A Guide to Business Overhead Costs | SMB Compass
Ezra Cabrera | November 6, 2020
Part of the life of an entrepreneur is dealing with business expenses. In reality, business owners won’t get to keep all the profit their company will generate. Even if their business is a sole proprietorship and they’re the only ones working on it, they have to deal with the overhead costs for small businesses since it’s one of the most important things that will keep their business afloat.
One of the benefits of being aware of the overhead costs is that it can affect the company’s bottom line significantly. It will also act as a guide as to where business owners can cut back so their company will gain more savings. In this article, we’ll cover everything there is to know about business operating costs, specifically the different types, how to calculate the overhead rate, and tips and strategies that entrepreneurs can implement to reduce them.
What are Overhead Costs?
In the simplest sense, a business’ overhead costs are the indirect expenses that are associated with your company’s day-to-day operations. In other words, these are business expenses that do not contribute to your company’s profit generation process. Although they don’t affect that said aspect of the business, it should still be well-accounted for, especially if you’re looking into cutting costs in your company. Typically, your overhead costs may remain every month. However, factors like overtimes and hourly wages can affect your monthly overhead expenses.
Some of the most common examples of overhead costs, include:
- Rent for office spaces, warehouses, etc.
- Utilities like electricity bills, gas, water, internet, etc.
- Office supplies
- Insurance for vehicles, employees, and properties
- Lawyer fees
- Loan interests
- Web hosting for small business
- Business licenses and permits
- Payroll
- Marketing and advertising materials
It’s important to closely monitor your overhead costs because it will easily sneak up on you. Since they don’t affect your business’s revenue-generating activities per se, it’s one of the expenses you should consider when trying to control your business expenses.
Why is It Important to Know your Overhead Costs?
Aside from the fact that your overhead costs can have a direct effect on your income statement and balance sheets, inaccurate calculation of it can lead to mistakes in the pricing of your products or services. If you don’t factor in your overhead expenses on the manufacturing of your product, your product could be priced too low which will result in the loss of profit for your business. On the other hand, overpriced products because of inaccurate estimates of your overhead costs, could lead to slow inventory turn-over. If you’re selling perishable products, a slow turn-over rate could lead to spoiling and loss of profit.
Moreover, having an idea of how much your overhead expenses are will also help you become a better business manager. Upon knowing that your overhead costs are greater than normal for that specific month or quarter, you can take the steps needed to reduce your business expenses. This can lead to more profits for your company.
3 Types of Overhead Costs
Overhead costs are divided into three categories: fixed, variable, and semi-variable. While the first two types are easy to track, semi-variable costs may vary monthly. Here’s how each of it works:
1. Fixed Overhead Costs
The majority of your overhead expenses will fall under the fixed cost category. As the name implies, this type of overhead expenses remains the same each month, regardless of how much profit your company generates in that particular month. For instance, a retail store owner pays $1,500 rent for the storage space each month. On a specific month, whether the company makes a $5,000 or $10,000 in sales, the business owner still has to pay $1,500 that particular month.
Other than rent, other types of fixed costs include:
- Loan interest rates
- Business insurance
- Property taxes
- Payroll costs
- Software Subscription Fees
2. Variable Overhead Costs
Variable costs are overhead expenses that vary or change from month to month. Depending on your business’ activities, you may or may not incur variable costs every month. Some examples of overhead costs include:
- Advertising and marketing expenses
- Shipping costs
- Legal expenses
- Consultation fees
- Office Supplies
While others may think that office supplies should be considered as an operating cost, it’s worth noting that they don’t directly affect the production or delivery of your service. For instance, an office chair won’t guarantee an increase in your sales. The business owner may not even think about sales when reordering or replenishing office supplies.
Among the downside of variables, costs are that they’re often hard to predict. This makes business budgeting even more challenging and daunting for business owners. On the upside, you can easily adjust your variable costs when there is an economic downturn. As a result, it will be easier for entrepreneurs to control their budgets during the slow times of the business.
3. Semi-Variable Overhead Costs
Expenses like utilities are considered as semi-variable expenses because these costs will always be present on your monthly expenses, but the cost could vary from one month to the next. However, you can always get a ballpark of how much these are going to cost by looking at your previous year or month’s spending on each category.
For instance, during summer, you may see an increase in the use of A/C in your office. As a result, your electricity bill could also shoot up. By looking at how much you spent on your office’s electricity bill in the previous year, you can get an estimate of how much your bill will cost this in the summer of this year.
Examples of semi-variable overhead cost include:
- Travel expenses
- Hourly wages
- Commissions
- Company vehicle expenses (i.e., gas)
3 Steps in Calculating Your Overhead Rate
Your overall overhead cost is one of the most significant metrics in your business. It measures or calculates the portion of the sales that go into paying your overhead. It also determines the costs that are not directly tied up to the production of goods or the delivery of your services, helping you come up with a better price for your products or services.
