How to calculate and reduce overhead costs
Calculating and reducing overhead costs is an effective way to improve your business profitability. In this guide, you'll learn about the different types of overhead costs and some examples. You'll also find a formula for calculating your overhead costs and tips for keeping them low.
What is an overhead cost?
An overhead cost is an indirect business expense. Most companies define an overhead as any essential spending not directly linked to delivering their core products or services. These costs can include rent, utilities, insurance, office supplies, marketing spend and the salaries and wages of some personnel. Business overheads won't go up or down with sales.
Why is it important to stay on top of overhead costs?
It's important to stay on top of overhead costs to maximise your profit margin. Your overheads remain constant – regardless of how much you sell, which can eat into your profit when sales are down. Equally, if you start selling more, your overheads won't go up, which is where you can add to your bottom line.
Types of overhead costs
There are three types of overhead costs – fixed, variable and semi-variable.
Fixed overhead costs
Fixed overheads are set costs you need to cover each week or month, like debt repayments, insurance, rent or staff salaries.
Variable overhead costs
Variable overhead costs fluctuate with your general business activity. For example, your variable overheads will drop if you close an office and increase if you decide to ramp up marketing. Likewise, if you increase your manufacturing output, your utilities will increase as well as your shipping and handling costs.
Semi-variable overhead costs
Semi-variable overhead costs are fixed base rates, with the flexibility to spend more if your business activity demands. You may add more HR support hours to your fixed monthly contract while you deal with a period of high staff turnover.
Examples of overhead costs
Examples of overhead costs are payroll, rent and utilities, advertising and insurance.
Payroll
Salaries and wages of administrative personnel are often considered an overhead cost because these are not changed by sales or production volumes.
Rent and utilities
Rent and utilities can account for a high proportion of your overhead costs. Keeping utility bills low by reducing consumption where possible can help improve profits.
Advertising
Advertising is considered an overhead because it is an expense not directly related to the production of goods or services.
Insurance
Insurance is often a necessary expense, but because it is also not directly related to the production of goods or services, it's considered an overhead cost.
How to calculate overhead costs
List your indirect business expenses
Listing indirect business expenses is the first step. That's because what businesses consider an overhead cost can differ. For example, one company will consider courier costs an overhead – they use couriers to keep their office ticking over. Another business might offer free expedited shipping on their online store, so couriers are a direct cost.
Total your overhead costs
Total your overhead costs by adding up what you spend on indirect costs each month.
Calculate your overhead rate
Calculate the overhead rate by dividing your total monthly overhead costs by monthly sales, then multiply by 100 to get a percentage. For example, if you spend $20,000 a month in overheads and earn $80,000 in revenue, your rate is $20,000/$80,000 = 0.25 or 25%.
You're spending 25 cents on overhead costs for every dollar you make. This doesn't mean the remaining 75 cents is pure profit – it's what's left over to cover your cost of sales, deliver your service or make your product. Or, in other words, the difference between gross and net profit.
Overhead cost formula
Overhead rate = overheads/sales
How to reduce overhead costs in your business
To reduce overhead costs in your business, it can be tempting to slash your largest expenses. However, doing so can often negatively impact your company in the long run. Instead, look at what expenses you could do without or find lower-cost alternatives. Even small savings here and there can add up quickly. Here's where to start:
Regularly track overhead costs
Regularly track your overhead costs to make sure every dollar you spend is worth it. Otherwise, you may overlook monthly spends of $50 here or $100 there on things that don't add value to your business.
Negotiate your contracts
Negotiate your contracts to get a discount or more value from your suppliers.
Optimise software subscriptions
Rather than paying for many software subscriptions and not necessarily getting full value from them, choose a scalable business management platform like MYOB. Pay for what you need and not for what you don’t.
Outsource administration tasks
Outsourcing administration tasks may seem counterproductive, but doing so may free your team to focus on value-add work or mean you can minimise your employee costs.
Embrace remote working
Embracing remote work can significantly reduce the overhead costs of running an office, from rent and utilities to coffee and cleaning supplies. With staff working remotely some or all of the time, you can downsize your office or get rid of it altogether.
Overhead costs FAQs
What is the difference between overhead costs and operating expenses?
The difference between overhead costs and operating expenses is that operating costs are what you spend on running your business day to day. Overhead costs are a subset of operating expenses that aren't affected by or linked to your sales or production.
What is considered a good overhead percentage?
A good overhead percentage depends on the kind of business and the stage it's in. For example, if your profit margins are lower, your overhead percentage should be too. Or, say your business is in a growth phase. Your overhead percentage may go way up as you wait for the investment to return an increase in sales.
What is not included in overhead costs?
Not included in overhead costs is any expenditure directly related to or affected by your sales. For example, the raw materials or parts you need to make your product, packaging to send it out or wages for staff who deliver services. What you categorise as an overhead cost will depend on your core business offering.
Lower your overheads, raise your profits
In business, overhead costs are unavoidable and often critical for long-term growth. But when overhead costs get out of hand, they can quickly eat into your profit margin. Keep an eye on overheads and avoid wasteful spending. With a business management platform from MYOB you’ll have insights and reporting built into every plan, so you can keep track of your spending. Start your free trial today.
Disclaimer: Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.