Overhead – General Definition
Those expenses not tied directly to production of revenue are considered overhead expenses. Examples of overhead include:
- Facilities – rent, utilities, security, site/building maintenance, sanitation etc.
- Management – payroll including matching taxes for upper management and administrative staff (front and back office)
- Insurance – general liability, errors and omissions, umbrella
- Office Operations – office supplies, office technology (computers, software, copiers etc.), postage, banking, professional/consulting fees, accounting etc.
- Taxes/Compliance – licensing, income taxes, local revenue taxes, governmental conformance
- Other – marketing/advertising, travel, meals & entertainment, training etc.
- Capital – depreciation, amortization, interest to service debt, financing costs
There are some expenses that are marginal (overlap) in nature and are often (mistakenly) classified as overhead. If this cost is necessary to produce a product that is sold or render a service, it is considered a cost of sales and not overhead. The following are some examples and an explanation of why they are grouped to cost of sales.
Transportation – Almost always classified as overhead when in reality they are cost of sales. Transportation costs include fuel, auto insurance, repairs and maintenance of vehicles, leases, registration and the scented Christmas tree hanging from the mirror. In general, almost all vehicles are used to further production, deliver goods or move the managers from one point to another for field work. A good example are the trucks used in construction by not only the direct delivery of materials but by the project managers. These are necessary tools to get the work done. Rarely does the office administration or office managers utilize a vehicle to do their work; if so, it is insignificant in comparison to the utility the vehicle brings to complete field work.
Sales Department – Without a doubt, the costs to produce sales are tied directly to the production of revenue. Without the sales staff, there would be little to no revenue generated. Sales staff wages and corresponding taxes/benefits are direct cost of sales. Included within this scope of costs are:
- Website development/e-commerce platforms
- Branding/Logo development costs
- External commissions paid to third party service providers (broker fees, dues and subscriptions in national/regional campaigns)
Think of an auto dealership. The pay salesmen to present the cars and interact with the customers. They develop advertising campaigns along with the brochures and social networking to make the campaign successful. All of these costs are directly related to the sale of the autos on the lot.
Technology – This particular form of costs is tricky. In general, most of the technology purchased is used to further the administration function of the company’s day to day operations. However, technology and industry specific software is purchased for the sale or manufacture of goods. When technology is purchased for this purpose; or certain software is purchased to design, produce or monitor production; this technology and corresponding software should be classified as cost of sales and not posted to overhead in office operations. Often the accounting staff has to separate the costs of technology into the two respective classifications.
Some Insurance – Certain policies are definitely cost of sales and not classified as overhead. Good examples include garage policies (auto operations such as car lots, auto repair facilities, auto storage, transportation etc.), worker’s compensation insurance and benefit insurance (key man, general group life and medical insurance). Those policies that are generic in nature such as general liability, errors and omissions and general bonding are considered overhead and not assign to cost of sales.
Most bookkeepers and accountants have difficulty distinguishing between cost of sales and overhead costs. There are several tools available to assist in determining the proper classification. Above are production based decision models; this means that if the cost is directly assignable to the product/service then it is a cost of sales and not in the overhead section of the income statement (profit and loss statement). A second decision tool is time driven. Those costs that would not stop production immediately are considered overhead in nature. As an example, if the front ran out of paper, it would not stop production. It would upset the front office staff and the management team, but production and sales would continue. Look at the list of traditional overhead costs at the beginning of this article, those costs if not paid would not stop production of goods or the rendering of services.
A final tool to decide if the respective cost is directly related to production or is overhead is industry specific standards. Some industries classify certain costs to certain sections of the income statement. For example, in residential construction, tools purchased to use at job sites are classed as indirect costs of construction in the cost of sales section of the financial report as illustrated here:
Costs of Construction
Sub-Total Direct Costs of Construction
Project Management (Field Payroll)
Insurance (Builder’s Risk, Worker’s Compensation)
Taxes and Compliance
Notice the logical relationships involved with the respective costs. Both direct and indirect costs of sales relate to building of homes, whereas the overhead more closely matches the concept of the front and back office aspect of a business operation.
There are other names used for overhead and include:
- General and Administrative (G&A)
- Operating Expenses
- Running Costs
- Fixed Costs (This term used as a substitute for overhead is considered incorrect by most accountants/CPA’s and academia.)
When using the term ‘Overhead’ remember it refers to those costs not directly attributable to the production of revenue. ACT ON KNOWLEDGE.
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