In business, you have to spend money to make money. If you sell shoes, you need a place to sell them. If you paint houses, you need ladders and equipment and a truck to transport them. Your employees, if you have them, must be paid. Accountants refer to the normal costs of business as operating expenses. Some of these costs, but not all, also go by the name overhead.
Operating expenses are simply the costs a company incurs in the normal, day-to-day activities of its business. If you own a shoe store, for example, your operating expenses would include such things as rent and utilities for your retail space, your workers' wages, cleaning supplies and, of course, the wholesale cost of all those shoes you sell. Operating expenses are distinguished from capital expenditures, which represent money reinvested in the business. If you decide to buy a plot of land and build your own shoe store rather than rent space from someone else, the cost of the land and construction would be capital expenditures. These are business costs -- but they aren't incurred in the day-to-day operations of your company. You're in business to sell shoes, not put up buildings.
The term "overhead" gets used broadly, but, in general, it refers to operating costs not directly related to the goods and services that a company is in business to provide. A company's rent is an example of an overhead cost. Phone lines, Internet service, cleaning costs and supplies all count as overhead. Overhead consists of different things depending on the company. For a plumber, the cost of maintaining a vehicle may count as overhead. For a delivery company, however, that may count as a direct cost of providing services. A manufacturer, for example, might consider the salaries of its administrative staff to be overhead, while production workers' labor and the costs of operating its factory get included in "cost of goods sold," an accounting category which, by definition, is not overhead.
Fixed and Variable Overhead
Overhead costs fall into two categories: fixed and variable. Fixed overhead costs stay the same regardless of how much business a company does. A plumbing company's rent, for example, is probably going to be the same whether the company goes out on 10 jobs a month or 1,000 jobs. But variable overhead costs increase when sales increase. If an increase in work means the plumbing company puts more miles on its trucks, the costs of gas and maintenance will rise.
In general, overhead costs are operating costs, but not all operating costs are overhead. On a company's income statement, overhead costs often are rolled into a broad category called "sales, general and administrative," often abbreviated SG&A, or something like "general operating costs." Operating costs directly related to selling goods and services appear under "cost of goods sold" or "cost of services sold."
- "Financial Accounting for MBAs," Fourth Edition; Peter Easton, et al; 2010
- Entrepreneur; Small Business Encyclopedia - Pricing a Product
- SIA Foundation; What Exactly is a Capital Expense vs. Operating Expense?