What Are Overhead Costs and How To Calculate Overhead

What Are Overhead Costs and How To Calculate Overhead
Understanding your overhead costs is an important part of managing your business. Here are a few basics you should know.
by Mary Hohn Feb 25, 2022 — 3 min read
What Are Overhead Costs and How To Calculate Overhead

This article is for educational purposes and does not constitute legal, employment, or tax advice. For specific advice applicable to your business, please contact a professional.

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, 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 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:


One thing to note is that operating expenses and overhead expenses are different. By looking at both, you can potentially spot opportunities to increase profitability for your small business.

How to calculate overhead cost

Overhead rate formula

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. Categorize all expenses. Categorize your business expenses as direct or indirect. If they’re direct, they’re necessary to produce your goods or service (e.g., raw materials). If they’re not required to produce your goods or service (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:
   ($12,500/$50,000) ✕ 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. If you are looking to see a more complete picture of your business’s financial health, there are several accounting and financial tools often used by small businesses. A profit and loss statement — or income statement — can help you look at your total revenue, total expenses, and net income at a glance. 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 costs to see where you can cut back.

How to reduce overhead costs with Square

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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