What are Overhead Costs and How Do You Calculate Them?

Whether you’re starting a new business or side hustle, or you’re looking to scale your current business, calculating and forecasting for overhead costs is always a significant factor in your business decisions. Overhead expenses affect all aspects of your business: from your income to profit margin, to whether you can afford to hire additional staff, purchase raw materials, or pay for marketing and advertising. It’s also an integral part of a business plan, which you’ll need if you want to secure funding in the form of loans, grants, or from investors. But what exactly are overhead costs and how can you calculate them? What is a healthy overhead cost? This guide will give you all the information you need so you can grow your business with confidence. What are overhead costs? Overhead costs are all the non-labour expenses that are required to operate a business. There are two general types of overhead costs: fixed and variable overhead expenses. Fixed expenses Fixed expenses are just that—fixed. These generally include operating expenses like rent or lease, depreciation of assets like vehicles or equipment, salaries and payroll, insurance, membership dues, utilities, and professional and administrative costs like legal and accounting. A fixed expense is basically any expense related to a business that doesn’t fluctuate regardless of your business activity. Fixed expenses are easy to budget for as they generally don’t vary over time. Variable expenses Variable expenses fluctuate month-to-month and include things like marketing, variations in the price of supplies or services you might need, seasonal changes like those experienced in retail, as well as office supplies. Variable expenses also include the cost of supplies and shipping, such as in wholesale and B2B2C (business to business to customer). Generally, variable expenses are harder to budget for. Take an average over the past fiscal year and consider any upcoming events, changes, or purchases you’ll make. Why you should know your overhead costs Knowing your overhead expenses helps empower you to make the best decisions you can for your business. If you aren’t aware of what you’re spending on a monthly basis, you might inadvertently cut into your profit margin. Conversely, if you’re not spending enough, your business might not be growing or you could spin your wheels thinking you don’t have the funds to undertake research and development. Maybe you want to increase your personal income but don’t know if the business can afford it. Knowing your overhead expenses can help you determine whether that’s the case. How to calculate overhead costs Calculating your overhead requires a careful eye. If you don’t take all expenses into account, you’ll have an inaccurate figure from which you’ll be making other business decisions. To calculate your overhead cost, follow these steps: 1. Make a list of all your expenses This list should be comprehensive and include all direct and indirect expenses, from taxes to coffee runs. You can track your expenses either on your own or by hiring a bookkeeper. 2. Categorize your expenses This might take a little more time and where you might want to invest in a good spreadsheet program like Excel or an accounting program like Wave or QuickBooks. Categorize each expense as either a direct expense or indirect expense. Direct expenses are necessary to produce your services or goods (e.g. supplies, materials, etc.). Indirect expenses are those that are not required to produce your goods or services (e.g. marketing costs or rent). Indirect expenses are considered overhead costs. 3. Tally all overhead costs Add up all the overhead costs (indirect expenses) for a month. This is your total monthly overhead cost. You can take this a step further by calculating your overhead rate (expressed as a percentage). 4. Calculate your overhead rate The overhead rate is a percentage of each dollar earned that goes into your overhead costs. Divide your total monthly overhead costs calculated in steps 1 to 3 by your monthly sales. Then times that by 100 to get the percentage. For example, if your overhead costs are $1,200 and your monthly sales are $10,000, you’ll get the following: ($1,200/$10,000) x 100% = 12% A healthy overhead rate generally doesn’t exceed 35%. Are overhead costs the same for every business? While most businesses will have similar categories of expenses, such as lease or rent, phone and internet, the cost will vary considerably. Keep in mind, this isn’t the same as the overhead rate, which should remain consistent across markets. Bigger businesses will spend more money on overhead costs, but they will bring in more sales, thus keeping the overhead rate (expressed as a percentage) the same. Where you will see variations is in different markets. An ice cream parlour won’t have the same overhead costs as, say, an accounting firm (or even freelance accountant). Where an ice cream parlour will have a fairly substantial electrical and heating bill, a freelance accountant will have a much higher office supplies overhead cost. Overhead costs will vary for tax purposes as well. Take the freelance accountant, for example. If they work from home, they will be able to “write off” some of their house expenses as a business expense. This includes part of the heating, electricity, gas, internet, and mortgage or rent. To find out what are healthy overhead costs in your market, do some investigations. In your research, find out what competitors’ products and services prices are, what they’re investing in marketing and branding, and even how they’re using physical space. If you have a physical or online shop, look at inventory management. From this information, you can figure out where to cut overhead costs and where you can invest. How do you allocate overhead costs? Similar to overhead rate, allocation of overhead costs can be expressed as an allocation rate. In order to allocate your overhead costs, you first need to calculate the overhead rate. This is expressed as a per unit or per service calculation: Total overhead / Total labour hours = Overhead allocation rate For example, say the total overhead for making one handmade table is $500. The total direct labour involved in making this table is 150 hours. Your calculation will look like this: $500 / 150 = $3.33 This means that for every hour necessary to make that table, you are spending $3.33. Say you want to calculate the overhead cost of making a different table is 100 hours. You can then take your allocation rate ($3.33) and multiply that by the amount of hours it takes to make this different table. This will look like: 100 hours x $3.33 = $333 This means that you must allocate $333 to make this table. But what does that mean? Well, if you only charged $333 for the table, you’d break even. If you want to make a 100 per cent profit, you’d double this and charge $666. You can see why it’s important for business owners to always assess their overhead costs, rates, and allocation rates in order to properly price their products and services. If you’re not, you could sell goods and services for far below what you need to break even, or even price yourself out of the market. If you can’t reasonably cut down the allocation rate of a product but find the market is priced a bit lower, you may want to look at other ways to cut your overhead costs. Staying ahead of the game in the world of business means empowering yourself with all the information you need to make the best decisions for your business, and that includes overhead costs.