What Are Overhead Costs and How Do You Calculate Them?

Overhead costs are the ongoing business expenses not directly tied to creating a product or service but essential for keeping your company operational. Accurately identifying and calculating these indirect costs is critical for setting prices, controlling spending, and determining overall business health. By understanding overhead, you can make informed financial decisions that support sustainable growth.

This guide will explain what constitutes an overhead cost, provide common examples, and outline a straightforward method for calculating your overhead rate.

What Are Overhead Costs in Business?

Overhead costs are all the indirect expenses required to run a business. These costs support the company's core activities but are not directly attributable to a specific product or service. For example, in a restaurant, the water used to cook pasta is a direct cost of that dish. However, the water used to mop the kitchen floor is an overhead cost because it supports the overall facility's operation, not a single meal.

Understanding this distinction is fundamental to accurate product costing and profitability analysis.

What Are Some Common Examples of Overhead Costs?

Businesses encounter a wide range of overhead expenses. Here are some of the most common categories:

• Rent or Property Costs: This is a typical fixed overhead, whether it's a monthly lease payment for office space or the depreciation on a company-owned building.
• Utilities: Expenses for electricity, water, and gas needed to light, heat, and maintain a work environment. If utilities are used directly in manufacturing (e.g., gas for a furnace), that portion may be a direct production cost.
• Insurance: Policies for property, liability, and employee health insurance are crucial overheads that protect the business.
• Administrative Salaries: Salaries for employees in HR, accounting, and management who are not directly involved in production are considered overhead.
• Office Supplies and Equipment: Costs for items like printer paper, software subscriptions, and computers that keep the administrative side of the business running.
• Employee Perks: Expenses for non-compulsory benefits like coffee, snacks, or gym memberships that contribute to company culture are indirect costs.

What Are the Different Types of Overhead Costs?

Overhead costs can be categorized by their behavior, which helps in budgeting and forecasting.

Additionally, for manufacturing companies, overhead is often split into manufacturing overhead (factory maintenance, supervisory salaries) and administrative overhead (head office costs).

How Do You Calculate Overhead Costs?

Calculating your overhead is a multi-step process that provides valuable financial insights. Based on our assessment experience, following these steps ensures accuracy:

1. List All Indirect Expenses: Compile a comprehensive list of every expense that is not a direct material or direct labor cost. This includes items like rent, utilities, office supplies, and administrative salaries.
2. Total the Overhead Costs: Add up all the expenses from your list over a specific period, such as a month or a quarter. This gives you your total overhead cost.
3. Calculate the Overhead Rate: The overhead rate is a key metric that shows the relationship between your indirect costs and your direct costs. It helps in pricing products correctly. The formula is: Overhead Rate = (Total Indirect Costs / Total Direct Costs) * 100 For instance, if your total overhead for a month is $10,000 and your direct costs (materials and labor) are $50,000, your overhead rate is 20%. This means for every dollar spent on direct production, an additional 20 cents is needed to cover overhead.

Why Is It Important to Track Overhead?

Effectively managing overhead is not just an accounting exercise; it's a core business strategy. Here’s why it matters:

• Accurate Product Pricing: To ensure profitability, the price of your product or service must cover both the direct costs and a proportionate share of overhead. Ignoring overhead leads to underpricing and financial loss.
• Improved Budgeting and Cost Control: Identifying your overhead allows you to create realistic budgets and pinpoint areas where you can reduce unnecessary spending.
• Informed Financial Decisions: Understanding your overhead rate is essential for evaluating business efficiency, forecasting profits, and making strategic decisions about expansion or investment.

To effectively manage your finances, you must regularly track overhead costs, differentiate them from direct production expenses, and use the overhead rate to guide your pricing strategy. Proper overhead allocation is a fundamental practice for any sustainable business.