Overhead costs: what they are and how to calculate them

Published Monday 20 April 2026

Table of contents

• What are business overheads?
• Why overhead costs matter
• Types of overhead costs
• Why overheads in business can be confusing
• Examples of overhead costs
• 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 understand 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 every quarter or month to spot cost reduction opportunities, such as 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 your profit margins and ensure your business covers all expenses while staying profitable.

What are business overheads?

Overhead costs are indirect business expenses that keep your company running but aren't directly tied to producing goods or services. These costs support your operations without contributing to making specific products.

Most small businesses share similar overhead expenses. Common examples include:

• Rent and utilities: office space and electricity bills
• Insurance: business liability and property coverage
• Administrative costs: accounting fees and office supplies

Why overhead costs matter

Overhead costs directly impact your business profitability and cash flow. Understanding these expenses helps you set accurate prices for your products or services so you can protect your profit margins.

When you know exactly what it costs to run your business, you can make confident decisions about growth and spending. Keeping a close eye on overheads also ensures you have enough cash on hand to cover slower periods and unexpected challenges.

Types of overhead costs

Three main types of overhead costs exist, each defined by how they respond to changes in your business activity. Understanding these categories helps you budget more accurately and identify cost-saving opportunities.

Fixed overhead costs remain constant regardless of how much you produce or sell:

• rent and lease payments
• insurance premiums
• full-time employee salaries

Variable overhead costs rise and fall with your business activity levels:

• marketing and advertising spend
• office supplies during busy periods
• temporary staffing costs

Semi-variable overhead costs combine a fixed base amount with usage-based charges:

• phone plans with base rates plus usage charges
• utilities with connection fees plus consumption costs

Some businesses use a four-category system that groups overheads by function rather than behaviour. This includes production overhead, administrative overhead, selling overhead, and financial overhead. You might see this classification in accounting textbooks or when working with accountants who use activity-based costing.

Why overheads in business can be confusing

Overhead classification causes confusion because the same expense can fall into different categories depending on your business type.

A common mistake is assuming fixed costs are always overheads because you pay them regardless of production. Another is assuming variable costs are always direct costs because they change with output.

Neither assumption is always correct.

The simplest test: ask yourself whether an expense directly helps create your product or service. If the answer is no, treat it as an overhead.

Why classification matters: how you categorise expenses affects your pricing accuracy and tax reporting. The same expense type can be classified differently depending on your business:

• Factory rent: direct cost, because it's needed for production
• Office rent: overhead cost, because it supports general operations

How to classify your costs: group expenses into clear categories when doing your bookkeeping.

• Production costs: materials, direct labour, and factory equipment. Eligible businesses with an aggregated turnover of less than $10 million may qualify for the $20,000 instant asset write-off
• Administrative costs: office rent, accounting fees, and management salaries
• Development costs: research, new product design, and software development

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

Examples of overhead costs

Overhead costs vary by business, but most fall into a few common categories.

Office and administrative costs:

• rent for office space
• utilities such as electricity and internet. Small businesses can receive a 20% bonus deduction on expenditure to improve energy efficiency
• office supplies, including deductible small-value items costing $100 or less
• salaries for administrative staff

Sales and marketing costs:

• advertising and promotions
• website hosting
• salaries for the sales team

General business costs:

• business insurance
• accounting and legal fees
• bank charges

How to calculate overhead costs

Calculating your overhead rate shows how much indirect cost to add to each product or service to cover your business expenses. This rate helps you set accurate prices and understand your true profit margins.

To analyse costs in detail, you can allocate overhead costs to specific products or services using activity-based costing. This approach reveals how much each item costs in both overhead and direct labour.

The overhead rate formula:

Overhead rate = Total overhead costs ÷ Allocation measure

Total overhead costs: the sum of all your fixed, variable, and semi-variable overheads.

For expenses of $1,000 or more where goods or services aren't received in full within 12 months, you'll usually need to apportion the expense across the service period.

