What Is Overhead Cost and How to Calculate It
Overhead costs refer to all indirect expenses of running a business. These ongoing expenses support your business but are not linked to the creation of a product or service.
Calculating overhead costs is not just important for budgeting but also determining how much the business should charge for a service or product to make a profit. For example, if you have a service-based business, then apart from the direct costs of providing the service, you will also incur overhead costs such as rent, utilities and insurance.
What this article covers:
- What Is an Example of an Overhead Cost?
- How Do You Calculate Overhead Cost?
- How Do You Allocate Overhead Costs?
What Is an Example of an Overhead Cost?
While overhead costs are not directly linked to profit generation, they are still necessary as they provide critical support for the profit-making activities. The overhead costs depend on the nature of the business. For example, a retailer’s overhead costs will be widely different from a freelancer.
Some examples of overhead costs are:
- Office supplies
- Advertising expenses
- Accounting and legal expenses
- Salaries and wages
- Government fees and licenses
- Property taxes
Overhead costs can include fixed monthly and annual expenses such as rent, salaries and insurance or variable costs such as advertising expenses that can vary month-on-month based on the level of business activity.
Some organizations also split up these costs into manufacturing overheads, selling overheads and administrative overhead costs. While administrative overhead includes costs front office administration and sales, manufacturing overhead is all of the costs that a manufacturing facility incurs, other than direct costs.
Direct costs required to create products and services, such as direct labor and materials, are excluded from overhead costs.
Businesses have to take into account both overhead costs as well as the direct expenses to calculate the long-term product and service prices. Doing so allows the business to earn profits on a long-term basis.
How Do You Calculate Overhead Cost?
To calculate overhead costs of the business, you need to categorize each overhead expense of your business for a specific time period, typically by breaking them down by month. While all indirect costs are overheads, you need to be careful while categorizing these costs.
For example, most businesses categorize legal expenses as overhead costs. However, if you own a law firm, these expenses directly contribute to production and hence are part of your direct costs.
Once you’ve categorized the expenses, add all the overhead costs for the accounting period to get the total overhead cost.
You can now find out the overhead percentage as a percentage of sales. An overhead percentage tells you how much your business spends on overhead and how much is spent making a product or service.
Calculate Overhead Rate
To calculate the overhead rate, divide the total overhead costs of the business in a month by its monthly sales. Multiply this number by 100 to get your overhead rate.
For example, say your business had $10,000 in overhead costs in a month and $50,000 in sales.
Overhead Rate = Overhead Costs / Sales
The overhead rate is $10,000 / $50,000 = .2 or 20%
This means that the business spends twenty cents on overheads for every dollar that it makes.
How Do You Allocate Overhead Costs?
Allocation of overhead costs is essential in calculating the total cost of manufacturing a product or service and hence in setting a profitable selling price.
Calculate Overhead Allocation Rate
To allocate the overhead costs, you first need to calculate the overhead allocation rate. This is done by dividing total overhead by the number of direct labor hours.
For example, if the total overhead for making a product is $500 and the total direct labor hours is 150 hours, the overhead allocation rate is:
Overhead allocation rate = Total overhead / Total labor hours
$500/150 = $3.33
This means for every hour needed to make a product, you need to allocate $3.33 worth of overhead to that product.
Allocate Overhead Costs
Apply the overhead by multiplying the overhead allocation rate by the number of direct labor hours needed to make each product.
If product X requires 50 hours, you must allocate $166.5 worth of overhead (50 hours x $3.33) to this product.
It is important that businesses monitor their overhead costs as they can drain business funds unnecessarily when not properly controlled. As they are not directly related to income, these expenses can become a larger share of the total costs and burden a business.