The most successful businesses in the world keep close track of their overhead costs and take steps to optimize those costs and expand their profits. Often, direct costs are allocated as overhead costs.
When this happens, the true cost of creating a product may be understated, allowing the price of that product to be set too low and causing the company to lose money on that product. If you’re a small business owner, you should pay close attention to your overhead costs.
In this article, we’ll be diving into what counts as an overhead cost, formulas to calculate them, as well as ways to reduce your overhead.
What are overhead costs?
Overhead costs are all expenses involved in running your business that can’t be allocated directly to a specific project or product. These costs are also commonly referred to as your overhead expenses.
Overhead costs are indirect costs like rent, executive expenses, and more.
Types of overhead costs
There are several different types of costs to consider when you determine your total overhead cost. Some of them are variable costs like electricity bills, some are semi-variable costs like employee wages, and some are fixed costs like office space rent or mortgage payments.
Overhead costs are always indirect costs. They are expenses not directly associated with the production of a product or service. These costs typically include:
- Facility rent or mortgage
- Insurance premiums
- Property taxes
- Executive salaries
These can be fixed or variable overhead costs, as long as they’re not directly related to production.
Operating expenses are costs related to the day-to-day activity of the business. These indirect costs include expenses like:
- Office supplies
- Office equipment
- Legal expenses
- Administrative costs
Total operating expenses are commonly referred to as administrative overhead.
Fixed costs are expenses you pay the same value for month after month, quarter after quarter, or year after year. These include costs like:
- Rent or mortgage payments
- Fixed loan payments
- Fixed service provider rates
- Direct costs
Direct costs are not overhead costs. In fact, they are the exact opposite. Also commonly called manufacturing overhead, cost of goods sold, or production costs, direct costs are expenses that can be directly tied back to a specific product or project. These include expenses like direct labor hours and raw materials.
How overhead costs compare to other types of costs and expenses
Overhead costs relate to the general costs your business pays to stay afloat, also called indirect costs. These are the costs your company pays regardless of which projects or products you’re currently working on.
For instance, you must pay your rent, utilities, and insurance bills no matter what project or product is currently in the works.
Direct costs, on the other hand, are costs you only incur for a specific project or product. 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 the labor you pay for employees to put the kits together.
Overhead cost formulas
There are two common formulas associated with overhead costs. These include:
The overhead rate tells you the amount of overhead incurred for every dollar of direct cost incurred. To calculate it, use the following formula:
Overhead Rate = Overhead Costs / Direct Costs
If the result is 20%, you spend $0.20 on overhead for every dollar you spend 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 all overhead costs. For example, if the result is 0.6, or 60%, it means you spend 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-related 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 cannot be allocated in that way should be considered overhead. As such, the lower this rate, the better your doing at capturing direct costs and allocating them appropriately.
- Overhead percentage. You’re keeping your overhead costs under control if they amount to 35% or less of your business revenue. If your overhead percentage is higher than 35%, there’s likely room for improvement.
The importance of overhead costs in accounting
It’s important to consider your overhead costs during your accounting for a few reasons:
- Spot opportunities for improvement. As you tally your overhead costs, you may see a few obvious areas where costs can be reduced or allocated as direct costs.
- Financial planning. Knowing how your overhead costs relate to your revenue allows you to plan for future growth.
- Find the best investment opportunities. When you dial overhead costs down on a granular level, you can determine where small increases in costs, or investments, can make a big difference in your bottom line.
How to reduce overhead costs
Businesses that cost too much to run eventually become 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.
Business accounting is crucial to your success, but if that 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. You might be surprised at just how easy the transition to a new option might be.
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 even where you might need to make larger investments.
You have a few options for expense tracking:
- Pen & Pad. You can take the old-school approach and track everything you do with a pen and a piece of paper.
- Spreadsheet. Use Excel or Google Sheets to keep track of everything your business spends.
- Software. Although expense tracking software may come with a small expense, that expense could be worth it since it’s the easiest, yet most effective way to find inefficiencies in your business expenses.
Nobody wants to downsize their business, but if you’ve appropriately allocated all of your direct costs and your true overhead costs are still eating into everything you have, you may have no choice. Here are a few areas where you may be able to cut costs:
- Office Space. If you’re not using every square inch of your office space, your office is inefficient. Consider moving to a smaller space to reduce costs.
- Payroll. It’s never fun to cut employee hours or move forward with layoffs, but if your business doesn’t have the work to sustain the man-hours you’re paying for, you should strongly consider these moves.
- Extras. Extras like bonuses and employee parties are fun, but if they eat too far into your bottom line, they could put your business's future in jeopardy.
This is part of downsizing, but it’s so important it’s worth mentioning again. 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.
Monitor overhead costs and expenses in real-time with Ramp
One of the most efficient ways to monitor overhead costs and optimize your business strategy is to take advantage of software solutions. Ramp is a leading, scalable solution for all businesses ranging from small mom-and-pop shops to multi-billion-dollar enterprises. Some of the most exciting features of the platform include:
- Unlimited spending cards so you can track each employee’s spending individually
- Automatic expense tracking on a granular level
- Bill payments
- Seamless accounting of all your business expenses
The bottom line
The bottom line here is simple. Your business expenses can either give you room to grow or bleed your company dry. Use the tools available to you to track and optimize these expenses, pushing your company’s growth to new heights. It’s also worth mentioning that Ramp’s expense analytics make it easy to see where your spending is working for you. When it’s time to invest in further business growth, Ramp can help you make educated decisions as to where that money should go. Check out Ramp today to see how the company can help bring your expenses in line with your goals.