Overhead costs: How they work and how your small business can manage them

Published Wednesday 26 November 2025

Table of contents

• What are business overheads?
• Types of overhead costs
• Why overheads in business can be confusing
• Examples of overhead costs
• Other categories of business expenses
• How to calculate overhead costs
• Tips for reducing business overheads
• Manage your overheads with ease
• FAQs on overhead costs

Key takeaways

• Calculate your overhead rate by dividing total overhead costs by an allocation measure (such as direct labour costs or machine hours) to determine how much indirect cost to add to each product or service for accurate pricing.

• Classify expenses by asking whether they directly help create your product or service—if not, treat them as overhead costs to ensure proper financial categorisation and budgeting.

• Review your overhead expenses quarterly or monthly to identify cost reduction opportunities through renegotiating supplier contracts, optimising workspace costs, and automating routine tasks without compromising quality.

• Include overhead costs in your pricing strategy alongside production costs to protect profit margins and ensure your business covers all expenses while remaining profitable.

What are business overheads?

are business expenses that aren't directly tied to producing your goods or services. These indirect costs keep your business running but do not contribute to making specific products.

Common overhead costs include the following:

• Rent and utilities: Office space and electricity bills
• Insurance: Business liability and property coverage
• Administrative costs: Accounting fees and office supplies

Types of overhead costs

Overhead costs fall into three main categories based on how they change with your business activity:

Fixed overhead costs stay the same regardless of production levels:

• Rent and lease payments
• Insurance premiums
• Full-time employee salaries

Variable overhead costs fluctuate with your business activity:

• Marketing and advertising spend
• Office supplies during busy periods
• Temporary staffing costs

Semi-variable overhead costs have both fixed and variable components:

• Phone plans with base rates plus usage charges
• Utilities with connection fees plus consumption costs

Some businesses also use a four-category system that groups overheads by function: production overhead, administrative overhead, selling overhead, and financial overhead.

Why overheads in business can be confusing

Each business may define overheads differently, which can cause confusion. Many people assume that fixed costs are indirect overheads because you pay them whether you produce anything or not.

Similarly, variable costs are often assumed to be direct – as the costs of production tend to go up and down depending on how much is being produced – and therefore not an overhead. However, it isn't always that clear cut.

Ask yourself: does this expense directly help create your product or service? If not, treat it as an overhead.

Why classification matters:The same expense can be classified differently depending on your business type:

• Factory rent: Direct cost (needed for production)
• Office rent: Overhead cost (supports general operations)

How to classify your costs:Group expenses into clear categories during accounting:

• Production costs: Materials, direct labour, factory equipment
• Administrative costs: Office rent, accounting fees, management salaries
• Development costs: Research, new product design, software development

This approach helps you calculate your overhead rate more easily and accurately.

Examples of overhead costs

Overhead costs vary, but most fall into a few common categories. Here are some examples:

• Office and administrative costs: Rent for office space, utilities like electricity and internet, office supplies (which can include deductible small-value items costing $100 or less), and salaries for administrative staff.
• Sales and marketing costs: Advertising, website hosting, and salaries for the sales team.
• General business costs: Business insurance, accounting and legal fees, and bank charges.

Other categories of business expenses

Overhead expenses are just one category of business costs. To avoid confusion, use these categories in the right context:

1. Cost of Goods Sold (COGS) : these are direct costs tied to producing goods/services.
2. Sales and General Administration (SG&A): these are operational costs not directly linked to production.
3. Depreciation and Amortisation: this accounts for the decrease in value of assets over time. For example, eligible businesses may be able to claim a $20,000 instant asset write-off in the 2023–24 and 2024–25 income years.
4. Interest: the costs associated with borrowing funds.
5. Income Taxes: the taxes on your business earnings.
6. Miscellaneous: small, irregular expenses that don't fit into other categories.

How to calculate overhead costs

Typically, overheads relate to your business as a whole. However, to get a true cost analysis of your products, you might want to allocate overhead costs to specific areas. For instance, you could use activity-based costing to allocate specific overhead expenses to your service or product. This helps you see how much each product or service costs in overhead and direct labour.

