What are overheads and how do they affect your business?

What are business overheads?

Overheads are the costs in business not directly related to the production of goods or services (indirect costs). If a cost is incurred to create a product or deliver a service, it is classed as a direct cost, not an overhead.

Common overhead cost examples might include your rent, insurance, and admin costs.

Types of overhead costs

There are three main types of overheads: fixed, variable, and semi-variable.

1. Fixed overheads are costs that remain the same regardless of how much your business produces during a set period, such as your rent or the salaries of office employees.
2. Variable overhead costs fluctuate depending on production. For instance, you may spend more on marketing and office supplies during busy periods.
3. Semi-variable overhead costs have both fixed and variable parts. There’s no avoiding them and they’ll rise during your busy periods. For instance, you may face additional costs on your phone plan and have to pay more for utilities on top of your base payment rate.

Why overheads in business can be confusing

Overheads can be confusing as each business determines what overheads are in a different way. It is often assumed that fixed costs are indirect (and an overhead) because you have to pay them whether you produce anything or not. Similarly, variable costs are often assumed to be direct – as the costs of production tend to go up and down depending on how much is being produced – and therefore not an overhead. However, it isn’t always that clear cut.

For instance, an overhead expense can be affected by how you classify production costs. Some businesses might count rent as a cost of production – e.g. rent for a factory – which would make it a fixed direct cost and, therefore, 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 for your small business will depend on what type of business you are and how your business is structured. Grouping your costs into categories during your accounting can help to streamline this process, e.g. manufacturing/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.

Other categories of business expenses

Overhead expenses are just one category of business costs. To avoid confusion, use the following in the correct contexts:

1. Cost of Goods Sold (COGS): these are direct costs tied to producing goods/services.

2. Sales and General Administration (SG&A): these are operational costs not directly linked to production.

3. Depreciation and Amortization: this accounts for the decrease in value of assets over time.

4. Interest: the costs associated with borrowing funds.

5. Income Taxes: the taxes on your business earnings.

6. Miscellaneous: small, irregular expenses that don’t fit into other categories.

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 labor costs.

To calculate your overhead rate, you’ll need to identify all of your overhead expenses – including fixed, variable, and semi-variable – that relate to the same product or service. Then use this formula:

Overhead rate = indirect costs / allocation measure

The indirect costs are the lump sum of your overhead expenses, and the allocation measure is any type of measurement that’s necessary to make the product or service. This could be the lump sum of any direct costs involved in production like your direct labor, machine or material costs, or it could be the direct labor or machine hours it takes to create your product.

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 labor costs. Within this same period, you had labor 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 labor costs your business four dollars in overhead expenses.

Tips for reducing business overheads

Regularly reviewing overheads, and reducing costs where necessary, plays a key role in financial planning for businesses. Try these cost reduction techniques to find some savings:

• Negotiate with suppliers and service providers: there’s often savings to be had within existing supply chains, particularly if contracts haven’t been revised for a while. Find out whether there’s room for negotiation with your existing suppliers, and check their competitors’ prices.
• Consider remote/shared workspaces: the normalisation of remote and flexible working has opened up opportunities for some businesses to cut overhead expenses. Instead of paying for a semi-empty office or workspace, investigate whether you could share an office with another company, take a look at co-working spaces, or even consider working fully remote!
• Leverage smart technology: there are plenty of technological tools that can automate tasks, saving you time and money. For instance, accounting software streamlines your financial practices, and cloud accounting automates data entry.
• Monitor expenses: keeping a close eye on business expenses and employing efficient expense management ensures your business’s profits aren’t frittered away on unnecessary purchases. Xero’s expense tracking tools give you the oversight you need.

How overheads affect the bottom line

To clearly understand your business’s finances, you’ll need to include your overhead expenses on your income 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.

Having high overheads will negatively affect your bottom line as they’ll eat into your net income, reducing your overall profit. Your business will then be less able to invest in itself and grow, so having a tight handle on your overhead expenses is key.

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. Not including overheads in this equation could mean your product is underpriced, reducing your potential profit margins.

You can analyze your stock management and see your most (and least) profitable lines with Xero inventory software.

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.

Implementing a quarterly or monthly review process can help you to keep overhead costs in check. Additionally, keep in mind you can decrease ‘nice-to-have’ overheads and alleviate some financial stress.

Not taking into full account the effect of overhead expenses can leave your business vulnerable to economic challenges as you’ll have less emergency funds to draw on. Day to day, overhead costs affect your cash flow management, and having high overheads will make it difficult to sustain positive cash flow. Over time this could potentially result in downsizing or business closure.

Keeping an eye on overhead costs is crucial for small businesses as you’re often operating within tight financial margins. Including overhead management as part of your cost control strategies, and accounting for overhead expenditure when you first start your business, will be important to keep your business not just afloat, but thriving.

Find out more about budgeting and financial forecasting.

Frequently asked questions

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 overheads is a vital part of budgeting for small businesses. It’s all about deciphering what are the core costs you need to keep your business running efficiently, and what overheads are nice to have when you’re financially strong, like team lunches, or could be better managed, like energy bills.

Find out more about effective cost cutting.

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.

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.