Overhead cost: what it is, how to calculate and cut

Published Monday 20 April 2026

Table of contents

• What are business overheads?
• Why overhead costs matter
• Types of overhead costs
• Examples of overhead costs
• Other categories of business expenses
• Why overheads in business can be confusing
• How to calculate overhead costs
• How to reduce business overhead costs
• How overheads affect your bottom line
• Manage your overheads with ease using Xero
• FAQs on business overheads

Key takeaways

• Calculate your overhead rate by dividing total overhead costs by your chosen allocation measure (such as direct labour costs or machine hours) to understand exactly how much you spend on indirect costs for every dollar of direct costs.
• Classify overhead costs as fixed, variable, or semi-variable so you can predict how your expenses will change as business activity rises or falls, and budget more accurately.
• Review overhead expenses monthly to catch unexpected spending early, and quarterly to renegotiate supplier contracts and cut costs that aren't essential to your operations.
• Reduce overhead costs without sacrificing quality by negotiating supplier rates annually, automating admin tasks with accounting software, and exploring remote work or shared office spaces to lower rent and utility bills.

What are business overheads?

Overhead costs are indirect business expenses that keep your company running but aren't tied to producing specific goods or services. Think of them as the costs you pay whether or not you make a sale, such as rent, insurance, and administrative wages, which accounting standards explicitly classify as administration and general overhead costs rather than property or plant assets.

Common overhead costs include:

• Rent: Office, retail, or warehouse space
• Insurance: Business liability, property, and professional indemnity coverage
• Utilities: Electricity, water, internet, and phone services
• Administrative salaries: Wages for staff not directly producing goods or services
• Office supplies: Stationery, printer ink, and general consumables
• Professional fees: Accounting, legal, and consulting services

Why overhead costs matter

Understanding your overhead costs gives you a complete picture of what it truly costs to run your business. This knowledge directly affects your pricing, profitability, and growth potential.

When you know your overheads, you can:

• set prices that cover all costs and protect your margins
• create accurate budgets and reliable financial forecasts
• identify spending cuts that won't affect quality
• spot cost creep before it damages profitability
• make confident decisions about scaling or investing

Without this visibility, you risk underpricing your products, overspending on non-essentials, or missing opportunities to improve efficiency.

Types of overhead costs

Overhead costs fall into three categories based on how they change with business activity.

Fixed overheads

Fixed overhead costs stay the same regardless of how much you produce or sell. You pay these amounts whether business is booming or slow.

Examples include:

• rent and lease payments
• insurance premiums
• permanent staff salaries
• equipment depreciation

Variable overheads

Variable overhead costs rise and fall with your business activity. The more you produce or sell, the higher these costs climb.

Examples include:

• marketing and advertising spend
• shipping and delivery costs
• sales commissions
• packaging materials

Semi-variable overheads

Semi-variable overhead costs combine a fixed base amount with variable usage charges. You pay a minimum amount regardless of activity, plus extra based on consumption.

Examples include:

• utility bills with base charges plus usage fees
• phone and internet plans with data limits
• equipment maintenance contracts with per-use fees

Examples of overhead costs

Common overhead expenses in most small businesses include:

• Rent and facilities: Payments for office space, retail premises, or warehouse facilities. This includes lease costs, building maintenance, and property rates.
• Administrative salaries: Wages for staff who support operations but don't directly produce goods or services, such as receptionists, office managers, and HR personnel.
• Insurance: Business liability, professional indemnity, property insurance, and workers' compensation premiums.
• Utilities: Electricity, gas, water, internet, and phone services for your business premises (if you run your business from home, you can claim a deduction of 50% on a shared private landline).
• Office supplies: Stationery, printer consumables, cleaning products, and general office equipment.
• Professional services: Fees for accountants, lawyers, consultants, and other external advisors.
• Marketing and advertising: Costs for promoting your business that aren't tied to specific sales, such as website maintenance, social media management, and brand advertising.
• Software subscriptions: Cloud-based tools for accounting, project management, communication, and other business functions.

Other categories of business expenses

Understanding how overhead fits alongside other expense categories helps you classify costs correctly and spot where your money goes.

• Cost of Goods Sold (COGS): Direct costs for producing goods or services, such as raw materials and production labour. These are not overhead costs.
• Sales, General and Administrative (SG&A): Operational costs supporting business functions. Many overhead costs fall into this category on your profit and loss statement.
• Depreciation and amortisation: The gradual reduction in asset value over time, spread across accounting periods.
• Interest: Borrowing costs on loans, credit lines, and other financing.
• Income taxes: Taxes calculated on your business profits.
• Miscellaneous: Small, irregular expenses that don't fit elsewhere.

Why overheads in business can be confusing

The key question: Does this cost directly contribute to creating your product or service? If yes, it's a direct cost. If no, it's overhead.

The same expense can be classified differently depending on your business operations. This matters because:

• Factory rent might be a direct cost if the space houses production equipment.
• Office rent is typically overhead because it supports general operations rather than production.

How you classify costs affects your pricing, how you calculate profitability, and financial reports. Grouping expenses into categories during your accounting, such as manufacturing, administration, and development, helps streamline this process.

