Overheads are the ongoing costs of running a business that are not directly attributable to producing a specific product or delivering a specific service. They are also called indirect costs or operating expenses. On the income statement, overheads are deducted from gross profit to arrive at operating profit.
While cost of goods sold captures the direct costs of trading, overheads represent everything else needed to keep the business operational: the office, the people who support the business, and the systems that hold it together.
Classification of Overheads
Overheads are typically classified by function on the income statement (as required by Companies Act 2006 Format 1) or by their behaviour in relation to activity levels.
By Function
| Category | Examples |
|---|---|
| Administrative expenses | Office rent, management salaries, insurance, professional fees, office supplies |
| Distribution costs | Delivery vehicle costs, warehousing, freight outwards, packing for dispatch |
| Selling expenses | Marketing, advertising, sales team salaries, trade show costs |
| Finance costs | Bank charges, loan interest, overdraft interest |
By Behaviour
| Type | Description | Examples |
|---|---|---|
| Fixed costs | Stay the same regardless of output | Rent, insurance, salaried staff |
| Variable costs | Change in proportion to activity | Commission, usage-based utilities |
| Semi-variable | Have both fixed and variable elements | Telephone (line rental + call charges), electricity (standing charge + usage) |
Understanding this classification is fundamental for budgeting, pricing, and break-even analysis.
Overheads on the Income Statement
Under the Companies Act 2006 Format 1 (analysis by function), overheads appear after gross profit:
| Income Statement Line | £ |
|---|---|
| Turnover | 750,000 |
| Cost of sales | (300,000) |
| Gross profit | 450,000 |
| Distribution costs | (45,000) |
| Administrative expenses | (280,000) |
| Operating profit | 125,000 |
| Interest payable | (10,000) |
| Profit before tax | 115,000 |
Under Format 2 (analysis by nature), the same costs are classified differently:
| Income Statement Line | £ |
|---|---|
| Turnover | 750,000 |
| Raw materials and consumables | (180,000) |
| Staff costs | (250,000) |
| Depreciation | (40,000) |
| Other operating charges | (155,000) |
| Operating profit | 125,000 |
Both formats arrive at the same operating profit, but Format 1 makes overhead categories more visible.
Common Types of Overheads
Administrative Overheads
| Overhead | Typical Annual Cost Range (Small UK Business) |
|---|---|
| Office rent and business rates | £10,000 - £50,000 |
| Office utilities (gas, electric, water) | £3,000 - £10,000 |
| Insurance (employer’s, public, professional) | £2,000 - £15,000 |
| Accounting and audit fees | £2,000 - £20,000 |
| Legal fees | £1,000 - £10,000 |
| IT and software subscriptions | £2,000 - £15,000 |
| Office supplies and stationery | £500 - £3,000 |
| Telephone and internet | £1,000 - £5,000 |
Staff-Related Overheads
Beyond direct salaries, employing staff creates additional overheads:
- Employer’s National Insurance – charged on earnings above the secondary threshold, at a rate and threshold set each tax year
- Workplace pension contributions – minimum 3% of qualifying earnings
- Training and development costs
- Recruitment costs
- Staff welfare – tea, coffee, social events
Depreciation
Depreciation of fixed assets used in administration (office furniture, computers, vehicles not used in production) is an overhead. It reduces operating profit but does not involve a cash outflow in the current period.
Overhead Allocation
When overheads need to be allocated to products, services, or departments for internal purposes such as management accounting, several methods can be used:
| Method | Basis | Best For |
|---|---|---|
| Direct labour hours | Hours of direct labour per product | Labour-intensive operations |
| Machine hours | Hours of machine time per product | Capital-intensive operations |
| Percentage of direct costs | Overhead as a % of direct cost | Simple, mixed operations |
| Activity-based costing (ABC) | Activities that drive costs | Complex, multi-product businesses |
| Floor space | Square footage used | Allocating premises costs |
Overhead Absorption Rate
Overhead Absorption Rate = Budgeted Overheads / Budgeted Activity Level
If budgeted overheads are £200,000 and budgeted direct labour hours are 20,000:
Rate = £200,000 / 20,000 = £10 per direct labour hour
Each product is then charged £10 for every direct labour hour it consumes.
Overheads and Pricing
To ensure prices cover all costs, businesses must factor overheads into their pricing:
Full Cost Per Unit = Direct Cost Per Unit + Allocated Overhead Per Unit
Selling Price = Full Cost Per Unit + Desired Profit Margin
If a product’s direct cost is £25 and allocated overhead is £15:
| Item | £ |
|---|---|
| Direct materials | 15 |
| Direct labour | 10 |
| Allocated overhead | 15 |
| Full cost | 40 |
| Desired margin (25%) | 10 |
| Selling price | 50 |
Overhead Ratio
The overhead ratio measures the proportion of turnover consumed by overheads:
Overhead Ratio = Total Overheads / Turnover x 100
| Company | Turnover (£) | Overheads (£) | Overhead Ratio |
|---|---|---|---|
| Company A | 500,000 | 200,000 | 40% |
| Company B | 500,000 | 350,000 | 70% |
A high overhead ratio leaves less room for profit. This ratio is particularly useful when compared against industry benchmarks through financial ratio analysis.
Controlling Overheads
Regular Review
- Compare actual overheads against budget monthly
- Investigate variances exceeding a set threshold (e.g., 5%)
- Challenge whether each overhead is necessary
Reduction Strategies
| Strategy | Example |
|---|---|
| Renegotiate contracts | Review insurance, telecoms, and utility contracts annually |
| Consolidate suppliers | Fewer suppliers may yield volume discounts |
| Automate processes | Replace manual data entry with software |
| Flexible working | Reduce office space requirements through remote working |
| Outsource non-core functions | Payroll processing, IT support |
| Review staffing | Ensure headcount matches workload |
Fixed Versus Variable
Converting fixed overheads to variable where possible reduces risk. For example, using cloud-based software (pay-per-user) instead of buying server infrastructure reduces fixed commitments.
Overheads and Corporation Tax
Most overheads are tax-deductible for corporation tax purposes provided they are incurred “wholly and exclusively” for the purposes of the trade. Exceptions include:
| Overhead | Tax Treatment |
|---|---|
| Client entertaining | Not deductible |
| Staff entertaining (annual party, up to £150 per head) | Deductible |
| Depreciation | Not deductible (capital allowances claimed instead) |
| Fines and penalties | Not deductible |
| Political donations | Not deductible |
| Business insurance | Deductible |
| Professional subscriptions | Deductible |
| Training costs (job-related) | Deductible |
Overheads and Cash Flow
Overheads represent a regular cash outflow that must be funded regardless of trading performance. When preparing a cash flow statement or cash forecast, overheads form the baseline of cash requirements.
Key points:
- Depreciation is a non-cash overhead – it reduces profit but does not consume cash
- Accruals recognise overhead costs before cash is paid
- Prepayments recognise cash paid before the overhead is incurred
- Seasonal businesses must budget for overhead payments during low-revenue months
Manufacturing Overheads
In a manufacturing context, overheads are split into production overheads and non-production overheads:
- Production overheads (factory rent, factory utilities, quality control) are included in the cost of manufactured goods and therefore in the cost of goods sold and stock valuation under FRS 102 Section 13
- Non-production overheads (office costs, selling costs) are treated as period costs and expensed on the income statement in the period incurred
This distinction affects both the balance sheet (stock valuation) and the income statement (gross profit versus operating profit).