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What Is Overhead? What Small Businesses Need to Know

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Table of Contents

Types of overhead

Calculating your overhead ratio, accounting reports, tips to reduce your overhead.

Overhead is a term used to describe business expenses that aren’t directly linked to creating a product, service or any other activity that contributes to a company’s income. While some business overhead is unavoidable, reducing these indirect expenses will help widen your profit margin.

Every business incurs some overhead expense, although some businesses (for example, a large retail department store) have much higher overhead costs than others (such as a freelance graphic designer working exclusively from home). A wide range of business expenses are typically considered overhead, including:

Advertising and marketing.

Utilities like electricity, climate control, water, phone and internet.

Accounting, legal and other professional services.

Property taxes.

Depreciation.

Business travel and meals.

Compensation for employees not directly involved in product production such as administrative or janitorial staff.

Office supplies and equipment.

Business rent or mortgage.

Licenses and fees.

Subscriptions to services like Zoom or Expensify.

Employee perks such as company swag, gym memberships, team-building activities and retreats, company cars, coffee and snacks.

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Overhead expenses generally fall into one of three major categories:

Fixed overhead: These are business expenses that remain stable from month to month such as rent, insurance, subscriptions or internet service.

Variable overhead: These costs rise or fall depending on how busy your business is. Variable expenses might include your shipping costs, which increase when you sell and ship more product and decrease when you sell less — falling all the way to zero if you haven’t made any sales during a particular period.

Semi-variable overhead: Overhead costs that you pay some portion of year-round, but that increase as you get busier, are considered semi-variable. Your electric bill might be an example of semi-variable overhead since you always pay something for this utility, but your electricity consumption may increase during busy times, causing this cost to fluctuate.

Some businesses find it useful to fine-tune their accounting analysis even further by dividing their overhead expenses into sub-categories like labor overhead, administrative overhead and selling overhead.

Knowing your overhead ratio provides a clear picture of how overhead impacts your business. In general, it’s good to aim for an overhead ratio of less than 35%. To figure out yours:

Examine all your business expenses incurred during a set time period (typically a month), carefully determining which of these expenses aren’t directly linked to your product or service, and therefore qualify as overhead.

Add up all of these indirect expenses to get your total overhead expense figure.

Determine your total sales income for the period you’re working with.

Finally, apply the following formula: (Monthly overhead / monthly sales) x 100 = Percentage of overhead cost to sales.

For example, if you spent $10,000 on overhead during the month of May, and took in $40,000 in sales during that same period, your overhead ratio would be (10,000 / 40,000) x 100 = 25%.

» MORE: Basic accounting concepts every small-business owner should know

Part of any business’s accounting responsibility is to maintain good records of overhead costs. Whether these costs are fixed, variable or semi-variable, they should be entered on your company’s profit and loss statement and on its balance sheet.

Profit and loss statement: Also known as a P&L, this statement shows what your company is earning versus what it’s spending and provides insight into your cash flow, company risk and overall performance.

Balance sheet: This is a financial statement that presents a quick snapshot of your company at a specific point in time by showing assets, liabilities and shareholder equity. Overhead costs are entered as current liabilities on your balance sheet.

Since overhead takes away from your net profit without contributing anything directly to creating your product or service, it makes sense to keep these costs as low as you possibly can without harming your business. Here are some easy ways to reduce yours:

Select your team carefully

Smart hiring choices keep labor overhead costs under control and reduce the need for painful terminations over time. Choose team members with skill sets, aptitudes and work styles that fit your company, and invest in training that gives your employees the necessary knowledge and skills to master the work your company needs done. When hiring, keep in mind that not all functions need to be performed by regular W-2 employees. For seasonal or occasional tasks, it may be more cost-effective to outsource and use independent contractors.

Work with an accountant

While this may feel like an additional expense initially, bringing a skilled accountant into the mix can save you big money in the long run. You’ll discover tax deductions you’d never even considered, maintain more accurate financial records and avoid mistakes that could cost your business a bundle. Investing in good accounting software that tracks income and expenses is another way to keep your bookkeeping accurate and up-to-date, whether or not you also decide to work with an accountant.

Have employees work from home

Commercial rent or mortgage is one of the largest contributors to overhead expenses. Allowing some of your staff to work from home could significantly reduce your square footage requirements, which gives you the choice between downsizing or sub-leasing excess space to offset your costs. If you decide to relocate, you may be able to find a neighborhood with more affordable commercial real estate if leaving your current area won’t hurt your bottom line.

Go paperless

Sending out physical invoices, statements and notifications — and retaining hard copies of files — contributes significantly to your paper, ink, postage, electric and storage space expenses. Send digital correspondence and back up important stored records to a hard drive and/or the cloud. To further reduce your paper consumption, consider replacing paper towels with electric dryers in company restrooms and paper cups with reusable mugs in the break room.

Cut costs on recurring charges

Overhead expenses like phone, internet , equipment rentals, service retainers and supplies may be unavoidable, but there’s no reason to pay top dollar for them. See if you can renegotiate your contracts or switch to providers and suppliers with lower rates. Converting from a traditional PBX office system to a phone-over-internet model may reduce your phone bill significantly, for example. Take stock of your current software subscriptions and see if there are any that you could downgrade to a more affordable service tier or cancel altogether.

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What Are Overhead Costs and How to Track Them

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If you have a business, you have overhead costs. Whether you work alone or have a staff of 50, overhead expenses are a part of doing business. Learn what overhead costs are, the different types of overhead your business may have, and how you or your bookkeeper can learn to easily calculate them.

Overview: What are overhead costs?

Overhead costs are the costs necessary to run your business. Overhead costs are not directly related to any specific product or service, and unlike items such as materials, do not directly generate a profit. However, overhead costs are still part of doing business and should be accounted for properly.

Calculating overhead costs isn’t an option for manufacturing businesses, since GAAP rules state that manufacturing overhead costs must be included in progress inventory and finished goods inventory on your balance sheet and included in the cost of goods sold on your income statement.

While that may sound intimidating, the process is fairly routine if you’re using accounting software , but those of you still recording transactions using manual ledgers will have to spend a little time calculating your overhead costs.

In order to understand overhead costs, it can be helpful to understand the difference between direct and indirect costs:

• Direct costs are any expense that your business incurs that is directly related to the production of goods or services. Direct labor and materials are considered direct costs.
• Indirect costs are not directly related to production costs, but are still necessary in order to run your business. For example, building rent is necessary to run your business, but is not directly related to the production process.

Once you understand the difference between direct costs and indirect costs, it becomes much easier to recognize and calculate overhead costs.

Types of overhead costs for small businesses

There are three types of overhead costs that can directly affect your small business. While the first two, fixed costs and variable costs are fairly easy to track, there is also a third category, semi-variable that small businesses may incur as well.

1. Fixed costs

Fixed costs are the easiest overhead expenses to manage. Fixed costs are the same each month and are not affected by an increase or decrease in production activity. Examples of fixed expenses include general operating costs such as:

• Mortgage payments
• Property taxes
• Asset depreciation
• Administrative salaries

For example, let’s say you own a small manufacturing business that makes wooden picture frames. You currently lease a building that houses both administrative staff and a small manufacturing area.

The rent on the building is $3,500/month. In May, you produced and sold $10,000 worth of frames, but broken equipment in June decreased output, so you only manufactured and sold $2,000 worth of frames. Regardless of the level of manufacturing output in May and June, your rent expense remained $3,500.

2. Variable costs

While the majority of your overhead costs will be fixed costs, there are some variable overhead costs that need to be calculated as well. Unlike fixed costs, you may or may not have variable costs for a particular month. Variable costs include:

• Office supplies
• Maintenance
• Advertising

For example, since you manufacture and sell picture frames, you incur shipping costs for each month you ship orders. However, if there’s a month when your business doesn’t sell any picture frames, you will not have any shipping expenses.

The same principle applies for any month in which no office supplies are purchased or no advertising is bought.

3. Semi-variable costs

Most of your overhead costs will fall into the fixed or variable cost category, but there are times when semi-variable costs will be used. These include:

• Sales salaries
• Hourly overtime

While costs such as utilities are incurred each month, the amount varies from month to month, putting them squarely in the semi-variable category.

How to calculate overhead costs

Once you understand the various types of overhead, you’re ready to calculate business overhead costs. One of the most important things to remember when calculating overhead is to not include any direct expenses, such as products and materials purchased that are used for resale, or direct labor.

Direct expenses should always be calculated in your cost of goods sold; including them in your overhead costs would increase your expenses.

The easiest way to calculate overhead costs is to add up your expenses for a specific period of time. Most businesses find it most helpful if they calculate their overhead expenses monthly.

For example, let’s say your manufacturing business had the following expenses for the month of May:

• Rent: $1,100
• Insurance: $300
• Property taxes: $160
• Shipping: $250
• Office supplies: $90
• Utilities: $175

Adding the totals, the overhead expenses for your business totaled $2,075 for the month of May.

