An Entrepreneur’s Guide to Overhead Costs for Small Businesses
Ezra Cabrera | April 13, 2022
Running a business costs money. The various expenses required to keep a company operating are known as overhead costs, and it’s important for small business owners to manage these closely each month. In this article, we’ll cover everything there is to know about overhead costs examples for small businesses, specifically the different types, as well as tips and strategies for reducing them, and calculating your overhead rate.
What are Overhead Costs?
Overhead costs are business expenses supporting a company's day-to-day operations but not directly generating revenue. In other words, they are indirect costs, and they are incurred regardless of the company's profit.
Some of the most common examples of overhead costs include:
Payments 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
Why Is It Important to Know your Overhead Costs?
Even though overhead costs are not revenue-generating, they affect a company's bottom line. Businesses need to pay their business overhead costs using a percentage of their sales each month. But the expenses don't vary based on what you make. The higher your overhead, the more it will eat into your profits.
Miscalculating overhead costs can lead to mistakes when pricing your products or services. If you aren't correctly factoring your overhead into the manufacturing of your product, one of two things could happen: 1.) You could price it too low, which would result in a loss of profit, or 2.) You could price it too high, leading to slow inventory turnover.
A slow turnover rate, particularly if you're selling perishable products, could result in inventory spoiling, which would also lead to a profit loss.
Proper overhead cost management certainly helps with budgeting. If overhead costs are higher than usual for a month or quarter, you'll know you need to reduce them.
Overhead vs. Operating Expenses
Businesses incur two types of expenses each month: overhead and operating expenses. As mentioned, overhead costs are indirect costs or business expenses that don't directly generate revenue. Operating expenses refer to direct labor, materials, and other costs that allow the business to continue running (thus, the term 'operating' expenses).
3 Types of Overhead Costs
Overhead costs are divided into three categories: fixed, variable, and semi-variable. Fixed costs are ongoing, meaning they reoccur each month, making them relatively easy to track. However, variable and semi-variable costs can vary and cause influxes in any given month. Let's break down how each category works.
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1. Fixed Overhead Costs
The majority of your overhead costs will fall under the fixed cost category. These indirect costs remain the same each month, regardless of how much profit your company generated in that month.
For example, if you own a retail clothing store and pay $1,500 in rent for the store space each month, you will still owe that $1,500 whether your store makes $5,000, $10,000, or $15,000 in profit in a given month. As the name implies, it's a fixed expense that does not change.
Other general examples of fixed expenses include:
Loan interest rates
Business insurance
Property taxes
Payroll costs
Software Subscription Fees
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2. Variable Overhead Costs
Variable costs are overhead expenses that vary depending on your month-to-month activities. It's also worth mentioning that not all business operations may incur variable overheads.
Some general examples of these costs include:
Advertising and marketing expenses
Shipping costs
Legal expenses
Consultation fees
Office Supplies
Commissions (if applicable)
Overtime
Administrative expenses
Variable costs can be hard to predict, and some may very well be out of your control. For instance, when the COVID-19 pandemic hit, businesses had to start investing in PPE for employees, which was an unforeseen overhead expense. Adjust your variable costs during an economic downturn to the best of your ability. When you know your business is heading into a slow season, you can be more mindful of your spending on items or services the company doesn't truly need during that slower period.
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3. Semi-Variable Overhead Costs
Costs like utilities are considered semi-variable expenses. That's because they reoccur each month, but the actual cost amount will vary from one month to the next. Take your office's electricity bill, for example. Electricity is a monthly cost, but in the summer months, when you need to use more air conditioning, this cost will increase.
General examples of semi-variable overhead costs include:
Travel expenses
Utilities
Hourly wages
Company vehicle expenses (i.e., gas)
3 Steps to Calculating Your Overhead Rate
Your overhead rate is one of the most significant metrics in your business. It measures or calculates the portion of your sales that will need to be put toward paying your overhead. It also determines the costs 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.
