Overheads are costs that don’t directly contribute to revenue. Where practical, reducing overheads is one path towards profitability that businesses should explore.
Usually related to administrative functions of a business, overheads might include accounting charges, human resources, or equipment hire. These are the line items that businesses can asses to minimize on the path towards better cash flow management and greater long-term profitability — a tactic we'll explore in this article.
Breaking down overheads
Let’s start by defining what overheads are in more detail. Any cost not linked to revenue is an overhead. They are the expenses involved in running your business and selling your product or service. If you stopped production or shut shop for a period of time, you'd still have to pay rent, insurance, utilities, marketing costs, wages, internet or other bills, and all of the expenses related to maintaining a business.
We can break overheads down into fixed and variable components. Examples of fixed overheads include:
Office or store rent
Insurance and property tax
As these illustrate, fixed overheads do not change with the scale a business whereas variable overheads do. Examples of the latter include:
Inputs to production
Wages and sales commissions
Utilities to run facilities and equipment
Assuming all other factors remain constant, increasing profitability can be achieved by reducing either fixed or variable overheads.
There are circumstances, however, where reducing one can have a negative knock-on effect on another area of your business. It pays to strategize and consider all factors.
Reducing fixed overheads
Fixed overheads tend to be locked into longer time horizons. For example, a year or multi-year contract often accompanies an office lease. The same applies to insurance policies and professional memberships. Naturally, there will be opportunity to re-evaluate the subscription cost at the time of renewal.
For most costs that fall under this category, this calculus will be simple: the service is too critical to not continue with and is essential to running the business. Insurance policies and rent on physical offices or locations are common examples.
Business software subscriptions are less defensible. Given the rate of change in the B2B and B2C market, it makes sense to seriously re-evaluate the effectiveness of your current stack of business apps. Is there an alternative app that's more efficient and cost effective? Six months to a year is a long enough time for use-cases to be iterated and improved upon — and significantly, for subscription costs to reduce and be more competitive.
Reducing variable overheads
The decision on whether to opt-out of or be more disciplined around variable overheads depends on the unit economics of your business. To make this assessment, it's best to understand your contribution margin across your product or service offering — and the impact that variable overheads have. This can affect the break-even point.
The contribution margin is a measure of the profitability per unit of product or service — calculated by subtracting the variable cost per unit from the selling price per unit. By reducing the variable cost per unit, contribution margin will increase. This, in theory, flows positively towards your business’ profitability.
What is not captured is the impact this can have on your businesses’ ability to produce and sell your product and service — which can impact costs or revenue elsewhere. For example, by reducing variable overheads, your employees might be required to do more to maintain the same levels of production and sales. This may result in lower levels of workplace satisfaction — and therefore higher rates of employee turnover down the line.
Key takeaway: with every change made, unanticipated consequences can impact profitability.
Sustaining long-term profitability
While reducing overheads can increase profitability in the short-term, tread with caution. When you're assessing the numbers, it's easy to prioritize short-term gain for long-term gain. Ensure you give yourself ample opportunity to consider the potential down-stream impacts.
Take the example of reducing or eliminating office rent. With the world moving towards remote work as the new normal, it's an opportunity many businesses have considered. The answer may be obvious if you run a brick-and-mortar business — but less so when having a physical office is under contention. Cutting out a physical office space will power profitability in the current financial year but can lead to employee dissatisfaction, due to remote working challenges, over time.
Financial costs aside, there is also a cost incurred for launching into new workflows and systems remotely. Even a small change to the status quo can rock the boat. As important as it is to minimize costs, remember that your workforces' productivity and happiness is also a big contributor to profitability — which can be at risk with every change.
There is a balance to strike between minimizing overheads and optimizing your business for productivity. Both are large determinants of long-term profitability.