Overhead Cost and How to Calculate It

What is overhead?

A business’s overhead is its fixed expenses of operations that aren’t related to production directly 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.

“Fixed overhead are expenses and costs that remain the same regardless of increased production or growth within your business, when it comes to certain categories such as office rent, salaries of permanent staff (key word here being permanent) and business insurance,” said Christian Maldonado, co-founder of TaxAdvisor365. “These costs usually don’t fluctuate regardless of your growth — until you hit a certain level to where you need to expand horizontally, not vertically (increasing pay would be a vertical example).”

Overhead is a significant aspect of solid accounting that a small business should know, 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 cut business costs in this category, you should regularly review your bills for services such as electricity and internet to see if better deals are available. “Even though overhead costs are not directly related to generating revenue in the business, they are necessary to maintain infrastructure, ensure compliance, create systems, amplify success and oversee business pipelines and processes,” said Natalia Vashkovets-Mawby, principal at Finance for the Now.

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. “As your business scales, you’ll see that these expenses grow vertically and increase in cost as your business activity increases,” said Maldonado. “These types of expenses need massive ongoing monitoring or they could cause your business to go under right ‘under your nose.’”

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

Overhead costs are the ongoing expenses necessary to keep your business running smoothly. Below is a chart outlining some common types of overhead costs and why they matter:

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. “Overhead is simple, it’s all ongoing business expenses that are not directly tied to producing the product or service you’re selling in your business,” Maldonado said. “Being able to identify both different overheads is key to create accurate pricing for your product/service and also project financials for the future health of your business.”

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. [Related article: What Is an Accounts Payable Process?]

“Sales efforts come before sales orders and before revenue appears in the profit and loss statement,” said Vashkovets-Mawby. “Depending on the lead time between initial sales efforts and delivering value to the customer, there can be a substantial lag between when overheads are incurred and when the revenue is posted. To make it even more interesting, salespeople can be working on a number of projects simultaneously.”

Calculating overhead is 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. “Allocating overhead costs can seem complex but are actually fairly simple when you take the time to see how they’re allocated against business activity,” Maldonado said. “It involves incrementally sorting indirect costs to specific cost objects such as products or a service department.”

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.

“A big portion of the organizational capacity and capabilities are locked in the overheads,” Vashkovets-Mawby said. “As a result, they are often responsible for constraints and bottlenecks, creating cost blowouts or hidden growth caps. Without intelligent resource allocation, businesses and their managers cannot fully leverage business infrastructure to improve operational efficiency, process effectiveness and grow the generation of value.”

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.

Mastering overhead costs

Understanding and managing overhead costs is fundamental to the financial health and operational efficiency of a business. By distinguishing between fixed and variable overhead businesses can determine their break-even point, allocate costs effectively and establish pricing strategies that ensure profitability. Moreover, regular reviews of overhead expenses can uncover opportunities for cost savings, which can enhance efficiency and boost margins. Ultimately, a clear grasp of overhead costs enables better budgeting, strategic decision-making and long-term business growth.

Amanda Clark and Jennifer Dublino contributed to this article.