Overhead costs are the costs you pay to keep your business running, whether the demand for your product is high or when you are barely producing. Having a reliable overhead record will help you set a better price for your product or service, show where you can save money, and streamline your business model. But these benefits only come from careful note-taking, so read on for the best way to calculate your business overhead costs.
Step
Method 1 of 3: Finding Overhead Costs
Step 1. Understand that overhead costs are costs that are not directly related to your product
These costs are also known as indirect costs. Indirect costs such as rent, administrative staff, repairs, machinery, and marketing costs are essential to business operations and must be paid regularly.
In this example, indirect costs such as postage and insurance must be paid for running the business, but not in making the product
Step 2. Understand that direct costs are the costs of creating a product or service
This fee will change based on the demand for your product and the price of the material in the market. If you run a bakery, the direct costs are labor costs and bread ingredients. If you run a health clinic, the direct costs are the salaries of the doctors there, stethoscopes, etc.
- As described above, the most frequent direct costs are wages and materials.
- Simply put, direct costs pay for anything on the assembly line, whereas indirect costs pay for the actual assembly line.
Step 3. List each expense for a month, a quarter, or a year
While you can choose any time frame you like, most businesses break down expense reports on a monthly basis.
- Be consistent with that time frame. If you calculate indirect costs on a monthly basis, also calculate direct costs on a monthly basis.
- Using a computer program such as QuickBooks, Excel, or FreshBooks will help with organization and easy access to lists.
- Don't worry about the details of every fee. You need a full picture of your expenses before you can calculate overhead costs.
Step 4. List all common (indirect) overhead costs
Every company has costs that are inevitable, including taxes, rent, insurance, licensing fees, utilities, accounting and legal teams, administrative staff, facility maintenance, etc. Write down whatever comes to your mind!
- Look at past expense and receipt reports to make sure you haven't missed anything.
- Don't forget about recurring costs, such as license renewal fees or infrequent license applications. These costs are still considered overhead costs.
Step 5. Use old costs or estimates if you don't know what costs are
If you are just starting a business, do thorough research on inventory costs, labor and other potential overhead costs.
- If you have old accounting books available, you can use them to plan your expenses for next year. These costs are usually a similar amount, unless you are making major changes to your business plan.
- Average old costs over the past 3-4 months to adjust for any statistical anomalies.
Step 6. Divide your list into direct and indirect costs based on your business model
Every business is different, and you can make an assessment of certain costs. For example, although legal costs are generally overhead, they contribute directly to production if you run a law firm.
- If you're still confused, think of overhead costs as the costs you'd still pay if you stopped production altogether. What keeps your business running every day?
- Update this list whenever there are new charges.
Step 7. Add up all indirect costs to get the total overhead costs
This is the amount of money you need to stay in business. In the example above, our annual overhead costs are $16,800. It's important to know the amount when creating a business plan.
Method 2 of 3: Understanding Business Overhead Costs
Step 1. Find your percentage of overhead
The overhead percentage tells you how much business you spent on overhead, and how much was spent making the product. To find out the percentage of overhead:
- Divide indirect costs by direct costs. In the example above, our percentage of overhead costs is 16,800/48,000 = 0.35.
- Multiply this number by 100 to get the overhead percentage. For example here: 35%.
- This means your business spends 35% of the available money on legal fees, administrative staff, rent, etc. for each product produced.
- The lower the percentage of overhead, the greater the profit you earn. A low overhead percentage is good!
Step 2. Use your overhead percentage to compare yourself to other similar businesses
Assuming that all similar businesses pay roughly the same direct costs, the company with the lower percentage of overhead made will make more money selling the product. By lowering your overhead percentage, you can sell your product at a more competitive price and/or earn a higher profit.
Method 3 of 3: Using Overhead For Better Business
Step 1. Divide overhead by labor costs to see how efficiently you use resources
Multiply this by 100 to get the percentage of overhead used by each worker.
- If this number is low, it means that your business is spending your overhead costs efficiently.
- If this number is too high, you may be hiring too many people.
Step 2. Multiply by what percentage of your income you pay for overhead costs
Divide the overhead by the amount made in the sale, then multiply by 100 to get the percentage. This simple method is used to see if you are selling enough goods/services to ensure you stay in business.
- Ex: If your soap business sales are $100,000 per month, and you have to pay $10,000 in expenses to run the office, you spend 10% of your income on overhead costs.
- The higher this percentage, the lower your profit margin will be.
Step 3. Trim or manage your overhead if these numbers are too high
Ask why you are not making big profits? You may be paying too much rent, or having to sell more product to cover overhead costs. Maybe you hired too many workers and didn't pay them wisely. Use these percentages to take a closer look at your business model, and make changes accordingly.
- All businesses pay for overhead costs, but businesses that manage overhead costs wisely will generate higher profits.
- However, low overhead costs are not everything. If you spend money on good equipment or to keep your workers satisfied, for example, the result may be higher productivity and higher profits.
Tips
- If you are calculating overhead costs for a past period, you can use actual facts and figures from company records for your calculations. If you are estimating overhead costs for future periods, use the average to estimate those costs. To calculate future indirect costs, for example, you must examine several periods in the past to calculate the average cost for each indirect cost that will apply to your business over the forecast future time period. As with future direct costs, you can estimate average costs based on past records and current figures. For example, direct labor can be calculated by multiplying the average hourly wage of direct labor by the average number of hours worked by direct labor over a given period of time. The resulting figure may not exactly match the figure paid out within that time period, but it is close enough.
- Track overhead percentages over time, i.e. monthly, quarterly and annually to help normalize differences caused by seasonal considerations, consumer purchasing patterns and raw material availability/costs.
