The better a business manages overhead costs, the more competitive and successful they are in the marketplace.
Overhead costs are necessary expenses paid to keep your business running, like utilities and taxes. These are indirect costs, not related to specific business activities that generate money.
Having a solid accounting of your overhead helps you set a better price for your products or services, shows where you can save, and can even reveal ways to streamline your operations.
Steps to Calculate Overhead
1. List All Business Expenses
Include overhead costs like rent, utilities, taxes, and building maintenance. Other expenses that are considered overhead include inventory, raw materials, and labor costs.
2. Classify Each Overhead Expense
Categorize each item on your list of expenses as direct or indirect costs. There are three types of overhead costs: fixed, variable, and semi-variable.
For example, if you manufacture coffee mugs, the shop floor labor and cost of raw materials are direct costs since they incur when the cups are being created.
Indirect costs are often referred to as the “real cost of doing business.” Indirect costs go beyond the direct costs. Examples include utilities, office equipment rental, computers, and mobile phones. Other common indirect costs include advertising and marketing, accounting, and payroll services.
Another example of an indirect labor cost would be an assistant who helps run the office but isn’t assigned to creating a specific product.
Indirect costs can be both fixed and variable. The majority of direct costs are variable as they change when additional units of a product or service are created.
Costs can also be categorized as semi-variable, also known as a semi-fixed cost or a mixed cost. It’s a cost composed of a mixture of both fixed and variable components.
Keep in mind that some items don’t fall easily into one category or the other, so you need to make your best guess.
3. Total the Overhead Costs
Most business owners find monthly is the most useful time period to calculate. Add all of the overhead costs for the month to calculate the total overhead cost.
4. Compare Overhead to Sales
Divide your monthly overhead cost by monthly sales, and multiply by 100 to find the percentage of overhead cost.
For example, a business with monthly sales of $900,000 and overhead costs totaling $225,000 has ($225,000/$900,000) * 100 = 25 percent overhead.
It’s important to know the percentage of each dollar that goes to overhead. In the example above, twenty-five cents of every dollar goes to overhead. This helps you allocate costs when you create a budget and set prices. The lower your overhead percentage (rate), the larger your profit.
5. Compare Overhead to Labor Cost
Calculate overhead cost as a percentage of labor cost. This measure is useful as an estimate of how efficiently resources are utilized. Divide the monthly labor cost into the total overhead cost for the month and multiply by 100 to express it as a percentage.
The lower the percentage, the more effectively your business is utilizing its resources.
Limitations of the Overhead Rate
According to Investopedia, the overhead rate (percentage) has limitations when applied to businesses with few overhead costs or when costs are mostly tied to production. Also, it's important to compare the overhead rate to companies within the same industry and roughly the same size. A larger business will have a higher overhead rate than one that's smaller and with less indirect costs.