Overhead costs: What they are and how to manage them for your small business

Published Thursday 27 November 2025

Table of contents

• What are business overheads?
• Other categories of business expenses
• Types of overhead costs
• Why overheads in business can be confusing
• How to calculate overhead costs
• Tips for reducing business overheads
• Manage your overheads with ease
• FAQs on business overheads

Key takeaways

• Calculate your overhead rate by dividing total indirect costs by an allocation measure (such as direct labour costs or hours) to understand how much overhead adds to each product or service you create.

• Classify overhead costs into fixed, variable, and semi-variable categories to better understand how they behave with changes in business activity and improve your budgeting accuracy.

• Implement four key strategies to reduce overheads: negotiate better rates with suppliers annually, optimise workspace costs through remote work or sharing arrangements, automate routine tasks with technology, and track expenses closely to spot unnecessary purchases.

• Review your overhead costs monthly or quarterly to identify potential savings and ensure they don't negatively impact your cash flow or profit margins.

What are business overheads?

are indirect business expenses that aren't tied to producing specific goods or services. Unlike direct costs, overheads are the ongoing expenses that keep your business operating.

Common overhead costs include:

• Rent: office or warehouse space
• Insurance: business liability and property coverage
• Administrative costs: accounting, legal fees, and office supplies

Other categories of business expenses

Overhead expenses are just one category of business costs. Other common types include:

• cost of goods sold (COGS): direct costs tied to producing goods or services
• sales and general administration (SG&A): operational costs not directly linked to production
• depreciation and amortisation: decrease in value of assets over time
• interest: costs associated with borrowing funds
• income taxes: taxes on your business earnings
• miscellaneous: small, irregular expenses that do not fit into other categories

Types of overhead costs

Three main types of overhead costs affect your business differently:

• : Stay the same regardless of production levelsExamples: rent, office salaries, insurance premiums
• : Change based on business activityExamples: marketing spend during busy periods, extra office supplies
• Semi-variable overheads: Combine fixed base costs with variable additionsExamples: phone plans with usage charges, utilities with base rates plus consumption

Why overheads in business can be confusing

Overhead classification varies by business type because the same cost can be direct or indirect depending on your operations.

Why the confusion happens:

• Factory rent: Direct cost (needed for production)
• Office rent: Overhead cost (supports general operations)
• Marketing spend: Could be overhead (brand awareness) or direct (product launch)

The key test: Does this cost directly create your product or service? If not, it's likely an overhead.

Classify your overhead costs based on your business type and structure. Group your costs into categories to streamline your accounting process, for example, manufacturing, administration, and development costs.

This makes it easier to see how much you spend on overheads compared to production costs. Overheads are indirect costs. They are not related to producing your goods or services. Overheads can be fixed, variable, or semi-variable.

How to calculate overhead costs

Calculating your overhead rate shows how much indirect costs add to each product or service you create.

Formula: Overhead rate = Total indirect costs ÷ Allocation measure

Where:

• Total indirect costs: Sum of all your overhead expenses
• Allocation measure: Choose one:

Use this rate to price your products accurately and understand your true costs.

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.

Tips for reducing business overheads

Reducing overhead costs protects your profit margins and frees up cash for growth investments.

4 proven strategies:

• Negotiate with suppliers: Review contracts annually to secure better ratesSave money on existing services
• Optimise workspace costs: Consider remote work, co-working spaces, or office sharingLower your rent and utility expenses
• Automate with technology: Use accounting software to streamline financial tasksSave time and avoid manual errors
• Track expenses closely: Monitor spending with expense tracking toolsSpot unnecessary purchases before they affect your profits

How overheads affect the bottom line

To clearly understand your business's finances, you'll need to include your overhead expenses on your profit and loss statement. Overhead costs will need to be taken from your net revenue, along with all your production-related costs, in order to reach your net income – also known as the bottom line.

Keeping your overheads low helps you increase your net income and gives you more opportunities to grow your business.

In order to do this, you should learn how to calculate your business's overhead costs and factor them into your business budget. For instance, when setting your product or service prices you should take into consideration both your production costs and your overhead expenses to ensure you're making a profit. Including overheads in your pricing helps you set the right price and protect your profit margins.

Use Xero inventory management software to analyse your stock and see which products are most profitable.

Why you should regularly review and adjust overhead costs

To stay on top of your overhead expenses you'll need to regularly review them for potential savings – such as cutting back on staff benefits – and avoid financial pitfalls, like consistently negative cash flow.

Review your overhead costs every month or quarter to keep them in check. You can also reduce non-essential overheads to improve your cash flow.

By tracking your overhead expenses, you can build stronger financial reserves and be better prepared for economic changes. Overhead costs affect your cash flow every day. High overheads make it harder to keep your cash flow positive. Managing overheads well helps you maintain healthy cash flow and support your business growth.

Track your overhead costs closely, especially if you have tight financial margins. Include overhead management in your cost control strategies from the start. This helps your business thrive.

Manage your overheads with ease

Financial management for small businesses is crucial to protect those tight profit margins, so get a handle on your business overhead costs.

Xero accounting software helps you track overhead expenses, manage stock, and monitor your business’s financial health. This makes it easier to keep your overheads low and your sales high.

FAQs on business overheads

Here are answers to common questions about business overheads.

What is the difference between overheads and operating expenses?

Overheads are part of operating expenses.Operating expenses include all costs to run your business, while overheads specifically refer to indirect costs that support general operations rather than creating products.

How can you reduce overheads without compromising quality?

Focus on efficiency over elimination. Smart cost management maintains quality while reducing waste.

Key strategies:

• Negotiate better rates with existing suppliers
• Automate routine tasks with technology
• Optimise energy usage to lower utility costs
• Distinguish essential vs nice-to-have expenses

Prioritise core operational costs while identifying areas for better management rather than cuts.

Read more about ways to cut business costs.

What are the 4 types of overhead costs?

You can group overheads as fixed, variable, or semi-variable. You can also categorise them by business function:

• administrative, for example, office salaries
• selling, for example, marketing costs
• production, for example, factory maintenance
• financial, for example, bank fees This helps you see where your indirect costs come from.

Are overhead costs tax deductible?

Yes, most overhead costs are tax-deductible business expenses. If a cost is common in your industry and helpful for your business, you can usually deduct it from your taxable income. Check with an accountant for details about your business.