How to calculate overhead rate

To get the most benefit out of calculating your overhead costs, the next step would be to calculate your overhead rate. In order to calculate your overhead rate, you’ll use the following formula:

Overhead Costs ÷ Sales = Overhead Rate

In this example, let’s say that you had $32,000 in sales for May. In order to calculate your overhead costs, you would take your overhead costs, which are $2,075 and divide them by your sales for the period, which total $32,000.

$2,075 ÷ $32,000 = .06 or 6%

This result means that for every dollar you earn, you spend $0.06 in overhead.

How do you allocate overhead costs?

There’s one more calculation you can perform using overhead costs: the overhead allocation rate. Similar to calculating the overhead rate, the overhead allocation rate helps you determine how much overhead needs to be allocated to produce a product or service. The calculation for allocating overhead is:

Total Overhead ÷ Total Labor Hours = Overhead Allocation Rate

For example, let’s say that your business had 140 direct labor hours for the month of May. We already know that the overhead cost for the month was $2,075. The calculation would be:

$2,075 ÷ 140 = $14.82

This means that for every labor hour spent manufacturing picture frames, you’ll need to allocate $14.82 in overhead.

You can also choose to use machine hours rather than labor hours when calculating your overhead allocation, replacing the number of labor hours with the number of machine hours in your calculation.

Why knowing your overhead costs is important

Overhead costs directly impact both your balance sheet and income statement, but perhaps even more important, not knowing or incorrectly calculating your overhead costs can result in decreased profits from inaccurate product pricing.

Not including your overhead costs when pricing a product or service can result in a significant loss of profit if a product is priced too low. Conversely, an incorrect estimate of overhead costs might cause you to overprice your products, resulting in sluggish inventory movement and obsolete stock gathering dust on a shelf.

Knowing your business overhead expenses also helps you be more proactive in managing your business. For example, if you have high overhead, you can take the necessary steps to reduce it. If your overhead in business is low, it may be a good time to consider adding an additional product to your current line.

Taking a few extra minutes to calculate your overhead costs can pay off both short term and long term. You’re in business to make money, and managing your overhead costs will help you do just that.

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Overhead Costs

Step-by-Step Guide to Understanding Overhead Costs

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What are Overhead Costs?

Overhead Costs represent the ongoing, indirect expenses incurred by a business as part of its day-to-day operations.

An overhead cost is a recurring expense necessary to support a business and allow it to continue operating, but these indirect costs are not directly tied to revenue generation.

Table of Contents

How to Calculate Overhead Costs

Overhead costs formula, indirect cost vs. direct cost: what is the difference, types of overhead costs: fixed vs. variable vs. semi-variable cost, overhead costs calculator, overhead costs calculation example.

Overhead costs are the ongoing costs paid to support the operations of a business, i.e. the necessary expenses to remain open and to “keep the lights on”.

However, while overhead expenses are necessary incurrences for a business to continue operating, these sorts of costs are not directly associated with the generation of revenue .

The fewer overhead costs there are, the more profitable a business is likely to be – all else being equal.

An overhead cost, contrary to a direct cost, cannot be traced to a specific piece of a company’s revenue model, i.e. these costs support operations, as opposed to directly creating more revenue.

Since overhead cannot be attributed to one specific revenue-producing business activity, the term is often used interchangeably with the term “indirect expenses”.

By quantifying the dollar value of a company’s overhead – i.e. how much it costs a business to stay open and operate – management can determine how many units it needs to sell to break even , as well as how much must be sold to meet its profit targets.

The process of calculating a company’s overhead consists of three steps:

• Step 1: Identify Each Overhead Cost : The first step is to determine each cost that meets the criteria and the associated amount for the specific time period.
• Step 2: Add the Total Overhead : The next step is to add all the costs deemed “overhead” to arrive at the total overhead cost.
• Step 3: Calculate Overhead Rate : The final step is to divide the overhead by sales to arrive at the overhead rate, which facilitates analysis of year-over-year (YoY) trends, as well as to be able to make comparisons to industry peers.

The formula for calculating a company’s overhead is as follows.

An overhead cost can be categorized as either indirect materials, indirect labor, or indirect expenses.

• Indirect Materials ➝ Material costs that do not qualify as direct materials, such as the cost of cleaning supplies in a factory.
• Indirect Labor ➝ Labor costs for employees not directly involved with the production process, such as compensation for the janitor or security guards.
• Indirect Expenses ➝ A catch-all term that encompasses any operating expense that is not a direct cost, such as utility bills and rent.

Certain costs such as direct material (i.e. inventory purchases) or direct labor must be excluded from the calculation of overhead, as these costs are “direct costs”.

To measure the overhead of a business correctly, any direct costs associated with creating revenue must be excluded.

The list below contains some of the more common examples of indirect costs :

• Administrative Costs
• Office Supplies
• Marketing and Advertising
• Telephone Bills
• Accounting and Legal Fees
• Property Taxes

However, something important to note is that each industry has a different definition for overhead, meaning that context must be considered in all cases.

An overhead cost can be segmented into one of the three distinct types:

• Fixed Costs ➝  Fixed costs remain constant irrespective of the number of units produced and sold in the period, e.g. rent.
• Variable Costs → Variable costs fluctuate based on the number of units produced and sold in the period, e.g. AWS server hosting fees.
• Semi-Variable Costs → Semi-variable costs – a hybrid between fixed and variable costs – are incurred regardless of the output, but there is also another component that can cause some variance contingent on the specific circumstances, e.g. a monthly telephone bill, or truck fuel.

We’ll now move to a modeling exercise, which you can access by filling out the form below.

By submitting this form, you consent to receive email from Wall Street Prep and agree to our terms of use and privacy policy.

Suppose a retail company is attempting to determine its total overhead for the past month.

For our hypothetical scenario, we’ll assume that the company operates multiple store locations and generates $100k in monthly sales.

• Month 1 Sales = $100,000

In Month 1, the company has identified the following costs are “overhead”:

• Rental Cost of Stores = $8,000
• Indirect Employee Salaries = $6,000
• Marketing and Advertising = $4,000
• Office Supplies and Utilities = $1,000
• Insurance and Property Taxes = $1,000

After adding together all the overhead expenses of our company, we arrive at a total of $20k in overhead costs.

• Monthly Overhead = $8,000 + $6,000 + $4,000 + $1,000 + $1,000

As a standalone metric, the $20k in overhead is not too useful, which is the reason our next step is to divide it by the monthly sales assumption to calculate the overhead rate (i.e. overhead divided by monthly sales) of 20%.

• Overhead Rate = $20k ÷ $100k = 0.20, or 20%

In our example scenario, for each dollar of sales generated by our retail company, $0.20 is allocated to overhead.

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How to calculate and reduce overhead costs

19 June 2024

Calculating and reducing overhead costs is an effective way to improve your business profitability. In this guide, you'll learn about the different types of overhead costs and some examples. You'll also find a formula for calculating your overhead costs and tips for keeping them low.

What is an overhead cost? 

An overhead cost is an indirect business expense . Most companies define an overhead as any essential spending not directly linked to delivering their core products or services. These costs can include rent, utilities, insurance , office supplies, marketing spend and the salaries and wages of some personnel. Business overheads won't go up or down with sales.

Why is it important to stay on top of overhead costs? 

It's important to stay on top of overhead costs to maximise your profit margin. Your overheads remain constant – regardless of how much you sell, which can eat into your profit when sales are down. Equally, if you start selling more, your overheads won't go up, which is where you can add to your bottom line. 

Types of overhead costs 

There are three types of overhead costs – fixed, variable and semi-variable. 

Fixed overhead costs

Fixed overheads are set costs you need to cover each week or month, like debt repayments, insurance, rent or staff salaries.

Variable overhead costs 

Variable overhead costs fluctuate with your general business activity. For example, your variable overheads will drop if you close an office and increase if you decide to ramp up marketing. Likewise, if you increase your manufacturing output, your utilities will increase as well as your shipping and handling costs.

Semi-variable overhead costs

Semi-variable overhead costs are fixed base rates, with the flexibility to spend more if your business activity demands. You may add more HR support hours to your fixed monthly contract while you deal with a period of high staff turnover.

Examples of overhead costs 

Examples of overhead costs are payroll, rent and utilities, advertising and insurance.  

Salaries and wages of administrative personnel are often considered an overhead cost because these are not changed by sales or production volumes. 

Rent and utilities 

Rent and utilities can account for a high proportion of your overhead costs. Keeping utility bills low by reducing consumption where possible can help improve profits. 

Advertising 

Advertising is considered an overhead because it is an expense not directly related to the production of goods or services. 

Insurance is often a necessary expense, but because it is also not directly related to the production of goods or services, it's considered an overhead cost.

How to calculate overhead costs

List your indirect business expenses .

