Difference Between Operating Expenses & Overhead

Small-business owners can greatly benefit from dividing their expenses into operating and overhead costs because it helps create optimal pricing strategies. As you produce or sell more or fewer products, some of your costs change, while others remain constant. Knowing how much it takes to make your product or create your service, and how much it costs to sell it and run your company, will help you set your prices correctly to achieve profit margins and total profits that will keep you in business.

Ins and Outs of Operating Expenses

Operating expenses, also known as manufacturing expenses, are costs associated with making a product or providing a service. For example, if you use steel to make a product, the more products you make, the more steel you’ll buy. While some expenses change based on the amount of product you make, such as the amount of steel needed, other expenses do not, such as the number of machines you use to make your product.

Typical operating expenses include the machinery, materials and energy needed to make your product; packaging; shipping materials; forklifts; and any other cost you would not have if you temporarily shut down production.

Understanding Overhead Expenses

Overhead is the expense involved in running your company and selling your product. If you stopped making your product for a week, you would still have to pay your rent, insurance, utilities, marketing costs, administrative salaries and wages, telephone bill, copy machine bill, Internet costs and all of the expenses related to having a company.

Impact on Pricing

It’s important to determine your production and overhead costs so you can set the optimal price for your product or service. For example, if it costs you $3 worth of food to serve a lunch special at your restaurant, you’ll need to know what it costs to operate your business, or your overhead, so you can put that cost, along with your desired profit, into your menu price.

If your overhead is $10,000 per month and you sell 2,000 meals per month, you’ll need to add $5 to each meal you serve to cover your overhead costs. Your break-even point for your lunch special would be $3 plus $5, or $8. If you want a profit of $10,000 per month, you’ll need to add $5 to each meal for a meal price of $13.

Fixed vs. Variable Expenses

While your overhead might not change as your production changes, your overhead cost per unit will. Knowing this, you can adjust your prices as your sales go up or down. For example, if your restaurant overhead is $10,000 per month, you will calculate a $5-per-plate overhead cost based on 2,000 customers per month. If a competitor closes or your marketing suddenly increases your customers to 2,500 per month, your overhead will now be $4 per meal.

You can decrease your prices to make yourself more competitive, keep your prices the same to make a larger profit or increase your spending on production or marketing.

Relevance of Labor Costs

Some businesses put all labor costs into overhead, while others divide them into administrative and production costs. If your production labor costs increase and decrease with the amount of product you make, you might want to apply production labor costs to your cost of production. If you have a finite number of production workers and pay them the same wages and benefits regardless of your sales volume, you can apply these costs to overhead.

If you have a sales force, their expenses – including salaries, commissions, mileage reimbursement, sales materials, phone expenses and entertainment budget – are part of your budget. Many small businesses break out these expenses as cost of sales because they are so closely tied to the amount of product you sell.