Overhead, also known as indirect expenses, is the cost of running a business. Without these expenditures, a company would not be able to function, but they do not contribute directly to the generation of profits. In a simple distinction between indirect and direct expenses, the desk an employee sits at is considered an indirect expense, while the materials for the product the employee makes at the desk are a direct expense. Without the desk, the employee cannot work, but the desk does not produce profits, while the materials the employee works with to create a product do.
Business owners have to consider overhead when they price products and services, and sometimes it can be a serious problem. If a retail store selling clothing pays a great deal for a premium location, for example, it must charge high prices for its stock, but customers may not be inclined to pay those prices, because they cannot see the reasons why the clothes should be so expensive. In this situation, the store may be forced to slash prices, which could mean that it barely meets its operating expenses.
Some examples of indirect expenses include rent, utilities, taxes, licensing fees, insurance for employees, travel, accounting services, and fines. Without these expenditures, the business likely could not exist, making them a very necessary part of the business. Direct expenses include things like employee salaries and wages, wholesale goods purchased for the purpose of resale, and raw materials purchased for the purpose of manufacturing. These expenses are designed to create profits for the business so that the owner makes money.
The percentage of overall operating expenses taken up by overhead can vary, depending on an array of factors. Most business owners aim to keep the expenses as low as possible, but they also recognize that a failure to invest in a business can cause long term problems. Refusal to move to a better location or to provide competitive benefits to employees can result in a decline over time, eventually causing a business to fail or require it to dramatically restructure to cope with changes.
In most nations, overhead expenses can be claimed on taxes, because the government recognizes that these expenditures are not voluntary, and that they would not be made if someone didn't own and operate a business. Typically, the amount is deducted from the gross receipts of the business, along with other expenses, to arrive at an adjusted income that is used to calculate the tax rate the business owner must pay.