Listing indirect business expenses is the first step. That's because what businesses consider an overhead cost can differ. For example, one company will consider courier costs an overhead – they use couriers to keep their office ticking over. Another business might offer free expedited shipping on their online store, so couriers are a direct cost. 

Total your overhead costs 

Total your overhead costs by adding up what you spend on indirect costs each month. 

Calculate your overhead rate 

Calculate the overhead rate by dividing your total monthly overhead costs by monthly sales, then multiply by 100 to get a percentage. For example, if you spend $20,000 a month in overheads and earn $80,000 in revenue, your rate is $20,000/$80,000 = 0.25 or 25%.

You're spending 25 cents on overhead costs for every dollar you make. This doesn't mean the remaining 75 cents is pure profit – it's what's left over to cover your cost of sales, deliver your service or make your product. Or, in other words, the difference between gross and net profit. 

Overhead cost formula 

Overhead rate = overheads/sales 

How to reduce overhead costs in your business

To reduce overhead costs in your business, it can be tempting to slash your largest expenses. However, doing so can often negatively impact your company in the long run. Instead, look at what expenses you could do without or find lower-cost alternatives. Even small savings here and there can add up quickly. Here's where to start: 

Regularly track overhead costs

Regularly track your overhead costs to make sure every dollar you spend is worth it. Otherwise, you may overlook monthly spends of $50 here or $100 there on things that don't add value to your business. 

Negotiate your contracts 

Negotiate your contracts to get a discount or more value from your suppliers . 

Optimise software subscriptions 

Rather than paying for many software subscriptions and not necessarily getting full value from them, choose a scalable business management platform like MYOB. Pay for what you need and not for what you don’t. 

Outsource administration tasks 

Outsourcing administration tasks may seem counterproductive, but doing so may free your team to focus on value-add work or mean you can minimise your employee costs.

Embrace remote working 

Embracing remote work can significantly reduce the overhead costs of running an office, from rent and utilities to coffee and cleaning supplies. With staff working remotely some or all of the time, you can downsize your office or get rid of it altogether. 

Overhead costs FAQs

What is the difference between overhead costs and operating expenses .

The difference between overhead costs and operating expenses is that operating costs are what you spend on running your business day to day. Overhead costs are a subset of operating expenses that aren't affected by or linked to your sales or production. 

What is considered a good overhead percentage? 

A good overhead percentage depends on the kind of business and the stage it's in. For example, if your profit margins are lower, your overhead percentage should be too. Or, say your business is in a growth phase. Your overhead percentage may go way up as you wait for the investment to return an increase in sales. 

What is not included in overhead costs? 

Not included in overhead costs is any expenditure directly related to or affected by your sales. For example, the raw materials or parts you need to make your product, packaging to send it out or wages for staff who deliver services. What you categorise as an overhead cost will depend on your core business offering. 

Lower your overheads, raise your profits

In business, overhead costs are unavoidable and often critical for long-term growth. But when overhead costs get out of hand, they can quickly eat into your profit margin. Keep an eye on overheads and avoid wasteful spending. With a business management platform from MYOB you’ll have insights and reporting built into every plan, so you can keep track of your spending. Get started with MYOB today.

Disclaimer:  Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.

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Home > Calculators > Business Overhead Cost Calculator

Business Overhead Cost Calculator

This business overhead cost calculation worksheet will help you in calculating the overhead costs of your business for use in the Financial Projections Template .

They are the support costs of a business which are not directly attributable to the goods the business is producing.

The Excel overhead cost analysis template, available for download below, helps in calculating costs by entering the amount under the relevant category for each of the five years.

It is important to realize that although the calculator lists a number of typical costs, the type of costs are very much dependent on the nature of the business. Consequently it may be necessary to amend the list of overheads shown in the calculator.

Business Overhead Cost Calculator Download

About the author.

Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

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Overhead Cost and How to Calculate It

To understand whether your business will make or lose money, you need to know your overhead expenses.

Table of Contents

There are many costs associated with running a business, but all of those costs don’t fall into the same bucket. One type is overhead costs, which are expenses not tied directly to the production of a product or service. These are the costs a business incurs regardless of whether they generate any money. Rent, utilities and insurance fall into this group.

It is vital to clearly understand your overhead costs and the expenses directly related to production because it helps establish your business’s break-even point — how much it needs to produce and sell to cover all of its costs. It can also be a key strategy for identifying efficiencies for cost savings.

What is overhead?

A business’s overhead is its fixed expenses of operations that aren’t directly related to production and, therefore, don’t vary with output. In other words, if your business stopped production for a day, you would still have to pay overhead costs to keep the business open. These include expenses such as rent, utilities, insurance and salaries for administrative personnel.

Overhead is a significant aspect of solid accounting , for several reasons. First, it reflects costs that a business can’t avoid simply by slowing or stopping production. Second, determining overhead costs is necessary to establish your business’s break-even point. Specifically, you can factor those overhead costs into the prices you set for your goods and services to ensure you aren’t selling your items at prices where you are losing money.

Understanding your overhead expenses is also essential because it is one of the most significant sources of cost savings for companies looking to streamline operations. To reduce your overhead expenses , you should regularly review your bills for services such as electricity and internet to see if better deals are available.

What is fixed and variable overhead?

When people talk about overhead, they’re typically referring to fixed overhead. This includes things such as business insurance and rent — expenses that remain constant regardless of your production or sales.

However, some expenses are considered variable overhead. These are costs directly related to production, such as raw materials for production and utility costs for running equipment.

The biggest difference is that fixed overhead costs must be paid regardless of whether the company produces or sells anything. This is where you can find ways to be more efficient and increase profits. However, both types of costs are necessary for your business to produce and sell products, and you need to calculate both to determine your business’s profitability point.

Types of overhead costs

Office supplies, property taxes, and professional services such as accounting and legal advice are also overhead costs. These can vary by industry, company size and other factors.

You also must be aware of what is excluded from overhead costs — not just variable production costs but also expenses for investment in assets , such as the cost of renovating your business facilities. These aren’t fixed costs; they are one-time expenses that help to increase the value of your business.

How to calculate overhead costs

To calculate overhead expenses, first you need to identify all of your fixed costs that aren’t directly related to production. Once you’ve identified all relevant costs, you total them.

Fixed Facilities Cost + Utilities + Licensing + Insurance + Sales and Marketing Costs + Administrative Fees = Overhead

Note what’s excluded from the formula above, especially expenses such as labor for production, which is a direct cost tied to production and not included in company overhead.

Of course, this is typically a lot easier to do with accounting software, which can help you identify relevant expenses and total them automatically over various periods.

Calculating overhead is also crucial for planning your budget. If you don’t understand your total fixed costs, it’s difficult to accurately forecast company revenue and expenses or make key decisions about investing in the future growth of your business.

How do you allocate overhead costs?

Allocating overhead costs means breaking down total overhead costs by hour or unit. In other words, you divide your total overhead cost so you can see exactly how much cost is tied to each individual unit of time or production.

(Fixed Facilities Cost + Utilities + Licensing + Insurance + Sales and Marketing Costs + Administrative Fees) ÷ Hours or Units of Production = Overhead per Unit

As with calculating total overhead, allocating overhead is easier with the right tools; it is a common feature of accounting software .

Why allocating overhead is important

By allocating your overhead costs, you can see how much profit (above and beyond your variable production cost) has to be produced per unit or per hour to cover fixed costs.

This process also breaks down your company’s overhead into a more tangible number; you’re tying those costs to something that isn’t so abstract, such as an hour of labor. Once overhead is laid out this way, its importance is easier to recognize, as it shows exactly how much your business needs to make per unit just to cover fixed costs.

Most importantly, allocating overhead helps keep costs in line. It also clearly demonstrates the importance of identifying efficiencies — finding ways to cut costs and increase profits.

The best accounting software for calculating and managing overhead costs

Accounting software makes it much easier to calculate and manage your overhead costs. Here are some of our picks for the best platforms for doing so.

Intuit QuickBooks

QuickBooks is full-featured accounting software that quickly calculates overhead costs. QuickBooks lets you classify overhead expenses as indirect material, such as office supplies; indirect labor, such as administrative salaries; and other indirect expenses, such as rent. Alternatively, you can classify expenses by function (e.g., manufacturing, office/administrative, selling/distribution) or behavior (e.g., fixed overhead, variable overhead, semi-variable). This lets you increase efficiency in different areas of your business and plan for lean times. Learn more in our QuickBooks review .

ZarMoney excels in its reports and data capability. It has over 40 built-in reports and can create dozens of customized options. In addition, ZarMoney separates overhead expenses from the cost of goods and allows you to track overhead costs over time. Advanced inventory features make it easier to get warehousing that is just the right size to keep that cost low. Learn more in our review of ZarMoney .

