What is overhead cost? Types, examples and formula

Published Thursday 2 April 2026

Table of contents

• What are business overheads?
• Why overhead costs matter to your business
• Types 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 indirect costs by your allocation measure (such as direct labour costs) to understand how much overhead adds to each product or service you sell.
• Track overhead costs consistently to spot cash flow problems early, make informed pricing decisions, and identify savings opportunities before they affect your bottom line.
• Reduce overhead expenses by negotiating better supplier rates, automating routine tasks with software, and reviewing workspace arrangements like remote work or co-working spaces.
• Include overhead costs in your pricing calculations by adding your overhead rate percentage to direct costs to protect profit margins and ensure sustainable business operations.

What are business overheads?

Overhead costs are the ongoing business expenses not directly tied to producing goods or delivering services. Unlike direct costs, which pay for materials or labour used in production, overheads cover the background expenses that keep your business running.

Common overhead examples include rent, insurance, utilities, and administrative salaries.

Why overhead costs matter to your business

Overhead costs directly affect your profitability. Small business owners lose an average of $40,000 annually to unmanaged overhead costs. Every dollar spent on indirect expenses reduces your net income, which limits your ability to invest in growth, build cash reserves, or weather slow periods.

Understanding your overhead helps you:

• price products accurately: include overhead in your pricing calculations to protect profit margins
• spot cash flow problems early: high overheads can drain cash faster than revenue comes in
• make informed decisions: know the true cost of running your business before expanding or hiring
• identify savings opportunities: track overhead trends to find areas where you can cut costs

When you track overhead consistently, you can see the true cost of running your business, not just the cost of making your products or delivering your services.

Types of overhead costs

Overhead costs fall into three main categories:

• fixed overheads: costs that stay the same regardless of production volume, such as rent, insurance premiums, and salaried employee wages
• variable overheads: costs that rise and fall with business activity, such as marketing spend, shipping supplies, and sales commissions
• semi-variable overheads: costs with a fixed base plus a variable component, such as utility bills with minimum charges or phone plans with usage fees

Fixed overhead costs

Fixed overheads are costs that remain the same regardless of how much your business produces during a set period, such as your rent or the salaries of office employees.

Variable overhead costs

Variable overhead costs change with business activity or production volume. Common examples include some indirect materials, certain utilities, and other indirect costs that rise as output increases.

Semi-variable overhead costs

Semi-variable costs contain both fixed and variable elements. A maintenance contract might include a fixed component of $3,000 monthly plus a variable charge per unit produced. They often increase as activity rises, though the pattern depends on the cost driver and contract terms.

Overhead examples by business type

Overhead costs vary depending on your business model. Here are common examples for different types of small businesses.

Service businesses such as consultants, agencies, and tradespeople typically have these overhead costs:

• office or home office expenses
• professional liability insurance
• software subscriptions
• vehicle costs for client visits

Retail businesses typically have these overhead costs:

• shop rent and utilities
• point-of-sale system fees
• store security and cleaning
• inventory management software

E-commerce businesses typically have these overhead costs:

• website hosting and platform fees
• payment processing costs
• customer service tools
• warehouse or storage rent

Keep in mind that classification depends on your business model. Factory rent might be a direct production cost for a manufacturer, while office rent is typically an overhead for a service business. The key distinction is whether the cost directly creates your product or service.

How to calculate overhead costs

Calculate your overhead rate to understand how much indirect costs add to each product or service you sell. This insight is essential for setting profitable prices and identifying cost-saving opportunities.

To find your overhead rate, gather all your overhead expenses for a specific period, then apply this formula:

Overhead rate = indirect costs ÷ allocation measure

The allocation measure can be direct labour costs, direct labour hours, machine hours, or total direct costs, depending on what drives your overhead spending.

Overhead rate formula

The overhead rate formula shows the relationship between your indirect costs and your chosen allocation base. The indirect costs are the total of your overhead expenses, and the allocation measure is the chosen cost driver used to assign overhead, such as direct labour hours, machine hours, direct labour cost, or direct material cost.

Overhead calculation example

Here's a practical example of how to calculate your overhead rate.

Start with your numbers:

• Total overhead expenses: $10,000
• Direct labour costs: $2,500

Then do the calculation:

$10,000 ÷ $2,500 = 4

Here's what this means:

For every dollar you spend on labour, you're spending four dollars on overhead. If your overhead rate seems high, it may be time to review your indirect costs or look for efficiency gains.

What your overhead percentage means

Your overhead rate shows how much you spend on indirect costs relative to your direct costs or revenue. A 20% overhead rate means you spend 20 cents on overhead for every dollar of direct costs.

Here's how to interpret your results:

• lower rates suggest efficient operations with more revenue flowing to profit
• higher rates may indicate opportunities to reduce indirect costs or increase productivity
• rising rates over time could signal growing inefficiencies that need attention

The ideal overhead rate varies by industry and business model. While industry benchmarks vary, service businesses often target 10–20%, while retail aims for 20–30%. What matters most is understanding your rate and tracking it consistently to spot trends.

Tips for reducing business overheads

Reviewing your overheads regularly helps you spot savings opportunities before they affect your bottom line. Try these cost reduction strategies:

• negotiate with suppliers: review existing contracts and compare competitor pricing to find better rates on recurring expenses
• reduce workspace costs: consider remote work arrangements, co-working spaces, or office sharing to lower rent and utility expenses
• automate routine tasks: use accounting software to handle data entry, invoicing, and reconciliation, which can reduce collection times to improve cash flow, freeing up time and reducing errors
• track expenses closely: monitor spending patterns with tools like Xero's expense tracking to catch unnecessary costs early

Set a regular review schedule, whether monthly or quarterly, to catch rising costs before they strain your cash flow. Small businesses often operate on tight margins, so consistent overhead monitoring can make the difference between growth and financial stress.

Manage your overheads with ease

Managing overhead costs protects your profit margins and helps you build a sustainable business.

With Xero accounting software, you can track expenses, monitor cash flow, and spot cost-saving opportunities in real time. Get one month free and see how simple overhead management can be.

FAQs on overhead costs

Here are answers to common questions about overhead costs.

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, both direct and indirect, while overheads refer specifically to indirect costs not tied to production.

How can you reduce overheads without compromising quality?

Focus on efficiency improvements. Negotiate better supplier rates, automate repetitive tasks with software, and review utility usage for savings. Prioritise essential overheads that keep operations running smoothly while adjusting discretionary spending based on business cycles.

What does 20% overhead mean?

A 20% overhead rate means you spend 20 cents on indirect costs for every dollar of direct costs. If your direct costs are $1,000, your overhead would be $200.

What's a normal overhead percentage for small businesses?

Overhead percentages vary widely by industry. Recent data shows typical rates now range from 36.31% to 72.97% due to factors like inflation.

Service businesses often run higher overheads than product-based businesses. Rather than targeting a specific number, focus on tracking your overhead over time and reducing it where possible.

How do I include overhead in my pricing?

Calculate your overhead rate, then add that percentage to your direct costs when setting prices. If your overhead rate is 25% and a product costs $100 in direct costs, add $25 for overhead, making your minimum price $125 before profit margin.