All businesses must have the necessary funds to drive the cost of production and aid in increasing the overall gross revenues.
However, if the overhead costs, which are the expenses required to keep the business running, exceed the regular amount, the business may suffer a revenue loss.
So, what is overhead? Business owners need to track their business expenses to avoid draining the company’s revenues.
What Is Overhead in Business?
Overhead refers to the working expenses that drive the operation of a business. However, it excludes the costs involved in manufacturing and producing goods and services.
So if you are looking at overhead vs. operating expenses, overheads are the expenses incurred by a business to stay operating regardless of its success in the industry. Unlike operating expenses, overheads are hard to trace to a specific business activity or cost of the unit.
These overhead costs are vital in a business as they allow the management to determine how much the enterprise should charge a product to maintain its profit margins.
Types of Overhead Costs
Overhead costs mostly fall under three types:
Most overhead costs fall under this category. This is because they are the companies/business expenses that remain stable or are present monthly.
- Mortgage payments
- Property taxes
- Payroll costs
- Company insurance
- Internet services
- Subscription fees.
As the name suggests, these expenses remain unchanged throughout the year.
Variable overhead costs are business expenses that vary with each monthly event.
Unlike fixed costs that remain unchanged for the rest of the year, variable overhead costs vary from month to year.
- Advertising costs
- Office supplies
- Overtime costs
- Legal expenses
- Maintenance fees
Note that variable overhead costs are hard to predict. For instance, take the Covid-19 Pandemic; many businesses were forced to close when it hit, and employees were told to work from home. This resulted in industries incurring expenses to offer overtime salaries for their workers.
In other companies that did not close down, such as the manufacturing industries, employers were forced to incur unbudgeted costs for face masks, sanitizers, and protective clothing for their employee’s safety. These were allocated overhead costs that were not there in the past.
These overhead costs are sustained regardless of the business activity levels. However, these expenses often increase depending on the demand and the business’s success.
For instance, most semi-variable overhead expenses include business utility costs such as:
- Electricity bills
- Hourly employee wages
- Travel expenses
- Company gas expenses
Depending on the type of overhead costs your business incurs, the management must keep track of these expenses to reduce any risk of draining the business revenue.
Small businesses should monitor their expenses and know what to invest in and not to spend money on to maintain the proper running of the enterprise.
How To Calculate Overhead Costs for Your Small Business
As a small business owner, you should learn how your overhead costs impact your business. It is your responsibility to know how to calculate these costs.
When doing your calculations, the first thing to do is to identify and list all your expenses against their costs.
Sort them into indirect and direct expenses, ensuring you do not include the direct expenses incurred during the production stage, such as raw materials and labor costs. These direct expenses should only be included at the last step when determining the sale of goods.
To stay on top of your finances, consider calculating the overhead costs by adding all the monthly expenses.
For example, by using this formula:
Rent + Property Taxes + Office Utilities = Monthly Overhead Expenses
If your rent is $1500, property taxes are $100, and office utilities cost up to $70 every month, then your total overhead costs are $1670
Tips To Reduce Your Overhead
Once you realize that your overhead expenses exceed your monthly or annual budget and are taking a toll on your company revenue, it may be time to reevaluate your priorities and make the necessary changes.
Here are three ways you can reduce overhead costs.
Invest in Expense Tracking Consultants and Tools
While it may seem like an additional expense to bring in a financial consultant, they are more knowledgeable in ways to save money for a business. Thus, they look at your accounting books and advise on the best way forward.
You can also invest in good accounting software that tracks your finances, offers real-time tracking, and may help notify you when the expenses exceed the regular amount.
Rent Office Equipment
If you notice that you are spending excess amounts on buying office equipment such as printers, fax machines, and computers, consider renting them instead to gain the extra cash. Renting office equipment often saves money as you can hire the items only when necessary.
Control Your Business’s Purchasing Power
When running a small business, you may lose track of how much company money is spent on purchasing and hiring equipment, tools, and labor to keep the business running. Ideally, it would help to designate a reliable staff member to handle all the purchasing and limit the purchases.
Ultimately, if the person is good at their job, they will save a lot of money.
What Is a Good Overhead Percentage?
Research shows that an excellent overhead percentage does not exceed 35% of your company’s total revenue.
For example, to calculate your overhead percentage, it is best to use this formula:
Overhead Rate = (Total Overhead Costs per month / Monthly Sales) x 100
Here is an overhead cost example. If your overhead costs add up to $5000 per month and your monthly sales total is $40,000, your overhead rate should be 12.5%.
This means that your overhead percentage is manageable. Strive to ensure that your overhead expenses fall under 35% or make the necessary adjustments.
Average Overhead Rates by Industry in 2023
Typical overhead rates range from one industry to another.
Thus, with an average estimate of 35% overhead rates. