Overhead
Ongoing business expenses not directly tied to producing goods or services.
Definition
Overhead refers to the ongoing operating costs of running a business that aren't directly attributable to producing specific products or services. This includes rent, utilities, administrative salaries, insurance, and general office expenses.
Overhead is often categorized as fixed (remains constant like rent) or variable (changes somewhat with activity like utilities). It's also sometimes called indirect costs, distinguishing it from direct costs that can be traced to specific products.
Why It Matters
Overhead must be covered by the combined contribution margins of all products and services. High overhead increases the sales volume needed to break even. Managing overhead efficiently is crucial for profitability.
When pricing, overhead must be allocated across products/services somehow. Common methods include allocating based on revenue, direct costs, or labor hours. The allocation method can significantly affect perceived product profitability.
Examples
- 1
A small business has monthly overhead of $15,000: rent $5,000, utilities $500, insurance $1,000, admin salary $7,000, software $1,500.
- 2
A consulting firm allocates overhead to projects based on billable hours—a 100-hour project absorbs 100 hours worth of overhead costs.
- 3
Reducing overhead by 10% ($1,500/month) has the same profit impact as generating $15,000 more revenue at 10% profit margin.
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