FreshBooks easily calculates overall overhead expenses, and it also lets you look at it from a variety of perspectives. For example, you can calculate the overhead absorption rate by direct material cost, direct labor cost, labor hours, machine hours or sales price. You can spot and correct inefficiencies by assessing overhead costs with these different methods. For instance, when using the labor cost method, you can decide if bringing on a new employee will be a good way to increase profits. FreshBooks allows you to categorize overhead expenses and easily enter new expenses through digital receipt scanning and mileage tracking. Learn more in our FreshBooks review .

Overhead cost FAQs

Is salary for production workers an overhead or a variable expense, how are sales commissions classified, are shipping and fulfillment overhead expenses, what is the best way to reduce your overhead expense, can reducing the cost of my raw materials reduce overhead.

Jennifer Dublino contributed to this article.

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Overhead costs in business: types and examples.

Published: January 04, 2024

Updated: January 10, 2024

Learn about business overhead, including various types of overhead costs, how to calculate them, what an overhead rate is, and different rate formulas.

For most small businesses, reducing overhead costs is a good way to help deliver  better profit margins . But before reducing overheads, business leaders should understand what they are and how they relate to business efficiency. 

Read on to find out what overhead costs are, how to calculate them, and how to identify potential reductions that could help boost the bottom line. 

What Are Overhead Costs? 

Overhead costs are all the costs a business incurs that aren’t directly involved with producing goods or services. Different types of businesses incur different overhead expenses. For example, a manufacturer’s overhead includes the cost of its accounting team, but excludes direct costs to make the products, such as raw materials and direct manufacturing labor. At a professionals services firm, the salaries of the accountants who serve clients are direct costs, while the rent on the office building are considered overhead.

Although every business has different overheads, some common overhead costs include:

• Office rental
• Business insurance
• Administrative salaries
• Professional services 

What Are the Different Types of Overheads? 

There are three main types of overhead costs: fixed, variable, and semi-variable. These categories reflect how the cost is tied to the output of a business’s goods or services.

Fixed Costs 

A fixed cost is one that remains steady, regardless of whether the business is delivering one unit or 100,000 units. Examples include rent, business insurance, or salaries. These overheads can be easier to budget for, as they do not typically fluctuate from one financial period to the next. However, higher fixed costs can create a larger and less flexible cost burden that must be covered before a business makes a profit.

Variable Costs 

Variable costs are proportional to business activity. While administrative staff salaries are a fixed cost since they must be paid regardless of output, some types of labor costs can be classified as variable. For example, hourly wages, freelance sub-contracted labor wages, workers who only get paid commission, and overtime wages are all considered variable costs because these costs are dependent on production and sales. Other variable costs include business-related travel, shipping to customers, and utilities. 

By their nature, variable costs may go down as business activity declines, but that’s not a desired outcome. Increasing profitability by trimming variable overhead costs tends to require changes in methods or increases in efficiency. For example, during periods of rising utility prices, companies may want to monitor energy overheads to find areas to cut costs, such as investing in more efficient office electronics, lighting options, or heating and cooling systems. Another option may be to consider a hybrid employee model in which employees work from home for part of the week, thereby cutting utility costs. 

Semi-variable Costs 

A semi-variable overhead cost has a fixed component and a variable component. For example, a business phone plan may have a fixed monthly price, but if workers on a business trip exceed the allotted data limit, extra costs may incur. Another example would be a business requiring extra cleaning services above the standard monthly cost – perhaps after a large conference, for instance. 

By regularly tracking changes in overhead, both as raw figures and allocated to other business metrics like sales revenue, decision makers can quickly spot troubling trends. 

Examples of Overhead Costs 

Different companies can have different overheads depending on the nature of their industry and work. 

Let’s look at Consultologists, a hypothetical consulting firm that provides writing and marketing services to clients in scientific and technical communities. The company’s main overheads are rent, utilities, and office equipment. Recently, Consultologists faced a significant increase in overheads because of a rise in rent costs. Due to the highly competitive industry in Consultologists’ region, it could not pass these higher costs onto customers without losing business, so decision makers were forced to look for areas to reduce overhead. 

To solve this problem, Consultologists relocated to a shared office space, complete with furniture and an “all-in” fee that included utilities, energy, and rent all in one lower monthly payment than before. Not only does the company now have more affordable month-to-month expenses, but more predictable expenses that make it easier for the financial team to budget and forecast.

How to Calculate Overhead Costs 

To calculate overhead costs, try to start by making a list of all indirect business expenses for the given financial period, usually a year, by combing through the company’s accounts payable disbursements and bank accounts. Try to be sure to include all fixed, variable, and semi-variable overhead costs.

To find your average monthly overhead, add all overhead costs for the year and divide that number by 12. 

How to Calculate Overhead Cost Per Unit 

Many businesses express overhead costs as “per unit” by comparing overhead expenses with production volume. This figure is often used to inform  pricing strategies  and production schedules. This overhead cost per unit is a blended standard of historical fixed, variable, and semi-variable costs and is especially useful for budgeting and forecasting.

Say a furniture company makes and sells $100 tables. Its direct costs (raw materials, manufacturing, design, labor) are $30 per table, yielding a $70 direct profit. However, to get a more holistic measure for the overall costs of running the business, the business should calculate the overhead cost of each unit produced. 

The formula to calculate overhead cost per unit is: 

Overhead Cost Per Unit = Total Overhead Cost / Number of Units Produced

Let’s say the furniture company has annual overheads of $50,000 and during that period produces 10,000 tables. The overhead cost per unit would be the total overhead cost ($50,000) divided by the number of units (10,000 tables), yielding a $5 overhead cost per unit. The business can then calculate the true cost of producing each table by adding each unit’s direct costs ($30) and its overhead costs ($5) to get a total of $35. This means a more realistic profit for each table is $65 ($100 – $35). 

How to Calculate Overhead Cost Per Employee 

In some industries, companies might want to calculate the overhead cost per employee, perhaps to make staffing decisions, analyze team profitability, set prices, or make budgeting decisions.

A simple way to do so is to add together all overhead costs for a certain period. Then divide the total overhead for that period by the number of employees. 

For example, let’s say a service business has a total overhead cost of $50,000 per month and 10 employees. The overhead cost per employee would be $5,000 ($50,000 / 10 employees). The business can use this figure to determine whether it makes sense to hire another employee – if the costs outweigh the benefits in terms of productivity and revenue generation, for instance, it may not be worth it. While overhead cost per employee can be a useful figure on its own, it’s important to consider it in combination with direct costs for the same period to help get a more comprehensive view of your business’s financial situation.

What Is the Overhead Rate? 

The overhead rate is a metric most often used to measure overhead expenses as a percentage of sales revenue. The overhead rate is important for budget planning and to identify if overheads are eating into sales revenue.

By tracking overhead rates over time, businesses can quickly catch increases when they start cutting into margins. For example, if a business notices that its overheads increased from 20% to 30% of sales revenue over a few months, it can take steps to identify why and then find ways to trim costs or increase sales before that percentage climbs higher.

How to Calculate Overhead Rate 

To calculate the overhead rate, divide the overhead cost by sales and multiply by 100. 

Overhead Rate = (Total Overhead Costs / Total Sales) x 100

For example, say an ice cream factory makes $325,000 in monthly sales revenue. For the same monthly period, its overhead costs total $175,000. This means the ice cream factory’s overhead rate is 54% ($175,000 / $325,000 x 100 = 54%). In other words, the company is spending $0.54 on overhead for every $1 in sales. 

The Bottom Line

Overheads may rarely stay exactly the same month to month, especially for businesses with many variable costs. But by regularly tracking changes in overhead, both as raw figures and allocated to other business metrics like sales revenue, decision makers can quickly spot troubling trends. This proactive approach can make it easier to reduce overhead costs when needed, helping to maximize profits.

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Overhead Costs: What Are They and How Do You Calculate Them?

5 minute read

By Devon Taylor

Overhead costs are ongoing business expenses that are not directly attributed to creating a product or service. Calculating and keeping track of overhead is important for any business. Not only does it make budgeting easier, but it’s also used to determine how much they should charge for their products in order to turn a profit.

To quickly summarize, overhead is any expense incurred to support a business while not being directly related to a specific product or service. Overhead costs often include employee perks, health benefits, rent, and technology such as computers, printers, or photocopiers. Almost every business has some form of overhead associated with their ongoing operations.

Overhead Explained

Companies pay overhead on an ongoing basis, regardless of how much money they earns in a particular month or quarter. Overhead costs are usually fairly fixed. That means they remain mostly constant from month-to-month.

A service-based business with a physical office usually has monthly overhead costs like rent, utilities, and insurance. They have to pay those costs in addition to the direct costs of providing their service. Those costs could include materials, supplies, and manpower expenses.

Some types of overhead expenses can be variable. That means the expense might increase or decrease depending on the business’s activity level. For example, a business’s rent payment is likely to be fixed. However, its shipping and mailing costs may vary from month-to-month.

