Overhead Costs in Business: Types and Examples

For most small businesses, reducing overhead costs is a good way to help deliver better profit margins. But before reducing overheads, business leaders should understand what they are and how they relate to business efficiency. 

Read on to find out what overhead costs are, how to calculate them, and how to identify potential reductions that could help boost the bottom line. 

What Are Overhead Costs? 

Overhead costs are all the costs a business incurs that aren’t directly involved with producing goods or services. Different types of businesses incur different overhead expenses. For example, a manufacturer’s overhead includes the cost of its accounting team, but excludes direct costs to make the products, such as raw materials and direct manufacturing labor. At a professionals services firm, the salaries of the accountants who serve clients are direct costs, while the rent on the office building are considered overhead.

Although every business has different overheads, some common overhead costs include:

• Office rental
• Business insurance
• Administrative salaries
• Professional services 
• Utilities
• Travel

What Are the Different Types of Overheads? 

There are three main types of overhead costs: fixed, variable, and semi-variable. These categories reflect how the cost is tied to the output of a business’s goods or services.

Fixed Costs 

A fixed cost is one that remains steady, regardless of whether the business is delivering one unit or 100,000 units. Examples include rent, business insurance, or salaries. These overheads can be easier to budget for, as they do not typically fluctuate from one financial period to the next. However, higher fixed costs can create a larger and less flexible cost burden that must be covered before a business makes a profit.

Variable Costs 

Variable costs are proportional to business activity. While administrative staff salaries are a fixed cost since they must be paid regardless of output, some types of labor costs can be classified as variable. For example, hourly wages, freelance sub-contracted labor wages, workers who only get paid commission, and overtime wages are all considered variable costs because these costs are dependent on production and sales. Other variable costs include business-related travel, shipping to customers, and utilities. 

By their nature, variable costs may go down as business activity declines, but that’s not a desired outcome. Increasing profitability by trimming variable overhead costs tends to require changes in methods or increases in efficiency. For example, during periods of rising utility prices, companies may want to monitor energy overheads to find areas to cut costs, such as investing in more efficient office electronics, lighting options, or heating and cooling systems. Another option may be to consider a hybrid employee model in which employees work from home for part of the week, thereby cutting utility costs. 

Semi-variable Costs 

A semi-variable overhead cost has a fixed component and a variable component. For example, a business phone plan may have a fixed monthly price, but if workers on a business trip exceed the allotted data limit, extra costs may incur. Another example would be a business requiring extra cleaning services above the standard monthly cost – perhaps after a large conference, for instance. 

By regularly tracking changes in overhead, both as raw figures and allocated to other business metrics like sales revenue, decision makers can quickly spot troubling trends. 

Examples of Overhead Costs 

Different companies can have different overheads depending on the nature of their industry and work. 

Let’s look at Consultologists, a hypothetical consulting firm that provides writing and marketing services to clients in scientific and technical communities. The company’s main overheads are rent, utilities, and office equipment. Recently, Consultologists faced a significant increase in overheads because of a rise in rent costs. Due to the highly competitive industry in Consultologists’ region, it could not pass these higher costs onto customers without losing business, so decision makers were forced to look for areas to reduce overhead. 

To solve this problem, Consultologists relocated to a shared office space, complete with furniture and an “all-in” fee that included utilities, energy, and rent all in one lower monthly payment than before. Not only does the company now have more affordable month-to-month expenses, but more predictable expenses that make it easier for the financial team to budget and forecast.

How to Calculate Overhead Costs 

To calculate overhead costs, try to start by making a list of all indirect business expenses for the given financial period, usually a year, by combing through the company’s accounts payable disbursements and bank accounts. Try to be sure to include all fixed, variable, and semi-variable overhead costs.

To find your average monthly overhead, add all overhead costs for the year and divide that number by 12. 

How to Calculate Overhead Cost Per Unit 

Many businesses express overhead costs as “per unit” by comparing overhead expenses with production volume. This figure is often used to inform pricing strategies and production schedules. This overhead cost per unit is a blended standard of historical fixed, variable, and semi-variable costs and is especially useful for budgeting and forecasting.

Say a furniture company makes and sells $100 tables. Its direct costs (raw materials, manufacturing, design, labor) are $30 per table, yielding a $70 direct profit. However, to get a more holistic measure for the overall costs of running the business, the business should calculate the overhead cost of each unit produced. 

The formula to calculate overhead cost per unit is: 

Overhead Cost Per Unit = Total Overhead Cost / Number of Units Produced

Let’s say the furniture company has annual overheads of $50,000 and during that period produces 10,000 tables. The overhead cost per unit would be the total overhead cost ($50,000) divided by the number of units (10,000 tables), yielding a $5 overhead cost per unit. The business can then calculate the true cost of producing each table by adding each unit’s direct costs ($30) and its overhead costs ($5) to get a total of $35. This means a more realistic profit for each table is $65 ($100 – $35). 

How to Calculate Overhead Cost Per Employee 

In some industries, companies might want to calculate the overhead cost per employee, perhaps to make staffing decisions, analyze team profitability, set prices, or make budgeting decisions.

A simple way to do so is to add together all overhead costs for a certain period. Then divide the total overhead for that period by the number of employees. 

For example, let’s say a service business has a total overhead cost of $50,000 per month and 10 employees. The overhead cost per employee would be $5,000 ($50,000 / 10 employees). The business can use this figure to determine whether it makes sense to hire another employee – if the costs outweigh the benefits in terms of productivity and revenue generation, for instance, it may not be worth it. While overhead cost per employee can be a useful figure on its own, it’s important to consider it in combination with direct costs for the same period to help get a more comprehensive view of your business’s financial situation.

What Is the Overhead Rate? 

The overhead rate is a metric most often used to measure overhead expenses as a percentage of sales revenue. The overhead rate is important for budget planning and to identify if overheads are eating into sales revenue.

By tracking overhead rates over time, businesses can quickly catch increases when they start cutting into margins. For example, if a business notices that its overheads increased from 20% to 30% of sales revenue over a few months, it can take steps to identify why and then find ways to trim costs or increase sales before that percentage climbs higher.

How to Calculate Overhead Rate 

To calculate the overhead rate, divide the overhead cost by sales and multiply by 100. 

Overhead Rate = (Total Overhead Costs / Total Sales) x 100

For example, say an ice cream factory makes $325,000 in monthly sales revenue. For the same monthly period, its overhead costs total $175,000. This means the ice cream factory’s overhead rate is 54% ($175,000 / $325,000 x 100 = 54%). In other words, the company is spending $0.54 on overhead for every $1 in sales. 

The Bottom Line

Overheads may rarely stay exactly the same month to month, especially for businesses with many variable costs. But by regularly tracking changes in overhead, both as raw figures and allocated to other business metrics like sales revenue, decision makers can quickly spot troubling trends. This proactive approach can make it easier to reduce overhead costs when needed, helping to maximize profits.

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