List of Partners vendors. Overhead refers to the ongoing business expenses not directly attributed to creating a product or service. It is important for budgeting purposes but also for determining how much a company must charge for its products or services to make a profit. In short, overhead is any expense incurred to support the business while not being directly related to a specific product or service.
A company must pay overhead on an ongoing basis, regardless of how much or how little the company sells. For example, a service-based business with an office has overhead expenses, such as rent, utilities, and insurance that are in addition to direct costs such as labor and supplies of providing its service.
Expenses related to overhead appear on a company's income statement , and they directly affect the overall profitability of the business. The company must account for overhead expenses to determine its net income, also referred to as the bottom line.
Net income is calculated by subtracting all production-related and overhead expenses from the company's net revenue , also referred to as the top line. Overhead expenses can be fixed , meaning they are the same amount every time, or variable , meaning they increase or decrease depending on the business's activity level.
Other examples of fixed costs include depreciation on fixed assets, insurance premiums, and office personnel salaries. Overhead expenses can also be semi-variable , meaning the company incurs some portion of the expense no matter what, and the other portion depends on the level of business activity.
For example, many utility costs are semi-variable with a base charge and the remainder of the charges being based on usage. Some common examples of overhead costs companies must assume are rent, utilities, administrative costs, insurance, and employee perks.
The costs associated with maintaining the office or manufacturing space companies must have in order to perform their business is an example of overhead. This includes rent as well as utilities such as water, gas, electricity, internet, and phone service. Additional costs such as a subscription to virtual meeting platforms like Zoom ZM also must be factored into a company's overhead.
Administrative costs are often one of the most expensive facets of a company's overhead. This can include the cost of stocking the office with the necessary supplies, the salaries of office associates, and external legal and audit fees. Administrative costs can range from the supply of toilet paper in the office restroom to hiring an external audit firm to ensure the company complies with industry-specific regulations. Depending on the company, businesses are required to hold many different types of insurance in order to operate properly.
These can include basic property insurance to protect the company's physical assets from fire, flood, or theft as well professional liability insurance, health insurance for its employees, and car insurance for any company-owned vehicles. While none of these costs are directly related to generating revenue for the company by providing a good or service, the business is often legally mandated to purchase these various types of insurance if it wishes to operate within most jurisdictions. Many larger companies offer a range of benefits to their employees such as keeping their offices stocked with coffee and snacks, providing gym discounts, hosting company retreats, and company cars.
All of these expenses are considered overhead as they have no direct impact on the business' good or service. Overhead expenses may apply to a variety of operational categories. General and administrative overhead traditionally includes costs related to the general management and administration of a company, such as the need for accountants, human resources, and receptionists.
Selling overhead relates to activities involved in marketing and selling the good or service. This can include printed materials and television commercials, as well as the commissions of sales personnel. Depending on the nature of the business, other categories may be appropriate, such as research overhead, maintenance overhead, manufacturing overhead, or transportation overhead. Overhead is typically a general expense, meaning it applies to the company's operations as a whole.
It is commonly accumulated as a lump sum, at which point it may then be allocated to a specific project or department based on certain cost drivers. For example, using activity-based costing , a service-based business may allocate overhead expenses based on the activities completed within each department, such as printing or office supplies.
And in most organizations they also have a natural tendency to grow out of control. If a company is to gain effective control of its overhead areas, therefore, it must find a way not only to deal with their troublesome diversity and ambiguity but also, to some extent, to thwart the natural dynamics of the organization itself.
If, in the face of these difficulties, the enormous task of reducing overhead costs is delegated in a special way to every manager in the company, overhead can be successfully cut.
All managers either request or supply overhead services, and so together they can recommend in detail which services can be pared back without damaging the organization. By formally placing the burden of the task on all managers at once usually the lowest-level managers included in the process are those who have roughly 20 to 40 subordinates overhead value analysis brings requesters and suppliers together to work on what they can see is a common, company-wide task.
In this way, managers feel freer to recommend changes. To ensure that the recommendations are soundly based and to guide, even challenge, managers as they go through the process, stage by stage, the chief executive officer will need to appoint a small, high-level task force. For larger organizations, more team members, even multiple teams, may be required. Inter- or intra-company comparisons or trend analyses seldom shed much light on this question, and in any case they are always open to challenge.
