How to Include Overhead Costs in Your Pricing

Overhead costs are business expenses not directly tied to creating a specific product or service but necessary for business operation. Accurately accounting for these costs is important for sustainable and profitable pricing. Ignoring or miscalculating overhead can lead to underpricing, resulting in financial losses. Including all costs in pricing ensures every sale contributes to financial health.

What Overhead Is

Overhead costs are expenses incurred regardless of production volume, meaning they must be paid even if no products are made or services are rendered. Common examples include rent for office or factory space. Utilities like electricity, water, and internet also fall into this category. Administrative salaries for office staff, human resources, or management are another significant overhead component.

Insurance premiums, covering general liability, property, or employee health, are also indirect costs. Office supplies, from pens to cleaning materials, are consumed in general business operations. Marketing and advertising expenses, which promote the business as a whole, are also considered overhead. Depreciation on assets like equipment or buildings also reflects overhead.

Determining Total Overhead Costs

Identifying and totaling all overhead costs is foundational for accurate financial management. This involves tracking indirect expenses over a specific accounting period (e.g., month, quarter, or year). Businesses can refer to various financial records to gather these figures.

Accounting software often categorizes expenses, simplifying report generation. Bank and credit card statements provide records of payments for rent, utilities, insurance, and other services. Invoices for office supplies, maintenance, or administrative services also contribute. Ensure all expenses not directly tied to materials or labor are included in this total.

Distributing Overhead to Products or Services

Once the total overhead costs for a period are determined, the next step involves allocating these indirect expenses to individual products or services. This allocation ensures that each item or service bears a fair share of the overall business costs. The choice of allocation method depends on the nature of the business and what drives its overhead expenses. Using a predetermined overhead rate helps distribute these costs consistently.

One common approach is Per Unit Allocation. This method divides the total overhead cost by the total number of units produced or sold in the period. For instance, if a business has $10,000 in total monthly overhead and produces 1,000 units, each unit would be allocated $10 in overhead ($10,000 / 1,000 units).

Another method is Labor Hour Allocation, used when direct labor hours significantly influence overhead. To apply this, the total overhead is divided by the total direct labor hours worked during the period. If the total monthly overhead is $20,000 and employees worked 800 direct labor hours, the overhead rate would be $25 per labor hour ($20,000 / 800 hours). Consequently, a product requiring 2 direct labor hours would be allocated $50 in overhead ($25 2 hours).

For businesses driven by direct material costs, the Direct Material Cost Percentage method is effective. This involves calculating overhead as a percentage of the total direct material costs. For example, if total overhead is $15,000 and total direct material costs are $100,000, the overhead rate is 15% ($15,000 / $100,000). A product using $50 in direct materials would then be allocated $7.50 in overhead ($50 15%).

Finally, the Sales Revenue Percentage method allocates overhead based on a proportion of sales revenue. This approach divides total overhead by total sales revenue for the period and expresses it as a percentage. If a business has $25,000 in monthly overhead and $250,000 in sales, the overhead rate is 10% ($25,000 / $250,000). A product generating $100 in sales revenue would therefore be allocated $10 in overhead ($100 10%).

Applying Overhead in Your Pricing Structure

Integrating allocated overhead costs into your pricing structure is a fundamental step to ensure profitability. After determining the overhead cost for each product or service, this amount is combined with the direct costs of production. Direct costs typically include the raw materials used and the direct labor involved in creating the product or delivering the service. Summing these figures provides the total cost per unit or service.

A common pricing strategy that incorporates all costs is Cost-Plus Pricing. With this method, a desired profit margin is added to the total cost to arrive at the final selling price. For example, if a product has direct costs of $30 and an allocated overhead of $10, its total cost is $40. If the business aims for a 25% profit margin, it would add $10 ($40 0.25) to the total cost, resulting in a selling price of $50. This approach ensures that both direct expenses and a portion of the overall operational expenses are covered, along with the intended profit.

Break-even analysis helps determine the sales volume needed to cover all expenses, meaning the point at which the business neither makes a profit nor incurs a loss. Recognizing how overhead contributes to total cost is basic to identifying minimum sales for operations. This understanding allows businesses to set prices that support financial viability and growth.