What are overheads: definition, examples & calculation
What are overhead costs: Basics of overheads
Overheads, also known as overhead costs or indirect costs, are all expenses that are required to support operational activities but cannot be directly allocated to a specific product, service or project. Instead, they are incurred for the entire company and hence necessary to maintain ongoing operations. They are therefore also referred to as indirect costs and can occur in both variable and fixed forms.
Real and Non-real overheads
Real overheads cannot be allocated to an individual cost unit and therefore override the cost causation principle. An example is the billing of electricity consumption for lighting, since it is usually not possible to break down the costs to the single lighting fixtures used.
Non-real overhead costs, on the other hand, can be allocated to a specific object and hence be considered accordingly in cost type accounting. For example, the consumption of cleaning lubricants per production machine can be clearly allocated. However, due to the high measuring efforts and the low gain in knowledge, companies usually dispense with this level of detail.
Primary and secondary overheads
In addition to the distinction between real and non-real, overhead costs can also be classified as primary (external overhead costs) and secondary (internal overhead costs).
Primary overheads are expenses that are charged by external suppliers or service providers (e.g. logistics costs of a freight forwarder, etc.). Secondary overheads, on the other hand, are expenses for services that are incurred internally and are usually included in the company’s personnel costs (e.g. canteen, office maintenance, IT helpdesk, etc.).
Good to know: In projects, the focus is initially on primary/external overheads, as these can be optimized much more quickly and rarely require far-reaching changes within the companies’ structures.
Difference between overheads and direct costs
Overhead costs can be regarded as counterpart of direct costs of the company, which are directly linked to the manufacture of a product or the provision of a specific service (e.g. raw material costs, hourly costs for the provision of a service, etc.).
The following table provides a clear comparison of the characteristics and examples of overheads and direct costs in order to clearly illustrate the differences between the two types of costs.
Characteristic | Overheads | Direct costs |
Definition | Costs that cannot be directly allocated to a product or service. | Costs that can be directly allocated to a specific product or service. |
Cost allocation | Indirectly (e.g. via key) | Directly |
Examples | Rent for production premises, administration salaries, depreciation on machines | Material costs for a product, wages of production employees, production costs
|
Distribution | Are distributed to several products or product categories | Are assigned directly to the respective products |
Cost behavior | Generally, remain constant or only vary with the production volume in exceptional cases (e.g.: output-dependent rent agreement) (fixed overheads) | Vary directly with the production volume (variable direct costs) |
Relevance for costing | Important for full cost accounting and pricing (“overheads”) | Decisive for calculating the cost price of a product (“variable unit costs”) |
Overheads in activity-based costing
Overheads play a central role in modern cost accounting approaches, as they make up a significant proportion of a company’s total costs. Overhead costs are usually allocated using methods such as process costing or activity-based costing (ABC), which enable a differentiated allocation to products or services. These approaches help to better understand the actual cost structures and promote a more precise calculation for managing the company. Transparent overhead cost allocation is therefore in many cases a decisive tool for operational decision-making procedures.
Examples of overhead costs
Department | Example of internal overheads | Example of external overheads |
Production | Depreciation and leasing costs for machines | License fees for patents and externally developed technologies |
Sales | Costs for internal trainings and further education programs | Expenses for both online and offline advertising |
Research & Development | Expenses for carrying out internal quality controls | Costs for commissioning external market research institutes |
Human Resources | Expenses for interviewing employees | Fees for the services of external recruitment agencies |
Finance | Costs for conducting internal security audits | Expenses for insurance services to reduce financial risks |
IT | Costs for first-level support within the company | Costs for the use of external software services |
Calculate overheads
In order to calculate a company’s overheads, several data sources need to be included. Most of the crucial information can be found in ERP systems, cost center reports and contracts. For minor expenses, it might also be necessary to analyze invoices.
EFS projects always start with the creation of a comprehensive data set including all relevant information. The resulting overview provides transparency regarding suppliers, individual prices, quantities, buyer, etc. This so-called spend cube also serves as the basis for the first initiatives, which are further developed with relevant stakeholders.
Amount of overheads
According to our project experience, the overhead costs of most companies in the retail/consumer goods sector are around 12-15% of turnover and therefore harbor numerous cost-cutting potentials. The active exploitation of those can hence have a significant positive impact on the overall operating results.
Calculating the proportion of overheads to products and sales
Depending on the company’s business model, allocating overhead costs to individual products is not that easy. First of all, it is necessary to record the complete E2E process and highlight the internally performed project steps that are paid for by overhead costs. In a second step, each service must be translated into costs using a KPI. For complex processes, different calculation logics are used to allocate the overhead costs first to a process step and then to a product, e.g: Let’s take a non-food retailer that deals with seasonal promotional sales. After the goods have been delivered by the external logistics provider, the following internal process steps take place:
A calculation logic on the overhead allocation to individual products must be defined for each of the activities mentioned. For internal logistics, for example, the space required in the truck is relevant. For product stocking, the working hours required by employees are decisive.
What is the overhead surcharge: Definition and meaning of the overhead rate
Overhead rates are percentage surcharges that are added to the company’s direct costs. This allows the allocation of overhead costs to existing cost units. Overhead rates are not only necessary to obtain a comprehensive picture of the company’s individual cost blocks, but also to ensure profitability when calculating products and services.
Why are overhead costs prioritized in cost-down projects?
Overhead costs are largely external costs that can be efficiently steered through a tendering process. This procedure has the advantage that service adjustments, service provider changes and the realization of savings can be made relatively quickly, whilst the company´s structures are not affected at all. Decent starting points can be found within logistics (sea freight, land freight, fine distribution, warehouse logistics), marketing (print, agency services), facility management (maintenance, consumables, etc.), etc.
Conclusion
Accounting for approximately 12-15% of turnover, overheads are a crucial cost block that can be developed into a competitive advantage through active management. The first step in EFS projects is therefore always to achieve full cost transparency before identifying potential savings and precise measures and levers.
The defined steps for the realization of the highlighted potentials are aligned in close collaboration between the EFS team and the client’s stakeholders. This approach ensures a common understanding of the project – not solely to increase the company´s efficiency, but also to create a baseline for sustainable cost control.