Overhead costs: what they are and how to calculate

Published Wednesday 22 April 2026

Table of contents

• What are business overheads?
• Why overhead costs matter to your business
• Types of overhead costs
• Examples of overhead costs
• How to calculate overhead costs
• Why overheads in business can be confusing
• Other categories of business expenses
• Reduce your overhead costs with Xero
• FAQs on overhead costs

Key takeaways

• Calculate your overhead rate by dividing total indirect costs by your chosen allocation measure (such as direct labor hours or direct costs) to see exactly how much overhead you incur per unit and set prices that actually cover all your costs.
• Include overhead costs in your pricing strategy by adding them to direct costs before setting prices, as businesses that leave overhead out of their pricing often run at a loss without realizing it.
• Reduce overhead expenses by negotiating with suppliers annually on an item-by-item basis, optimizing your workspace through remote work or shared offices, and automating tasks with technology to improve your profit margins.
• Review variable overhead costs monthly and fixed costs quarterly to maintain healthy cash flow and spot non-essential expenses you can cut to free up resources for business growth.

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 (making sure to review costs on an item-to-item basis rather than just accepting a total figure), optimizing workspace through remote work or shared offices, and automating tasks with technology to improve profit margins.
• 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 the indirect costs that keep your company running but aren't tied to producing specific goods or services. These expenses continue whether you make sales or not, which is why they're also called operating costs. Common examples include rent, insurance, and administrative salaries.

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.

Why overhead costs matter to your business

Overhead costs directly affect your profit margins, pricing decisions, and cash flow. When you understand your overheads, you can set prices that actually cover all your costs, identify where to cut spending, and protect your business during slow periods.

How overheads affect the bottom line

Overhead costs reduce the profit available for business growth and investment. Here's how overheads affect your profitability:

• Income statement impact: overhead expenses lower your net revenue when calculating net income.
• Profit reduction: high overhead costs leave less money for reinvesting in your business.
• Growth limitations: excessive overhead expenses restrict your ability to expand or improve operations.

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

Businesses that don't include overhead in pricing often operate at a loss without realizing it. Follow these steps to build overhead into your pricing strategy:

1. Calculate your 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 profit from each sale
4. Review pricing regularly as overhead costs change

You can analyze your inventory, track inventory costs incurred over the fiscal year, and see your most (and least) profitable lines with the inventory tools in Xero accounting software.

Types of overhead costs

Overhead costs fall into three main categories based on how they change with your business activity. Understanding these categories helps you budget more effectively and identify cost-saving opportunities.

Fixed overheads stay the same regardless of production levels.

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

Variable overheads fluctuate with business activity.

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

Semi-variable overheads combine 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. These expenses vary by industry but typically include the following:

• 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

How to calculate overhead costs

To calculate overhead costs, divide your total indirect costs by an allocation measure like direct labor hours or direct costs. Just as large institutions calculate their corporate overhead rate by dividing indirect costs by direct costs, this gives you an overhead rate that shows how much overhead you incur per unit of production.

Follow these three steps to calculate your overhead costs.

Step 1: Identify all overhead expenses

List every indirect cost by category:

• 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 your 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.

Now let's see how this works in practice.

Overhead costs calculation example

Calculate your overhead rate using these real numbers.

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. Use this 4:1 ratio to:

• Set profitable prices: include $4 of overhead cost for every $1 of labor when pricing services.
• Control costs: compare your overhead ratio against industry standards.
• Make decisions: evaluate whether to hire more staff or reduce overhead expenses.

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 they rise and fall with production levels.

In practice, it's not always that clear-cut. The same cost can be an overhead for one business but a direct cost for another.

Overheads are indirect costs that support your business whether you're producing or not. How you classify a specific cost depends on your business type and structure.

Follow these steps 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?

Other categories of business expenses

Overhead expenses are just one category of business costs. While the IRS recently discontinued its dedicated Business Expenses publication, here are other typical business expense categories to account for:

• Direct costs: expenses tied directly to producing goods or services
• Cost of goods sold: materials and labor for products you sell
• Operating expenses: day-to-day costs of running your business

Reduce your overhead costs with Xero

Xero's accounting software helps you track and analyze overhead costs in real time, giving you the insights you need to make smarter business decisions. Start managing your overhead more effectively today.

Explore Xero's features

FAQs on overhead costs

Here are answers to common questions about business overhead costs.

What's the difference between overhead and operating costs?

Overhead costs are indirect expenses that support your business operations, while operating costs include both direct and indirect expenses needed to run your business.

How often should I review my overhead costs?

Review variable overhead costs monthly and fixed costs quarterly to maintain healthy cash flow and identify opportunities to reduce expenses.

Can overhead costs ever be direct costs?

Yes, the same expense can be classified differently depending on your business type. For example, rent for a retail store is overhead, but rent for a manufacturing facility might be a direct cost if the space is used exclusively for production.

What's a good overhead rate for small businesses?

Overhead rates vary widely by industry. Service businesses typically have lower overhead rates (1.5:1 to 3:1), while manufacturing businesses often have higher rates (3:1 to 5:1). Compare your rate to industry benchmarks to assess performance.