What are Overhead Costs and How Do You Calculate Them?

Oct 27, 2021
5 minute read
Two men in a woodworking shop calculate their overhead costs on a laptop

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 thatfixed. 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 cos