Overhead costs refers to expenses that are not directly involved in providing your goods or services.
These costs are still essential to a business’s daily operations. They include all of the costs that “keep the lights on” like rent, utilities, and administrative expenses.
Understanding your overhead costs is essential for both budgeting and maximizing your profitability. Generally speaking, you have more leeway to cut costs in your overhead as opposed to your direct costs, or operating costs.
It’s also important information for setting your prices. By knowing your overhead costs, you’ll know how much gross profit you need to make from sales to come out with a positive net income (also known as a break-even point).
The overhead formula involves summing up all of your indirect expenses in a given period.
Indirect (or overhead) expenses are typically categorized into four buckets:
It’s worthwhile to go through the process of bucketing your expenses into these categories for budgeting purposes. At a glance, you can see the overhead costs in each facet of the business and make a snap judgment on where you can spend more or less.
Once you have each bucket calculated, simply add them up in the following formula:
Overhead Costs = Administrative Overhead + Operating Overhead + Selling Overhead + Financial Overhead
It’s also possible to calculate your overhead costs by summing up individual expense categories. This saves you the extra step of bucketing expenses, but then you lose a layer of data that might be helpful for budgeting.
Our template helps you easily tally up relevant expenses to calculate overhead costs. Otherwise, follow our step-by-step guide to find your overhead amount:
Download our overhead cost calculator for an in-depth walkthrough with visuals and tables that help you understand your overhead costs at a deeper level.
Using an overhead cost calculator impacts both your understanding of the past and planning for the future. Here’s how.
To get an idea of the future, simply look to the past.
Our overhead cost calculator provides a full, itemized breakdown of your overhead costs by expense type. You can even compare your overhead costs across different periods of time to see how they’re trending.
With this information, you get a loose idea of what your operational costs are that you need to budget and plan for.
Overhead costs are generally viewed as being more within the control of a business—you need direct costs to provide a good or service and cutting costs there could affect the quality of product you provide.
The effects of making a change to your overhead costs doesn’t impact your production and sales process. You could squeeze savings on office supplies or move to a more cost-effective location and still provide quality goods or services to your customers.
By using an overhead cost calculator, you get insight into where your spending is above or below expectations. With this information, you can set budgets that maximize your profitability and help your business thrive.
You know that your prices need to cover your direct costs and your indirect costs to turn a profit.
The difference between a price and the direct costs is referred to as the gross profit. By knowing the gross profit you make on a single sale and your overhead costs, you start to understand how many sales need to be made to turn a profit.
This framework can also be used to determine your prices.
For example, if you forecast you’re going to sell 100,000 units with a $10 direct cost per unit and $500,000 in overhead costs, you can calculate the minimum break-even price. With $1.5 million in total costs, each unit must be greater than $15 to turn a profit.
There’s no such thing as a fool-proof business plan. However, the more data you incorporate into your planning, the less it's based on guesses and hypotheses.
With an understanding of your overhead costs, you start to unpack the financial viability of a business, project, or new initiative.
Take, for example, the decision to expand to a second location. By looking at your overhead costs, you get an idea of how much revenue that location must drive to be a net positive on the business.
By taking the time to crunch the numbers, you get a clearer picture of the business’s financial health in the present—the perfect stepping off point for planning for the future.
Direct costs include anything that goes into the production of goods or provision of services. Typically, this includes the materials used in production or the salaries of workers involved in the production process.
Overhead costs cover all other costs that aren’t directly involved in production. Expenses like rent, utilities, or software are common examples of overhead costs.
An overhead rate is a framework for understanding the proportion of overhead costs to some other aspect of the business. The formula is:
Overhead Rate = Total Overhead Costs / Total Allocation Base
What you use for the total allocation base depends on how you want to frame your overhead costs. Common examples are direct labor hours, labor costs, or units produced.
For example, you may want to understand the overhead rate in the production of one unit of your product. If your total overhead costs are $500,000 and in that time you produced 10,000 units, the overhead rate for one unit is $50 ($500,000/10,000).
There’s no ideal percentage of costs that should be overhead. Ultimately, it depends on the industry and the unique context of your business.
Compare a service provider that embraced remote work and thus doesn’t have rent or property taxes to a brick and mortar retail location. They would have very different expectations about what percentage of their costs are overhead costs.
As a rule of thumb, small businesses aim for an overhead percentage below 35%.
You need the following information to use an overhead cost calculator:
Download our overhead cost calculator for a list of line items to consider as business overhead.