Overhead costs: What they are and how to manage them

Published Friday 23 January 2026

Table of contents

• What are business overheads?
• Types of overhead costs
• Examples of overhead costs
• Why overhead costs matter to your business
• Why overheads in business can be confusing
• Other categories of business 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 chosen allocation measure (like direct labor hours or costs) to determine how much overhead expense you incur per unit and ensure profitable pricing.
• Include overhead costs in your pricing strategy by adding them to direct costs before setting prices, as businesses that don't account for overhead often operate at a loss without realizing it.
• Reduce overhead expenses by negotiating with suppliers annually, optimizing workspace through remote work or shared offices, and automating tasks with technology to improve profit margins by 10-50%.
• Review overhead costs monthly for variable expenses and quarterly for fixed costs to maintain healthy cash flow and identify opportunities to eliminate non-essential expenses that limit business growth.

What are business overheads?

Business overheads are indirect costs that keep your business running but aren't directly tied to producing goods or services. These costs exist whether you're making sales or not.

Common overhead costs include:

• Rent: office or warehouse space costs
• Insurance: business liability and property coverage
• Administrative expenses: office supplies, utilities, and staff salaries

Direct costs like raw materials or production labor don't count as overheads because they're directly linked to creating your products or services.

Types of overhead costs

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

Fixed overheads: costs that stay the same regardless of production levels

• Examples: rent, insurance premiums, base salaries
• Benefit: predictable monthly expenses for easier budgeting

Variable overheads: costs that fluctuate with business activity

• Examples: marketing spend, office supplies, shipping costs
• Benefit: expenses align with revenue during busy and slow periods

Semi-variable overheads: costs with both fixed and variable components

• Examples: phone plans with base fees plus usage charges, utilities with connection fees plus consumption costs
• Benefit: some cost predictability with flexibility for growth

Examples of overhead costs

Here are some common overhead costs you might see in your business.

• Rent for office space or storefronts
• Utilities like electricity, water, and internet
• Insurance premiums for liability or property
• Salaries for administrative staff
• Marketing and advertising expenses
• Office supplies and equipment
• Software subscriptions for accounting or project management
• Legal and professional fees

Why overhead costs matter to your business

Understanding your overheads is about more than just bookkeeping. It directly impacts your pricing, profitability, and overall financial health, helping you make smarter decisions for your business.

How overheads affect the bottom line

Overhead costs directly impact your bottom line by reducing the profit available for business growth and investment.

How overheads affect profitability:

• Income statement impact: overhead expenses reduce your net revenue to calculate net income
• Profit reduction: high overhead costs leave less money for business reinvestment
• Growth limitations: excessive overhead expenses limit your ability to expand or improve operations

Why overhead management matters:Lower overhead costs mean higher profit margins, giving you more resources to invest in marketing, equipment, or staff expansion.

Include overhead costs in your pricing strategy to ensure profitability:

1. Calculate total overhead costs per product or service unit
2. Add overhead costs to direct costs for complete cost analysis
3. Set prices above total costs to generate profit margins
4. Review pricing regularly as overhead costs change

Why this matters: Businesses that don't include overhead in pricing often operate at a loss without realizing it.

You can analyze your inventory and see your most (and least) profitable lines with the inventory tools in Xero accounting software.

Why overheads in business can be confusing

Overheads can be confusing because each business defines them differently. Many people assume fixed costs are indirect overheads because you pay them whether you produce anything or not. Variable costs are often treated as direct costs, because production costs rise and fall with how much you produce, and so they are not seen as overheads. In practice, it is not always that clear cut.

How you classify overhead depends on your business type and structure. The same cost can be an overhead for one business but a direct cost for another.

How to classify your costs:

1. Group expenses by function: manufacturing, administration, sales, and development
2. Ask the key question: is this cost essential to create your specific product or service?
3. Apply the test: would you still pay this cost if production stopped temporarily?

Remember: Overheads are indirect costs that support your business whether you're producing or not.