Accordingly, to ensure that no reasonable option for cutting costs escapes examination, top management should set an initial cost-reduction target, uniform for all functions, that overshoots whatever the true potential may be. This is a jolting figure when first announced, and admittedly arbitrary; a case can be made for varying it by as much as 10 percentage points either way.
But it is not too high to be credible. Only a really challenging target will a foster an exhaustive search for savings options, b permit a proper balancing of cost-reduction decisions across the organization, and c support, if necessary, a fundamental rethinking of basic services. An additional benefit of the intentional overshoot is that—since no area has been singled out beforehand to achieve a higher target than others—managers down the line usually perceive the target as fair, though rough.
In the course of supplying end products or services to another unit of the organization, the average manager incurs overhead costs.
Ordinarily, he provides these services with reasonable efficiency, and the best way of substantially cutting their costs is to reduce the demand, or requirements, that led to their creation in the first place. Accordingly, each manager responsible for a cost center will be required to: a identify the various services his department receives from other cost centers in support of its own activities: b list each of the end products or services he supplies for example, reports, completed forms, analyses, advice, decisions , and state to whom they go; and c estimate how much total effort and expense go into each of these services the results are often eye-opening.
Thus a service should be broken down into its various components and their costs. It would, of course, take months to trace the flow of every single end product or service and get an accurate fix on its cost. Because later judgments on the value of these services will be understandably rough, only an order-of-magnitude cost for each service is required.
Certain functions, such as EDP and engineering, typically engage in nonrecurrent, and in some respects unique, projects or assignments. Each project, whether currently under way or in a backlog, should be costed as if it were a service. The subsequent search for cost-reduction options will consider not only the impact of paring down the existing projects but also the potential of reducing total in-house staff capacity to handle such projects over the uncertain longer term.
One side benefit of this costing step is that it enables managers to compare their list of end products and services with the basic mission or charter of their cost center and with that of major supportive functions. Inconsistencies or mismatches are often clues to services that can readily be reduced or dropped.
Before questioning the end products of the supporting functions in detail, however, the manager examined the basic content of the accounting overhead budget, which included such features as elaborate allocation, and even reallocation, of corporate overhead to the operating divisions. Another side benefit of pinpointing costs is that elements of the resulting data base, along with certain other features of this approach, can later on be built into the ongoing budgeting process, providing top management with a better basis for challenging budget submissions.
The assessment of the options occurs at the next stage. Most services have one primary receiver, so the receiver representatives in each challenge group will be drawn from just one area. For services with many receivers—market performance reports or in-house newspapers—a few representative users should be selected to participate in the challenge groups.
Occasionally, managers who do not actually receive a particular service or end product should be included in the relevant challenge groups because they are concerned with some aspect of the service. For instance, an insurance company lawyer who sets overall specifications for policyholder contracts would be needed when the specifics of these contracts are questioned. Once assembled, the challenge group should take each end product and service in turn and, with the guidance of the task force, should a examine feasible ways of reducing requirements for it and b suggest a series of possible incremental reductions, short of eliminating the service entirely.
Exhibit I shows a framework that has proved useful for thinking through ways of reducing demand. It forces managers to consider every combination of service and cost-reduction options to meet the stretching target. In some overhead areas, it is worth making some effort to find options for streamlining where a specific service is unchanged, but the costs to produce it are decreased , but in most areas this added effort produces only marginal improvement on the basic approach. As a rule, most of the options that might be listed are already known to the supplier of the services.
Thus, rather than go through a long analysis of the obvious, the task force should start by asking the manager to produce a tentative list of feasible options. Subsequently, the challenge group will seek to modify and build on this list. The challenge group should attempt only to list the best feasible ways and associated pros and cons to make substantial cuts in the costs of and demands for a particular service.
The group should list all options, no matter how risky, as long as they are technically possible and legal, until it has identified enough of them to meet the initial overall target. After reviewing all the options, top management decides which cuts will actually be made.
Each member of the challenge group, therefore, whether supplier or receiver, should assume the individual responsibility to search out all the options and try on his own to identify the best possible ways to achieve the target.
