Being able to accurately calculate overhead cost is a must for small businesses. This figure plays an important role in creating an effective budget, helping decide what to charge for goods or services, and making your business profitable. Knowing the overhead cost, you can also look for new ways to save money ("cutting overhead" is an often-used business phrase) and set pricing.
Overhead is a cost necessary to keep your small business running, but it's not connected to creating or providing a specific service or product. Typically, overhead expenses appear on monthly income statements and are an important part of any business's accounting. Good accounting software, such as that offered by Skynova, will help you track and record overhead expenses to ensure your books are balanced.
Here's what you need to know about overhead cost and how to calculate it.
What Is Considered Overhead Cost?
While overhead cost may help you turn a profit, this is done through indirect support rather than by directly generating profits. A bakery business owner could consider the space they rent as overhead, for instance, but not the cost of ingredients to produce their pastries.
Overhead costs can vary a lot depending on the kind of business you run. A freelance web designer's overhead expenses would probably be quite different from a construction company, and the overhead for one business might not be allowed for another. For example, a small publisher faced with copyright infringement might be able to claim legal fees as overhead, but their lawyer couldn't do the same since legal fees are directly related to how they make money.
Overhead costs can be considered fixed, variable, or a hybrid of the two, called semi-variable.
Examples of overhead costs include:
- Rent
- Property taxes
- Administrative expenses
- Utilities
- Sales and marketing
- Repair and maintenance of motor vehicles and machinery
- Office supplies
- Travel
- Accounting expenses
- Legal costs
Fixed Overhead Costs
Fixed overhead costs don't change, regardless of how your business activity level and income may vary. The costs are easily predicted but necessary to the smooth running of a small business. You must take them into account to have a clear understanding of your overall financial picture.
Examples of fixed overhead costs include:
- Web hosting
- Rent or mortgage payments
- Depreciation expense of fixed assets
- Janitorial services
- Administrative costs, such as salaries
Variable Overhead Costs
As the name suggests, variable overhead costs change, perhaps because the number of services provided by a company increases or decreases or their production output fluctuates - driving up overhead costs with a rise in volume and diminishing them with a decrease in output.
For example, a business's electricity bill - which goes up and down depending on power usage - would be considered a variable overhead expense. Other examples of variable overhead costs include:
- Vehicle repairs
- Sales commissions
- Water and gas bills
- Hiring seasonal support staff
- Raw materials for production
Semi-Variable Overhead Costs
A semi-variable cost occurs on a regular, ongoing basis but isn't a fixed amount based on business activity. For example, your internet plan might be charged on a monthly basis but will go up if you exceed your data cap. This is one example of a semi-variable overhead expense.
Other examples of semi-variable overhead costs include:
- Monthly phone plans (with extra data and long-distance charges)
- Staff bonuses
- Indirect labor
- Building maintenance
How Do You Calculate Overhead Cost?
Many businesses are built on a solid foundation of overhead costs; calculating them accurately can often be the difference between success and failure, especially in a time when small business bottom lines are being hurt by hard economic conditions caused by the COVID-19 pandemic.
Finding all the overhead costs that apply to your business, sorting them by category, and adding them up to figure how much of every dollar earned goes to them is essential in getting a clear picture of your finances and profits and protecting your bottom line.
Because knowing your operating expenses is essential, it's a good idea to use proven small business accounting and budgeting software, such as Skynova's, which can help you put together a balance sheet and track and calculate business expenses ranging from office equipment and staff salaries to vehicle maintenance costs.
Categorize Each Overhead Expense
Before you total your overhead expenses, it's wise to break down the costs into categories so you can see where your money is going and make accurate financial statements. In general terms, the types of overhead costs fall into two buckets: general ones that affect the business as a whole (e.g., mortgage payments) and those that apply to specific aspects of your business (e.g., the costs of running a specific department, like accounting).
How you categorize your overhead costs depends on the type of business you run. Common categories include:
- Transportation overhead: This can cover costs related to work travel, gas mileage, and more if transportation expenses aren't directly related to the goods you produce or the services you offer.
- Marketing overhead: Social media campaigns, advertising, signage, agency fees, special events - the costs to market your business are included here.
- Administration overhead: Administrative overhead involves back-office expenses, such as human resources (HR), payroll, and accounting.
- Research overhead: Here, we have the costs to do market research and product research, ranging from consultant fees to produce customized market reports to design and prototyping expenses.
- Manufacturing overhead: Also known as factory overhead, this involves the indirect costs of running a manufacturing facility (as opposed to direct costs for materials and labor), such as machinery maintenance and equipment depreciation.
Add All Overhead Costs for the Account Period
Once you have your overhead costs categorized, add them up for whatever account period you're using, whether monthly, quarterly, a calendar year, a fiscal year, or something else. The sum tells you your total overhead costs for that period.
Calculate the Overhead Rate
An overhead rate compares how much you spend on overhead versus the revenue you generate. If you have an overhead rate of 10%, for instance, that means you pay $0.10 in overhead on every $1 you bring in.
It's important to know your overhead rate or you might have an inflated view of what you're earning. For example, as a self-employed plumber, you might make $1,000 in a week doing house calls and charging for your time. But you don't really make $1,000 because you haven't factored in overhead costs, such as car fuel and maintenance, insurance, and professional licensing.
It's simple to calculate this rate: overhead rate = overhead costs/sales.
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Let's say you had $60,000 in sales and $15,000 in overhead expenses in a quarter: The overhead rate is $15,000 divided by $60,000, or 0.25, which is 25%. You would spend $0.25 in overhead for every $1 you make in sales.
How Do You Allocate Overhead Expenses?
Allocating overhead costs is essential to calculating the total dollar value of producing a specific product or service. To determine the overhead allocation rate, you would divide the overhead total by some specific measure, such as the number of direct labor or machine hours.
Therefore, the equation might be total overhead/direct labor hours. If a manufacturing production line has $6,000 in overhead costs and 150 hours in direct labor hours, the calculation would be $6,000/150, or $40. This would be the hourly overhead cost to create the product.
Using this formula, if a shorter run for the same product took about 20 hours, the overhead cost would be about $800 (20 hours times $40).
Let Skynova Help You Manage Your Small Business Accounting
Being able to track and account for expenses effectively, such as administrative overhead and the cost of goods sold, is essential to the survival and success of any small business. With the all-in-one invoicing and accounting solution offered by Skynova, you have the software to track overhead costs and much more. This means you can make customized invoices, track sales tax and expenses, store receipts, choose between accrual and cash accounting, and create balance sheets.
Skynova offers a full suite of software products designed for small businesses, covering invoices (including recurring and subscription invoices), retainers, credit notices, credit notes, and work orders. Make Skynova an overhead cost and you'll discover that it soon pays for itself.