Overhead costs: What they are and how to manage them

Published Saturday 31 January 2026

Table of contents

• What are business overheads?
• Common overhead cost examples
• Types of overhead costs
• Why overheads in business can be confusing
• 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 indirect costs by your allocation measure (like direct labor costs) to understand the true cost of each product or service and set profitable prices.
• Classify overhead costs into fixed, variable, and semi-variable categories to better understand how they change with business activity and plan your budget accordingly.
• Review overhead expenses regularly through quarterly or monthly assessments to identify cost-cutting opportunities like negotiating supplier contracts, exploring flexible workspaces, and automating tasks with technology.
• Include overhead costs in your income statement calculations and pricing decisions to protect profit margins and ensure your products or services are priced to cover both direct production costs and indirect business expenses.

What are business overheads?

Overhead costs are business expenses not directly tied to producing goods or services. These indirect costs keep your business running but don't contribute to creating your product. Common examples include rent, insurance, utilities, and administrative salaries.

Common overhead cost examples

Overhead costs vary by industry, but some are common across most businesses. These are the ongoing expenses required to operate, separate from the direct costs of creating your product or service.

• Rent and utilities: Payments for your office, factory, or retail space, plus electricity, water, and internet.
• Administrative salaries: Wages for employees not directly involved in production, such as receptionists, accountants, and human resources staff. For tax compliance in Canada, you must report each salary on a T4 or T4A slip by the end of February.
• Insurance: General liability, property, and workers' compensation insurance.
• Office supplies: Items like paper, ink, pens, and other stationery.
• Marketing and advertising: Costs to promote your business that aren't tied to a specific sale. The deductibility of these costs can vary; for instance, advertising directed to a Canadian market may be fully deductible if it meets certain content criteria.
• Professional fees: Payments for legal, accounting, or consulting services

Types of overhead costs

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

• Fixed overheads: Costs that stay the same regardless of production levels, such as rent or office salaries
• Variable overheads: Expenses that fluctuate with business activity, like marketing spend or office supplies during busy periods
• Semi-variable overheads: Costs with both fixed and variable components, such as phone plans with base rates plus usage fees

Why overheads in business can be confusing

Classifying overheads can be confusing because businesses categorize costs differently. Many assume fixed costs are always overhead expenses since you pay them regardless of production.

Similarly, seem like direct costs because they change with production levels. However, this classification isn't always straightforward.

Classification depends on your business type:

• Factory rent: Direct cost because it's essential for production
• Office rent: Overhead cost because it supports general business operations

The same expense can be classified differently depending on its role in your business.

Overhead classification depends on your business type and structure. The key principle: overheads are indirect costs not related to producing your goods or services.

Streamline how you classify costs by grouping them into categories:

• Manufacturing and production expenses
• Administrative costs
• Development and research costs

This approach makes calculating overhead versus production costs much easier.

Other categories of business expenses

Business expense categories help you organize costs correctly. Here are the main types:

• Cost of Goods Sold (COGS): Direct costs for producing goods or services
• Sales and General Administration (SG&A): Operational costs not directly linked to production
• Depreciation and Amortization: Decrease in asset value over time
• Interest: Costs associated with borrowing funds
• Income Taxes: Taxes on your business earnings
• Miscellaneous: Small, irregular expenses that don't fit other categories

How to calculate overhead costs

Allocating overheads helps you understand the true cost of each product or service. While overheads typically relate to your entire business, you can allocate them to specific areas for better cost analysis.

Activity-based costing lets you assign overhead expenses to individual products or services. This shows exactly how much each offering costs in both overhead and direct labor expenses.

Calculate your overhead rate using this simple process:

Step 1: Identify all overhead expenses (fixed, variable, and semi-variable) for your product or service.

Step 2: Apply the formula: Overhead rate = indirect costs ÷ allocation measure

Key terms:

• Indirect costs: Total of your overhead expenses
• Allocation measure: Any measurement needed to make your product, such as direct labor costs, machine costs, or production hours

Overhead costs calculation example

Overhead calculation example:

Given:

• Overhead expenses: $10,000
• Labour costs: $2,500

Calculation:

$10,000 ÷ $2,500 = 4

Result: Every $1 spent on labor costs your business $4 in overhead expenses.

Tips for reducing business overheads

Regular overhead reviews are essential for financial planning. Here are proven cost reduction strategies:

• Negotiate with suppliers: Review contracts that haven't been updated recently and compare competitor prices for potential savings
• Explore flexible workspaces: Consider remote work, shared offices, or co-working spaces instead of maintaining underused office space
• Automate with technology: Use accounting software and cloud-based tools to automate tasks and reduce manual work
• Track expenses closely: Monitor spending patterns to identify unnecessary purchases and maintain healthy profit margins. Xero's expense tracking tools give you the oversight you need.

How overheads affect the bottom line

To clearly understand your business's finances, you'll need to include your overhead expenses on your income statement. You subtract overhead costs and production-related costs from your net revenue to work out your net income, also known as the bottom line.

Keeping overheads under control helps protect your bottom line, so more of your net income becomes profit. When you manage overhead expenses closely, you free up more cash to invest in and grow your business.

In order to do this, you should learn how to calculate your business's overhead costs and factor them into your business budget. For instance, when setting your product or service prices you should take into consideration both your production costs and your overhead expenses to ensure you're making a profit. Not including overheads in this equation could mean your product is underpriced, reducing your potential profit margins.

You can analyze your stock management and see your most (and least) profitable lines with Xero inventory software.

Why you should regularly review and adjust overhead costs

To stay on top of your overhead expenses, you'll need to regularly review them for potential savings, such as cutting back on staff benefits, and avoid financial pitfalls, like consistently negative cash flow. Understand the tax implications, as the Canadian government limits claims for food, beverages, and entertainment to 50% of the reasonable cost.

Implementing a quarterly or monthly review process can help you to keep overhead costs in check. Additionally, keep in mind you can decrease 'nice-to-have' overheads and alleviate some financial stress.

When you factor overhead expenses into your planning, you build stronger cash reserves and are better prepared for economic ups and downs. Day to day, overhead costs shape your cash flow. Keeping them in check makes it easier to maintain positive cash flow. Over time, managing overheads well supports a more stable and sustainable business.

Keeping an eye on overhead costs is especially helpful for small businesses, as you often operate within tight financial margins. Including overhead management as part of your cost control strategies, and accounting for overhead expenditure when you first start your business, will be important to keep your business not just afloat, but thriving.

Find out more about budgeting and financial forecasting.

Manage your overheads with ease

Effective overhead management protects your profit margins and supports business growth.

Xero accounting software helps you track overhead expenses, manage inventory, and monitor your financial health. to see how you can keep overheads low and sales high.

FAQs on overhead costs

Here are answers to some common questions about overhead costs.

What is the difference between overheads and operating expenses?

Overhead costs are a type of operating expense. Operating expenses include all costs to run your business, including direct costs like raw materials. Overheads are specifically the indirect costs that support the business but aren't tied to production.

Are salaries an overhead cost?

It depends. Salaries for employees who are not directly involved in producing goods or services, like administrative or marketing staff, are considered overhead. Salaries for production line workers are direct costs, not overhead.

How can you reduce overheads without compromising quality?

Focus on efficiency and smart spending. You can negotiate better rates with suppliers, use technology to automate tasks, and optimize energy use. Regularly reviewing expenses helps you cut non-essential costs without affecting the quality of your product or service.