How Overhead Is Calculated

Expenses related to overhead appear on a company’s income statement. They directly affect the overall profitability of the business. The company must account for overhead expenses to determine its net income, also referred to as its “bottom line.”

Net income is calculated by subtracting all production-related and overhead expenses from the company’s net revenue. (Also referred to as its top line revenue.) In some cases, overhead expenses can be known as “semi-variable.”

Semi-variable means that a company incurs some portion of the expense no matter what.  The other portion depends on the level of business activity. Utility costs can vary depending on the amount of power used in a certain time frame, for example.

Calculation Formula

There are a number of different ways of calculating overhead . The general rule is: Overhead rate = Indirect costs/ allocation measure. The indirect costs are the overhead costs. Meanwhile the allocation measure would include labor hours or direct machine costs, which is how the company measures its production.

Overhead expenses can be found on a company’s income statement. Then they are subtracted from its income to arrive at a net income figure. Analyzing overhead is critical to showing the profitability of a company. It’s required on most quarterly and annual financial statements.

Types of Overhead

As mentioned, there are many different types of overhead that a company must manage and pay for. Some common examples of overhead costs include rent, utilities, administrative costs, insurance, and employee payments and perks.

Let’s take a deeper dive into various types of overhead expenses. We’ll discuss how they can impact a business, in both the short- and long-term. While all businesses have some type of overhead, not all businesses incur the same overhead expenses.

Rent and Utilities

Rent is the cost associated with maintaining an office or manufacturing space. Most companies still require some sort of physical location. (And even if the company buys the space instead of renting it, mortgage costs would replace the rent expense.) Another expense of maintaining a physical location is utilities. Gas, water, power, internet, and phone services are all classified as overhead costs.

Additional costs associated with rent and utility might include items such as a subscription to virtual meeting platforms such as Zoom or Microsoft Teams. It could also include subscriptions to industry magazines, newspapers, and other publications.

Administrative Costs

Companies that have more than one employee (or are not sole proprietorships) tend to have administrative costs. These costs are frequently one of the most expensive types of overhead.

Administrative costs include expenses such as stocking the office with supplies, salaries for office associates, and external legal and accounting fees. Administrative costs can range from buying toilet paper for the washroom to hiring an external accounting firm to audit the company’s finances.

Depending on the type of business, a company might be required to hold many different types of insurance. Insurance can include basic property insurance to protect an organization’s property and physical assets from fire, flood, or theft. It could also include professional liability insurance, health insurance for employees, and even car insurance for any company-owned vehicles.

While none of these costs are directly related to generating revenue for the company (by providing a good or service), businesses are often legally required to purchase different types of insurance, depending on their local laws and regulations.

Employee Perks

In addition to salaries, many companies offer a range of benefits and perks to their employees. It helps retain their talent and keeps them engaged and motivated. These types of perks include everything from keeping offices stocked with coffee and snacks, to paying for gym memberships or happy hour outings.

Other types of employee perks include hosting company retreats, providing access to a corporate vehicle, and subsidizing health and wellness treatments like massages. All perks and benefits are considered overhead, as they have no direct impact on the goods or services being produced.

Other Types of Overhead

Other types of overhead expenses include the need for human resources staff and office receptionists. Selling overhead relates to activities involved in marketing, like billboards, online advertisements, or television commercials.

Depending on the nature of the business, other types of overhead might also be incurred. This could include research, maintenance, manufacturing, and transportation costs. Overhead expenses can grow or retract over time, depending on the operational pace of a business.

Special Considerations

Overhead is viewed as a “general expense.” That means it applies directly to a company’s operations. It’s commonly accumulated as a lump sum, at which point it may then be allocated to a specific project or department.

For example, using activity-based costing, a service-based business may allocate overhead expenses based on the activities completed within each department, such as printing or office supplies. Most businesses spread overhead costs around between various departments.

The Bottom Line

Overhead costs are an essential component of most business operations. As a rule, overhead includes all expenses related to the operation of a business that are not directly attributed to creating a product or service. It would be rare for a company to not have any overhead expenses at all.

Tracking and calculating overhead is important, since it allows businesses to assess their expenses and determine their profitability. Most publicly traded companies are required to track and report their overhead expenses as part of their quarterly financial obligations.

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Devon Taylor

Managing Editor

Devon is an experienced writer and a father of three young children. He's simultaneously trying to build college funds and plan for an eventual retirement. He's been in online publishing since 2013 and has a degree from the University of Guelph. In his free time, he loves fanatically following the Blue Jays and Toronto FC, camping with his family, and playing video games.

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What Is Overhead?

Understanding overhead, special considerations.

• Overhead FAQs

The Bottom Line

• Business Essentials

Overhead: What It Means in Business, Major Types, and Examples

Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.

Overhead refers to the ongoing business expenses not directly attributed to creating a product or service. It is important for budgeting purposes but also for determining how much a company must charge for its products or services to make a profit . In short, overhead is any expense incurred to support the business while not being directly related to a specific product or service.

Key Takeaways

• Overhead refers to the ongoing costs to operate a business but excludes the direct costs associated with creating a product or service.
• Overhead costs can be fixed, variable, or a hybrid of both.
• Different categories of overhead exist, such as administrative overhead, which includes costs related to managing a business.
• The income statement reports overhead expenses.

Investopedia / Paige McLaughlin

A company must pay overhead on an ongoing basis, regardless of how much or how little the company sells. For example, a service-based business with an office has overhead expenses, such as rent, utilities, and insurance  that are in addition to direct costs (such as labor and supplies) of providing its service.

Expenses related to overhead appear on a company's income statement , and they directly affect the overall profitability of the business . The company must account for overhead expenses to determine its net income, also referred to as the bottom line . Net income is calculated by subtracting all production-related and overhead expenses from the company's net revenue , also referred to as the top line .

Types of Overhead

Overhead expenses can be fixed , meaning they are the same amount every time, or variable , meaning they increase or decrease depending on the business's activity level. Overhead expenses can also be semi-variable , meaning the company incurs some portion of the expense no matter what, and the other portion depends on the level of business activity.

Fixed Overhead

Fixed overhead is overhead costs that remain static for a long period of time and do not change as business activity ebbs and flows. Even if the business is growing or slowing, fixed overhead remains the same. Examples include rent, depreciation, insurance premiums, office personnel salaries. and the cost of licenses.

Variable Overhead

Variable overhead consists of the overhead costs that fluctuate with business activity. These are overhead costs that are not static. As business activity increases, so does variable overhead. As business activity slows, the variable overhead decreases. Examples include office equipment, shipping and mailing costs, marketing, legal expenses, and maintenance.

Semi-Variable Overhead

Semi-variable overhead is a combination of fixed and variable overhead where some costs are incurred regardless of business activity but may also increase if business activity grows. Examples of semi-variable overhead include commissions and utility costs. For utilities, a base amount is charged and the remainder of the charges are based on usage.

Other Types

Other categories of overhead may be appropriate depending on the business. For example, overhead expenses may apply to a variety of operational categories . General and administrative overhead traditionally includes costs related to the general management and administration of a company, such as the need for accountants, human resources, and receptionists.

Selling overhead relates to activities involved in marketing and selling the good or service. This can include printed materials and television commercials, as well as the commissions of sales personnel. Other categories such as research overhead, maintenance overhead, manufacturing overhead, or transportation overhead also apply.

Examples of Overhead

Some common examples of overhead costs companies must assume are rent, utilities, administrative costs, insurance, and employee perks.

Rent and Utilities

The costs associated with maintaining the office or manufacturing space companies must have in order to perform their business is an example of overhead. This includes rent as well as utilities such as water, gas, electricity, internet, and phone service. Additional costs such as a subscription to virtual meeting platforms like Zoom ( ZM ) also must be factored into a company's overhead.

Administrative Costs

Administrative costs are often one of the most expensive facets of a company's overhead. This can include the cost of stocking the office with the necessary supplies, the salaries of office associates, and external legal and audit fees. Administrative costs can range from the supply of toilet paper in the office restroom to hiring an external audit firm to ensure the company complies with industry-specific regulations.

Depending on the company, businesses are required to hold many different types of insurance in order to operate properly. These can include basic property insurance to protect the company's physical assets from fire, flood, or theft as well as professional liability insurance, health insurance for its employees, and car insurance for any company-owned vehicles. While none of these costs are directly related to generating revenue for the company by providing a good or service, the business is often legally mandated to purchase these various types of insurance if it wishes to operate within most jurisdictions.

Employee Perks

Many larger companies offer a range of benefits to their employees such as keeping their offices stocked with coffee and snacks, providing gym discounts, hosting company retreats, and company cars. All of these expenses are considered overhead as they have no direct impact on the business's goods or services.

Overhead is typically a general expense, meaning it applies to the company's operations as a whole. It is commonly accumulated as a lump sum, at which point it may then be allocated to a specific project or department based on certain cost drivers . For example, using activity-based costing , a service-based business may allocate overhead expenses based on the activities completed within each department, such as printing or office supplies.