The best way to make sure that this happens will differ considerably from company to company and from function to function. In every case, however, it is essential that top management clearly assign the burden beforehand. To reinforce that assignment, companies have used a variety of tactics:. The amount the company saves from implementing an option identified by a challenge group is usually quite small—a few thousand dollars on average, or less than a full year of work for one person.
Consequently, managers are not justified in spending a great deal of time gathering data on each option and deliberating its attractiveness. Rather, they must try to use only the available facts and judgments in deciding between savings and risks. The procedure is as follows.
For each of its options, each challenge group states the work-load reduction and cost decrease it expects the change would make. The group also explicitly states the possible adverse consequences of each option, their severity, and the likelihood of their occurrence. If, as often happens, receivers and suppliers disagree sharply on these points, both points of view are recorded for consideration by higher management.
Finally, the group ranks its choices among the options in descending order of attractiveness. This step forces lower-level managers to weigh and choose among many diverse alternatives. Whether or not they believe any of the various options should be implemented, they are obliged to indicate a priority list should top management decide that some of the options should be acted on.
Each higher-level manager critically reviews the resulting options and rankings, challenges any judgments that appear questionable, possibly introduces his own ideas for example, increasing spans of control, or cutting out a layer of management , and reranks the options according to his own perspective.
He may also convene a new challenge group in order to develop additional options or improve judgments. The final ranking decisions are made at whatever level the chief executive officer deems appropriate.
In any case, he carefully reviews all options, paying particular attention to the marginal ones where the pros and cons appear to balance. For example, a fairly large bank was weighing the option of getting out of the stock transfer business which was a manual operation running at a loss and transferring it to a competitor with efficient, computer-based systems.
The challenge group ranked this option very low on its list. In the course of the review process, however, top management challenged that option and asked for an intensive search for other feasible options in the same area. The group eventually developed a safer alternative: improving the service and restructuring the prices to achieve breakeven. This option both protected jobs and plugged a continuing cost drain without the risk of jeopardizing customer relationships.
Top executives, with their broad, company-wide perspective, have a chance to see a spectrum of detailed options that are normally known only to lower-level managers. Expenses can be divided into several different types, including equipment costs, inventory , and facilities costs. These business expenses can be further divided into overhead or operating costs, each of which depends on the nature of the business being run. Operating expenses are incurred by a company through its normal business operations.
That means these expenses are required and cannot be avoided because they help the business continue running. Operating expenses are also referred to as opex. These expenses are found on the income statement and are components of operating income. Most income statements exclude interest expenses and income taxes from operating expenses. Examples of operating expenses include materials, labor, and machinery used to make a product or deliver a service.
For example, operating expenses for a soda bottler may include the cost of aluminum for cans, machinery costs, and labor costs. Reducing operating expenses can give companies a competitive advantage.
It can also increase their earnings , which can be a boon to investors. But reductions in opex can have a downside, which may hurt the company's profitability. Cutbacks in staff and therefore, salaries can help reduce a company's operating expenses. But by cutting personnel, the company may be hurting its productivity and, therefore, its profitability. One way to determine the operating expenses for a particular business is to think about the costs eliminated by shutting down production for a period of time.
For example, even though production for the soda bottler in the example above may shut down, it still has to pay the lease payments on the facility. Overhead expenses are other costs not related to labor, direct materials, or production. They represent more static costs and pertain to general business functions, such as paying accounting personnel and facility costs. These costs are generally ongoing regardless of whether a business makes any revenue.
Unlike operating expenses, these costs are fixed , meaning they can be the same amount over time. In the scenario with the soda bottler above, the facility lease payments are still owed even if no current production takes place within the facility. Therefore, facility costs are overhead expenses.
Likewise, the company still incurs other business expenses, such as insurance payments and administrative and management salaries. They may also be semi-variable, so the amounts that need to be paid may change slightly over time. Utilities are one example. The cost of power can change based on usage. If the soda company increases production, it will have to pay more for electricity.
Overhead expenses also include marketing and other expenses incurred to sell the product. For the soda bottler, this includes commercial ads, signage in retail aisles, and promotional costs.
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