Here are the three steps you can follow to calculate overhead costs:
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1. List Down All Your Overheads
Before you can calculate your overhead expenses, you need to identify them all. Remember, all overhead expenses are indirect costs, whether fixed, variable, or semi-variable. To determine which of your expenses are considered overhead costs, examine whether that expense directly influences the production of goods or services.
You may have bought a desk or desk chair to do your work, but those items will not directly generate any revenue for you, so they are an overhead cost. Raw materials, on the other hand, are direct expenses because they physically make up the products that your company sells for a profit. This means they are not an overhead cost.
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2. Add Up All the Overhead
Once you've completed your list of overhead expenses and associated costs, add them to your monthly overhead costs.
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3. Calculate the Overhead Rate
To calculate overhead costs, divide your total overhead by monthly sales and multiply the quotient by 100.
Overhead Rate = (Total Overhead Costs per month / Monthly Sales) x 100
For example, if your overhead costs add up to $7,500 per month and your monthly sales total is $30,000, your overhead rate would be 25%.
Overhead Rate = ($7,500 / $30,000) x 100% = 25%
In this specific example, the overhead rate tells us that 25% of every dollar earned from your product must be put towards paying for the overhead costs of your business.
It would be best to always try to keep your overhead ratio of less than 35%. For businesses with a low profit margin, an overhead rate of 10% could be too high, so they should work on reducing their overhead costs to keep their business thriving.
4 Ways How to Reduce Overhead Costs in Business
Lower overhead costs essentially translate to higher profit margins. If you find yourself going over the ideal 35% rate, or simply want to know how to reduce overhead costs in business, here are five strategies for lowering those indirect expenses:
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Go Paperless
When you're thinking of reducing costs, start by evaluating your office supplies. Continuously having to resupply paper and ink adds up. Not only is paperless cost-effective, but it's also more environmentally friendly.
Invest in software or a cloud-based system to electronically store all important company records. The software cost will be significantly less than the ongoing cost of purchasing unnecessary supplies. Going digital also eliminates clutter and allows business owners to be more organized. Be sure to have all your documents backed up in the event of any computer or software glitches.
It would be best if you always tried to keep your overhead ratio of less than 35%. For businesses with a low profit margin, an overhead rate of 10% could be too high, so they should work on reducing their overhead costs to keep their business thriving.
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Budget your Travel
Travel can eat up a good chunk of your company's budget but is often necessary for business growth. Be proactive and make a budget for each trip you take so you have an allotted limit to which you have to adhere. This will motivate and encourage you to be more savvy. You can use airline miles you've accumulated for flights, stay in business hotels, and apply for their loyalty programs to obtain discounts on future stays. You should also evaluate the necessity of a trip before booking any travel accommodations. If a virtual meeting could just as well suffice, opt for that.
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Invest in Expense-Tracking Tools
Many software options are available today that help business owners track unnecessary spending or highlight areas where overspending is taking place. Such tools can provide insights as to where businesses can cut costs when it comes to overhead expenses. Plus, when tax season comes, having a reliable accounting tool will make it easier for accountants to spot any tax-deductible expenses, resulting in more savings for the company.
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Lease Equipment
If you spend too much of your company's money on office equipment like computers, photocopiers, and other office space essentials every year, consider leasing these items instead. Renting allows you to upgrade more easily to the latest versions of computers and other equipment. Additionally, costs like equipment repairs and maintenance will also be lowered if not eliminated when leasing.
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Market to Your Existing Customers
One of the best ways to reduce your marketing costs is to focus on improving your customer's experience with your company and brand. Satisfied customers are more likely to recommend your products or services to friends and family, and word of mouth remains the most powerful marketing tool. You can also encourage current customers to promote your brand via social media and online reviews or testimonials. Potential customers will likely trust organic promotion via their peers rather than paid advertising.
The Bottom Line: Overhead Costs for Small Businesses
Overhead costs are part of running a business. Business owners who diligently track and manage these expenses can make adjustments when necessary to ensure that their business is maximizing its profits and improving the company's bottom line. The more you save on your overhead costs, the more of your earnings would be.
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