There are many costs associated with running a business, but all of those costs don’t fall into the same bucket. One type is overhead costs, which are expenses not tied directly to the production of a product or service. These are the costs a business incurs regardless of whether they generate any money. Rent, utilities and insurance fall into this group.
It is vital to clearly understand your overhead costs and the expenses directly related to production because it helps establish your business’s break-even point — how much it needs to produce and sell to cover all of its costs. It can also be a key strategy for identifying efficiencies for cost savings.
A business’s overhead is its fixed expenses of operations that aren’t directly related to production and, therefore, don’t vary with output. In other words, if your business stopped production for a day, you would still have to pay overhead costs to keep the business open. These include expenses such as rent, utilities, insurance and salaries for administrative personnel.
Overhead is a significant aspect of solid accounting, for several reasons. First, it reflects costs that a business can’t avoid simply by slowing or stopping production. Second, determining overhead costs is necessary to establish your business’s break-even point. Specifically, you can factor those overhead costs into the prices you set for your goods and services to ensure you aren’t selling your items at prices where you are losing money.
Understanding your overhead expenses is also essential because it is one of the most significant sources of cost savings for companies looking to streamline operations. To reduce your overhead expenses, you should regularly review your bills for services such as electricity and internet to see if better deals are available.
If you have high office rent or mortgage expenses, consider subleasing a part of the space to a noncompeting company.
When people talk about overhead, they’re typically referring to fixed overhead. This includes things such as business insurance and rent — expenses that remain constant regardless of your production or sales.
However, some expenses are considered variable overhead. These are costs directly related to production, such as raw materials for production and utility costs for running equipment.
The biggest difference is that fixed overhead costs must be paid regardless of whether the company produces or sells anything. This is where you can find ways to be more efficient and increase profits. However, both types of costs are necessary for your business to produce and sell products, and you need to calculate both to determine your business’s profitability point.
Why it matters
Rent or mortgage
It has to be paid regardless of whether your business is open.
You have to pay a certain amount regardless of whether your business opens on any given day. Some of these are fixed monthly costs, while others may fluctuate. For example, natural gas bills tend to be higher in the winter than in the summer.
Coverage has to remain in place even when you’re closed.
These costs include the salaries of employees who don’t have anything to do with production — people whose pay does not fluctuate with production or sales.
Sales and marketing
Marketing costs aren’t tied to production; they have to be paid either way.
Office supplies, property taxes, and professional services such as accounting and legal advice are also overhead costs. These can vary by industry, company size and other factors.
You also must be aware of what is excluded from overhead costs — not just variable production costs but also expenses for investment in assets, such as the cost of renovating your business facilities. These aren’t fixed costs; they are one-time expenses that help to increase the value of your business.
For your calculations to be accurate, it’s essential to know what is covered as an overhead cost. Make sure you track this along with your expenses.
To calculate overhead expenses, first you need to identify all of your fixed costs that aren’t directly related to production. Once you’ve identified all relevant costs, you total them.
Fixed Facilities Cost + Utilities + Licensing + Insurance + Sales and Marketing Costs + Administrative Fees = Overhead
Note what’s excluded from the formula above, especially expenses such as labor for production, which is a direct cost tied to production and not included in company overhead.
Of course, this is typically a lot easier to do with accounting software, which can help you identify relevant expenses and total them automatically over various periods.
Calculating overhead is also crucial for planning your budget. If you don’t understand your total fixed costs, it’s difficult to accurately forecast company revenue and expenses or make key decisions about investing in the future growth of your business.
Allocating overhead costs means breaking down total overhead costs by hour or unit. In other words, you divide your total overhead cost so you can see exactly how much cost is tied to each individual unit of time or production.
(Fixed Facilities Cost + Utilities + Licensing + Insurance + Sales and Marketing Costs + Administrative Fees) ÷ Hours or Units of Production = Overhead per Unit
As with calculating total overhead, allocating overhead is easier with the right tools; it is a common feature of accounting software.
By allocating your overhead costs, you can see how much profit (above and beyond your variable production cost) has to be produced per unit or per hour to cover fixed costs.
This process also breaks down your company’s overhead into a more tangible number; you’re tying those costs to something that isn’t so abstract, such as an hour of labor. Once overhead is laid out this way, its importance is easier to recognize, as it shows exactly how much your business needs to make per unit just to cover fixed costs.
Most importantly, allocating overhead helps keep costs in line. It also clearly demonstrates the importance of identifying efficiencies — finding ways to cut costs and increase profits.
Accounting software makes it much easier to calculate and manage your overhead costs. Here are some of our picks for the best platforms for doing so.
QuickBooks is full-featured accounting software that quickly calculates overhead costs. QuickBooks lets you classify overhead expenses as indirect material, such as office supplies; indirect labor, such as administrative salaries; and other indirect expenses, such as rent. Alternatively, you can classify expenses by function (e.g., manufacturing, office/administrative, selling/distribution) or behavior (e.g., fixed overhead, variable overhead, semi-variable). This lets you increase efficiency in different areas of your business and plan for lean times. Learn more in our QuickBooks review.
ZarMoney excels in its reports and data capability. It has over 40 built-in reports and can create dozens of customized options. In addition, ZarMoney separates overhead expenses from the cost of goods and allows you to track overhead costs over time. Advanced inventory features make it easier to get warehousing that is just the right size to keep that cost low. Learn more in our review of ZarMoney.
FreshBooks easily calculates overall overhead expenses, and it also lets you look at it from a variety of perspectives. For example, you can calculate the overhead absorption rate by direct material cost, direct labor cost, labor hours, machine hours or sales price. You can spot and correct inefficiencies by assessing overhead costs with these different methods. For instance, when using the labor cost method, you can decide if bringing on a new employee will be a good way to increase profits. FreshBooks allows you to categorize overhead expenses and easily enter new expenses through digital receipt scanning and mileage tracking. Learn more in our FreshBooks review.
While it is clear that the salary for a clerical worker is an overhead expense, it is less clear when you are talking about the salary of a person such as a factory worker, who produces a product or service. This type of expense is semi-variable. Generally, production salaries for a regular number of hours is considered overhead, while overtime pay is a variable expense.
In addition, if the business experiences a temporary dip in sales, you will most likely retain this employee for when business picks up. However, if you have a longer-term reduction in orders, this employee may be laid off.
It depends. If your sales people get commissions only on new sales, commissions are a cost of sales variable expense. However, if they continue to receive commissions on existing sales plus new sales, it is a semi-variable type of overhead expense.
Whether you are using in-house employees or an external fulfillment company, fulfillment is a semi-variable cost because it partially depends on the volume of items sold. Shipping cost is more closely related to sales — the more items you sell, the more items you need to ship — so it is not an overhead cost. However, postage and shipping for items that are not the products you sell are overhead costs.
This varies from company to company. However, it is a good idea to look at your largest overhead expenses, such as rent and utilities, first, since they will have the biggest impact. Could your business run just as well in a smaller office with hybrid and remote workers, or in a less-expensive building or area? Can you reduce your utility expenses by improving energy efficiency or installing solar panels on your facility? If interest is a large part of your monthly expenses, you may want to see if you can refinance your business loan. Outsourcing certain tasks is another way to reduce salary and benefit overhead.
No, the cost of raw materials is part of the cost of goods sold (COGS), a variable cost. Reducing the cost of materials will not affect your overhead, but it will increase your profit margin for each item sold.
Jennifer Dublino contributed to this article.