Last Updated on
February 9, 2023
Overhead is a type of business expense that refers to the indirect costs that a business incurs in order to operate. This can include rent, utilities, administrative costs, insurance, and property taxes. Overhead costs are not directly tied to producing a product or service, but are absolutely necessary for the business to function. They can have a significant impact on a business’s bottom line, as it’s possible for these costs to add up quickly and eat into profits.
But what's the difference between overhead costs and operating expenses?
Operating expenses, which can refer to direct costs, are the costs incurred by a business in order to maintain its daily operations. Operating expenses are directly related to the production and sales of a company’s products or services, and are considered a necessary part of doing business.
This includes the costs of manufacturing, packaging, selling, and marketing your products or services, as well as the materials, labor, equipment, and utilities and other costs that go into creating or providing your product or service. They are incurred to produce revenue and are accounted for in the income statement under operating expenses.
While some overhead expenses can fluctuate month by month, others will require significant spending on a long-term basis. As you build your business plan and decide on what to invest in, it’s important to consider which overhead costs are necessary, and which you can do without.
The particulars of overhead expenditures will vary depending on many factors, like the kinds of inputs required for your product, whether there are “busy seasons,” and how much marketing and sales is required will factor into your ability to acquire customers.
One trend that is affecting overhead costs for businesses is the increase in digital technology and automation. As more businesses move online, they are able to reduce overhead costs by eliminating the need for physical office space and are instead opting for remote work or co-working spaces. Additionally, automation can help reduce labor costs and improve efficiency, which can also help to lower overhead expenses.
Fixed, variable, and semi-variable overhead costs are generally considered to be the main types of overhead costs.
Fixed overhead costs are expenses that remain constant regardless of the level of production or sales. These costs include rent, salaries, and insurance. They are incurred whether the business is producing or not. These costs are considered fixed because they don’t change based on the level of production or sales.
Variable overhead costs, on the other hand, change as the level of production or sales changes. These costs include materials, utilities, and direct labor. They are incurred only when the business is producing or selling. Variable overhead costs are considered variable because they change based on the level of production or sales.
But not all overhead costs can be neatly categorized as fixed or variable, and some costs may have elements of both. This is where semi-variable comes into play.
Semi-variable overhead costs include costs that have a fixed and a variable component. These costs typically include a fixed portion, such as rent or insurance, and a variable portion, such as utilities or supplies. The fixed portion of the cost remains constant regardless of the level of production or sales, while the variable portion changes with the level of production or sales.
In the early stages of your business journey, we recommend minimizing overhead as much as possible since it can become a major expense that won’t directly help you increase revenue.
These expenses stay the same over a given period. The two biggest costs include paying rent for a facility and salaries or wages for employees that don’t create or sell your product. The most expensive of the two is facility costs.
In the early stages of business, cost reduction can be essential. Keeping initial facilities costs low will not only make it easier to operate, it will show investors or research agencies who might consider funding your work that you’re thinking clearly about the business side of your endeavor.
Buying a facility with lab and office space will be extremely expensive, so we don’t recommend committing to the idea of a dedicated space right away. Instead, depending on your business needs, you might be able to operate by renting a single bench in an incubator. If you need more space than that, consider renting or leasing for the time being.
As you reduce the scientific risk of your idea through data collection and analysis, you’ll start gaining momentum. This is where you’ll begin to consider whether or not you need a dedicated lab space for your team or company. You might even consider getting some office space, depending on the administrative needs of your business. The same advice applies here as well: it’s not always beneficial to rush into buying office space.
If you do currently pay for a facility or space in one, consider reevaluating your office space as it can have a significant impact on your overhead costs. Take a close look at the size and location of your current space, and determine if it truly meets the needs of your business. One option to consider is downsizing your office space and decluttering it to find a smaller, more cost-effective location.
Alternatively, you could consider relocating to a different area without negatively impacting revenue or productivity. One cost-saving solution could be to implement a remote working policy for some of your employees, which can significantly reduce the cost of office space. By evaluating your office space and implementing changes, you can make a significant impact on your overhead costs.
We know that work often requires us to be in-person for meetings and projects, but we also know that being alone can be very productive. Be strategic about how you plan face-to-face team time, and structure your time in the lab accordingly.
One of the more positive consequences of the COVID-19 pandemic is that workplaces have begun using fully-remote or hybrid work models when possible, so there are more tools available to support working outside of the lab.