Calculating your overhead rate shows how much indirect cost you need to add to each product or service to cover your business expenses.

The overhead rate formula:Overhead rate = Total overhead costs ÷ Allocation measure

What each part means:

• Total overhead costs: Sum of all your fixed, variable, and semi-variable overheads
• Allocation measure: The basis for distributing costs, such as:

Overhead costs calculation example

Here's how to calculate your business overhead costs.

Let's say your company has overhead expenses that come to $10,000 for the latest financial period and you want to know how the overhead costs relate to labour costs. Within this same period, you had labour costs amounting to $2,500.

To find the overhead rate, divide $10,000 (indirect costs) by $2,500 (direct costs), which equals four.

This means you spend four dollars on overhead for every dollar spent on labour.

Tips for reducing business overheads

Reduce overhead costs to improve your profit margins and cash flow. Review your expenses regularly to find savings without lowering quality.

Proven cost reduction strategies:

• Renegotiate supplier contracts: Check old agreements, compare competitor pricing, and negotiate better rates.
• Optimise workspace costs: Try flexible options like shared offices, co-working spaces, or remote work. If you work from home, you can claim 70 cents per hour for running expenses using the ATO's fixed rate method.
• Automate routine tasks: Use technology to reduce manual work and costs. You can use accounting software to streamline your finances and cloud-based tools to automate data entry and reporting.
• Track expenses closely: Monitor your spending to spot unnecessary purchases. Use expense tracking tools to catch cost creep before it affects your profits.

How overheads affect the bottom line

High overhead costs reduce your business profits by lowering the amount left after production expenses.

Overhead expenses appear on your profit and loss statement as operating costs. They're subtracted from your gross profit (along with other operating expenses) to calculate your net income.When overhead costs are too high, you have less money available for:

• Reinvesting in business growth
• Building emergency cash reserves
• Paying owners or shareholders
• Expanding operations or services

To do this, learn how to calculate your business's overhead costs and include them in your budget. When you set your prices, consider both production and overhead costs to make sure you earn a profit. Including overheads in your pricing helps you protect your profit margins.

You can analyse your stock management and see your most and least profitable lines with Xero Inventory.

Why you should regularly review and adjust overhead costs

To stay on top of your overhead expenses, you'll need to review them regularly for savings – such as cutting back on staff benefits – and avoid financial pitfalls like negative cash flow.

Review your overheads every quarter or month to keep costs in check. You can also reduce 'nice-to-have' overheads to ease financial stress.

Factoring in overhead expenses helps you build stronger emergency funds and prepare for economic challenges. Managing overhead costs helps you maintain positive cash flow and support your business growth over time.

Keep an eye on overhead costs, especially if you run your business on tight margins. Include overhead management in your cost control strategies from the start to help your business thrive.

Find out more about budgeting and financial forecasting.

Manage your overheads with ease

Financial management is crucial for small businesses. Get a handle on your overhead costs to protect your profit margins.

With Xero Accounting, you can track overhead expenses, manage stock, and monitor your business's financial health. This helps you keep overheads low and sales high.

FAQs on overhead costs

Below are answers to common questions about overhead costs and how they affect your business.

What is the difference between overheads and operating expenses?

Overheads are a subset of operating expenses.Operating expenses include all costs to run your business, but overheads are the indirect costs that support your operations rather than production.

How can you reduce overheads without compromising quality?

When you cut overhead expenses, focus on efficiency and smarter spending. For example, negotiate better rates with suppliers, use technology to automate tasks, and optimise energy use to lower your bills.

Stay on top of your overheads to budget well. Focus on the core costs you need to run your business, and manage 'nice-to-have' overheads like team lunches or energy bills when your finances allow.

Find out more about effective cost cutting.

What is overhead cost with example?

Overhead costs are fixed operating expenses not linked to a product or service. These include regular expenses your business needs to operate, such as:

What are the 4 types of overhead?

Overhead costs usually fall into four categories: production, administrative, selling, and financial overhead. Each covers a different part of your business's indirect costs and may include fixed, variable, and semi-variable costs.

What is not included in overhead costs?

Costs directly related to making and selling a product are not overhead. These include labour, materials, and production costs you can trace to your product or service.