Handling Overhead Costs
Overhead: An overview
Overhead involves expenses that do not go directly into the production of your goods and services, but which are nevertheless essential for your business to continue operations.
Most overhead expenses involve the cost of general and administrative services, such as salaries, equipment, rent, legal support, and data processing. There are also operations overhead costs, such as utilities, which are linked to the cost of operations but are not directly factored into the cost of each unit of product produced.
Separating the personal from the business
In many small businesses, particularly family-owned ones, one of the biggest causes of unreliability in assessing the profitability of the business is the lack of segregation of costs between household expenses and business expenses. For instance, many family-owned businesses, being run from within the family residence, do manage to save on rent expenses and utilities in a practical sense. However, there is still a need to allot a reasonable sharing ratio in order to properly gauge just how much expenses the business actually accrues: both extremes, namely that of either the business absorbing all or none of the utilities expense in favor of the household, are unreasonable.
But there’s another issue to consider as well: many businesses become too comfortable with the sharing arrangement that, once they have to move out to find their own place, they become shocked with the actual costs of overhead that is involved. This is why cost allocation is good practice—it gives the business a reasonable picture of what their real costs are, regardless of special arrangements.
Distributing the overhead
Many small businesses soon find that they will have to handle more than one product or service, and that they will have to judge the profitability of each of these products or services. Overhead expenses will then have to be distributed among these different business units in order to get a better picture of how each of the units are fairing assuming that they were autonomous units.
There are many ways by which overhead expenses can be distributed among different business units. The most common methods involve dividing overhead according to (1) real estate area occupied by each business unit, (2) pegging against a reference cost incurred by each unit, and (3) percentage of revenues earned.
There are pros and cons to each of these methods. For instance, using real estate area as a reference only makes sense for businesses such as manufacturing plants where area does become one of the most significant overhead cost components, but not for desk-based services. The important thing is for the general manager to see to it that the allocation of overhead is as fair as possible.