What are overhead costs? A guide for small businesses

Published Monday 8 June 2026

Table of contents

• What are overhead costs?
• Types of overhead costs
• Examples of overhead costs
• Overhead costs vs. direct costs and COGS
• How to calculate overhead costs
• How overhead costs affect the bottom line
• Tips for reducing business overhead costs
• Why you should regularly review overhead costs
• Track your overhead costs with Xero
• FAQs on overhead costs

Key takeaways

• Overhead costs are the indirect expenses of running your business that aren't tied to producing a specific product or service, such as rent and insurance.
• Knowing your overhead rate helps you set prices that cover all your costs, protect your profit margins, and avoid undercharging for your products or services.
• Overheads fall into three categories: fixed, variable, and semi-variable. Classifying them correctly gives you a clearer picture of where your money goes each month.
• Reviewing your overheads on a regular schedule, whether monthly or quarterly, helps you spot unnecessary spending and keep your cash flow healthy.

What are overhead costs?

Overhead costs are the ongoing expenses of running your business. They aren't directly tied to producing a product or delivering a service. Instead, they support your operations as a whole.

Common examples include office rent, utility bills, insurance premiums, and administrative salaries. You'd pay these costs whether you serve one customer or one hundred.

Understanding your overheads matters because they directly affect your profitability. If you don't account for them when setting prices or planning your budget, you risk underestimating your true cost of doing business.

Types of overhead costs

Overhead costs generally fall into three categories: fixed, variable, and semi-variable. Knowing which type each expense belongs to helps you forecast spending and plan more accurately.

• Fixed overheads. These stay the same regardless of how much your business produces. Examples include office rent, annual insurance premiums, and salaried staff wages. You'll pay these amounts whether it's a busy month or a quiet one.
• Variable overheads. These rise and fall with your level of activity. Shipping costs, packaging materials, and sales commissions are common examples. During busier periods, you'll spend more on these items.
• Semi-variable overheads. These have a fixed base cost plus a variable component that changes with usage. A phone plan with a set monthly fee and per-minute charges beyond a cap is a typical example. Utility bills often work the same way: you'll pay a standing charge plus usage-based fees.

Examples of overhead costs

It helps to group overhead costs into categories so you can see exactly where your indirect spending goes. Here are the most common types, broken down by function.

Administrative overheads

These cover the day-to-day costs of running your office and back-office functions:

• Office rent and property rates
• Accounting and legal fees
• Office supplies and equipment
• Administrative staff salaries
• Software subscriptions for accounting, payroll, and communication tools
• Insurance premiums

Production overheads

If your business manufactures goods, you'll have indirect production costs that aren't tied to a single product:

• Factory rent and maintenance
• Equipment depreciation
• Utility costs for production facilities
• Quality control and safety compliance
• Supervisory staff salaries

Selling overheads

These are the indirect costs of marketing and distributing your products or services:

• Advertising and marketing spend
• Sales team salaries and commissions
• Travel and entertainment for client meetings
• Delivery and distribution costs not tied to a specific order
• Website hosting and maintenance

Overhead costs vs. direct costs and COGS

Overhead costs, direct costs, and cost of goods sold (COGS) are related but distinct concepts. Mixing them up can lead to inaccurate pricing and budgeting, so it's worth understanding the differences.

Direct costs are expenses you can trace to a specific product or service. Raw materials and production labour are common examples. If you stop making that product, those costs disappear.

Cost of goods sold (COGS) is the total of all direct costs for the goods or services you've sold during a period. It appears on your profit and loss statement and is subtracted from revenue to calculate gross profit.

Overhead costs are indirect. They keep your business running but can't be traced to a single product or service. Your office rent supports everything you do; it doesn't belong to one product line.

Here's a practical way to tell them apart: if an expense would vanish when you stop producing a specific item, it's a direct cost. If it would remain because it supports your broader operations, it's an overhead.

How to calculate overhead costs

Calculating your overhead costs helps you understand the true cost of your products or services. There are several formulas you can use, depending on what you want to measure.

Overhead rate formula

The overhead rate shows how your indirect costs relate to a specific cost driver, such as direct labour or machine hours. To calculate it, use this formula:

Overhead rate = total indirect costs / allocation measure

The allocation measure is any metric tied to production, such as total direct labour costs, direct labour hours, or machine hours. The result tells you how much overhead is generated for every unit of that measure.

Overhead rate as a percentage of sales

This formula shows what proportion of your revenue goes toward covering indirect costs. It's useful for benchmarking your efficiency over time or against industry averages.

Overhead percentage = (total overhead costs / total sales) × 100

For example, if your overhead costs are $15,000 and your total sales are $50,000, your overhead percentage is 30%. As a general benchmark, a healthy overhead ratio is typically considered no higher than 35% of total revenue, though this varies by industry.

