Costs in a business are traditionally divided into operating and administrative categories. Both are necessary for the company, but operating costs are closely tied to specific products and services whereas administrative costs are incurred on behalf of the enterprise as a whole. This latter expense is sometimes referred to as "overhead."
The distinctions are most clearly visible in manufacturing operations where, for instance, the "factory" has its own warehouses and yards while the "headquarters" is located elsewhere. All of the costs associated with production itself, including engineering, warehousing, energy, maintenance, and the like—and not least labor and raw materials costs—are accounted for as operating expenses. Ideally the accounting systems are well-enough developed so that these costs can be subdivided by major product lines. Supposing that the company makes golf carts, 4-wheeled recreational vehicles, and boats. Factory costs associated with each should then be available and, indeed, assignable down to each unit produced.
At the headquarters of the company administrative expenses are incurred. These include executives and staff salaries and fringes. Accruing in addition will be the costs of the buildings' rents and maintenance, outside services, expenditures on advertising and sales promotion, personnel, health programs, executive travel costs, etc. Let us assume that the company has engineers at the factory but also engages two engineers to conduct research. The research function will be part of the administrative expense. Depreciation on all of the company's assets, all taxes paid, all insurance carried will be part of administration. And all of these expenses will be accounted for as overhead. The money spent on these items or activities support all three of the major product lines together, not separately.
Given this definition of overhead—as costs incurred to make something else possible—it is clear that different kinds of overhead will be incurred in a larger operation. The factory itself will have an overhead ("factory overhead"), namely the costs associated with factory management staffs and services. Sales office operations may have overhead costs associated with general supervision, etc. The general overhead is that of the company's central management.
On a company's income statement, sales represent the incoming money and net profits after tax represent what is left over. Operating profit is an intermediate sum left over after production costs have been taken from sales. The difference between operating profit and net profit is another definition of overhead. It is the cost of "all else" after products are made and/or services have been delivered.
From this comes the concept of "overhead absorption" commonly used in service operations or in contracting. Where the chief cost of an operation is the salary of employees, companies often develop an "overhead rate" used as a multiplier of salaries. In bidding a job, managers first calculate costs based on the individuals who will do the work, the amount of time they will spend, travel expenses, and other necessary purchases. Then the managers apply an "overhead," usually by multiplying the initial estimate by some factor like 1.8. This means that every dollar of salaries paid to employees must absorb 80 cents of overhead. Overhead rates are typically developed once a year and used thereafter. The obvious implication of an "overhead rate" is that the operation must sell enough staff time to absorb all of the overhead. And only after that does the operation make a profit.
A somewhat analogous concept arises in charitable operations that spend money on fundraising. Here, ideally, as little of each collected dollar is deducted for the fundraising itself as possible—and as much as possible handed over for the actual charitable operation itself.
In successful companies and in good times there is a tendency for overhead to increase because the money is there and additional services provide better information, less stress, and more amenities. When the economy slows or a company runs into difficulties, it will first reduce its overhead by shedding nice-to-have but not-absolutely-necessary services. The public is often amazed that a company can keep on operating after letting so many people go. The hidden part of this process is that the public is unaware just how much "weight" the company had put on before forced to go on a diet.
SEE ALSO Activity-Based Costing; Product Costing
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