When determining if a cost is an overhead, overheads are an indirect cost, which means they're a cost not related to the production of your goods or services, and can be fixed, variable, or semi-variable.

How to calculate overhead costs

Overhead rate shows how much you spend on indirect costs for every dollar of direct costs or production activity. Calculating this rate helps you set accurate prices and understand your true cost structure.

To get a complete picture of product costs, you can allocate overhead to specific areas using activity-based costing. This approach reveals how much each product or service costs in both overhead and direct labour.

Calculate your overhead rate in three steps.

Step 1: Identify overhead costs

List and add up all your indirect expenses for the period. Include rent, insurance, utilities, administrative salaries, and other costs not tied to production.

Step 2: Choose an allocation measure

Select what you'll compare your overheads against. Common allocation measures include:

• Direct labour costs: Total wages paid to production staff
• Direct material costs: Raw materials and components used in production
• Machine hours: Total time equipment runs for production

Choose the measure that best reflects how your business uses resources.

Step 3: Apply the formula

Overhead rate = Total overhead costs ÷ Allocation measure

The result tells you how much overhead you incur for every dollar (or hour) of your chosen measure. A rate of 0.50 means you spend 50 cents on overhead for every dollar of direct costs.

Overhead costs calculation example

This calculation works as follows.

Scenario: Your business has $10,000 in overhead expenses for the quarter. Direct labour costs for the same period total $2,500.

Calculation: $10,000 ÷ $2,500 = 4

Result: Your overhead rate is four, meaning every dollar you spend on labour costs your business four dollars in overhead.

What this means: A high overhead rate like this suggests your indirect costs are significant relative to production. You might explore ways to reduce overhead or increase production efficiency to improve this ratio.

How to reduce business overhead costs

Reducing overhead costs directly improves your profit margins. Four practical strategies to lower these expenses:

• Negotiate supplier contracts: Review existing agreements annually and compare competitor pricing. Even small rate reductions add up across multiple suppliers.
• Optimise workspace costs: Consider remote work arrangements, co-working spaces, or office sharing to reduce rent and utilities. If you work from home, check the IRD website for the current square metre rate you can claim, which has been set at $55.60 for the 2025 income year.
• Automate administrative tasks: Use accounting software to handle invoicing, reconciliation, and reporting. Automation reduces staff time spent on repetitive work.
• Track expenses consistently: Monitor spending patterns monthly to catch unnecessary purchases early. Xero's expense tracking tools help you spot cost-saving opportunities before they slip by.

How overheads affect your bottom line

High overhead costs eat directly into your profits and limit what you can reinvest in growth.

On your profit and loss statement, overheads appear as operating expenses. They reduce your net revenue alongside production costs to determine your final profit figure.

Excessive overheads create three main problems:

• Lowernet income: Less money available to reinvest in the business or pay yourself
• Reduced growth capacity: Fewer resources for expansion, new equipment, or hiring
• Tighter cash flow: Less flexibility to handle unexpected expenses or opportunities

Regular reviews prevent overhead costs from creeping up unnoticed. Build these checks into your routine.

Monthly actions: Complete these tasks each month:

• Compare actual spending against budgeted amounts
• Spot unexpected rises in utilities, supplies, or services
• Flag any new recurring expenses for review

Quarterly actions: Complete these tasks each quarter:

• Renegotiate terms with suppliers and service providers
• Distinguish essential costs from nice-to-have expenses
• Plan strategic cuts that won't compromise operations

Manage your overheads with ease using Xero

Keeping overhead costs under control protects your profit margins and frees up cash for growth.

With Xero accounting software, you can track expenses by category, monitor spending patterns in real time, and generate reports that show exactly where your money goes. Automated bank feeds and expense tracking reduce the admin time you spend on bookkeeping.

Get one month free to see how Xero can help you manage your overheads.

FAQs on business overheads

Common questions and answers about managing overheads in your business.

What's the difference between overheads and operating expenses?

Overheads are a subset of operating expenses. Operating expenses include all costs to run your business, while overheads refer specifically to indirect costs that aren't tied to producing goods or services.

How can you reduce overheads without compromising quality?

Focus on efficiency rather than elimination. Negotiate better supplier rates, automate repetitive tasks with software, and optimise energy usage. Distinguish between essential costs and nice-to-have expenses, then cut the latter first.

Learn more about effective cost-cutting strategies.

What does a 20% overhead rate mean for my business?

A 20% overhead rate means you spend 20 cents on indirect costs for every dollar of direct costs. For example, if your direct labour costs $100, you're spending an additional $20 on overhead to support that work.

Should I include owner's salary in overhead costs?

It depends on your role. If you actively produce goods or deliver services, your salary may be a direct cost. If you focus on managing and administering, it's typically classified as overhead. Consult your accountant for guidance specific to your business structure.

How do I know if my overhead rate is too high?

Compare your overhead rate to industry benchmarks and track it over time. A rising rate without corresponding revenue growth suggests overhead is eating into profits. If overhead exceeds 35–50% of total costs in most service businesses, it's worth investigating where you can cut back.