When managing a business, you deal with a variety of expenses—some are directly related to producing your goods or services, and others are not. The expenses that aren’t tied to making a specific product but are still essential for daily operations are known as overhead costs in accounting.
These costs play a major role in running a business smoothly. Even if you don’t sell a single item today, you still have to pay rent, keep the lights on, maintain your internet connection, and pay support staff. These are all overheads—ongoing costs that keep your business functioning behind the scenes.
In accounting, understanding overhead costs is important because they impact pricing, budgeting, and overall profitability. From rent and utilities to office supplies and admin salaries, these expenses don’t go into your product directly, but they definitely show up in your financial statements.
For example, if you’re running a bakery, your overhead costs would include the rent for the bakery space, electricity for the lights and ovens, the salary of the cashier, and insurance. While these costs support the bakery’s operations, they are not part of the bread or cake you sell. These expenses are critical to keeping the business running, but they aren’t tied to a specific product or service.
So, what is overhead costs in accounting? Simply put, overhead costs are the necessary, indirect costs that a business must pay to keep its operations running smoothly, even if they don’t directly relate to producing a specific product or service.
Definition: What Are Overhead Costs in Accounting?
In accounting, overhead costs (also called indirect costs) are the ongoing business expenses that support your operations but do not directly generate income. These are the costs you must pay to keep your business running, even if you don’t make a sale today.
Examples of Overhead Costs:
- Rent for office or factory space
- Utility bills (electricity, water, internet)
- Salaries of support staff (HR, admin, security)
- Office supplies
- Insurance
- Equipment maintenance
- Depreciation of assets
These costs are necessary but are not part of the actual product or service you sell.
Real-Life Example: Bakery Business
Let’s say you run a small bakery.
Direct costs:
- Flour, sugar, eggs (used in baking)
- Wages for the bakers
- Packaging materials
Overhead costs:
- Rent for the bakery shop
- Electricity used to run ovens and lights
- Salary of the cashier or cleaner
- Internet and phone bill
- Equipment repairs (like fixing the oven)
Even if you bake only 10 cakes today instead of 100, you still have to pay rent and electricity. These expenses are your overhead costs.
Why Overhead Costs important in Accounting
Understanding what are overhead costs in accounting is important because:
- It helps you set the right price for your products or services.
- It gives you a clearer picture of your true profit.
- It helps with budgeting and cost control.
- It is needed for financial reporting and tax calculations.
For example, if your total sales were $5,000 this month but your overhead costs were $2,000, and your direct costs were $2,500, your profit is only $500—not $2,500.
Types of Overhead Costs
Overhead costs can be divided into three main types:
1. Fixed Overheads
These stay the same no matter how much you produce.
- Rent
- Insurance
- Salaries of permanent staff
Why These Are Overhead Costs
| Overhead Item | Explanation |
|---|---|
| Rent | Rent is paid for the space where the business operates—like an office, shop, or factory. It is not tied to making a specific product or service, but it’s essential to keep the business running. |
| Insurance | Insurance protects the business from risks like fire, theft, or liability. It is a general expense required for business safety and continuity, not linked to production. |
| Salaries of Permanent Staff | This includes administrative roles like HR, receptionists, or managers. They support business operations but don’t directly produce goods or services. Hence, their salaries are overhead costs. |
2. Variable Overheads
These change with the level of production or sales.
- Electricity
- Office supplies
- Hourly wages
| Overhead Item | Explanation |
|---|---|
| Electricity | Electricity powers the lights, machines, computers, ovens (in a bakery), etc. It’s necessary for business operations but isn’t tied to one specific product. It supports the overall environment. |
| Office Supplies | Items like pens, paper, files, printer ink, etc., are used by staff for general tasks. These are not directly part of a product but are required for daily business functions. |
| Hourly Wages (for support roles) | Wages paid to cleaners, security staff, or temporary admin workers who help the business run smoothly. These roles are not directly involved in making or delivering the product, so their wages are overhead. |
3. Semi-variable Overheads
These are a mix of fixed and variable.
- Telephone bill (fixed base + charges for extra usage)
- Maintenance costs
| Overhead Item | Explanation |
|---|---|
| Telephone Bill | The telephone bill typically has a fixed base cost for the line rental or basic service, regardless of how much you use the phone. However, additional charges apply for extra usage, such as long-distance calls or internet data. This makes it a semi-variable overhead cost because you have a consistent baseline cost, but extra charges can increase based on usage. |
How to Calculate Overhead Costs
To calculate total overhead costs for a month:
| Overhead Category | Example Cost |
|---|---|
| Rent | $1,200 |
| Utilities (Electricity, Water, Internet) | $300 |
| Admin Salaries | $1,500 |
| Office Supplies | $150 |
| Insurance | $200 |
| Equipment Maintenance | $100 |
| Total Overheads | $3,450 |
Then, you can use the Overhead Rate:
Overhead Rate (%) = (Indirect Costs ÷ Direct Costs) × 100
This helps you understand how much overhead you’re paying compared to your production costs.
Example:
If your total overhead expenses are $4,000 and your direct costs (like raw materials and direct labor) are $8,000:
Overhead Rate = ($4,000 ÷ $8,000) × 100 = 50%
This means for every $1 spent on direct costs, you’re also spending $0.50 on overhead.
Final Thoughts
Understanding what is overhead costs in accounting is essential for managing a business efficiently. It’s not just about how much you sell—it’s also about how much you spend to keep things running behind the scenes.
Whether you’re a baker, a freelancer, or a shop owner, keeping track of your overhead helps you stay profitable and make better financial decisions.