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.

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Types of overhead

Overhead costs can be broken into three categories:

  • Fixed: Fixed overhead expenses are costs that stay the same every month and don’t change with business activity. They include rent or mortgage payments, utilities, insurance, property taxes, depreciation of assets, annual salaries, payroll costs, and government fees.

  • Variable: Variable costs are affected by business activity and can increase or decrease from month to month. They include administrative business overhead costs such as shipping, legal expenses, office supplies, equipment maintenance, marketing, and consulting fees.

  • Semi-variable: These costs are present no matter what, but the amounts can vary depending on business activity. While they have a minimum base rate, the overall rate can fluctuate depending on usage. Examples of semi-variable costs include some utilities, travel expenses, hourly wages with overtime, and commissions.

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:

  • Assess your sales. With Square POS, you have access to real-time analytics and advanced sales reporting so you can see how you’re selling. By tracking this closely, you can see when business is slow, and whether it’s time to reduce costs.

  • Automate operations. With a modern POS system like Square, you can automate some of your operations. For example, with Square Marketing, you can save time (and thus money) since it enables you to set up ongoing email marketing campaigns.

  • Cut back on paperwork. With a Square account, you have access to Square Dashboard, which allows you to manage sales, invoices, customer profiles, and locations from a central hub. With all of this information online, you can cut back on administrative paperwork (and office supplies to boot!).

  • Manage your employees or contractors. Whether you have full-time employees or contractors,Square Dashboard makes it easy to manage employees.

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.