Business Glossary

What are Overhead Costs?

Overhead costs, also known as fixed costs or just overheads, are expenses a company is committed to paying regardless of its output. They are shown in the operating expenses (OPEX) section of a company’s profit and loss account.

Examples of overhead costs

Most overhead costs relate to maintaining a workspace, such as rent/mortgage, utilities and mandatory insurance. Core labour costs are also overhead costs because permanent employees must be paid their salary or wage regardless of output.

In modern businesses, contracts for managed services and/or software licences may also be considered overheads. For example, if a company signs up for a yearly licence package, it must pay for that licence regardless of how much or how little the software is used.

Whether or not a cost is considered an overhead cost depends on the nature of the cost in relation to the business context. For example, the rent on a company’s permanent office is a fixed cost and will be seen as an overhead. However, the rent on overflow space used at peak times is a variable cost that is tied directly to production. This means it’s more likely to be considered part of the cost of goods sold (COGS) or the cost of revenue (COR).

Overhead costs can be variable

Although they are often called fixed costs, many overheads are variable – at least to some extent. For example, in accounting, core utility costs are considered fixed costs. In reality, however, they are usually variable costs because they are billed according to use and this generally varies according to the season.

Overhead costs vs capital expenses

Capital expenses (CapEx) are expenses that relate to the purchase (or development) of an asset that is expected to deliver value for over a year. Like overheads, capital expenses are costs that a business is committed to paying regardless of how much or how little it ends up using the asset. In fact, it’s common for businesses to have to pay capital expenses before they can even use the asset.

The main difference between capital expenses and overheads is that capital expenses are expected to be finite. For example, if a business commissions a new IT system, it will only have to pay the development costs once. It might, however, choose to pay for an ongoing maintenance package. If it did, this would probably be an overhead cost.

The importance of minimising overheads

Minimising overheads has long been a priority for companies in all business sectors. Modern companies are becoming increasingly creative in how they approach this. Even sectors with traditionally high overheads (such as manufacturing) are leveraging new strategies to help reduce them.

Probably the most obvious example of this is the fact that many companies are giving up permanent offices in favour of remote working and temporary meeting spaces.

Another example of modern businesses minimising overheads is the way companies are increasingly leveraging technology to streamline administration. Automated invoicing or inventory management solutions can reduce resource requirements. Traditionally, selling, general and administrative costs formed a significant percentage of overhead costs. To a certain extent, that is still the case today but the level of administrative overhead is shrinking rapidly.

The potential danger of minimising overheads

On the one hand, it’s indisputably important to keep overheads as low as possible. On the other hand, focusing too much on minimising overheads can lead to missed opportunities and reduced profitability.

The key point to remember is that all companies want reliable income. They therefore generally reserve their best deals for customers who are prepared to commit to them. The more a customer is prepared to commit, the better the deal they are likely to be offered (or be able to negotiate).

In short, therefore, if a company is sure that it will need a supply of a product or service, the best option can be to accept a higher overhead in the interests of the overall value it offers.

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