Overhead cost: What it is, types, and how to manage yours

Published Friday 5 December 2025

Table of contents

• What are business overheads?
• Types of overhead costs
• Other categories of business expenses
• Why overheads in business can be confusing
• How to calculate overhead costs
• Why understanding overhead costs matters to your business
• 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 (direct labour costs, materials, or machine hours) to understand how much overhead expense you incur for every dollar of direct costs.

• Classify overhead costs into fixed (rent, insurance), variable (marketing, supplies), and semi-variable (utilities with usage charges) categories to better predict and manage these expenses as your business activity changes.

• Review overhead expenses monthly to track spending patterns and quarterly to renegotiate contracts and assess necessity, preventing cost creep that directly reduces your profit margins.

• Reduce overhead costs strategically by negotiating supplier contracts annually, optimising workspace through remote work or co-working spaces, and automating administrative tasks with accounting software to maintain quality while improving profitability.

What are business overheads?

are business expenses not directly tied to producing goods or services. These indirect costs keep your business running but don't contribute to specific products.

Common overhead costs include:

• Rent: Office or warehouse space
• Insurance: Business liability and property coverage
• Admin costs: Office supplies and utilities

Types of overhead costs

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

• Fixed overheads: Stay the same regardless of production levels (rent, office salaries, insurance premiums)
• Variable overheads: Fluctuate with business activity (marketing spend, office supplies, shipping costs)
• Semi-variable overheads: Combine fixed base costs with variable additions (phone plans, utilities with usage charges)

Other categories of business expenses

Business expense categories help you understand where overhead fits in your overall cost structure:

• Cost of Goods Sold (COGS): Direct costs for producing goods or services
• Sales and General Administration (SG&A): Operational costs supporting business functions
• Depreciation and Amortisation: Asset value decreases over time
• Interest: Borrowing costs on loans and credit
• Income Taxes: Taxes on business profits
• Miscellaneous: Small, irregular expenses that don't fit elsewhere

Why overheads in business can be confusing

Overhead classification varies between businesses because the same cost can be direct or indirect depending on your operations.

Why classification matters: A cost's relationship to production determines whether it's overhead. For example:

• Factory rent might be a direct cost if it houses production equipment
• Office rent is typically overhead as it supports general operations

The key question: does this cost directly contribute to creating your product or service?

For instance, an overhead expense can be affected by how you classify production costs. Some businesses might count rent as a cost of production – for example, rent for a factory – which would make it a fixed direct cost and not an overhead However, others might say their rent is a fixed indirect cost that the business has to pay whether or not they're open – such as an office building – which makes it a fixed overhead.

How you classify your overhead costs depends on your business type and structure Grouping your costs into categories during your accounting can help streamline this process, for example, manufacturing and production, admin, and development costs You'll then be able to calculate how much you're spending on overhead costs versus production more easily.

When determining if a cost is an overhead, the key thing to remember is that 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

Typically, overheads relate to your business operations as a whole. However, to get a true cost analysis of your products you may want to allocate overhead costs to specific areas. For instance, you could use activity-based costing to allocate specific overhead expenses to your service or product. You'll then be able to determine how much a particular product or service is costing you in both overhead expenditure and direct labour costs.

Overhead rate calculation shows how much overhead expense you incur for every dollar of direct costs or production activity.

Step 1: Identify overhead costs

Add up all indirect expenses (rent, insurance, admin costs)

Step 2: Choose an allocation measure

Choose what you will compare your overheads to:

• Direct labour costs: Total wages for production staff
• Direct material costs: Raw materials and components
• Machine hours: Time equipment runs for production

Step 3: Apply the formula

Overhead rate = Total overhead costs ÷ Allocation measure

Overhead costs calculation example

Here's an example of how to calculate your business overhead costs.

Let's say your company has overhead expenses that come to $10,000 for the latest financial period and you want to know how the overhead costs relate to labour costs. Within this same period, you had labour costs amounting to $2,500.

To find the overhead rate, divide $10,000 (indirect costs) by $2,500 (direct costs), which equals four.

In other words, every dollar you spend on labour costs your business four dollars in overhead expenses.

Why understanding overhead costs matters to your business

Understanding your overhead costs is key to your business's financial health. It gives you a complete picture of what it truly costs to run your business, which helps you make smarter decisions.

When you know your overheads, you can:

• Set prices that cover all your costs and ensure profitability.
• Create more accurate budgets and financial forecasts.
• Identify areas where you can reduce spending without affecting quality.
• Gain a clearer view of your business's performance and sustainability.

How to reduce business overhead costs

Reducing your overheads can lift your profit margins over time. Follow these steps to learn how to reduce these costs.

1. Negotiate supplier contracts: Review existing agreements annually and compare competitor pricing to secure better rates
2. Optimise workspace costs: consider remote work, co-working spaces or office sharing to reduce rent and utility expenses; if you use a home office, you can calculate your claim using the official square metre rate, which is $53.10 for the 2023–2024 income year
3. Automate with technology: Use accounting software to eliminate manual tasks and reduce administrative overhead
4. Track expenses actively: Monitor spending patterns to identify unnecessary purchases and cost-saving opportunities with Xero's expense tracking tools

How overheads affect your bottom line

High overhead costs directly reduce your business profits and limit growth opportunities.

How overheads affect profitability:Overheads appear on your profit and loss statement as operating expenses. They reduce your net revenue alongside production costs to determine your final profit.

The profit impact: Excessive overheads mean:

• Lower : Less money available for business reinvestment
• Reduced growth capacity: Fewer resources for expansion and improvements
• Tighter cash flow: Less financial flexibility for unexpected expenses

Regular overhead reviews prevent cost creep and identify saving opportunities:

Monthly actions:

• Track spending patterns: Compare actual costs to budgeted amounts
• Identify cost increases: Spot unexpected rises in utilities, supplies, or services

Quarterly actions:

• Review contracts: Renegotiate terms with suppliers and service providers
• Assess necessity: Distinguish between essential costs and nice-to-have expenses
• Plan adjustments: Make strategic cuts without compromising operations

Manage your overheads with ease using Xero

To protect those tight profit margins, manage your business overhead costs.

With Xero accounting software you can track overhead expenses, manage stock and monitor your business’s financial health, so you can keep your overheads low and sales high. Try Xero for free today to get started.

FAQs on business overheads

Here are some common questions and answers about managing overheads in your business

What is the difference between overheads and operating expenses?

Overheads are a subsection of operating expenses. While operating expenses cover everything you need to keep your business running (including direct costs), overheads only refer to indirect costs that support broader business operations

How can you reduce overheads without compromising quality?

When you cut overhead expenses, focus on efficiency and smarter spending to make your finances work harder For instance, you could try negotiating better rates with suppliers, embrace technology to automate rudimentary tasks, and optimise energy usage to lower your utility bills.

Focus on which costs you need to keep your business running efficiently, and which overheads are nice to have when you are in a strong position, like team lunches – for which you can generally only claim 50% of the cost – or could be better managed, like energy bills

Find out more about effective cost cutting.