Why Is Overhead Cost Important?

Overhead cost is important because it is the cost to run your business. Understanding and managing your overhead well, particularly how it relates to your business output, will help ensure your business is profitable and to obtain the best margins you can on your sales.

What Are Different Types of Overhead?

Broadly speaking, overhead can be organized into three main types. Fixed overhead includes expenses that are the same amount consistently over time. These can include rent and depreciation on fixed assets. Variable overhead expenses include costs that may fluctuate over time such as shipping costs. Semi-variable costs are a blend of the two. Utilities are an example of a semi-variable cost. 

How Is Overhead Calculated?

Since overhead is often considered a general expense, it is accumulated as a lump sum. This is then allocated to a specific product or service. There are a number of different ways of calculating overhead, however, the general rule is the following: Overhead rate = Indirect costs/ Allocation measure. The indirect costs are the overhead costs, while the allocation measure would include labor hours, or direct machine costs, which is how the company measures its production.

Overhead refers to the costs of running a business that are not directly related to producing a good or service. These costs can be fixed, such as rent, or variable, such as transport costs. They can also be semi-variable, such as utilities. Effectively managing your overhead allows you to keep costs low, set competitive prices, and maximize the most of your revenues.

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What exactly are overhead costs? A company incurs various costs, which can be divided into direct and overhead costs. Contrary to the former, the latter cannot be assigned directly to any cost drivers (which generally comprise of company products or services). If renting a factory producing bikes amounts to £20,000 per month, it is not possible to directly assign the cost of rent to each cost driver. It is for this very reason that it is advised to apply overhead rates to be able to assign overhead costs to individual cost drivers. Accordingly, if you add overhead costs to direct costs, what will result is the total cost of a product or service.

Overhead rates refer to that percentage of direct costs that enable assigning overhead costs to the respective cost object. It is determined on the basis of the causation principle. Overhead rates can be calculated by using the cost allocation method for each cost centre category.

What are overhead costs?

The cost of a product or service is made up of direct and overhead costs, with both having a direct effect on the resulting price. Since direct costs can be assigned to individual cost drivers (which stands in stark contrast to overhead costs), they are easily determinable. However, to cover overhead costs, it is advised to include them in the cost of individual products or services and to take them into account when determining their final value.

In general, there are two types of overheads – either cost centre or those related to cost drivers . Examples of the latter type include costs for rental, depreciation, as well as training- vehicle-, building-, energy-, advertising-, or telephone and internet-related costs. On the other hand, cost centre overheads relate to branches, business departments, and product groups. Overhead costs can be generally split into four separate categories:

• Material overheads (e.g. warehouse rental, salaries of workers from the purchase department, from the incoming goods warehouse, as well as those inspecting the goods)
• Production overheads (e.g. factory rental, natural wear and tear of machinery)
• Sales overheads (e.g. sales and marketing department salaries)
• Administrative overheads (e.g. HR and accounting department salaries, office supplies)

How to determine overhead costs

Before you determine the overhead rate and, consequently, account for individual cost objects, spread the overhead costs across each cost centre . The latter term refers to company units, often referred to as departments or operating sectors. In such a way, it is possible to observe in which sectors a company incurs most of its costs, which in turn helps to calculate the cost of individual products. To spread overhead costs across respective cost centres, you must firstly find out the sum of all overheads.

Spreading overhead costs across cost centres in practice

By means of the cost allocation method in table form – one of many cost accounting instruments – it is possible to spread overhead costs across all cost centres. This practice also requires a highly cost-reflective breakdown of overhead types. In the following example, overheads such as salary, rent, and insurance were broken down in the following manner:

• Employee salaries according to their respective cost centres
• Rental costs according to the surface used (sq. m.) of respective cost centres
• Employee insurance costs according to their respective cost centre

Example: calculating the overhead rate by means of the cost allocation method

For a good understanding of the entries from the cost allocation method of calculation, let’s stick to one cost centre only: the material overheads costs . There are a total of 8 employees – those from the purchase department, the incoming goods warehouse, and those who inspect the incoming goods. Employees receive a monthly salary of £2,500, which amounts to the total overhead cost of £20,000. The monthly insurance cost of each employee amounts to £500, resulting in the total insurance cost of £4,000. Warehouse rental is £6,000.

Calculating overhead costs

To calculate overhead costs, simply divide the total by the calculation base , with the latter referring to the direct costs (e.g. material costs) of respective cost centres. In the following example, calculating the overhead rate for the material overheads is done by dividing the total overhead cost of £30,000 by the calculation base of £100,000, giving a rate of 0.3 (30%).

Allocating overhead costs to cost objects

In the example above, the calculation base for material overheads stems from the total amount of purchased and processed materials. It is only upon determining the overhead rate that the overhead costs can be allocated to individual cost drivers. For example, if materials for a single product cost £1, they are treated with an overhead rate of 30%, which results in the total cost of £1.30.

Cost-plus pricing

Cost-plus pricing is necessary when a company manufactures various goods at different costs. The cost difference can then be traced back to materials and various manufacturing processes. With this form of calculation, you can decide between single and multiple overhead rates.

Single overhead rate : In this case, the total amount of overhead costs is settled with one overhead rate, which is determined by dividing the former by the total direct costs amount from a given financial period. However, the main disadvantage of this method lies in the fact that there is an unchanging ratio between overhead costs and different direct cost types.

Multiple overhead rate: Using the multiple overhead rate means that each production department may have its own predetermined overhead rate. With overhead and direct costs in mind, such departments can be materials-, production-, administration- and sales-based. It is by means of this method that the overhead rate was calculated in the example above. Labour hours and machine hours are commonly used in many factories.

If you managed to calculate the overhead costs by means of respective overhead rates, you can now determine the final price of a product or service (from the sum of direct and overhead costs). The contribution margin , on the other hand, indicates the extent to which a product was involved in the success of any given company. Find out more about the contribution margin and how to calculate it in our article here.

Please note the legal disclaimer relating to this article.

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Start » strategy, 10 smart and practical ways to cut your overhead costs.

Need to trim your overhead costs? Small business owners share their best tips for reducing expenses while maintaining employee and customer satisfaction.

Every small business knows it can be tricky to reduce expenses without sacrificing internal or external quality. If you need to cut your overhead costs, the first step is setting aside time to comb through every single expense you have and understand exactly how much you're spending. Once you've taken that step, you can start to assess what's necessary, what can be reduced and what should be eliminated entirely.

"Print out a profit and loss statement that spans the past 12 months," said Claudio Conte, CPA and co-founder of Bullstrap . "Go line by line … [and] look into each expense to determine where there are possible areas of waste or excess. Applying this practice quarterly or bi-annually allows for a higher percentage of funds to be devoted towards income generating areas, and cutting funds going towards wasteful areas."

This can be a daunting task no matter how frequently you do it. To help, we asked entrepreneurs and small business owners how they recommend cutting costs while maintaining employee and customer satisfaction. Follow their tips as you're evaluating each line item on your budget.

Make a permanent shift to remote work

Countless companies explored large-scale remote work for the first time during COVID-19. Making a permanent move to telecommuting for roles where it makes sense to do so can have a huge impact on your overhead costs.

"Scrutinize the company and employee tasks, and allow those who can telecommute to work from home," said Sahin Boydas, founder and CEO at RemoteTeam.com . "Allowing some or all employees to telecommute will reduce the amount of money spent on office coffee, bring down printing costs and dramatically reduce the amount of energy consumed overall by the business."

If you do still need to maintain a physical office, you may wish to negotiate your lease options or move to a smaller space to account for the reduced number of in-office employees.

[Read: 4 Practical Ways to Stay Connected to Coworkers While Working Remotely ]

Audit your software subscriptions

Many business owners rely on cloud-based tools to help manage their business. However, the monthly subscription costs for these systems add up quickly, so it's a good idea to periodically audit your recurring subscriptions.

"While $10 a month might seem really affordable at first, once you set up subscriptions for project management, accounting, photo editing, social media management, proposals, scheduling, etc., you’ve racked up a pretty hefty monthly bill," said Nerissa Zhang, CEO of The Bright App . "Opt for the free version of these online tools when you can and [find] one subscription that combines the functionality of several different services into one."

Scale down your variable costs

In the current remote-work climate, variable costs like office supplies, business travel and food can often be cut or reduced. Raquel T. Morris, chief operating officer of FinDec , recommends adjusting these items in your monthly budget as needed.

"By reviewing each expense item, I can determine what liabilities must be met versus what can be temporarily … scaled down," said Morris. "Although we all love snacks in the company pantry, cutting the budget by 25% makes a huge difference. Reducing travel and using Zoom … is a great way to save money and keep employees and clients safe. We have [also] found better deals online by simply spot-checking the cost of office supplies."

