An Entrepreneur’s Guide to Overhead Costs for Small Businesses
Running a business costs money. The various expenses required to keep a company operating are known as overhead costs, and it’s important for small business owners to manage these closely each month. In this article, we’ll cover everything there is to know about overhead costs examples for small businesses, specifically the different types, as well as tips and strategies for reducing them, and calculating your overhead rate.
What are Overhead Costs?
Overhead costs are business expenses that support a company’s day-to-day operations but do not directly generate revenue for the company. In other words, they are indirect costs and they are incurred no matter how much profit the company makes.
Some of the most common examples of overhead costs include:
- Payments for office spaces, warehouses, etc.
- Utilities like electricity bills, gas, water, internet, etc.
- Office supplies
- Insurance for vehicles, employees, and properties
- Lawyer fees
- Loan interests
- Web hosting for small business
- Business licenses and permits
- Marketing and advertising materials
Why Is It Important to Know your Overhead Costs?
Even though overhead costs are not revenue-generating, they absolutely affect a company’s bottom line. Businesses need to pay their overhead costs using a percentage of their sales each month. But the expenses don’t vary based on what you make. The higher your overhead, the more it will eat into your profits
Miscalculations of overhead costs can also lead to mistakes when pricing your products or services. If you aren’t properly factoring your overhead into the manufacturing of your product, one of two things could happen: 1.) you could price it too low, which would result in a loss of profit, or 2.) you could price it too high which would lead to slow inventory turnover.
Particularly if you’re selling perishable products, a slow turn-over rate could result in inventory spoiling which would also lead to a profit loss.
Proper management of overhead costs certainly helps with budgeting. If you have a month or quarter where they are higher than normal, you’ll know you need to make reductions.
Overhead vs. Operating Expenses
Businesses incur two types of expenses each month: overhead and operating expenses. As mentioned, overhead costs are indirect costs or business expenses that don’t directly generate revenue for the business. Operating expenses refers to business expenses like direct labor, materials, and other costs that allow the business to continue running (thus, the term ‘operating’ expenses).
3 Types of Overhead Costs
Overhead costs are divided into three categories: fixed, variable, and semi-variable. Fixed costs are ongoing, meaning they reoccur each month, so they are relatively easy to track. However, variable and semi-variable costs can vary and cause influxes on any given month. Here we’ll break down how each category works.
1. Fixed Overhead Costs
The majority of your overhead costs will fall under the fixed cost category. These types of indirect costs remain the same each month, regardless of how much profit your company was able to generate in that month.
For example, if you own a retail clothing store and you pay $1,500 in rent for the store space each month, you will still owe that $1,500 whether your store makes $5,000, $10,000 or $15,000 worth of profit in a given month. As the name implies, it’s a fixed expense that does not change.
Other general examples of fixed expenses include:
- Loan interest rates
- Business insurance
- Property taxes
- Payroll costs
- Software Subscription Fees
2. Variable Overhead Costs
Variable costs are overhead expenses that vary depending on your month-to-month activities. It’s also worth mentioning that not all business operations may incur variable overheads.
Some general examples of these costs include:
- Advertising and marketing expenses
- Shipping costs
- Legal expenses
- Consultation fees
- Office Supplies
- Commissions (if applicable)
- Administrative expenses
Variable costs can be hard to predict, and some may very well be out of your control. For instance, when the COVID-19 pandemic hit, businesses had to start investing in PPE for employees which was an unforeseen overhead expense. To the best of your ability, adjust your variable costs when there is an economic downturn. When you know your business is heading into a slow season, you can be more cognizant of your spending on items or services the company doesn’t truly need during that slower period.
3. Semi-Variable Overhead Costs
Costs like utilities are considered a semi-variable expense. That’s because they reoccur each month, but the actual cost amount will vary from one month to the next. Take your office’s electricity bill, for example. Electricity is a monthly cost, but in the summer months when you need to increase the use of air conditioning, this cost will increase.
General examples of semi-variable overhead costs include:
- Travel expenses
- Hourly wages
- Company vehicle expenses (i.e., gas)
3 Steps to Calculating Your Overhead Rate
Your overhead rate is one of the most significant metrics in your business. It measures or calculates the portion of your sales that will need to be put towards paying your overhead. It also determines the costs that are not directly tied up to the production of goods or the delivery of your services, helping you come up with a better price for your products or services.
Here are the three steps you can follow to calculate overhead costs:
1. List Down All Your Overheads
Before you can calculate your overhead expenses, you need to identify what they all are. Remember, all overhead expenses are indirect costs – whether they are fixed, variable, or semi-variable. To determine which of your expenses are considered overhead costs, examine whether that expense directly influences the production of goods or services.
