Why Overhead Costs Matter to Entrepreneurs?

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Why Overhead MATTERS To ENTREPRENEURS

Analyzing the definition of key terms often provides more insight into concepts.  Overhead can be defined as activities supporting the production process that are not direct costs, or direct labor.  As an entrepreneur, it is essential to know why overhead costs impact your small business.  I first start by defining

Overhead is all expenses not related to producing your product or providing your service. In other words, overhead refers to the indirect costs of running your business.

Types of Overhead

There are three types of overhead costs:

  • Fixed Costs – These expenses stay consistent each month. They are not dependent on the number of products produced or services provided.
  • Variable Costs – These expenses vary depending on the number of products produced or services provided.
  • Semi-Variable Costs – This is also known as a mixed cost. These expenses contain both fixed and variable components. An example would be your telephone bill.

 Examples

Let’s look at some examples of overhead costs.  They would be rent, advertising, insurance, interest, legal fees, labor burden, repairs and maintenance, supplies, taxes, telephone bills, travel expenses, and utilities.  As you can see, these costs have nothing to do with the manufacturing of your product or the services you provide.  But they are a necessary expense for your business.

Where Are These Costs Located?

Your Income Statement has your overhead costs.   They will be all the costs except direct labor direct materials and direct payments.

Why These Costs Matter To Entrepreneurs?

There are many benefits to knowing your overhead costs.  One of the advantages is setting prices that result in a profit.  You must factor your overhead into the total cost to run your business. Now you can use your overhead costs to determine your net profit.  Your net profit is the result of deducting all your expenses from your revenues. 

Many entrepreneurs will look at their overhead expenses and find ways to lower them to increase their profits.  It is easy for these costs to creep up over the years, and it is a good idea to review them regularly.

How to Calculate Your Overhead Costs?

After you have appropriately recorded your overhead expenses, you may need to calculate your overhead rates.  When calculating your overhead rate, you will compare it to your revenue.

Each business overhead rate will be different.  My business overhead rate is different from yours; therefore, it is necessary to compute your overhead rate. Now before you can calculate your overhead rate, you need to determine your overhead costs for a specific time.  Once you have learned all your overhead expenses add them together.  To calculate your overhead rate, you will divide your overhead costs by your sales.

Overhead Rate = Overhead Expenses / Sales

Let’s do an example.  Your business had $5,000 in overhead costs last month and $45,000 in sales.  The overhead calculation would be $5,000/$45,000.  The result is .11 or 11 percent.  In other words, your business spends 11 cents on overhead for every dollar it makes—the smaller your overhead rate, the larger your net income.

In Summary

Overhead are the indirect expenses that are not part of producing your product or providing your service.  Your overhead costs matter because the more expenses you have, the lower your profit will be.  It is easy for these expenses to creep up each year.  That is why I suggest that you review your costs regularly.

Remember, a low overhead rate means more profit for your business.

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