Overheads are the expenses required to run a business, whether it is a product that is in high demand or a product that is rarely made. A reliable record of your overheads will help you offer a better price for your product or service, identify where you can save money, and identify ways to optimize your business model. However, these benefits only come with careful bookkeeping, so read on to find the best way to calculate your business overhead.
They are also known as indirect costs. Indirect costs include things like rent, administrative staff, repairs, equipment, and distribution costs that are necessary for your business operations and must be paid on a regular basis. Indirect costs such as postage and insurance are necessary to run a business but not to manufacture a product.
This cost will vary depending on the demand for your product and the market price of the materials. For example, if you open a bakery, your direct costs are wages and ingredients. If you’re running a health clinic, it’s doctors’ salaries, stethoscopes, etc. The most common direct costs, as illustrated above, are salaries and supplies. Put simply, the direct costs pay for things on the assembly line, while the indirect costs pay for the assembly line.
While you can use any timeframe of your choice, most companies bill by month. Be consistent with your time frame – if you calculate indirect costs monthly, then you must also calculate your direct costs monthly. Using a computer program like QuickBooks, Excel, or Freshbooks can be useful for keeping your list organized and accessible. Don’t worry about which output goes where just yet. You need a complete picture of your expenses before you can calculate overhead.
All businesses have inevitable expenses, including taxes, rent, insurance, license fees, utilities, accounting and legal services, administrative staff, premises maintenance, etc. Don’t neglect anything! Check past expense reports and receipts to make sure you’re not missing anything. Don’t forget about recurring expenses like license renewals or application costs that don’t occur regularly. They still count as overhead.
If you are a new or aspiring entrepreneur, you will need to do thorough research into the cost of supplies, labor and possible overhead. If you have old ledgers, you can use them to plan next year’s expenses. Unless you’re making big changes to your business plan, it’s often the same numbers. Average the old costs over 3-4 months to account for statistical deviations.
Every business is different, and you may need to make judgments about certain expenses. For example, while legal costs are typically considered overhead, if you run a law firm they have a direct impact on production. If this still confuses you, think of overhead as the cost you would still have to pay if you stopped producing anything. What keeps your business running every day? Always update this list as new issues come up.
That’s the amount of money you need to stay in business. In our example, the annual overhead is €16,800. Knowing this number is crucial for creating a business plan.
The overhead rate tells you how much your company spends on overhead and how much on manufacturing a product. To calculate the overhead rate: Divide the indirect costs by the direct costs. In our example, the overhead rate, expressed in decimal notation, is 0.35 (16,800 / 48,000 = 0.35). Multiply this number by 100 to get the overhead percentage. In this case that is 35%. That means your company spends 35% of its money on legal fees, administrative staff, rent, etc. for every product it produces. The lower the overhead rate, the greater your profit. A low overhead rate is good!
Assuming that all similar companies have roughly the same direct costs, companies with a low overhead rate will make more money selling their products. By lowering your overhead rate, you can sell your product at a competitive price and/or make higher profits.
Multiply by 100 to find the percentage of overhead used by each employee. If this number is low, it means your business is spending its overheads efficiently. If this number is too high, you may have too many employees.
Divide your overhead by the amount earned from sales and multiply by 100 to get the percentage. This is an easy way to find out if you’re selling enough goods/services to stay in business. Example: If my business sells $100,000 worth of soap monthly and it costs me $10,000 to keep the business running, then I’ll spend 10% of my earnings on overheads. The higher this percentage, the lower the profit margin.
Wondering why you’re not making a huge profit? Maybe you’re paying too much rent or you need to sell more products to cover overhead. Perhaps you are hiring too many employees and are not using your resources wisely so that they can all remain employed. Use these percentages to take a closer look at your business model and make changes accordingly. All companies pay overhead costs, but those that manage their overhead costs sensibly make a bigger profit. Nonetheless, low overhead isn’t everything. For example, if you spend money on good equipment or employee happiness, you could achieve higher productivity and higher profits.
If you’re calculating overhead for a past period, you can use actual facts and figures from the company’s records for your calculations. If you’re estimating overhead for a future period, you’ll need to use averages. For example, to calculate indirect costs in the future, you may need to examine several historical time periods and calculate the average cost for each indirect expense that will be in effect at your business during the future time period you want to estimate. Likewise, you must estimate an average value for future direct expenses, based on past records and on current numbers. For example, direct labor costs can be calculated by multiplying the average hourly wages of employees at your company by the average number of hours worked by your employees over a given period of time. The result may not be exactly what is ultimately paid in this period, but it will be a close estimate. Tracking overhead rates over time—that is, monthly, quarterly, and yearly—helps normalize for seasonal variations, customer buying patterns, and raw material availability/costs.
The steps outlined here are designed to give you a better idea of how to derive quantifiable data about a business. However, every business is different, so optimizing total costs is not an exact science.