You may have bought a desk or desk chair to do your work, but those items will not directly generate any revenue for you, so they are an overhead cost. Raw materials, on the other hand, are direct expenses because they physically make up the products that your company sells for a profit. This means they are not an overhead cost.
2. Add Up All the Overheads
Once you’ve completed your list of overhead expenses and associated costs, add them all up to get your total for the month.
3. Calculate the Overhead Rate
To calculate overhead costs, you divide your total overhead by your total monthly sales and multiply the quotient by 100.
Overhead Rate = (Total Overhead Costs per month / Monthly Sales) x 100
For example: if your overhead costs add up to $7,500 per month and your monthly sales total is $30,000, your overhead rate would be 25%.
Overhead Rate = ($7,500 / $30,000) x 100% = 25%
In this specific example, the overhead rate tells us that 25% of every dollar earned from your product must be put towards paying for the overhead costs of your business.
You should always try to keep your overhead ratio of less than 35%. For businesses with a low-profit margin, an overhead rate of 10% could be too heavy for their business so they should work on reducing their overhead costs to keep their business thriving.
4 Ways On How to Reduce Overhead Costs in Business
Lower overhead costs essentially translate to higher profit margins. If you find yourself going over the ideal 35% rate, or simply know how to reduce overhead costs in business, here are five strategies for lowering those indirect expenses:
When you’re thinking of reducing costs, start by evaluating your office supplies. Continuously having to resupply paper and ink adds up. Not only is paperless cost-effective, but it’s more environmentally friendly as well.
Invest in software or a cloud-based system that lets you store all important company records electronically. The software cost will be significantly less than the ongoing cost to continue purchasing unnecessary supplies. Going digital also eliminates clutter and allows business owners to be more organized. Be sure to have all your documents backed up in the event of any computer or software glitches.
Budget your Travel
Travel can eat up a good chunk of your company’s budget but is often necessary for business growth. Be proactive and make a budget for each trip you take so you have an allotted limit you have to adhere to. This will motivate and encourage you to be more savvy. You can use airline miles you’ve accumulated for flights, stay in business hotels, and apply for their loyalty programs to obtain discounts on future stays. You should also evaluate the necessity of a trip before booking any travel accommodations. If a virtual meeting could just as well suffice, opt for that.
Related: 6 Practical Tips to Effectively Stick to a Business Budget
Invest in Expense-Tracking Tools
There are a lot of software options available today that help any business owner track any unnecessary spending or highlight areas where overspending is taking place. Using such tools can provide insights as to where businesses can cut costs when it comes to overhead expenses. Plus, when tax season comes, having a reliable accounting tool will make it easier for accountants to spot any tax-deductible expenses, resulting to more savings for the company.
Related: 6 Tips to Help Keep Track of Small Business Expenses
If you’re spending too much of your company’s money on office equipment like computers, photocopy machines, and other office space essentials every year, consider leasing these items instead. Renting allows you to upgrade more easily to the latest versions of computers and other equipment. Additionally, costs like equipment repairs and maintenance will also be lowered if not eliminated when leasing.
Market to Your Existing Customers
One of the best ways to reduce your marketing costs is to focus on improving your customer’s experience with your company and brand. Satisfied customers are more likely to recommend your products or services to friends and family, and word of mouth remains the most powerful marketing tool. You can also encourage your current customers to promote your brand via social media and through online reviews or testimonials. Potential customers are more likely to trust organic promotion via their peers than paid advertising.
Overhead Costs for Small Businesses: Bottom Line
Overhead costs are part of running a business. Business owners who are diligent in tracking and managing these expenses will be able to make adjustments when necessary to ensure that their business is maximizing its profits and improving the company’s bottom line. The more you save on your overhead costs, the more of your earnings would be.
Frequently Asked Questions
How do you calculate overhead cost per unit?
In calculating the overhead cost per unit, all you have to do is divide the total overhead cost by the number of units produced (or you’re planning to produce).
For example, your total overhead cost is $10,000, and you produced 1,000 units, your overhead cost per unit would be $10. That means for every unit you sell, $10 of the price will go towards your operating expenses.
What is a good overhead ratio?
Overhead ratios will vary from one industry to the next, considering that each faces different expenses. For instance, a good overhead ratio for professional services would be 50%, while a good ratio for retail and restaurant businesses would be 25% and 35%, respectively.
What are overhead expenses in healthcare?
Medical and healthcare businesses incur around 60% to 70% of their overhead costs. Their most common overhead expenses include:
- Staff salary and benefits
- Medical equipment
- Facility expenses (i.e., rent or mortgage)
- Building depreciation
- Clinic supplies and fixtures
- Malpractice insurances
- Promotions and marketing
- Professional fees (i.e., accounting, legal, consulting, etc.)
- Other insurance policies