While there is debate surrounding the shift to WFH, many employers and employees have embraced workplace flexibility. Keep communication open with your team to see what works best for you as a group.
Employee wages are a significant part of overhead costs for any business. To reduce these costs, one strategy is to downsize staff if it can be done without affecting morale or productivity. However, a more proactive approach is to make more informed hiring decisions from the beginning.
This can include seeking out employees who have a diverse range of skills and backgrounds, or investing in training and development to allow for internal promotions and filling of gaps. By carefully selecting and developing employees, companies can minimize the need for costly staff replacements in the future.
By selecting your team carefully, you may even be able to consolidate responsibilities in the beginning. Rather than paying multiple people to execute each role, try to combine those roles in a way that makes sense in the context of your business and offers some sort of cost savings. Hiring new employees can often be quite difficult in the beginning anyways, so combining roles might be a good idea.
Administrative costs can contribute substantially to your overhead. This includes managing things like lab space, office space, lab and office supplies, human resources, finances, communications, and more. Before you reach a certain size, you can often outsource these costs and use free or low-cost tools to help.
Startups can save on administrative costs in their early stages by implementing a few strategies, including:
By implementing these cost-saving strategies, startups can reduce their administrative expenses and have more resources to invest in growth and expansion.
That being said, don’t run the risk of destabilizing your business. Asking someone with no bookkeeping experience to balance your books can lead to larger problems down the road. Part of your role as a founder and executive is to notice when you need to hire someone who is experienced and qualified in managing operations.
Depending on your needs, you may need certain equipment right away to run your business. But investing in equipment for your company can be a significant financial commitment.
Buying scientific instrumentation or office equipment will result in an immediate spike in overhead costs, including the insurance, property taxes, inspection and mechanics supervision, security, licenses, record keeping, and even security costs that go into acquiring the equipment.
These indirect costs can add up, making it even more expensive to simply buy a piece of equipment for your business. However, there are alternatives to buying equipment outright that can help mitigate the costs. One option is to rent or lease equipment instead.
Equipment leasing can provide companies with the use of the equipment without having to worry about the upfront cost, maintenance, or repairs, making leasing a cost-effective and flexible solution for many businesses.
The variable costs of your overhead will change from month to month. Some months you may have a lot of costs. Other months you may have very few or none at all. It will mostly depend on the quantity of products or services you are producing at the time, and shift as your output levels change.
Fairly universal examples are things like shipping costs, seasonal employee wages or consulting fees, advertising and marketing, equipment repair, and legal costs.
Startups can consider outsourcing tasks or hiring part-time and contract-based employees to fill specific needs without incurring the costs associated with full-time employees, such as benefits and paid time off.
By outsourcing specific functions, a business can fill staff gaps and save on office supplies and other overhead expenses. When done correctly, outsourcing can allow a startup to scale back or expand their operations as needed, by simply adjusting the use of third-party services.
However, it is important to be cautious when choosing suppliers and service providers. Research the company’s performance and consider only outsourcing tasks that are well-suited to freelancing, such as accounting or marketing, to ensure that the quality of work is not affected.
You may also want to rely on part-time staffing if you anticipate ramping up during specific times of year. If so, you can factor the increase in labor costs into your budget and create short-term contracts for those times or pay contract-based employees on an hourly basis.
For consultants, like lawyers, accountants, and subject-matter specialists, paying a flat rate for a project or creating short-term retainers will likely be more cost effective. As you grow, you might add some of these as full-time employees and in-house roles, but we recommend taking your time on this.
When you’re starting your business or launching a new product, your advertising and marketing needs will increase. We recommend having a permanent member of your team who understands these areas of business so that they can implement strategies that will have a good return on investment, and can help you manage marketing costs in the beginning.
You will always need to do some amount of marketing to raise and maintain awareness about your product, but focus your efforts and your finances on product launches.
The reality is that equipment breaks, and it’s always when you least expect it. If you own your equipment, we recommend ensuring you have a good warranty and/or excellent insurance. Because of asset depreciation, we tend to think that leasing or renting your equipment is the most financially savvy option, since repairs are either included or facilitated.
These costs, also known as semi-fixed or mixed costs, are more constant than variable overhead, but still can fluctuate over time. Things like utilities, sales costs, sales commissions, and shipping costs are considered semi-variable overhead expenses.
Utilities are a relatively constant cost that can add up and become a significant expense for any business. Although things like electricity usage might change based on how much production is happening, or whether you’re using a lot of heating or cooling, you may end up paying a lot per month for your utilities bill.