Automate administrative tasks

Instead of hiring a part- or full-time administrative assistant to shift "back office" work off your plate, try to automate things like invoicing, appointment scheduling, client follow-up and other manual tasks.

"Those very generic and mostly simple tasks can be automated with very little effort," said Alex Kehoe, co-founder and operations director of Caveni SEO . "Even complex internal data collection can be fully automated in the same way and used to augment other automation tools."

You can further reduce costs by investing in an automated live chat service as the first point of contact for customer questions.

"Live chat systems can help multiple customers at once and that's something an employee can't necessarily do," said Sturgeon Christie, CEO at Second Skin Audio . "You can be incredibly responsive … [and] offer a better overall customer service experience, [which] helps drive customer loyalty. The one-time investment … can save your business money, time and stress."

Negotiate with vendors

Vendors and suppliers are often willing to help out their small business clients and cut them a break to weather the current economic climate.

"Figure out if your suppliers can work on a net-term basis of 60 to 90 days or [offer] flexible monthly payment plans," said Richard Lin, founder and CEO of Thryve . "That way, you reduce risk in the business and stay on top of cash flows."

Samantha Anderson, co-founder and president of Origin 63 , suggested reaching out to your technology and service providers and find out if they're willing to discount your subscriptions.

"Software companies may extend up to a 10% discount right now, and that means a 10% cost reduction," Anderson added.

[Read: Negotiating a Vendor Contract? Here's What You Need to Know ]

Although we all love snacks in the company pantry, cutting the budget by 25% makes a huge difference.

Raquel T. Morris, chief operating officer, FinDec

Invest in culture to reduce turnover

You may have already stopped hiring new employees to save money, but it's just as important to focus on keeping the ones you have. Voluntary employee turnover costs U.S. businesses $1 trillion per year , so it's worth it to invest in culture initiatives that keep people around.

"Do what you can to raise morale and give staff members a reason to stay … even if you have to invest more elsewhere," Jason VanDevere, CEO and owner of Goal Crazy Planners . "I suggest more company outings, refresher courses and getting employees more directly involved in company goals to give them a greater sense of purpose."

Evaluate your marketing strategy

As a business grows, so does its marketing spend — but before you continue with your current strategy, evaluate each channel and campaign to determine your return on investment.

"Review your marketing mix [and] compare how much you are spending and gaining from each channel," said Irina Georgieva, co-founder and CEO of Enterprise League . "If, for example, you are investing a lot in PR … but you don’t see a significant increase in your website traffic, it is very likely that you are targeting the wrong marketing channel."

Georgieva noted that businesses should test and measure different marketing channels if you find one isn't working, then allocate your budget according to the data.

Tap into the gig economy

If your business has made the difficult decision to furlough or lay off full-time employees but you still need help completing projects, qualified freelancers and independent contractors can help you affordably fill those gaps.

"When you hire a freelancer, you do not need to pay for benefits … [and they] are willing to work for the fraction of a cost compared to full-time employees," said Drew Cheneler, founder of SimpleMoneyLyfe . "Shop around and … hire freelancers who put their money where their mouth is. Make sure your freelancer has a portfolio of previous work for you to review, a rolodex of customer testimonies and a flexible schedule."

Go paperless

If your business still relies on physical printing, try adopting a paperless, all-digital system to eliminate multiple printing-related costs and keep you better organized.

"A digital workplace that is less reliant on paper is cost-effective and good for the environment," said Sherry Mae Mandajos, chief marketing officer of Tankarium . "Information and data are easily accessible using the technology’s 'search and find' feature."

Hire an accountant

No matter how confident you feel in your business's budget, it never hurts to have another set of eyes. A professional accountant can offer an objective analysis of your budget and potentially help you save even more on overhead costs.

"[Our accountant] reduced company spending by 20% just from small things and waste alone," said Hosea Chang, COO of Hayden Los Angeles . "That taught me a valuable lesson: you have way more money than you think you do. If you sit down and review your spending, you can release all those funds, cut your spending and redirect the funds to other areas of your business."

[Read: How to Find the Right Accounting Firm for Your Business ]

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Construction overhead costs: how to calculate it.

If you’ve been involved in the everyday operations of a business, you likely understand the importance of managing your expenses.

Costs associated with production, staffing, supplies, and other essential elements can impact your bottom line. This is especially true when you start your own construction business and have a long list of overhead costs to manage each month.

Do you worry about having visibility into where your business is spending its money or about whether you’re set up to handle basic business requirements? If so, learning to calculate overhead could be one of the best decisions you make as a proprietor.

The good news is that you don’t need to feel intimidated when it comes to calculating overhead costs and making adjustments as needed.

Whether or not you consider yourself an accounting expert, there are many ways to reclaim or establish control of your business finances. This guide will explain everything you need to know about calculating overhead in your construction business.

Key Takeaways

• Overhead can be calculated by adding up your recurring expenses for the year and dividing by 12
• Overhead can be categorized into two main groups – direct cost (job-based) and indirect cost (general)
• Keeping track of your spending is one of the easiest ways to reduce overhead costs
• Overhead costs should be added into estimates for each construction project to ensure profitability

Here’s What We’ll Cover:

Introduction to Overhead for Construction Businesses

What is overhead in construction, types of construction costs and expenses, options for managing construction overhead, mistakes to avoid in construction overhead, how to reduce your overhead costs, the bottom line for construction businesses.

Frequently Asked Questions

Simply put, overhead is what you pay to keep your business running. You need to know your overhead costs to stay in control of your finances and spending. An easy way to calculate monthly overhead is to add up all of your day-to-day business expenses for a year and then divide by 12.  

Some construction business owners might find themselves in a tough spot when it comes to calculating overhead. In a field like construction, it’s all too easy to lose track of the exact amounts a business spends on specific job costs, equipment repairs, budgets, bids, indirect expenses, direct expenses, and other miscellaneous business expenses .

Project and site managers might not even have access to specific numbers until after a contract or project has closed.

Unfortunately, the hard truth is that if you continually guess at your job costs, business expenses, and overhead, you’ll always be left with less revenue at the end of the day.

Although some numbers can shift and change based on a project’s results or duration, a commitment to good accounting principles at the core of your business should remain stable. 

In terms of overhead in your construction business, this means that you should strive to:

• Learn the skills and tools needed to calculate totals correctly
• Accurately track and forecast business expenses for better long-term financial results
• Make changes and adapt when and if you discover problems with overspending
• Utilize outside or professional help when your business expenses are in limbo

Overhead is what you need to pay to “keep the lights on” for your construction business. You need to pay these daily or fixed monthly expenses to stay in business. 

Overhead costs in construction can usually be divided up into two categories: Indirect and Direct Overhead Costs.

The construction industry is unique in that the type of construction and construction projects can change drastically from job to job. Whether you are a general contractor or a specialized craftsperson, some costs and expenses repeat monthly or project to project.

These types of construction costs and expenses are often called indirect and direct overhead costs:

Indirect overhead costs are the day-to-day costs of running your business. Advertising, office rental, phone, insurance, utility bills, office supplies, and vehicle expenses all fall into the Indirect (or General) overhead costs category. 

Direct overhead costs are those connected to a job or a project. These can include temporary rentals, rented toilets for the job site, utilities, fencing, or even temporary office space, water supplies or cooling stations for your employees. Direct overhead costs are also called “Project Specific Overhead” or “Job Overhead” costs. 

Within construction companies, many expenses don’t fall into an official overhead category. This is because the term overhead traditionally refers to indirect costs that go towards keeping the business in operation without directly contributing to specific jobs or projects. 

While these costs might take some time to identify, overhead is an especially important principle for industries like construction with greater needs for raw materials and hired labor. 

To help make this easier to understand, here are a few key categories you should consider when learning how to calculate overhead in your construction business:

• Overhead Expenses: This category includes costs that impact the entire construction company from an administrative and legal standpoint. You should include things like rental space, employee benefits, insurance costs, marketing, legal fees, and recurring tax or property payments. 
• Direct and Indirect Costs: The cost of materials per project varies greatly in construction. It also includes an indirect costs category for things extremely difficult to track per job site, like nails, wood scraps, and small building materials. These supplies aren’t the same as general overhead costs associated with running the business.
• Labor Costs: Labor and employee costs will vary based on the type of workers you hire. Some employees are year-round, while others may be contracted for specific jobs. Remember to make these distinctions as you factor up overhead for each job. 

1. Create a Comprehensive List of Overhead Costs

When calculating your overhead costs, the best way is to develop an organizational system that flows into your general accounting procedures or software. This way, it’s harder to miss payments and receipts that could make a huge difference in factoring your costs. 

Overhead costs in construction can include:

• Rent for office space and other facilities
• Benefits and salaries of full-time employees
• Insurance coverage for both people and equipment
• General liability coverage
• Transportation costs 
• Labor hours
• Utilities like electricity, gas, and water
• Government fees and licenses
• Taxes on property, land, or other assets
• Depreciation costs
• Maintenance costs
• Other job costs

Depending on the specific type of construction your company handles, you may also have a separate category of manufacturing overhead costs. If you don’t produce any goods directly, this category may not apply. 

