How to track, manage, and reduce your overhead costs
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The most successful small businesses keep a close eye on their overhead costs, picking up on inefficiencies and taking steps to optimize those costs to expand their profit margins.
In this article, we’ll lay out what counts as an overhead cost, how to calculate your total overhead, and some tips for reducing your business overhead expenses.
What are overhead costs?
Overhead costs refer to the ongoing expenses associated with operating your business that do not directly contribute to your production level or sales volume. Examples of overhead costs include rent, office supplies, insurance, and administrative costs.
Types of overhead costs
There are several different types of costs to consider when determining your total overhead costs.
These include variable costs like electricity bills, semi-variable costs like employee wages, and fixed costs like rent or mortgage payments.
Let’s explore these three different types of costs in more detail:
- Fixed overhead costs: These are costs that remain constant regardless of your level of production or sales. Examples include rent, property taxes, and depreciation.
- Variable overhead costs: These costs fluctuate in direct proportion to your level of production or business activity. Examples include utility bills like electricity and water, or raw materials needed for production.
- Semi-variable overhead costs: These costs have both fixed and variable components. For instance, a telephone bill might have a fixed monthly charge plus additional charges based on usage. Employee sales commissions also fall under this category.
Understanding the different types of overhead costs will help you budget more effectively, since you’ll be accounting for costs that vary from month to month.
Overhead costs vs. direct costs
Overhead costs are a type of indirect cost, that is, expenses that are necessary for running a business but are not linked to the creation of a specific product or service.
For instance, rent, utilities, and insurance bills are indirect expenses you must pay to maintain your business operations, no matter what product is currently in the works.
Direct costs, on the other hand, are expenses that can be directly traced to the production of a specific product or service. For instance, if you’re building toy car kits, the plastic pieces, glue, and included tools would be direct costs of that product, as would be the labor you pay for employees to put the kits together.
How to calculate overhead costs
There are two common formulas associated with overhead costs. These include:
Overhead rate formula
Overhead rate tells you the amount of overhead you incur for every dollar of your direct costs. To calculate it, use the following formula:
Overhead Rate = Overhead Costs / Direct Costs
If the result is 20%, that means you're spending $0.20 on overhead for every dollar you spent on direct costs for that project.
Overhead Percentage = Income / Overhead Costs
The result of this equation tells you what percentage of your income you spend on your total overhead costs. For example, if the result is 0.6, or 60%, that means you're spending 60% of your business income on overhead costs.
Interpreting your results
As a business owner, it’s best to keep your overhead costs as low as possible, but how do you know how well you’re doing? Here’s how you should interpret the results of the overhead formulas above:
- Overhead rate. Generally, you should strive to allocate as many costs as possible to specific projects or products, making them direct costs. Only costs that can’t be allocated in that way should be considered overhead. As such, the lower this rate, the better you’re doing at capturing direct costs and allocating them appropriately.
- Overhead percentage. The general advice is to keep your overhead costs under 35% of your business revenue. That said, during periods of growth for your business, you may need to raise your overhead percentage to build new products.
Overhead costs in accounting
In accounting, overhead costs are categorized as expenses on an income statement. They’re usually grouped together under a category such as "Operating Expenses," "General and Administrative Expenses," or simply "Overhead Costs." You can deduct overhead costs from your gross profit to arrive at your operating profit.
When overhead costs are initially incurred, they may be recorded as assets on your balance sheet if they provide future economic benefits. For example, prepaid rent or prepaid insurance are considered assets when paid because they represent future economic benefits. However, as the benefits are realized over time, these costs are expensed on the income statement.
How to reduce overhead costs
Operating a business that isn’t cost-effective increases your chances of becoming insolvent. If your costs are high, consider the following options for reducing operational costs:
Your business relies on the vendors you choose to use, but those vendors are also a business. Vendors set their prices for their products and services—just like you.
When you review your vendors and procurement costs, you may find that there are more competitive options out there. Of course, vendors may reward loyalty, but if you find a lower-cost option, allow your current vendor the opportunity to keep your business first. You might be amazed at what vendor and procurement management can do for your business.
Use accounting software
Business accounting is crucial to your success, but if your software costs you too much money, it can eat into your bottom line. Look into how much you pay for your accounting software and compare other options to see how much you can save.
It’s impossible to reduce your expenses if you’re not sure what those expenses are. It’s important to keep track of your business expenses to determine where costs can be shed, where you can allocate costs as direct costs, and where you might need to make larger investments.
You have a few options for expense tracking:
- Pen and paper. You can take the old-school approach and track everything you do with a pen and a piece of paper.
- Spreadsheets. Use Excel or Google Sheets to keep track of everything your business spends.
- Automated software. Expense tracking software is the easiest way to track your expenses while easily spotting ways to cut costs.
Identify cost inefficiencies
Once you have a clear view of your financials, it should be easier to identify inefficient sources of spending so that you can make a plan to reduce them. Here are a few areas where you can consider cutting costs:
- Subscriptions and memberships: If there are services or memberships that are not essential to your operations, consider cancelling them to reduce your monthly expenses.
- Payroll. It’s never ideal to cut employee hours or introduce layoffs, but if your business doesn’t have the work to sustain the labor hours you’re paying for, you might have to consider it.
- Extras. Extras like bonuses and employee parties are fun, but if they eat too far into your bottom line, it could be time to dial them back.
Nobody wants to downsize their business, but if you’ve appropriately allocated all of your direct costs and your overhead costs are still high, you may be left with no choice.
In the United States, office space typically costs between $8 and $23 per square foot per year. That means a 3,000-square-foot office will cost between $24,000 and $69,000 per year.
If you’re not using all that square footage, cutting down to a 2,000-square-foot office can save you between $8,000 and $23,000 per year. Plus, it can help you cut down on utility costs.
Monitor overhead costs and expenses in real time with Ramp
With Ramp, our corporate cards track your overhead costs and other expenses in real time, with automated expense categorization and reporting.
You can define your expense categories and set category restrictions on employee cards to control which types of purchases can be made from which vendors.
We also offer AI-powered insights that point out where your business can save money.
Learn more about how Ramp can help streamline your expense reporting.