Other categories of business expenses

Overhead expenses are just one category of business costs. Here are other typical business expense categories to account for:

• Cost of goods sold (COGS): Direct costs tied to producing goods or services
• Selling, general and administrative expenses (SG&A): Operational costs not directly linked to production
• Depreciation and amortization: The decrease in value of assets over time
• Interest: The costs associated with borrowing funds
• Income taxes: Taxes on your business earnings
• Miscellaneous: Small, irregular expenses that do not fit into other categories

How to calculate overhead costs

Calculating overhead costs helps you understand the true cost of your products or services and set profitable prices.

Step 1: Identify all overhead expenses

• Fixed costs: rent, insurance, base salaries
• Variable costs: utilities, office supplies, marketing
• Semi-variable costs: phone bills, equipment maintenance

Step 2: Choose your allocation method

Select a measurement that reflects how overhead relates to production:

• Direct labor hours: best for service businesses
• Machine hours: ideal for manufacturing
• Direct costs: works for most small businesses

Step 3: Apply the overhead rate formula

Overhead rate = Total indirect costs ÷ Allocation measure

This rate shows how much overhead expense you incur for each unit of your chosen allocation measure.

Overhead costs calculation example

This example shows how to calculate your overhead rate.

Your business numbers:

• Total overhead expenses: $10,000
• Direct labor costs: $2,500
• Time period: one month

Calculation:Overhead rate = $10,000 ÷ $2,500 = 4

What this means:For every $1 you spend on labor, you spend $4 on overhead expenses. This 4:1 ratio helps you:

• Set profitable prices: Include $4 of overhead cost for every $1 of labor when pricing services
• Control costs: Identify if your overhead ratio is higher than industry standards
• Make decisions: Evaluate whether to hire more staff or reduce overhead expenses

Tips for reducing business overheads

Reducing overhead costs improves your profit margins and gives you more financial flexibility during slow periods.

Cost reduction strategies:

• Negotiate with suppliers: review contracts annually and compare competitor pricing to reduce supply costs by 10-20%
• Optimize workspace: consider remote work, shared offices, or co-working spaces to cut rent expenses by up to 50%
• Automate with technology: use accounting software and cloud accounting tools to reduce manual work and administrative costs
• Track expenses: monitor spending with tracking tools to identify and eliminate unnecessary purchases

Why you should regularly review and adjust overhead costs

Review your overheads regularly to protect your business from financial stress and maintain healthy cash flow.

Review schedule:

• Monthly: track variable overhead expenses like utilities and supplies
• Quarterly: evaluate fixed costs like rent and insurance for potential savings
• Annually: reassess all overhead categories and eliminate non-essential expenses

Benefits of overhead management:

• Improved cash flow: lower overhead costs mean more working capital
• Financial flexibility: reduced fixed costs help weather economic downturns
• Growth opportunities: savings from overhead reduction can fund business expansion

Why good overhead control matters: Managing overhead costs well helps protect your cash flow and reduces the chance you will need to cut back or close your business during tough periods.

Keeping an eye on overhead costs matters for small businesses because you often operate within tight financial margins. Build overhead management into your cost control strategies from the start. When you start your business, make sure you budget for overhead costs so your business can thrive, not just stay afloat.

Find out more about budgeting and financial forecasting.

Manage your overheads with ease

Managing your finances well helps protect tight profit margins, so keep a close eye on your business overhead costs.

With Xero accounting software you can track overhead expenses, manage stock, and monitor the financial health of your business with ease, helping you to keep your overheads low and sales high. Get one month free and see how Xero can help streamline your financial management.

FAQs on overhead costs

Here are answers to some common questions about overhead costs.

What is considered overhead cost?

An overhead cost is any expense your business incurs that is not directly tied to producing a good or service. Think of them as the costs to keep your business running, such as rent, utilities, and administrative salaries.

What are the main types of overhead?

Overheads are typically grouped into three types. Fixed costs stay the same, like rent. Variable costs change with business activity, like marketing. Semi-variable costs have both a fixed and variable component, like a phone plan with a base rate and usage fees.

What is the difference between overheads and operating expenses?

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

How can you reduce overheads without compromising quality?

When cutting overhead expenses, the key is to 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 optimize energy usage to lower your utility bills.

Staying on top of your overhead costs is an important part of budgeting for small businesses. You need to work out which overhead costs are essential to keep your business running efficiently, and which ones are nice to have when you can afford them, like team lunches, or could be better managed, like energy bills.

Find out more about effective cost cutting.