Overhead cost per unit

If you produce physical goods, knowing the overhead cost per unit helps you set prices that cover all your expenses. The formula is straightforward:

Overhead cost per unit = total overhead costs / total units produced

For instance, if your monthly overhead is $12,000 and you produce 2,000 units, each unit carries $6 in overhead costs. Add this to your direct cost per unit to find your true production cost.

Overhead costs calculation example

Here's a worked example using the overhead rate formula.

Say your business has $10,000 in overhead expenses for the latest financial period, and you want to understand how those costs relate to labour. Your direct labour costs for the same period total $2,500.

Divide $10,000 (indirect costs) by $2,500 (direct labour costs). The result is four.

This means for every dollar you spend on labour, your business spends four dollars on overhead. If that ratio feels high, it may be time to review your indirect expenses and look for savings.

How overhead costs affect the bottom line

Your overhead costs have a direct impact on your net income. On your profit and loss statement, overheads are subtracted from gross profit alongside other operating expenses. The higher your overheads, the less profit you keep.

High overheads can squeeze your margins in several ways. They reduce the cash available for reinvesting in your business and limit your ability to offer competitive pricing. They also make it harder to build a financial buffer for quieter periods.

Overheads also affect your pricing decisions. When setting prices, you need to factor in both your direct production costs and your overhead costs. If you only account for direct costs, you could end up selling at a loss without realising it.

You can analyse your product profitability and identify your strongest lines with Xero inventory software.

Tips for reducing business overhead costs

With research indicating that over half of small businesses have cut costs to maintain financial stability, finding savings on overheads is a practical priority. Here are some strategies to try.

• Negotiate with suppliers and service providers. There are often savings within your existing supply chain, particularly if contracts haven't been reviewed recently. Ask your current suppliers about better rates and compare competitor pricing.
• Consider remote or shared workspaces. If your team doesn't need a dedicated office every day, co-working spaces or hybrid arrangements can cut your rent and utilities significantly.
• Choose technology that consolidates functions. With 41% of small business owners reporting rising software costs, picking tools that combine multiple functions helps control spending. Accounting software that handles invoicing, bank reconciliation, and expense tracking in one place can replace several standalone subscriptions.
• Monitor expenses closely. Regular expense reviews help you catch unnecessary spending before it adds up. Xero's expense tracking tools give you real-time visibility into where your money goes.
• Review recurring subscriptions. Audit your software, memberships, and service subscriptions quarterly. Cancel anything your team no longer uses or that duplicates another tool's functionality.

Why you should regularly review overhead costs

Overhead costs tend to creep upward if left unchecked. A subscription you signed up for two years ago, a service contract that auto-renewed at a higher rate, or utility costs that have drifted higher can all erode your margins over time.

Setting up a monthly or quarterly review process helps you stay on top of these changes. During each review, compare your current overhead spending against previous periods and your budget. Look for costs that have increased without a clear reason.

Regular reviews also help you distinguish between essential overheads and "nice-to-have" expenses. When cash flow is tight, knowing which costs you can reduce or pause gives you options before the pressure becomes urgent.

Not accounting for overheads properly can leave your business vulnerable. High indirect costs make it harder to maintain positive cash flow, and over time this can limit your ability to invest, hire, or weather a downturn. Find out more about budgeting and financial forecasting to build overhead reviews into your broader financial planning.

Track your overhead costs with Xero

Keeping overhead costs under control starts with having clear visibility into your spending. When you can see exactly where your money goes each month, you're better placed to spot savings and protect your profit margins.

Xero brings your income, expenses, and bank transactions together in one place so you can track overheads alongside your other costs in real time. Customisable reports let you break down spending by category, compare periods, and spot trends before they become problems. To get started, get one month free.

FAQs on overhead costs

Here are answers to some common questions about overhead costs for small businesses.

What is the difference between overheads and operating expenses?

Operating expenses cover all costs of running your business, including both direct and indirect expenses. Overheads are a subset of operating expenses that includes only the indirect costs not tied to a specific product or service.

How can you reduce overheads without compromising quality?

Focus on efficiency rather than cutting corners. Negotiate better supplier rates and consolidate software tools where possible. Automating repetitive administrative tasks also frees up time and reduces staffing costs without affecting the quality of your output.

What is a good overhead rate?

There's no single "good" rate because it depends on your industry, business model, and growth stage. Service businesses typically run lower ratios than manufacturers. The most useful approach is to track your own ratio over time and investigate any upward trends before they erode your margins.

Do overheads differ for service businesses vs. product businesses?

Yes. Product businesses typically have higher production overheads from factory rent, equipment, and utilities. Service businesses tend to have more administrative overheads, such as office costs and software subscriptions, but lower production-related indirect costs overall.

What expenses are not considered overhead?

Any cost directly tied to producing a specific product or service is not an overhead. Raw materials, production wages, and packaging for individual items are direct costs. Owner draws, loan repayments, and income tax payments are also excluded from overhead as they fall into separate accounting categories.