What Is Overhead Cost and How to Calculate It
We have all heard the saying, “you have to spend money to make money,” a true statement when running a company. Everything from renting an office to hiring staff generates overhead costs you need to account for when starting your business.
So what is overhead in accounting terms? Figuring out the overhead as a percentage of your sales will tell you how much your business spends on it, which can help you decide on pricing.
- Overhead costs are all of the indirect costs of running a business
- Raw materials and labor are not included in overhead costs
- To determine the overhead cost a business incurs for the month, simply add up all indirect operating costs of running your business in one month
- Allocation of overheads is essential in figuring out the total cost of manufacturing a product, which will determine how much you will want to sell it for to make a profit
- Without calculating overhead and careful monitoring, overhead amounts can drain business funds and reduce profit margins
- A business owner can reduce overhead by evaluating workplace efficiency, and making sure you are using the most cost-effective resources to run your business
What this article covers:
- What Is Overhead Cost?
- Types of Overhead Costs
- What Are Overhead Cost Examples?
- How to Calculate Overhead Cost?
- How Do You Allocate Overhead Costs?
- How To Reduce Overhead Cost?
- Frequently Asked Questions
NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice, please contact an accountant in your area.
What Is Overhead Cost?
Overhead costs refer to all indirect expenses of running a business. These ongoing payments support your business but are not directly linked to creating a product or service.
It is important to research overhead for budgeting and determine 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, shipping costs, and insurance.
Types of Overhead Costs
- Fixed Overhead
These costs remain constant regardless of production and business profit, like administrative costs, insurance costs, or rent.
- Variable Overhead
These variable costs change depending on the production volume or the number of services you provide. This may include gas for an oven, maintenance on your vehicles, and shipping or utility costs like heat and water that vary depending on how much you use them.
- Semi-Variable Overhead
This includes semi-variable cost items like sales commissions on top of staff salaries or phone service with additional roaming charges added due to travel for work. Any bills or costs may start at a predictable base amount but vary if use is high.
What Are Overhead Cost Examples?
While overhead expenses are not directly linked to profit generation, they are still necessary as they provide critical support for profit-making activities. The overhead fees depend on the nature of the business. For example, a retailer’s overhead will be widely different from a freelancer’s.
Some examples of overhead include:
- Rent for your business space
- Utility bills
- Office Supplies
- Advertising expenses
- Administration cost
- External legal expenses and legal fees
- Professional services
- Salaries and wages
- Transportation overhead
- 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 that can vary month-on-month based on the level of business activity.
Some organizations also split these into manufacturing overheads, selling overheads, and administrative overhead costs. While administrative overhead includes front office administration and sales, manufacturing overhead is all of the costs that a manufacturing facility incurs, other than direct costs.
Costs required to create products and services, such as direct labor and materials, are excluded from overhead.
Businesses have to consider both overhead costs and direct expenses to calculate long-term product and service prices. Doing so allows the business to earn profits on a long-term basis.
How to Calculate Overhead Cost?
If you have been wondering how to calculate overhead costs, it is simple. You just need to categorize each overhead expense of your business for a specific time period, typically by breaking them down by month. While all indirect expenses are overheads, you must be careful while categorizing them.
For example, most businesses categorize legal expenses as overhead. However, if you own a law firm, these expenses do not count as examples of overhead as they directly contribute to the production and are part of your direct costs.
Once you’ve categorized the expenses, add all the overhead expenses 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 on 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 Formula
The overhead rate is $10,000 / $50,000 = .2 or 20%
This means the business spends twenty cents on overhead for every dollar it makes.
It’s not difficult to keep track of all expenses and costs when you get help from software like FreshBooks expense software. This type of service allows your business to track expenses in one place, making it easier to monitor and control overhead costs for your business. Click here to find out more.
How Do You Allocate Overhead Costs?
Allocation of overhead expenses is essential in calculating the total cost of manufacturing a product or service, hence setting a profitable selling price.
Calculate the Overhead Allocation Rate
You first need to calculate the overhead allocation rate to allocate the overhead costs. This can be done in many different ways depending on your business. Some might be done by dividing total overhead by the number of products sold or 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:
$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 of overhead (50 hours x $3.33) to this product.
It is important that businesses monitor their overhead expenses 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 become a burden.
How To Reduce Overhead Cost
Some ways you can reduce your business overhead include:
- Evaluate your workspace and think about shifting to working remotely or moving into a shared office space to reduce rent costs if possible
- Ensure your processes are as time-saving as possible, automating for efficiency, eliminating excess employee hours, and supply use where feasible.
- Check out the competitors to your usual vendors and see if you can find a lower price for your materials, etc., or work to consolidate vendor services if they offer price breaks.
- Calculate whether purchasing supplies in bulk will save you money
- Making sure your business software is working for you, as monthly subscription fees can add up quickly
- Reduce your paper consumption using (free) digital services to save on administrative expenses, like emailing invoices and paying employees through direct deposit.
There will always be some cost to running a business, and it is important to factor in your fixed overhead costs, as well as variable and semi-variable costs, into your monthly bookkeeping to ensure you are allocating enough of your profits to pay these necessary costs and operating expenses.
FreshBooks offers a variety of tools that can assist with a company’s overhead management, ensuring your books are balanced and your business needs are met so you can focus on other factors of running your company.
FAQs on Overhead Cost
What is overhead vs. direct costs?
Direct costs are also called operating costs, and these are the costs that go into purchasing materials or paying worker salaries, whereas overhead is the money being paid out for costs that don’t translate directly into production and revenue for the business, like insurance, rent, software, etc.
What is usually included in overhead?
Overhead includes everything it costs to run a functioning business, from rent to payroll to business licenses to accounting fees and many other costs that vary from business to business. These costs are necessary to run the business but do not directly contribute to producing goods or services.
What expenses are not overhead?
Any costs that are directly related to manufacturing and selling a product are not considered overhead, including labor, materials, and production costs, are not overhead. These are called “direct costs” or “operating costs.”
What are the 4 types of overhead?
The four overhead types are:
- Long-run capacity fixed overhead includes costs like machinery and facilities that are used over a long period of time
- Operating fixed overhead is the costs that pay to run the long-run capacity assets like power, heat, insurance, rent, property taxes, etc. These expenses do not change no matter how busy you are
- Variable overhead figures change as production increases or decreases. For example, if you are a delivery company, the cost of fuel and maintenance for company cars will vary depending on how much you drive.
- Semi-variable overhead includes costs that stay fixed up to a certain level of production and then fluctuate, like paying bookkeepers a monthly rate but needing to increase their rate when more work needs to be done.
What is COGS vs. overhead?
The cost of goods sold (COGS) refers to the direct costs of producing goods the company sells. This cost includes raw materials and direct labor costs of producing the products. The overhead is the indirect costs of doing business.
For example, if you were manufacturing ladders, the COGS would include the metal and labor costs of building the ladders, while overhead would include factory rent, power costs, the charges for shipping the ladders to retailers, etc.
About the author
Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields. Check out what she’s up to on linkedin: https://www.linkedin.com/in/jami-gong/.