How to Find Overhead and Calculate Your Overhead Rate

Overhead refers to the ongoing expenses a business incurs that are not directly tied to the creation of a specific product or service. These are the costs necessary to keep the business operating, regardless of production levels or sales volume. Understanding these indirect costs is fundamental for any business to manage its financial health and make informed decisions.

Recognizing Overhead Expenses

Identifying overhead expenses involves categorizing various costs that support business operations but do not directly contribute to the production of goods or services. These indirect costs are incurred regularly and are not easily traceable to a single unit of output. Businesses typically group these expenses into several categories to facilitate tracking and analysis.

Administrative expenses include costs associated with the general management and operational support of the business. Examples are salaries for non-production staff such as administrative assistants, human resources personnel, and accounting department employees. Office supplies, postage, and small equipment used for general office functions also fall into this category.

Occupancy costs are the expenses related to maintaining the physical space where the business operates. This includes rent or mortgage payments for office buildings or factory space, property taxes assessed by local municipalities, and utility bills for electricity, water, gas, and internet services.

Sales and marketing expenses cover the costs associated with promoting and selling products or services. This can involve advertising campaigns, the creation and distribution of promotional materials, and the salaries of sales staff if their compensation is not directly tied to specific product commissions.

Insurance and professional fees are also common overhead expenses. This includes premiums for various business insurance policies, such as general liability or property insurance. Legal fees for general business matters and accounting fees for financial record-keeping and tax preparation are also considered overhead.

Depreciation is another form of overhead, representing the expense of wear and tear on long-term assets not directly involved in production. This includes depreciation on office equipment, furniture, or buildings used for administrative or sales functions.

Miscellaneous overhead costs encompass smaller, recurring expenses that do not fit neatly into other categories. These might include bank fees, charges for cleaning services, general office maintenance, or subscriptions to industry publications. While individually small, these costs are necessary for day-to-day operations.

Summing Overhead Expenses

Aggregating all identified overhead expenses over a consistent period is the next step in understanding a business’s indirect costs. This process involves gathering financial data from various sources and then simply adding the amounts together. The chosen period for this calculation, such as monthly, quarterly, or annually, should align with the business’s reporting cycles and analytical needs.

Businesses typically find these expense figures within their accounting software systems, such as QuickBooks or Xero. Bank statements, vendor invoices, and internal expense reports also serve as reliable sources for extracting individual overhead cost amounts.

Once all individual overhead expenses for the chosen period are identified, the calculation process is straightforward addition. For instance, if a business has monthly rent of $2,500, administrative salaries of $6,000, and utilities of $800, the total monthly overhead would be $9,300 ($2,500 + $6,000 + $800).

Analyzing Overhead

Analyzing the total overhead figure provides valuable insights into a business’s operational efficiency and cost structure. This analysis often involves expressing overhead as a rate or ratio, allowing for comparisons over time or against industry benchmarks. These ratios help businesses understand how much of their revenue or direct costs are consumed by indirect expenses.

One common way to express overhead is as a percentage of sales. This ratio is calculated by dividing total overhead costs by total sales revenue and then multiplying by 100 to get a percentage: (Total Overhead / Total Sales) x 100. For example, if a business has $40,000 in monthly overhead and $100,000 in monthly sales, its overhead is 40% of sales. This indicates how much of each sales dollar goes towards covering indirect operating expenses.

Another useful ratio is overhead as a percentage of direct costs. The formula for this is (Total Overhead / Total Direct Costs) x 100. Direct costs typically include direct labor and direct materials, which are expenses directly tied to producing a product or service. This ratio illustrates how much overhead is incurred for every dollar spent on direct production, providing a perspective on the burden of indirect costs on production activities.

Interpreting these ratios is important. A lower overhead ratio generally suggests greater efficiency in managing indirect expenses. While there is no universal “ideal” overhead ratio, as it varies significantly by industry, comparing a business’s current ratios to its historical performance or to average ratios within its industry can highlight areas for potential improvement.