2. Add Up Total Expenses

Once you have a complete and categorical list, it’s time to add everything. The best way to do this is to choose a set period of time (for instance, one month’s worth of overhead) and get your grand total.

The reason for choosing one standard period of time is this is the most commonly used time frame for business owners to look at financial reporting like an Income Statement. You will not have a good idea of your true overhead rate if you don’t account for all expenses or the bills have not been received. Accountants or bookkeepers tend to accrue recurring expenses at month-ends even if the bill has not been received and recorded yet. 

3. Calculate Your Overhead Rate

The next step in the process is determining your overhead percentage rate . There are many ways to calculate the overhead rate. Some are calculated by the quantity of sales by project/product, the dollar value of sales by project, the number of employees in each project/job, total anticipated sales by project, etc. Using the dollar value of sales as an example, the math here is also relatively straightforward since you’ll be dividing the total you found in the second step by your monthly sales total. 

The equation looks like this:

To get a percentage instead of a decimal after you first divide, multiply the result by 100. This will give you a percentage number that you can easily work with for a greater understanding of your business operations.

For example, if you have a 25% overhead rate, your company invests 25 cents in overhead for every dollar you make.

The appropriate overhead rate is industry-specific, so you should take some time to research what the standard is for businesses in your region. A good rule of thumb is 10% overhead with 10% profit.

4. Choose the Right Method for Allocating Overhead

If you want to get even more granular with calculating overhead in your business, you can begin to allocate certain categories of your overhead expenses.

In accounting, overhead allocation simply refers to the practice of distributing indirect costs to the projects/jobs or product lines and service lines you offer that generate revenue to ensure that you can report on profit and loss on a more granular level. 

This practice generally provides more visibility than simply lumping all types of overhead together.

Overhead allocation depends on whether your construction company is focused on manufacturing, general contracting, land development, or other specialties. Typically, the more your business grows and spends, the greater your need for overhead allocation. 

Depending on how you manage your accounting, you may receive different suggestions for allocation. Below are two of the most common ways to allocate overhead costs in this industry. 

Rate of Direct Costs

This approach is appreciated for its simplicity because you will look at the costs of one job as a whole. Then, you’ll use a fairly standard percentage for determining how much overhead is needed to cover the job costs. This direct relationship relies on historical data and experience to guide future overhead decisions.

Proportion of Direct Job Costs

On the other hand, when you allocate overhead using a proportion of direct costs, you’re looking for accurate and exact numbers. If you have several jobs or contracts at once, this method divides the overhead amount evenly based on percentage. 

Accounting professionals often prefer the proportional approach, as it allows for more accurate tracking of every dollar spent on overhead. 

5. Double-check All Expenses and Costs

When managing overhead, it’s important to keep a pulse on how much money flows in and out. Failing to carefully monitor these costs can strain your business resources unnecessarily. Additionally, since overhead costs don’t usually generate income directly, they can hinder your growth and ability to invest in new projects.

Another important question to answer is: Who holds power regarding overhead cost decisions? Do multiple people within your organization have the ability to pay recurring bills or decide which fees are important? While it can be helpful to have administrative support, giving access to too many staff members can encourage your overhead to spiral out of control.

As a manager or owner, you must double-check the numbers carefully. This helps you reduce excess spending and avoid critical mistakes. A good tracking system can help you keep track of your business expenses throughout your company. FreshBooks expense and receipt tracking software can help you see the big picture and monitor your spending. Click here to give it a try.

6. Make Adjustments to Your Yearly Budget

Have you done all the math and realized that your overhead costs are too high? Remember, it’s never too late to make changes. 

You can improve your financial situation by:

• Trimming excess overhead costs
• Taking a closer look at your profit margins
• Raising prices on goods and services as needed
• Developing more in-depth accounting procedures

You may need to combine multiple solutions to adjust your yearly budget in a way that’s not only practical but also encourages a positive financial trend.

Now that you understand how to calculate your business’s overhead percentages, it may be time to consider a different approach. 

To get a better handle on overhead management, you can take one of several approaches, or a combination of the following. 

• The DIY approach: If bookkeeping and tracking is your strong suit, consider a do-it-yourself method for tracking overhead. This provides the greatest transparency, as you’ll need to be extremely hands-on in monitoring recurring overhead. Unfortunately, it might also be taxing on your personal time commitments. 
• The tech-based solution: When you choose a cloud-based accounting software like FreshBooks, you can eliminate much of the stress involved with manual tracking. Platforms like FreshBooks are uniquely designed for industries like construction, which require much of your management time to be spent elsewhere. Click here to start your free trial.
• An external finance professional: If you hire an outside consultant, accountant, or tax professional, it can make a huge difference in your business structure. Although this option has a bigger price tag, you may reap dividends by saving valuable time, money, and effort.

Despite your best efforts, there are times when you’ll run the risk of making a mistake with your overhead. During these moments, keep an open mind, and be willing to seek financial help. 

To help you avoid some common pitfalls that construction business owners encounter in this area, we’ve provided a list of common mistakes in construction accounting :

• You allocate overhead incorrectly: As mentioned previously, there are a few different categories to consider for construction overhead. Sometimes, construction businesses try to allocate overhead costs like rent, utilities, and insurance to a specific job only. This misrepresents how overhead percentages can affect the entire company, and in turn, it will result in erroneous reporting.
• You go through lulls in tracking: Once you’ve developed an expense tracking system, stick with it. No matter how busy your construction business gets or how many new jobs you take, you can’t afford to lose sight of vital financial data. If you find it hard to track overhead during certain times of the year, consider outsourcing this aspect of your bookkeeping for a set amount of time. 
• You don’t get back on track financially: If your overhead calculations don’t reveal what you’d like them to about the longevity of your business, remember that future is in your hands. Make adjustments and tweak your business model, but don’t give up. Succumbing to poor overhead management will harm your company’s financial future. 

It seems simple, but you can reduce your overhead costs by looking at your current expenses and seeing where you can cut costs. If you have administrative personnel or employees making purchases for you, explain the importance of cost savings to them. Keeping careful track of your spending can help your business reduce overhead costs in the long run. 

When you want to see your business become successful, you must be willing to dive deep into the practices and habits that encourage business growth.

By learning the ins and outs of your own business overhead, you’ll not only be able to answer for every dollar your business spends, but you’ll be better equipped to make long-term decisions that affect you and your employees. 

Always remember to come back to the basics. Start with listing your exact job costs, complete a few simple math steps to determine totals and percentages, double-check everything, and make adjustments as needed. The entire process can be as simple or as complex as you need it for your unique organization.

The ability to establish a thriving business is always available to you, no matter how long you’ve been in business. When you invest time in the right strategies and tools, you can chart a new path forward in your entrepreneurial journey.

If you want to simplify your construction company’s finances. Check out our guide on the Best Construction Accounting Software for easy-to-use solutions that can help you manage your projects and expenses effortlessly.

It’s important not to overlook the day-to-day expenses associated with running a business. Overhead costs can sneak up on you! It’s important to know your overhead costs and adjust them if you or your employees spend too much. 

Adding your overhead costs and forecasting accordingly can turn a possible money-losing project into a profitable job. You can calculate indirect overhead costs by adding your recurring monthly expenses. Think of overhead as the costs of keeping a roof over your company’s head. When you realize that it’s part of the long-term success of your business, it becomes a solid plan you can build on.

FAQs on Construction Overhead Costs

What is the 20% overhead charge.

The 20% overhead charge means a construction company spends 20% of its revenue on a build. A lower overhead percentage rate means more profits for the company and that the company has been more efficient and cost-effective.

What are overhead costs examples?

Some examples of overhead costs are utility bills, office rentals, wages, and insurance. Overhead costs are anything that relates to the cost of operating the business but are not direct costs like those that pertain to creating a product or service.

What are 4 types of overhead?

The 4 simple types of overhead are production overhead, administrative overhead, selling overhead, and distribution overhead. There are more, however, like insurance, bonding premiums, vehicle and equipment expenses, and more. The list can go on and differs from company to company.

What is a good percentage of overhead costs?

The lower the percentage of overhead, the better for the business overall because that means more profits. The average overhead costs for construction sit around 10%, but this can vary depending on the project and its scope. The larger the project, the higher the overhead, and the smaller, the lower — on average. 

Does overhead include payroll?

Yes, overhead does include payroll. This is called an indirect overhead expense. Things like salaries and payroll fall into this category and are considered fixed expenses. Fixed overhead expenses stay the same month to month and generally don’t change with business activities. 

More Resources for Construction Business Accounting

• Construction Business Tax Deductions
• How to Start a General Contractor Business

Jami Gong, MPAcc, CPA

About the author

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.

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