Allocation measure: the basis for distributing costs. Common allocation measures include:

• direct labour costs
• machine hours used
• direct material costs
• production hours

Overhead costs calculation example

Here's how to calculate your overhead rate:

1. Gather your total overhead expenses (example: $10,000)
2. Determine your direct labour costs (example: $2,500)
3. Divide total overhead by direct labour costs ($10,000 ÷ $2,500 = 4)

What this means: you spend $4 on overhead for every $1 spent on labour. Use this ratio to factor overhead into your pricing and budgeting.

Tips for reducing business overheads

Reducing overhead costs improves your profit margins and frees up cash flow for growth. The key is finding savings without compromising the quality of your products or services.

Review your expenses quarterly or monthly to spot opportunities. Here are proven strategies that work:

• Renegotiate supplier contracts: review old agreements, compare competitor pricing, and request better rates
• Optimise workspace costs: consider shared offices, co-working spaces, or remote work arrangements. Home-based businesses can claim 70 cents per hour using the ATO's fixed rate method.
• Automate routine tasks: use accounting software to streamline finances and cloud-based tools to handle data entry and reporting
• Claim tax deductions: you may be able to claim a 20% bonus deduction on technology expenditure to help digitise your small business
• Track expenses closely: monitor spending regularly and use expense tracking tools to catch cost creep early, ensuring you keep complete and accurate records for at least five years to substantiate your claims

How overheads affect the bottom line

Controlling overhead costs protects your profits by preserving the money left after production expenses.

On your profit and loss statement, overhead appears as operating costs. These are subtracted from gross profit to calculate net income. When you control overheads effectively, you have more money available for:

• reinvesting in business growth
• building emergency cash reserves
• paying owners or shareholders
• expanding operations or services

Calculate your overhead costs and include them in your budget. When setting prices, factor in both production and overhead costs to protect your profit margins.

With Xero Inventory, you can analyse stock management and identify your most and least profitable product lines.

Why you should regularly review and adjust overhead costs

Review your overheads every quarter or month to keep costs in check and avoid cash flow problems.

When managing cash flow carefully, consider reducing discretionary overheads like subscriptions or non-essential services. Regularly managing your overheads helps you build stronger emergency funds and prepare for economic challenges.

Keep an eye on overhead costs, especially if you run your business on tight margins. Manage your overheads as part of 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

Understanding your overhead costs protects your profit margins and supports sustainable growth.

Track your overhead expenses, manage stock, and monitor your financial health in one place with Xero Accounting. Get one month free to try Xero Accounting.

FAQs on overhead costs

Here are answers to common questions about overhead costs.

What is the difference between overheads and operating expenses?

Operating expenses include all costs to run your business, while overheads are specifically the indirect costs that support operations rather than production. All overheads are operating expenses, but not all operating expenses are overheads.

How can you reduce overheads without compromising quality?

Focus on efficiency rather than cutting everything equally. Negotiate better supplier rates, automate repetitive tasks, and review subscriptions for services you no longer use. Prioritise essential overheads and scale back discretionary spending like team events when managing cash flow carefully.

What is overhead cost with example?

Overhead costs are indirect expenses that support your business operations without being tied to specific products or services. Examples include office rent, business insurance, and utility bills.

What are the 4 types of overhead?

The four functional types of overhead are:

• Production overhead: indirect manufacturing costs like factory utilities and equipment maintenance
• Administrative overhead: general office costs like management salaries and accounting fees
• Selling overhead: costs related to sales and marketing like advertising and commissions
• Financial overhead: costs of managing money like bank fees and interest payments

This functional classification differs from the behavioural classification (fixed, variable, semi-variable) covered earlier.

What is not included in overhead costs?

Direct costs are not overhead. These include expenses you can trace directly to a specific product or service, such as:

• raw materials used in production
• wages for workers who make the product
• packaging for finished goods

Disclaimer: Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.