In business, overhead or direct overhead cost refers to an expenditure of operating a company. Overheads are that expenditure that cannot be easily identified with any single cost unit, such as labor or raw material. Although most businesses have some kind of overhead, many businesses are able to reduce their overhead costs by doing so on a routine basis. A routine maintenance program and an organized billing system can go a long way in reducing overhead costs.
A routine maintenance program, also referred to as inventory control, involves the collection, storage, preparation and distribution of data and materials used in performing business activities. For example, if a company manufactures widgets, they will need to purchase raw materials as well as tools to produce the widgets. The cost of the raw materials alone can run into thousands of dollars per piece. Overhead associated with purchasing, storing, and distributing the materials eventually adds up to a substantial portion of the business’ overhead cost.
On the other hand, suppose a company produces goods on an assembly line. Goods purchased from suppliers come off the line in pre-assembled containers. Goods assembled on the line then proceed through a series of tasks, each of which incurs an overhead cost. Each completed task adds to the total overhead cost until the factory’s inventory reaches a level above overhead. At that point, the factory must either order additional items to complete the tasks left behind or cease production and accept lower profits.
Another example involves materials. Some companies buy raw materials at wholesale prices and sell them individually at retail rates. Some companies combine the two processes. Materials that are sold on a wholesale basis, such as materials for heavy construction or machine manufacturing, incur high overhead costs because it takes more time to mix the materials and process them. By contrast, materials sold on an individual basis, such as office supplies, incur much lower overhead because the items are purchased in their unprocessed state and the quality assurance is not as intensive.
What is overhead also affects the cost of doing business. An accountant determines overhead based on the prices paid for materials, labor, and advertising. The cost of overhead can actually be a measure of the quality of a company’s products or services. A company’s overhead expenses can influence whether customers perceive the company to be high quality or low quality because of the costs incurred by the company.
What is overhead for you may not be what is overhead for your neighbor. Therefore, an effective way to determine what is overhead for you is to ask yourself how your company fits into the market, particularly in comparison with similar companies who do not engage in activities that you conduct. What are the differences between your business and those of other companies? What do you offer that other companies do not?
What is overhead for you does not necessarily have to be what is overhead for your neighbor. For example, if you conduct many sales per month, you do not necessarily need to pay the same amount of overhead as a company that has a very small sales force. You can reduce your overhead cost by determining what is local overhead and what is overhead for your company.
What is overhead for you can also affect the cost of procuring materials and labor. The price of materials can be affected by the overhead cost associated with the vendor. It is important for you to obtain cost quotes from several vendors before you select a vendor. This will allow you to compare materials and determine whether you are spending too much or too little for the materials. What is overhead for you therefore can be determined by taking a careful look at the price of materials, labor, and other miscellaneous overhead costs associated with your company.