Having a good understanding of overhead costs helps you accurately price your products and services, identify overspending, and remain profitable. In this article, we explain what overhead costs are and how to calculate overhead rates for your business.
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Accurately identifying and calculating overhead costs is crucial to your business’s profitability. Failing to do so can result in charging too little for your products or services, directly impacting your bottom line. In addition to being a basic bookkeeping requirement for tax purposes, tracking and measuring your overheads also helps you properly budget for them.
Luckily, once you understand how to categorize and work out your overhead costs, it’s easy to do. To help you out, this article explains what overheads are and how to calculate your overhead costs in 4 steps.
- Overheads are the indirect costs of running your business. They are expenses you incur regardless of how many products you make or services you deliver.
- Overhead costs include rent, insurance, and fees for professional services like legal or accounting advice.
- To calculate the overhead rate of your business, divide your total overhead costs by one or more allocation measures, such as direct costs, sales, or labor hours.
- The allocation measure—or combination of measures—you use depends on what’s the most useful comparison for your business’s circumstances.
What Are Overhead Costs?
Overhead costs are the indirect costs of operating a business. They include any costs that keep your business running but aren’t directly related to creating a product or delivering a service. While overhead costs aren’t explicitly linked to sales, they do support profit-making activities.
Overhead costs include expenses like:
- Rent or mortgage payments for a business space
- Utility bills
- Mobile phone plans for employees
- Advertising and marketing expenses
- Office supplies
- Professional services, like accounting and legal services
- Administrative or professional salaries
- Transportation costs, like the cost to maintain and fuel company vehicles
- Repairs and maintenance
- Government fees and licenses
- Domain name and web hosting
- Software subscriptions
- Property taxes
Overhead vs. Direct costs
When assessing the overall costs of your business, it’s important to consider both overhead and direct costs. Direct costs are directly connected to the output of a product or service, such as labor and materials.
For example, if you run a bakery, direct costs can include the cost of flour, sugar, butter, and eggs to make cakes. But this is only part of the picture. You also have to rent premises, pay for the electricity to keep ovens running, hire an accountant to help you with your taxes each year, and more. These are all examples of overhead, or indirect, costs.
If you stopped making cakes today, your direct costs would stop, but you would still need to pay your overhead costs.
There are some costs that can be categorized as both overhead and direct costs—like salaries and wages, depending on their nature.
For example, the salaries of administrative staff typically count towards overhead. They’re the same each month and must be paid, even if you stop manufacturing your product or service.
In comparison, hourly wages or the salaries of staff directly involved in the manufacturing of a product may be categorized as direct costs.
Why Track Overhead Costs?
Tracking your overhead costs helps you design your budget, price your product or service, and increase your profitability. It’s also typically required for record-keeping purposes.
For budgeting purposes
Overhead costs must be paid, regardless of your monthly revenue. It’s important to know how much they are, as this is the minimum amount of money you need to make each month to stay in business.
To set the price of your product or service
You need to understand the real cost of production of your product or service to properly price it. If you don’t take overhead costs into account, you may underprice your product or service and struggle to make a profit.
By calculating your total overhead costs, you can allocate a portion of your overhead to each unit you produce and account for this in the price you set.
For example, if the direct cost of producing a unit is $10 and your overhead rate compared to direct costs is 25%, the total cost is $12.50. You can then price your product to take this into account.
To identify ways to save money and increase profitability
If your overhead is too high, it can eat into your profitability. Tracking your overhead is a good way to identify and address overspending.
For example, tracking your overhead may reveal high administrative costs. By reducing these, you can improve your profit margins.
Understanding your overhead rate can also highlight which of your products or services are profitable and which aren’t. While a product may appear profitable based only on its direct costs, assigning an overhead cost to each unit could reveal a significantly smaller profit margin.
For reporting and accounting purposes
Businesses need to keep records of their financial accounts for reporting and tax purposes. Publicly listed companies also need to provide copies of these records to their shareholders.
When preparing a business’s accounts, overhead costs typically need to be included on income statements or balance sheets (for manufacturing businesses).
Types of Overhead Costs
Overhead costs can be fixed, variable, or semi-variable.
These costs remain the same month to month. They don’t vary depending on the amount of product or service you make or deliver.
Most overheads are fixed costs—for example, insurance, rent, property taxes, and web hosting.
These overheads change based on the number of products you manufacture, services you deliver, or other circumstances. While you know you have to pay for them each month or year, their cost varies.
Delivery, advertising, vehicle maintenance costs, and utilities are generally variable overheads. For example, the cost of your monthly electricity bill may change due to a seasonal increase in production or higher energy costs.
