How to Calculate Overhead Costs

Whatever the size of your business and whatever sector you're active in, you can't escape overhead costs. These recurring expenses can be fixed, variable or even semi-variable and covering them will be essential to your business's success. They can also make up a large proportion of your outgoings each month and must be paid regardless of the company's current volume of business, so it's essential that you understand them and factor them into your financial planning.

What Are Overhead Costs? 

Overheadcosts are the recurring expenses necessary to sustain a business but don't contribute to income. These are also called indirect costs because they are not part of business activities that generate revenue. Overhead costs exclude the direct costs associated with creating a product or service, such as labour and material. They can typically be divided into three groups, fixed, variable and semi-variable.

Types of Overhead Costs 

Fixed overhead costs will be the same monthly and include outgoings such as rent or mortgage payments, insurance and property taxes. Variable overhead costs will be affected by business activity and will likely increase when business activity increases. They can include things like shipping, advertising and materials. Finally, semi-variable overhead costs will fluctuate each month based on usage. Examples here include vehicle use, wages and some utilities. 

Tracking Overhead Costs 

Overhead costs will vary for every business and even month to month, so it's important that you understand the different types, classify your overheads accordingly and plan to track and cover them each month. As they vary, it can be tricky to forecast your overheads accurately, but you can do a few things to calculate and control them.

Calculating Overhead Costs 

The best way to get an accurate guide of upcoming overhead costs is to look at what you spent last year. Essential expenses to look at here will include mortgage and rent payments, insurance, wages and supplies. You'll be able to quickly source this information using an online accounting tool. It's then helpful to add these costs together and divide them into monthly expenses, so you know how much to put aside regularly. 

Once you know your overhead costs, the next step is calculating your overhead rate to compare these costs to your revenue. To do this, it's simply a case of dividing your overhead costs by your income from sales to get a percentage.

For example, if your costs last month were £2,000 and your income was £25,000, your overhead rate would be 0.08 or 8%. This means that for every pound made, 8p was spent on overhead costs. As wages may well be one of your highest overhead costs, it can also be beneficial to calculate the overhead percentage in relation to labour cost – that is, dividing monthly overhead costs by the monthly labour costs and multiplying by 100. With both of these calculations, aim to have a low percentage, as the lower your overhead costs, the higher your profit. As a guide, you should aim for an overhead rate of less than 35%. 

Why Are Overhead Costs Important?

Understanding and controlling your overhead costs is essential if you're going to make a profit. Knowing your outgoings means you can price your goods and services to produce a profit. You'll also learn how much you need to make to break even. Your overhead costs information will feed into several other key financial metrics, such as your breakeven analysis, overhead absorption rate and billable hour price, to help you develop a comprehensive and rounded picture of your business' finances. In addition, by tracking overhead costs, you'll also be able to identify any that are rising quickly and so need to be managed or any that can potentially be reduced.