What are overheads?
Overhead costs are all the costs your business incurs whether or not you are actively producing anything.
While direct costs relate to expenses that are incurred when delivering a product or service, overhead costs are things your business pays for, regardless of whether you’re delivering one unit or 100,000 units.
A list of common overhead costs are:
- Office rental
- Business insurance
- Salaries
- Professional services (e.g. accounting)
- Utilities
- Travel
- Equipment
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What are the different types of overheads?
There are three main types of overhead: fixed costs, variable costs, and semi-variable costs.
Fixed costs
A fixed cost remains steady, regardless of your business activity. Examples include office rentals, business insurance, salaries, or accounting services.
Variable costs
While staff salaries are a fixed cost, since they must be paid even if the office shuts down, freelance sub-contracted labour is considered a variable cost because it can be removed completely if production stops. Other variable costs include travel, equipment or vehicle maintenance and energy bills.
Companies need to monitor and understand their overheads, particularly those that fluctuate and rise over time (like the cost of energy, for example).
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Semi-variable costs
A semi-variable overhead cost usually has a fixed component and a variable component. For example, a phone plan has a fixed monthly component, but if you exceed the number of calls allowed on your plan, you incur a variable extra cost. Another example would be if you need to pay for extra cleaning services over and above your standard monthly cost, due to extra work being carried out.
Overhead costs vs expenses
Overhead costs typically include indirect expenses like rent and utilities, supporting overall operations. Expenses cover both direct and indirect costs, encompassing overheads along with direct costs like materials and labour, impacting the bottom line.
Examples of overhead costs
Different companies will have different overheads depending on the nature of their industry and company.
42 Group is a consulting firm that provides writing and marketing services to clients in the scientific and technical communities. The company’s main overheads are rent, utilities, and office equipment, says managing director Lawrie Jones.
Recently, 42 Group was presented with a significant increase in overheads because of an increase in rental costs. “The increase was well above the rate of inflation and would have had an impact on overhead costs and tipped us into paying business rates," says Jones. "We didn’t feel that we could absorb that cost, but we couldn’t pass it on to customers.”
Instead, 42 Group moved from a private rented office into a managed workspace. This reduced overheads by offering a lower monthly rent figure, but also by providing an 'all in' fee that included utilities, energy and rent in a single, lower figure. “It gave us a very clear ceiling to our overhead costs which ensured we didn’t spend too much and put our profitability at risk,” says Jones.
How to calculate overhead costs
“It’s critically important that you know all of the costs in your business, not just those associated with sales,” says Frances Fawcett, an SME board advisor with Fawcett Management. “If you don’t understand your overhead costs, the risk is that you go through a quiet period and spend less on direct costs, but you’re still paying high overheads associated with rent or heating.”
To calculate overhead costs, start by making a list of all of your business expenses, including allowable expenses, and then highlight those costs that don't rise or fall with the production of goods or services. Now, total these highlighted expenses (it’s typical to calculate overheads over a 12-month period, which gives you an annual total). Dividing this number by 12 provides an average figure for monthly overheads over a year.
How to calculate overhead cost per unit
Many businesses express overhead costs as 'per unit'.
For example, if your company is making tables, the direct costs (raw materials, manufacturing, design, retail) might be £30 for a £100 table. Although this might look like a 70% profit margin, the business needs to account for the overhead costs when calculating profit margins. The formula to calculate overhead cost per unit is:
Overhead Cost Per Unit = Total Overhead Cost / Number of Units Produced
In other words, if your business has annual overheads of £50,000 and during that period produces 10,000 tables, then the overhead cost per unit would be the total overhead cost (50,000) divided by the number of units (10,000) giving an overhead cost per unit of £5.
The business can then calculate the true cost of producing its tables to be £35, meaning the profit margin on a £100 table is 65%.
How to calculate overhead cost per employee
In some industries, companies might want to calculate the overhead cost per employee. For example, a service company might base the price of its consulting on the total cost of providing one, two or more employees for a set number of days or weeks.
The calculation for overhead cost per employee involves adding together all overhead and labour costs for a certain period (including salary, health and other benefits, holiday pay, and pension), and dividing that by the number of employees.
Let’s say your business has a total overhead cost of £50,000 per month and 10 employees. Your overhead cost per employee = £50,000 / 10 = £5,000.
What is overhead rate?
Overhead rate is most often used to measure how much money a business is spending on overheads as a percentage of sales. However, it can also be used to express overheads as a proportion of other business costs, such as labour costs or machine hours.
The overhead rate is important in helping to plan budgets, and also to identify if the overheads are becoming an increasing proportion of sales. “If you were spending 20% of sales on overheads, but that suddenly increases to 30%, then you know that you need to take steps to reduce overheads,” says Fawcett. “For example, you might reduce office overheads by switching to remote working, or implement energy-saving policies to cut the cost of energy bills.”
Overhead rate formula
To calculate the overhead rate, a business would divide the overhead cost by sales and multiply this by 100.
Overhead Rate = Total Overhead Costs / Total Sales x 100
For example, an ice cream factory might have total overhead costs of £175,000 per month. For the same period, sales are £325,000. The ice cream factory would calculate the overhead rate as follows: £175,000 / £325,000 = 0.54 X 100 = overhead rate = 54%. This means the company is spending 54p on overheads for every £1 in sales.
It’s useful to track the overhead rate formula throughout the year, advises Fawcett. “Your percentage will fluctuate depending on seasonality and the level of business.
You need to look at that whole picture across the year so you don’t just understand direct costs, but you know what percentage of expenses related to overheads have to be covered by your profit margin.”
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