Overhead costs are ongoing expenses a business incurs in its operations. They must be paid even if a company has a low volume of business. There are two types of overhead costs: fixed and variable.
Fixed overhead costs are expenses that do not change as the level of production changes. No matter what the level of output a business produces, these costs remain the same. Some examples of overhead fixed costs are rent, salaries, depreciation and insurance. For example, suppose company ABC rents office space for $5,000 a month; this is a fixed overhead cost that must be paid.
Variable overhead costs are expenses that fluctuate with the amount of business activity and output. Variable overhead costs decrease as production output decreases and increase when production output increases. Some examples of variable overhead costs are supplies or utilities. For example, suppose company DEF, a toy manufacturer, has total variable overhead costs of $15,000 and produces 10,000 units per month, or $1.50 per unit. However, the next month it receives a big order due to increased demand for the holiday season. For that month, it must produce 100,000 toys at $1.50 per unit. Its total variable overhead costs increase to $150,000 for the month.
Unlike fixed costs, variable costs vary with the level of production. Generally, variable overhead costs tend to be small in relation to the amount of fixed overhead costs. Variable overhead costs can change over time, while fixed costs cannot. For example, during an economic downturn, company ABC may stop its production of toys because there is a lack of demand. It minimizes its total variable overhead costs this way. However, the company cannot change its fixed costs.