To calculate your overhead costs, here are 3 steps to can follow:
1. List Down All Your Overhead Expenses
Before you can calculate your overhead expenses, it’s smart to write all the costs down. To determine which of your expenses are considered an overhead cost, consider whether that expenses directly influences the production of goods or services. Raw materials, for example, is considered a direct cost because it plays a huge role in the production of goods and therefore isn’t considered as an overhead cost. What’s considered as an overhead expense is the cost of marketing that specific product.
2. Add Up All the Overhead Expenses
Once you have your list, write the costs for each beside each item. Add it up and you’ll get the total of your overhead expenses for the month.
3. Calculate the Overhead Rate
To calculate your overhead rate, you’ll also have to determine your monthly sales. Once you have that, you only have to divide the total of your monthly overhead costs by your monthly sales. Then, Multiply the quotient by 100 to get the rate.
Overhead Rate = (Total Overhead Costs per month / Monthly Sales) x 100
For instance, if your overhead costs add up to $7,500 per month and your monthly sales total to $30,000, your overhead rate would be 25%.
Overhead Rate = ($7,500 / $30,000) x 100% = 25%
The overhead rate tells you that for every dollar that you earn for that product, 25% of it goes towards paying the overhead cost of the business. In this case, for every dollar earned, $0.25 goes into the business overhead expenses.
As much as possible, keep your overhead rate less than 35%. For businesses with a low-profit margin, an overhead rate of 10% could be too heavy for their business so they should work on reducing their overhead costs to keep their business thriving.
5 Ways to Reduce Your Overhead Costs
The lower your overhead rate is, the more profit you will get. If you find yourself going over the ideal 35% overhead rate, or simply want to reduce your overhead expenses, there are some things you can do. Check out these # tips to lessen your company’s overhead expenses:
Go Paperless
You may not realize it, but one of the things that are eating up your overhead expenses are the papers and ink you use for recording your company’s documents. To cut down this expense in your business, one alternative way is to keep all your company’s records on the computer. Instead of constantly replenishing papers and ink to print the company’s important documents, invest in software or a cloud-based system that lets you store important company records electronically. This won’t only translate to more savings in the long-run, but it will also eliminate clutter and ensures that your documents are stores in a secure and safe place.
Also, don’t forget to store the physical back-up documents in a separate location in case of emergencies (i.e., software glitches).
Stick to a Budget for Each Business Trip
Trips can take up so much of your company’s budget. But they’re often necessary especially if you’re trying to grow your business. To reduce costs on business-related travels, have a budget for each of your trip and stick to it. If you travel frequently, you’ll most likely have a lot of miles stored that you can use for your next business trips. You can also look for business hotels as they’re way cheaper than luxury hotels. Also, apply for the hotel loyalty programs to get discounts for your next stay.
Related: 6 Practical Tips to Effectively Stick to a Business Budget
Another way to reduce your cost of travel is to assess whether you really have to travel or not. Oftentimes, there are some issues or situations that could be solved through virtual meetings. If it can be done without you or an employee having to fly across states or countries, then it means more savings for your business.
Invest in a Good Expense-Tracking Tool
There is a lot of software available today that lets you track any unnecessary spending or determine areas where you’re overspending. Using this tool will give you an insight as to where you can cut costs when it comes to your overhead expenses. Plus, when the tax season comes, having a reliable accounting tool will make it easier for your accountant to spot any tax-deductible expenses which leads to more savings on your part. It’s a win-win.
Related: 6 Tips to Help Keep Track of Small Business Expenses
Lease Equipment
If you’re spending much of your company’s money on office equipment like computers, photocopy machines, and other office essentials, every year, consider leasing it, instead. Renting allows you to upgrade more easily to the latest versions of computers and other equipment. Plus, other costs like equipment repairs and maintenance could also be lessened or eliminated when you’re leasing.
Market to Your Existing Customers
One of the best ways to reduce your marketing costs is to focus on improving your customer’s current experience. If they are satisfied with the services or products that they bought from you, they’re more likely going to recommend you to their friends and family. Even though we’re at the digital age today, word-of-mouth remains to be a powerful marketing tool.
You can also encourage your current customers to promote your brand. In exchange, you can offer them discounts or freebies for every referral. Don’t forget to ask them to leave reviews or testimonials. Even if it’s only one or two sentences, the positive praise on your business will attract a lot of potential customers, thus, helping you increase your sales even more.
Overhead Costs for Small Businesses: Bottom Line
Overhead costs for small businesses should be one of the many factors that business owners should consider when running a business. By knowing where you stand on that metric, you can make the necessary adjustments to ensure that your business is maximizing the profits from every product or service that the offers. Sparing a few minutes of your time to check and calculate overhead costs for small businesses is a great way to improve your company’s bottom line.
Remember that you’re in this to generate a profit and make money. The more you save on your overhead costs, the better your chances are at increasing your company’s profits. By tracking and managing your overhead costs, you’ll have a better chance of achieving that goal.
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