Semi-variable overheads involve a set amount each month, with additional costs depending on usage.
A mobile phone plan for an employee is an example of a semi-variable overhead. While you pay a standard fee for the monthly plan, this could increase when the employee travels for work and uses roaming or exceeds their data allowance.
How to Calculate Overhead Costs
List all expenses
To start, make a list of all your monthly business expenses, including both direct costs and overhead costs.
Identify and categorize your overhead costs
Next, identify which expenses are overhead costs and categorize them. This involves breaking costs into categories based on nature and/or purpose—for example, administrative overheads, marketing and advertising, and rent and utilities.
It can be challenging to identify expenses that aren’t obviously overhead costs. What counts as an overhead can vary depending on the nature of your business.
Subject to any tax or accounting rules, you can decide how your business categorizes overheads. What’s important is to use a consistent approach across the business.
Total your overhead costs
Once you know what your overhead costs are, add them together to calculate your total overhead.
Calculate the overhead rate
The overhead rate calculates overhead costs as a percentage of other metrics like direct costs, sales, or labor hours. It helps you understand how your overhead costs affect your business. The lower the overhead rate, the more efficiently a business is using its resources.
The overhead rate formula is:
Total overhead costs / Allocation measure x 100
The allocation measure is the other metric you want to compare your overhead costs with. It may be direct costs, labor hours, machine hours, or sales.
The right metric to use depends on what’s most helpful to your business. For example:
- Direct costs can be a useful metric for construction companies to compare their overheads with the cost of raw materials and direct labor.
- Machine or labor hours may be the most useful metric for large manufacturing businesses to understand how efficiently they use these resources
- Comparing overhead costs to sales helps most businesses gauge the profitability of a product.
Businesses often use a combination of several different allocation measures to understand their overhead costs.
An accountant can assess your business’s situation and advise you on the best metric to use.
You can measure the overhead rate for any period—weekly, monthly, or annually—as long as you use the same period when totaling your overhead costs and the other metric.
Imagine your total monthly overhead costs are $15,000. Let’s also say that your monthly direct costs are $75,000. Your overhead rate as a percentage of direct costs is:
15,000 / 75,000 x 100 = 20%
Now, assume your total monthly sales are $130,000. Your overhead rate as a percentage of your sales is:
15,000 / 130,000 x 100 = 11.5%
When calculating labor or machine hours, don’t convert the figure to a percentage. So, if your business’s monthly labor hours total 600, your overhead rate compared to labor hours is:
15,000 / 600 = 25
This means that it costs you $25 in overheads for each hour an employee works.
The acceptable overhead rate for your business depends on the nature of your product or service and your industry.
💡 Pro Tip:
A good way to gauge an ideal overhead rate is to compare yours with the industry average. An accountant can advise you on this. Generally speaking, an overhead rate of less than 35% is considered healthy.
How to Reduce Overhead Costs
To reduce your overhead costs, you need to closely review all of your expenses and decide whether you can eliminate certain expenses or take any cost-saving measures.
For example, you might:
- Engage a professional accountant. They can review your costs and help you identify areas to reduce your expenses or maximize your tax deductions.
- Find more affordable premises. To decrease your rent, look for a cheaper lease elsewhere. Or, consider allowing some employees to work from home to reduce the amount of office space you need.
- Automate repetitive administrative tasks. An app like Connecteam is a great way to automate repetitive tasks such as scheduling and task management. This saves you time and money so you can focus on profit-generating activities.
- Review your insurance. Look around for other business insurance providers. Some may offer lower premiums or discounts for new customers.
- Outsource. Some tasks might be suitable to outsource to consultants or freelancers, especially if you don’t have the budget for a full-time salary. Freelancers can temporarily fill skills gaps in your organization, without the ongoing expense of a permanent employee.
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Tracking and calculating overhead costs is an essential part of running your business—as is determining your overhead rate. Dividing your total overhead cost by other metrics like direct costs, sales, and labor hours gives you the overhead rate for your company.
By understanding how to identify overheads and calculate the overhead rate relevant to key metrics, you can gauge whether your overhead is affecting your profitability. This insight also helps you make more informed decisions and ensures your business stays afloat.
What is a typical overhead rate?
The typical overhead rate depends on the nature of a business. For example, a typical overhead ratio for a restaurant is said to be around 35%, while it’s around 50% for the professional services industry.
Is overhead the same as profit?
Overhead and profit are two different business accounting concepts. Overhead refers to the indirect costs of running a business like rent, legal fees, and business insurance. Profit is the money a business makes after deducting all of its expenses—including overhead—from its revenue.