What is an overhead?
June 2023 | Published by Xero
Overhead (definition)
Overheads are business expenses that aren’t directly involved in delivering products or services to customers.
Many businesses say an indirect cost is an overhead. That means the cost was not directly incurred to buy stock, make products, or deliver services.
Other businesses say fixed costs are overheads. That means the cost stays constant whether or not the business makes any sales (or even opens its doors) that day.
Why the meaning of overhead gets confusing
While indirect costs and fixed costs are often the same, there are significant differences between the two. For example, sales and marketing costs are indirect (they don’t go into your product or service) but they’re not fixed (they tend to go up and down throughout the year). So some businesses might call that an overhead while others might not.
The meaning of overhead can also be affected by how you classify production costs. Some businesses might count rent as a cost of production – especially if it’s rent for a factory. While others might say it’s a fixed cost that the business has to pay whether or not they’re open, which makes it an overhead to them.
An employee may be counted as an overhead (a fixed cost that you have to pay even when the business is closed), but they may be counted as a cost of sales if they’re directly employed in delivering a service.
Using the word ‘overhead’ in business
Because of the variable meanings of ‘overhead’, it’s a good idea to steer away from the term. One way to avoid confusion is to instead use the six generally accepted categories of business expense:
- cost of goods sold (or cost of sales)
- sales and general administration
- depreciation (and amortisation)
- interest
- income taxes
- miscellaneous
This removes the need to refer to overheads. If you find it useful to refer to some costs as overheads, just make sure you have a clear and consistent definition of what overhead means for your business.
Learn more about these six categories of operating expenses.
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Disclaimer
This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.