The term of ‘overhead costs’ refers to the expenses you pay to continue with your business. They are not connected to the costs of producing something, even if the sales are high or low. Having an accurate knowledge of your overhead costs is extremely useful for setting the right price for the service or product you are offering. But how do you calculate overhead cost? Today we are going to go through this process step by step and learn more about it.
How Do You Calculate Overhead Cost? An Overview
1. Understand What Are Overhead Costs
The first step before you learn to calculate overhead costs is to understand what they are. Also called indirect costs, they refer to administrative or technical factors that are used in your business. They must be essential for the business and you need to pay them regularly. A couple of examples of these costs are:
- Office supplies;
- HR staff and expenses;
- Accounting, etc.
Regardless of the revenue you have, these are costs that must be paid one way or another.
2. Make a Comprehensive List
You can choose any time frame you want to calculate the overhead costs, but most companies choose to break them down by month. Include here all the indirect costs you can think of. A good solution is to use a computer program that can make your work easier, such as Freshbooks, QuickBooks, or Excel.
But how do you calculate overhead cost without knowing all the costs? It can be quite confusing to do so, which is why it’s better to make a list of all the expenses, and then break them down into direct and indirect. Keep in mind that some costs may fall into both categories, so you need to think about that. To make sure you included all the expenses, look at expense reports, receipts, bills, and other such papers you keep. You may want to include infrequent expenses as well, such as filing permits, renewing licenses, etc.
3. Calculate the Total Overhead Costs
Once you put them separately in the document, it’s time to calculate the total costs. Add all the indirect costs you wrote down for a month (or the period you chose). This represents the total amount you need to stay in business.
4. What Is the Average Overhead Cost Percentage and How to Calculate It?
The next step is to calculate the overhead percentage, also called overhead rate. This lets you know how much money goes into creating a product and how much for sustaining the business. The formula for this is to divide the indirect costs by the direct ones. For example, if your indirect costs are $16,800 and the direct ones are $48,000, your rating will be 0.35. Multiply it by 100 and you’ll get the overhead percentage: 35%. Naturally, the lower your overhead rating, the bigger your profit.
5. Compare Your Business to Others
Now that you found out how do you calculate overhead cost, the next logical step would be to compare yourself to other businesses in the field. Depending on your business, your points of interest may be different. Starting from the hypothesis that all businesses in the field have the same direct costs, the winners will be the ones who have a lower overhead rating.
6. Find Out If You’re Using Your Resources Efficiently
To find out this, divide the overhead costs by the labor costs. Multiply the result by 100 to find out the percentage of overhead that goes for each worker. Once again, the lower this number is, the better you are spending your overhead costs. However, if the number you have is too high, you may be having too many employees.
7. What Percentage of the Revenue Pays for Overhead?
If you want to know this, you need to divide the overhead costs by the profit you made in sales. Next, multiply it by 100 to see what percentage of the revenue pays for overhead. In this way, you can find out if you sell enough services or goods to keep up your business. For example, if your business sells products that amount to $100,000 a month, and your indirect costs are $10,000, then your percentage is 10%. The higher your percentage, the lower your profit margin is.
8. Adjust the Overhead Costs
Though they might seem complicated at first, these calculations are extremely useful for the way in which you’re running your business. As you have seen, you can find out whether you’re paying too much rent or if you need to boost your sales to cover the overhead costs. Some people even learned that they have too many employees and they’re not spending as much/less as they should to keep all of them on the job.
However, don’t let yourself convinced entirely by these numbers. Having a low overhead isn’t everything when you’re running a business. There are plenty of companies who spend a lot of money on workers’ satisfaction or on good equipment. In this case, they get to enjoy higher profits, as well as an increase in productivity.
9. Apply It to Your Company
So how do you calculate overhead cost and, most importantly, what do you do with that information? As we showed above, you can use the total overhead cost formula to assess your spending. Then, you need to use the information to compare your company to the rivals and see what you can improve. However, it’s extremely important to note here that not all the strategies and changes can work for your company. Even if a certain adjustment worked for one of your competitors, it might not yield the same results with you. That’s why it’s essential to consider all the factors and variables before changing anything.
Here you have a clip that explains more about this indicator and how to calculate it:
To sum up, the overhead cost can show you a lot of things about your business. It helps you stay on top of your expenses and see what can be optimized and how can you improve your workflow.
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