How to calculate overhead ratio

Keeping overhead costs under control is key to boosting your company's bottom line. Calculating your overhead ratio regularly can help you stay on top of these expenses and catch issues early.

With a little know-how, overhead doesn't have to trip you up. Here's how to zero in on these costs and keep them in check the easy way.

What is the overhead ratio?

The overhead ratio (also called the overhead cost ratio or operating expense ratio) compares your operating expenses to your income. It shows how much revenue is being eaten up by overhead—the costs that aren't directly tied to making your product or delivering your service.

Here's the simple formula:

Overhead Ratio = Total Operating Expenses ÷ (Taxable Net Interest Income + Operating Income)

The overhead ratio is different from your operating profit margin. It focuses specifically on the balance between expenses and income, not your overall profitability. Knowing both ratios gives you a clear picture of your financial health and helps you make smarter spending decisions.

Examples of overhead expenses

Overhead covers all the costs that keep your business running but aren't directly linked to production. Think rent, utilities, insurance, admin salaries, marketing, and depreciation.

Here's a quick checklist of common overhead expenses:

• Rent and facilities: Payments for offices, warehouses, storefronts—even potential home office write-offs
• Utilities: Non-negotiables like electricity, water, heating and cooling
• Admin salaries: Pay for support staff like office managers, receptionists and execs
• Marketing: Ad spend and promos to bring in business
• Insurance: Liability, business interruption, professional liability, company vehicles
• Depreciation: The gradual loss of value of business assets over time
• Other costs: Legal fees, accounting, office supplies, repairs, certain non-production taxes

How to calculate the overhead ratio

The overhead ratio formula is pretty straightforward. The key is choosing the right allocation bases—the metrics you'll use to assign overhead costs to different parts of your business.

Picking the right allocation base is important. It makes sure your cost analysis and profit calculations are on the money. You want to match up your overhead expenses to your day-to-day activities in a way that makes sense.

Some of the most common allocation bases are:

• Direct labor hours/costs: Spreads out overhead based on production time or labor cost
• Machine hours: Allocates overhead by equipment usage time
• Direct material costs: Assigns overhead as a percentage of materials costs
• Sales price: Divides up overhead based on product/service prices

Once you've got your base, you can figure out your absorption rate:

Absorption Rate = (Overhead Costs ÷ Chosen Allocation Base) x 100

So let's say your business has $50K in overhead and $200K in labor costs. Your direct labor absorption rate would be:

($50,000 ÷ $200,000) x 100 = 25%

That means for every dollar you spend on wages, you tack on an extra quarter for overhead. Super helpful for setting prices and budgeting.

What is a good overhead ratio?

Generally, a lower overhead ratio is a good sign. It means you're spending less on operating costs relative to income. That usually translates to higher profits and a stronger position in your market.

On the flip side, a higher than normal ratio can be a red flag. It might mean your costs are out of whack. If your number is way above the norm for your industry, take a closer look at your spending, vendor relationships, and processes. There may be room for improvement.

Don't just look at the number itself—the trend matters too. A ratio that's steadily dropping is a sign your cost control strategies are working. One that keeps climbing warrants a deeper dive.

Overhead ratio vs. operating profit margin

These two metrics come at performance from different angles:

• The overhead ratio zeroes in on operating costs vs. income. It's all about how well you manage expenses.
• Operating profit margin takes a wider view of how well your core business makes money.

For small business finance teams, it pays to know the difference. The overhead ratio pinpoints overspending, while operating margin shows the bigger profitability picture.

Analyzing both together is the way to go. You'll get a 360 view of your operational efficiency and be able to spot specific areas to optimize your costs.

Common mistakes to avoid with the overhead ratio

Calculating your overhead ratio correctly is key to making sound financial calls. Steer clear of these common slip-ups to make sure your numbers are painting a true picture.

Forgetting depreciation

One frequent flub is leaving out depreciation—the gradual loss of value of your tangible assets as they age and wear out. Skip this in your overhead math and you'll lowball your actual operating costs.

There are a few ways to calculate depreciation, like the straight line method (spreads the cost evenly over an asset's lifespan) or declining balance (more depreciation early on).

Accounting software can be a big help here. It applies the right depreciation method automatically and folds those costs right into your financial reports.

Inaccurate data entry

Data entry mistakes can really throw your overhead ratio out of whack. Watch out for things like transposed numbers, missing decimal points, duplicate entries, and miscategorized expenses.

To cut down on goofs, put some checks in place. Have a second set of eyes verify the numbers. Use data validation tools that flag inconsistencies and duplicates.

Faulty industry benchmarking

Measuring your overhead ratio against industry benchmarks can lend valuable perspective—if you're comparing apples to apples.

Make sure you're stacking yourself up against similar-sized companies in your specific niche, with comparable business models. A higher ratio than your peers could point to inefficiencies...or it might reflect investments in future growth.

With benchmarking, context is everything. The raw numbers never tell the full story.