also to semi-variable or variable costs.

For example, extra office space can be needed every time the business surpasses certain activity level because of the hiring of additional employees. Monitoring and control of overhead costs is key because the company has to guarantee financial sustainability even when production and sales decrease.

Example

South West Services is a young company that provides consultant services. The company grew considerably during its first five years and was able to buy a large office space. There, about fifty people worked comfortably at nice workspaces. Due to an economic downturn, most of its clients lowered demand of consultant services and revenues dropped. The company operates in a region with tropical weather so air conditioning was required.

Electricity service is very expensive and that is why the electricity bill became a relevant overhead cost during the downturn. The firm then had to implement different work schedules, encourage working at home and closed some of the less utilized rooms with the purpose of reducing that overhead cost.