Fixed overhead
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Fixed overhead costs are a type of cost that does not vary with the level of production or sales. They are also known as indirect costs and include expenses such as rent, insurance, utilities, and property taxes. Fixed overhead costs are necessary for a company to remain operational, but are not directly related to the production of goods or services. They are sometimes referred to as period costs, because they are charged to an accounting period and do not get allocated to specific products. Fixed overhead costs are incurred regardless of the amount of production or sales, and must be carefully managed by management to ensure they stay within budget.
Example of fixed overhead
- Rent: Rent is a necessary fixed overhead cost for businesses that operate from or own a physical space. This can include office space, a retail store, or a warehouse.
- Insurance: Insurance is essential to most businesses, and can include property, liability, and life insurance.
- Utilities: Utilities such as electricity, water, gas, and internet are a common fixed overhead cost.
- Property taxes: Property taxes are taxes paid on the value of real estate owned by the business.
- Depreciation: Depreciation is the gradual reduction in an asset’s value due to wear and tear over time.
- Salaries for administrative staff: Salaries for administrative staff, such as accounting and office personnel, are a fixed overhead cost.
- Advertising and marketing costs: Advertising and marketing are necessary for any business, and can include costs for website design, print and television ads, and promotional materials.
- Legal fees: Legal fees for contract work and other legal services are a fixed overhead cost.
Steps dealing with fixed overhead
Fixed overhead costs are a necessary part of any business, and must be managed carefully to ensure they are within budget. The following are the steps in managing fixed overhead costs:
- Identify all fixed overhead costs: All costs that are not directly related to the production of goods or services should be identified as fixed overhead costs. This includes rent, insurance, utilities, property taxes, and any other indirect costs.
- Estimate future fixed overhead costs: Estimate the costs for the coming year by looking at the current costs and making adjustments to account for any expected changes.
- Prioritize fixed overhead costs: Determine which fixed overhead costs are most important to the business and focus on controlling these costs first.
- Set a budget: Establish a budget for each fixed overhead cost, and ensure that the costs stay within the budget.
- Track fixed overhead costs: Regularly monitor the fixed overhead costs to ensure that they are staying within budget.
- Make adjustments: If necessary, make adjustments to the budget to ensure that the fixed overhead costs are kept under control.
Advantages of fixed overhead
Fixed overhead costs can be beneficial to a company as they provide a predictable budget for the business and help to ensure that costs are kept within their limits. The advantages of fixed overhead costs include:
- Predictable budgeting: Fixed overhead costs provide a reliable budget that can help to manage the company’s finances and ensure that expenses are kept within the allowed limits.
- Improved forecasting: Knowing the fixed overhead costs helps with forecasting, enabling the company to plan for the future and ensure that resources are allocated to the most important areas.
- Increased efficiency: By having a budget for fixed overhead costs, the company can identify areas of inefficiency and take steps to reduce costs.
- Reduced risk: Fixed overhead costs can help to reduce the risk of unexpected costs, as they can be budgeted for in advance.
- Improved cash flow: Predictable overhead costs can help the company to manage its cash flow more efficiently by ensuring that the costs are planned for in advance.
Limitations of fixed overhead
Fixed overhead costs are an important part of the cost structure of any business, but can also present some drawbacks. The following are some of the limitations of fixed overhead costs:
- Fixed overhead costs are not easily changed, so costs may be too high or too low for the current level of production.
- Fixed overhead costs are not directly related to the production of goods or services, so they can be difficult to allocate to specific products.
- Fixed overhead costs are not flexible and can be difficult to adjust when there are changes in the level of production or sales.
- Fixed overhead costs can be difficult to manage, as they must be carefully monitored to ensure they stay within budget.
- Fixed overhead costs can be difficult to track, as they are not directly related to production or sales.
- Because fixed overhead costs are not variable, they can be difficult to control in times of economic downturn.
In addition to controlling fixed overhead costs, there are several other approaches related to managing them. These include:
- Planning and Budgeting: Establishing a budget for fixed overhead costs helps to ensure that the costs are in line with the company's goals. This is done by setting up a budget for the year and then tracking expenses on a regular basis.
- Outsourcing: Some fixed overhead costs can be outsourced to other companies or even to other countries. This can be used to manage costs and maintain quality control.
- Automation: Automation can be used to reduce the amount of labor needed to complete a task, thereby reducing the amount of fixed overhead costs associated with it.
- Negotiation: Negotiating with suppliers and vendors can help to keep fixed overhead costs down by getting the best prices possible.
In summary, managing fixed overhead costs requires careful planning, budgeting, and negotiation. Automation and outsourcing can also be used to reduce costs, while still maintaining quality control.
Suggested literature
- Farkas, M., Kersting, L., & Stephens, W. (2016). Modern Watch Company: An instructional resource for presenting and learning actual, normal, and standard costing systems, and variable and fixed overhead variance analysis. Journal of accounting education, 35, 56-68.
- Winsen, J. K. (1979). A note on the possibility of income manipulation through the absorption of fixed overhead. Accounting & Finance, 19(2), 23-31.
- Novin, A. M. (1992). Applying overhead: how to find the right bases and rates. Strategic Finance, 73(9), 40.
