Overhead Cost and How to Calculate It

What is overhead?

A business’s overhead is its fixed expenses of operations that aren’t directly related to production and, therefore, don’t vary with output. In other words, if your business stopped production for a day, you would still have to pay overhead costs to keep the business open. These include expenses such as rent, utilities, insurance and salaries for administrative personnel.

Overhead is a significant aspect of solid accounting, for several reasons. First, it reflects costs that a business can’t avoid simply by slowing or stopping production. Second, determining overhead costs is necessary to establish your business’s break-even point. Specifically, you can factor those overhead costs into the prices you set for your goods and services to ensure you aren’t selling your items at prices where you are losing money.

Understanding your overhead expenses is also essential because it is one of the most significant sources of cost savings for companies looking to streamline operations. To reduce your overhead expenses, you should regularly review your bills for services such as electricity and internet to see if better deals are available.

What is fixed and variable overhead?

When people talk about overhead, they’re typically referring to fixed overhead. This includes things such as business insurance and rent — expenses that remain constant regardless of your production or sales.

However, some expenses are considered variable overhead. These are costs directly related to production, such as raw materials for production and utility costs for running equipment.

The biggest difference is that fixed overhead costs must be paid regardless of whether the company produces or sells anything. This is where you can find ways to be more efficient and increase profits. However, both types of costs are necessary for your business to produce and sell products, and you need to calculate both to determine your business’s profitability point.

Types of overhead costs

Office supplies, property taxes, and professional services such as accounting and legal advice are also overhead costs. These can vary by industry, company size and other factors.

You also must be aware of what is excluded from overhead costs — not just variable production costs but also expenses for investment in assets, such as the cost of renovating your business facilities. These aren’t fixed costs; they are one-time expenses that help to increase the value of your business.

How to calculate overhead costs

To calculate overhead expenses, first you need to identify all of your fixed costs that aren’t directly related to production. Once you’ve identified all relevant costs, you total them.

Fixed Facilities Cost + Utilities + Licensing + Insurance + Sales and Marketing Costs + Administrative Fees = Overhead

Note what’s excluded from the formula above, especially expenses such as labor for production, which is a direct cost tied to production and not included in company overhead.

Of course, this is typically a lot easier to do with accounting software, which can help you identify relevant expenses and total them automatically over various periods.

Calculating overhead is also crucial for planning your budget. If you don’t understand your total fixed costs, it’s difficult to accurately forecast company revenue and expenses or make key decisions about investing in the future growth of your business.

How do you allocate overhead costs?

Allocating overhead costs means breaking down total overhead costs by hour or unit. In other words, you divide your total overhead cost so you can see exactly how much cost is tied to each individual unit of time or production.

(Fixed Facilities Cost + Utilities + Licensing + Insurance + Sales and Marketing Costs + Administrative Fees) ÷ Hours or Units of Production = Overhead per Unit

As with calculating total overhead, allocating overhead is easier with the right tools; it is a common feature of accounting software.

Why allocating overhead is important

By allocating your overhead costs, you can see how much profit (above and beyond your variable production cost) has to be produced per unit or per hour to cover fixed costs.

This process also breaks down your company’s overhead into a more tangible number; you’re tying those costs to something that isn’t so abstract, such as an hour of labor. Once overhead is laid out this way, its importance is easier to recognize, as it shows exactly how much your business needs to make per unit just to cover fixed costs.

Most importantly, allocating overhead helps keep costs in line. It also clearly demonstrates the importance of identifying efficiencies — finding ways to cut costs and increase profits.

The best accounting software for calculating and managing overhead costs

Accounting software makes it much easier to calculate and manage your overhead costs. Here are some of our picks for the best platforms for doing so.

Intuit QuickBooks

QuickBooks is full-featured accounting software that quickly calculates overhead costs. QuickBooks lets you classify overhead expenses as indirect material, such as office supplies; indirect labor, such as administrative salaries; and other indirect expenses, such as rent. Alternatively, you can classify expenses by function (e.g., manufacturing, office/administrative, selling/distribution) or behavior (e.g., fixed overhead, variable overhead, semi-variable). This lets you increase efficiency in different areas of your business and plan for lean times. Learn more in our QuickBooks review.

ZarMoney

ZarMoney excels in its reports and data capability. It has over 40 built-in reports and can create dozens of customized options. In addition, ZarMoney separates overhead expenses from the cost of goods and allows you to track overhead costs over time. Advanced inventory features make it easier to get warehousing that is just the right size to keep that cost low. Learn more in our review of ZarMoney.

FreshBooks

FreshBooks easily calculates overall overhead expenses, and it also lets you look at it from a variety of perspectives. For example, you can calculate the overhead absorption rate by direct material cost, direct labor cost, labor hours, machine hours or sales price. You can spot and correct inefficiencies by assessing overhead costs with these different methods. For instance, when using the labor cost method, you can decide if bringing on a new employee will be a good way to increase profits. FreshBooks allows you to categorize overhead expenses and easily enter new expenses through digital receipt scanning and mileage tracking. Learn more in our FreshBooks review.

Jennifer Dublino contributed to this article.