How to Understand Your Overhead Costs

How to Understand Your Overhead Costs
Understanding your overhead costs is a crucial part of managing your business. Here are a few basics on how to calculate and reduce the business overhead costs.
by Mary Hohn Feb 26, 2022 — 4 min read
How to Understand Your Overhead Costs

You inevitably incur overhead costs when you’re running your business, so it’s important to understand how they affect your bottom line. If you take a closer look at them, you may find ways to cut back on overhead costs so you can increase your profit margin — and give your business a competitive advantage.

What are overhead costs?

Overhead costs are the indirect costs associated with the day-to-day operations of a business. While they’re not directly related to your product or service, they’re non-labor costs essential for running a business. They include fixed costs, such as rent and mortgage, and recurring expenses, like administrative and marketing fees.

If you’re not closely monitoring your overhead costs, they’re easy to overlook. While you’re consumed with other significant business expenses, such as raw materials, manufacturing, inventory, and other startup costs, your overhead costs can sneak up on you. But since they’re not directly tied to generating revenue, they’re some of the first expenses you should evaluate when trying to control your costs.

Types of overhead

Overhead costs can be broken into three categories:

Examples of common overhead costs

Some common overhead costs to expect when running a business to ensure your business charge the right amount and make profits:

How to calculate overhead rate?

Calculating your overhead rate is useful for assessing costs that are not directly tied to production, helping you better price your products or services.

To calculate your overhead rate, take the following steps:

  1. Make a list of all business expenses. Create a comprehensive list of your business expenses, including all operating expenses and every type of overhead expense.
  2. Categorise all expenses. Categorise your business expenses as direct or indirect. If they’re direct, they’re necessary to produce your goods or services (e.g., raw materials). If they’re not required to produce your goods or services (e.g., marketing costs), they’re considered indirect costs, or overhead.
  3. Tally all overhead expenses. Add up all the indirect (overhead) costs for the month to get your total overhead cost.
  4. Calculate your overhead rate. Next, figure out what percentage of each dollar earned goes toward overhead costs to get your overhead rate. To do this, divide your total monthly overhead costs by your total monthly sales and multiply by 100. For example, if you have monthly sales of $50,000 and monthly overhead costs of $12,500, your formula would look like this:($50,000/$12,500) ✕ 100 = 25% overhead

As a general rule, it’s best to make sure your business doesn’t exceed a 35% overhead rate, but there’s no cut-and-dried answer to what your overhead should be. That said, you should monitor it on a regular basis. If your business is going through a slow period, it’s smart to reevaluate your overhead expenses to see where you can cut back.

How to reduce overhead costs?

If you’re looking to reduce overhead costs, we’ve got your back. Here are four ways Square can help you get ahead by lowering your overhead costs:

Reducing your overhead costs often translates to more flexibility. Flexibility in your budget affords you the freedom to make strategic business moves, such as pricing your products more competitively or launching new offerings, which can give you an edge and help you grow.

Mary Hohn
Mary Hohn writes for Square, where she covers topics that affect business owners — from starting a business to growing a business — and the tools and technology that help them succeed.


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