From creating a budget to drumming up new investment, an understanding of everyday business costs will help you drive your business forward. One major component of operational costs is overhead. So, what is an overhead cost, and how do you calculate these expenses in accounting? We’ll cover the major types of overhead costs below.
What is an overhead cost?
An overhead cost is any necessary expense needed to run your business. While you can’t eliminate overhead entirely, you can reduce overhead costs. Things like business insurance, administrative costs, rent, and utilities are all overhead cost examples.
Although they are related, the overhead cost meaning differs to that of cost of goods sold (COGS). Overheads are related to the direct and indirect costs of running a business in general, while COGS relates to the cost of producing goods or providing services. While materials and labour qualify as cost of goods sold, money spent to keep the lights on for production qualifies as overhead.
It’s also important to distinguish the overhead cost meaning from operating expenses. Operating expenses is a broader category that includes both COGS and overhead. All costs associated with production and operation fall under operating expenses on the income statement.
Types of overhead cost
There are three main types of overhead cost to be aware of.
Fixed overhead costs remain the same from month to month. This category includes things like mortgage or rental payments and government fees. Your business activity may fluctuate, but fixed costs will remain the same.
Variable overhead costs will fluctuate along with your business activity. Things like legal expenses and shipping costs will be dependent on your daily operations. As activity decreases, so too will these overhead costs.
Semi-variable overhead costs sit in the middle. They might come with a base rate that’s fixed, but there’s a variable rate on top of this determined by business activity. Vehicle usage and utility costs often fall into this third category.
Overhead cost examples
Now that we’ve covered the overhead cost definition, here are some more extensive examples to illustrate each type.
Fixed overhead cost examples:
Rent and mortgage payments
Monthly cleaning services
Monthly phone plan
Fixed interest payments
Variable overhead cost examples:
Building maintenance and repair
Semi-variable overhead cost examples:
Some utility bills
Cleaning bills for services on top of regular maintenance
Your business may incur all of these costs or just a few, dependent on the type of services you provide and whether you have a brick-and-mortar location. Online or service-oriented businesses will generally have lower overhead costs.
How to calculate overhead
For accounting purposes, it’s helpful to group all of these assorted costs into categories. This helps keep costs organised on your financial statements. For example, all manufacturing costs could be grouped together, as could all administrative or research and development costs.
Tracking overhead is also important for keeping on top of business finances. Here’s how to calculate overhead:
Step 1: Track all of your overhead costs for the accounting period in question.
Step 2: Add all overhead expenses together.
Step 3: Calculate overhead rate by dividing the overhead costs by the sales during the same period.
Overhead Rate = Overhead Costs / Sales
For example, if your business had $10,000 in overhead costs this month and generated $50,000 in sales, your overhead rate would be 20% according to the formula:
$10,000 / $50,000 = .20
In other words, you spend 20 cents on overhead for every dollar earned.
The bottom line
Learning how to track, record, and calculate overhead costs holds numerous benefits for any business. You’ll be able to get a clearer sense of your profits and look for ways to tighten up overhead for greater efficiency. It’s worth looking for new ways to reduce overhead expenses, because this can increase your business’s net profit.
We can help
GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.