Business Tips

Overhead Costs: Understanding How They Factor into Your Business

Read Time: 5 min

When you’re running a business, there are a lot of overhead costs to keep track of. However, the cost of running a business varies by industry. Accounting for these costs will help you assess whether your bottom line is healthy or not. You may also find costs to cut back to help increase your profit margin. Overhead expenses can sneak up on you, so it’s important to monitor them closely. By managing these costs effectively, you leave more room to expand your business and find a competitive advantage. So, what are you waiting for?

What is Overhead?

overhead costs for small business

Overhead expenses are the indirect day-to-day costs of running a business. Overhead costs can be especially high for small businesses, especially for businesses in their first year, which is why they should be monitored closely. What that means is these costs are not directly related to the product or service you sell. Overhead in business counts as any non-labor costs that are required for operation. These expenses include rent, mortgage, and other fixed costs. There are also recurring expenses, such as the cost of marketing.

Overhead costs are easy to overlook if you’re not paying close attention. These costs impact your business with little notice if you’re focused too much on other business expenses like startup costs or inventory. But overhead expenses are the best ones to review if you want to control costs. This is because they are not specifically tied to generating revenue.

Types of Overhead Costs

To monitor your overhead expenses you should understand the types of overhead your business has. In business, it falls into three categories: Fixed, semi-variable, and variable.

Fixed

Your fixed overhead costs are just that– they are expenses that stay constant every month. Your business activity does not impact these expenses. Items that are considered fixed costs include rent or mortgage payments, insurance, property taxes, salaries, payroll costs, etc.

Semi-variable

Semi-variable costs are always present but how much they are will depend on business activity. They typically have a minimum base rate and depending on usage can fluctuate. They include costs such as credit card processing fees, certain utilities, hourly wages with overtime, and commission.

Variable

The third type of overhead cost is variable costs. Your business activity affects how much your variable costs are. They may increase or decrease based on this. Shipping, legal expenses, equipment maintenance, marketing, and office supplies are all examples of variable costs.

Depending on your business, these costs could be dependent on factors such as weather, season, or any other extenuating circumstance. They should be accounted for in your business impact analysis due to their varying nature.

How to Calculate Overhead Costs

Understanding your overhead costs will help you make better business decisions. This calculation is important for financial planning and budgeting. It can also help you determine the pricing on your products and services that are not tied to production costs. Here is how you can calculate your overhead rate using the following steps:

Step 1: Create a list of all your expenses

overhead expenses

You’ll start by making a detailed list of all the indirect expenses you incur to operate your business each month. This list will include items like rent, taxes, office equipment, and utilities. These items represent your overhead costs. You’ll leave out costs like raw materials and other expenses that are related to the production of goods and services.

It’s important to remember that you can’t attribute every cost to a specific category when categorizing your overhead and direct costs. For example, an overhead cost for your business could be a direct expense for other businesses. Therefore how you categorize your costs should be based on your specific business’s operation.

Step 2: Add up all your business overhead costs

Take all the expenses that you’ve categorized as overhead costs and tally them up. You will use this sum to calculate your aggregate overhead cost. This is the total amount of money that’s needed to run your business.

Step 3: Calculate the overhead rate

Also called the overhead percentage, the overhead rate is the amount your business spends to make the product(s) or provide its services to customers. To compute this rate you will divide the indirect costs by the direct costs and multiply by 100. So for example, if your overhead rate is 10%, that means your business spends 10% of its revenue to produce a good or provide a service. The lower your overhead rate, the more efficient your business is. Hence, the more profitable it is.

There are other comparisons that are also helpful to use your overhead costs against. For example, when you’re creating a pricing strategy for your products or services, you should know the percentage of dollars that goes towards your overhead expenses. You can find this percentage by taking your monthly overhead costs and dividing it by your monthly sales, then multiplying by 100.

So if your business did $10,000 in monthly sales and had overhead costs of $3,000, then that would be ($3,000/$10,000) X 100 = 30% overhead.

Common Overhead Costs for Small Businesses

It’s true that each business will have overhead costs that vary from a business in another industry entirely. However, there are common overhead costs most small businesses share. These costs are a key component of what it costs to run your business. Additionally, these ongoing costs must be paid no matter how much volume your business generates each month. Below are some of the common overhead costs that businesses incur.

Rent

Unless your business outright owns the property where you operate, you’re going to be paying rent or a mortgage. The exception for this could be if you’re running your business out of your home. There are some businesses like drop shipping that have this structure. However, as you grow and expand, your needs for a designated space may also grow.

Utilities

Running a business–whether it’s a restaurant or in an office setting–requires power and energy. Depending on the building, you may have both electricity and gas bills, as well as a monthly water bill. These will range depending on the nature of your business and what state you conduct business in.

Insurance

Your business is required to have certain types of insurance by law. For example, if you have employees, you must provide worker’s compensation, unemployment, and disability insurance. Additionally, you may have to provide liability insurance or renter’s insurance for your location.

Marketing

To generate sales for your business, you must get the word out. Marketing could include direct mail, digital ads, and paid social media. This expense will fluctuate greatly but it’s an important step to consider when calculating your overhead costs.