To reduce these costs, it’s important to consider implementing more eco-friendly alternatives. For example, switching to LED bulbs, “green” outlets, and energy-saving power strips may have a higher initial cost, but they will result in lower utility bills over time.
Another cost-saving strategy is to move to a paperless office, which can save on paper, printing, and electricity expenses. Another way to save on utilities costs is by implementing an energy management system. This can help monitor energy consumption, identify areas of energy waste and suggest ways to reduce consumption.
Additionally, with an energy management system businesses can also take advantage of different energy tariffs and take actions to lower their bills. Look at manufacturing facilities and office buildings that use passive heating and cooling and are LEED certified.
Startups can sometimes use compensation effectively to keep overhead costs low. This includes offering flexible compensation packages and providing incentives.
Instead of offering traditional salary and benefits packages, startups can offer more flexible options, such as equity or profit-sharing, to attract and retain employees. This can help keep compensation costs low while still providing employees with a sense of ownership in the company.
Businesses can also provide incentives or commission for employees to come up with cost-saving ideas and strategies. This can help encourage a culture of cost-consciousness and encourage employees to think critically about ways to reduce expenses. While commissions are a great incentive for salespeople, you may want to be conservative with commissions and instead offer slightly larger salaries so that your sales budget is more predictable. You may be able to offer non-financial incentives, such as additional vacation days as rewards for your salespeople.
It’s also important to set clear performance expectations and tie compensation to meeting or exceeding those expectations. This can help ensure that employees are motivated to work efficiently and effectively, and that compensation costs are aligned with business performance.
Depending on your industry, you may even consider providing the option for remote work that can help save on office expenses such as rent, utilities, and internet service and attract a wider pool of talent from different locations.
Although it may be surprising that depreciation is considered an overhead cost, it isn’t like other expenses that fall within the category. Unlike rent, salaries, and other cash expenses, it is considered a non-cash expense and accounting measurement. Nonetheless, it’s considered a part of your overhead costs and is an important thing to know about when tracking overhead, as it impacts your company’s financial statements.
There are different types of assets a company can own (or lease) that are either tangible or intangible. Tangible assets, like equipment, inventory, or factories depreciate, meaning they lose value over their useful lifespans. This is one aspect of depreciation. The other involves spreading out, or “writing down,” the cost of a tangible asset over time to account for its original cost in periods in which it’s being used.
No matter what, a physical asset will depreciate, but, depending on how long you hold onto the item, you will be able to account for that asset’s depreciation. If the item is considered a current asset, because it will be used up or sold shortly, it will not depreciate. In contrast, if the item is a noncurrent tangible asset, or fixed asset, it will depreciate in value over time.
If you have fixed assets on your balance sheet, not only will they lose value each year they’re in use, their costs will also need to be depreciated over time for accounting and tax purposes.
While depreciation of fixed assets doesn’t have the same effect on your cash flows as paying salaries or rent does, it does impact your business’s income statement, cash flow statement, and balance sheet, affecting your company’s overall financial performance by reducing your gross profit.
Make sure to depreciate any fixed assets you may have so that they are all accurately represented on the balance sheet, giving you the ability to take full advantage of beneficial tax breaks. Your accountant will likely already be on top of this.
Now, if you haven’t purchased any fixed assets; you’re not sure purchasing lab equipment makes sense right now; you aren’t currently paying income tax because you have no profits to tax (e.g., you’re still performing research and development and don’t have a product to sell or drug to license), then depreciation won’t really apply to you.
However, equipment costs still will affect you. If you’re planning on buying lab equipment, depreciation will provide some tax breaks (if you’re generating a profit), but that’s about it. You’ll use up a large chunk of budget to purchase a fixed asset, and see little return via depreciation. Instead, consider leasing your next scientific instrument to preserve cash reserves, extend cash runway, and continue R&D without the need to raise more money or worry about how depreciation can have an effect (indirectly) on your overhead costs.
If you’re an early-stage founder or small business owner, looking at business overhead costs can be terrifying because you can’t immediately connect them to profitability, unlike operating costs. Nonetheless, they are critical in sustaining your business, and will grow as your business grows.
When you start your business, it’s ideal to keep these costs as low as possible since they don’t directly contribute to making your product. Cost-cutting can be especially important when a company is facing financial problems or there is an economic downturn.
If you’ve read our article about fundraising for your start-up, think about joining an incubator or an accelerator for support on some of these overhead expenses, as well as help with business planning.
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