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

Published Monday 30 March 2026

Table of contents

• What are business overheads?
• Why overhead costs matter for your business
• Types of overhead costs
• How do overhead costs differ from other 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 labour costs) to understand how much overhead you spend for every dollar of direct costs and price your products accurately.
• Review your overhead costs quarterly to identify rising expenses early and separate essential overheads from nice-to-haves so you know where to cut if cash flow tightens.
• Reduce overhead costs without compromising quality by negotiating better supplier rates annually, automating routine tasks with accounting software, and considering remote work or co-working spaces to cut rent expenses.
• Include overhead costs in your pricing strategy because these indirect expenses directly reduce your profit margins and can cause you to sell at a loss if not properly factored into your prices.

What are business overheads?

Overhead costs are the indirect expenses your business pays to keep running, regardless of how much you produce or sell. Unlike direct costs tied to creating a product or delivering a service, overheads support your broader operations.

Common examples include:

• rent and utilities
• insurance premiums
• administrative salaries
• office supplies

How you classify a cost depends on your business type. For example, factory rent might be a direct production cost for a manufacturer, but office rent is typically an overhead for a service business.

Why overhead costs matter for your business

Overhead costs directly affect your profitability. Every dollar spent on overhead reduces your net income, so managing these expenses is essential for healthy margins.

How overhead impacts your business:

• Reduces profit margins: High overheads eat into revenue, leaving less for growth and investment
• Affects pricing accuracy: If you don't factor overhead into your prices, you may sell at a loss without realising it
• Limits cash flow: Excessive overhead can create cash flow problems, even when sales are strong
• Constrains growth: Businesses with tight overhead control have more flexibility to invest and expand

Include overhead costs on your profit and loss statement to see your true net income.

Types of overhead costs

You can categorise overhead costs in two ways: by how they behave and by what business function they support.

By cost behaviour:

• Fixed overheads: Stay the same regardless of production levels, such as rent or salaried office staff
• Variable overheads: Fluctuate with business activity, such as marketing spend or office supplies during busy periods
• Semi-variable overheads: Combine a fixed base with variable elements, such as utility bills or phone plans that increase with usage

By business function:

• Administrative overhead: Office expenses, accounting fees, and management salaries
• Selling overhead: Advertising, sales commissions, and promotional costs
• Production overhead: Factory rent, equipment maintenance, and indirect materials (for product-based businesses)
• Financial overhead: Interest payments, bank fees, and loan-related costs

How do overhead costs differ from other expenses?

Overhead costs are one category of business expenses, but they're often confused with other cost types. Here's how they differ:

• Cost of goods sold (COGS): Direct costs tied to producing goods or services, such as raw materials and production labour
• Operating expenses: All costs to run your business, including both overheads and direct costs
• Sales, general, and administrative (SG&A): Operational costs not directly linked to production, which often overlap with overhead
• Depreciation and amortisation: The gradual decrease in asset value over time
• Interest: Costs associated with borrowing funds
• Income taxes: Taxes on your business earnings

Key distinction: Overheads are always indirect costs. If an expense directly creates your product or service, it's a direct cost or part of COGS, not overhead. However, it's worth noting that for smaller businesses, there can be some exceptions to the rules for how COGS is calculated.

How to calculate overhead costs

Overhead rate shows how much overhead you spend for every dollar of direct costs or hour of labour. Use this formula:

Overhead rate = total indirect costs ÷ allocation measure

Here's what these terms mean:

• Total indirect costs: The sum of all your overhead expenses (fixed, variable, and semi-variable)
• Allocation measure: A production metric like direct labour costs, machine hours, or material costs

Knowing your overhead rate helps you price products accurately and identify where costs are eating into profits. Since most overhead rates range from 25–50%, calculating yours provides a benchmark against industry norms. You can allocate overhead to specific products or services to see their true cost, not just their direct expenses.

Overhead costs calculation example

Here's a worked example of calculating your overhead rate.

The scenario: Your business has $10,000 in overhead expenses and $2,500 in direct labour costs for the same period.

The calculation: $10,000 ÷ $2,500 = 4

What this means: For every $1 you spend on labour, you spend $4 on overhead. If you're pricing a job that requires $500 in labour, you'd need to factor in $2,000 in overhead costs to cover your true expenses.

Tips for reducing business overheads

Reviewing your overheads regularly helps you spot savings opportunities and avoid cash flow problems. Here are practical ways to reduce overhead costs:

• Negotiate with suppliers: Revisit contracts annually and compare competitor pricing to secure better rates
• Reduce workspace costs: Consider remote work, co-working spaces, or office sharing to cut rent expenses
• Automate routine tasks: Use accounting software to streamline bookkeeping and reduce manual admin time. Research shows 79% of finance leaders have reduced month-end close time by adopting new accounting software.
• Track expenses closely: Monitor spending weekly or monthly to catch unnecessary costs early
• Review overheads quarterly: Schedule regular reviews to identify rising costs before they become problems

Xero's expense tracking tools help you monitor costs and spot savings opportunities in real time.

Make overhead reviews a habit. Schedule monthly or quarterly reviews to catch rising costs early. Separate essential overheads from nice-to-haves, so you know where to cut if cash flow tightens. Small businesses often operate on tight margins, so consistently managing overheads helps you stay profitable and prepared for economic challenges.

Manage your overheads with ease

Managing overhead costs protects your profit margins and keeps your business financially healthy.

With Xero accounting software, you can track expenses in real time, categorise costs automatically, and spot savings opportunities before they slip away. Try Xero free for 30 days and see how easy overhead management can be.

FAQs on overhead costs

Here are answers to common questions about overhead costs and how they affect your business.

What is overhead cost and example?

Overhead cost is any indirect expense that keeps your business running but isn't tied to producing a specific product or service. Examples include office rent, utility bills, insurance premiums, and administrative salaries.

What are the 4 types of overhead?

The four main types of overhead are:

• Administrative overhead: Office costs, accounting fees, and management salaries
• Selling overhead: Advertising, sales commissions, and marketing expenses
• Production overhead: Factory rent, equipment maintenance, and indirect materials
• Financial overhead: Interest payments, bank fees, and loan costs

What is the difference between overheads and operating expenses?

Operating expenses include all costs to run your business, both direct and indirect. Overheads are a subset of operating expenses that covers only indirect costs, such as rent, utilities, and administrative salaries.

How can you reduce overheads without compromising quality?

Focus on efficiency rather than elimination. Negotiate better supplier rates, automate repetitive tasks, and reduce energy waste before cutting costs that affect your team or customer experience. Review essential overheads and identify areas where you can trim without compromising operations.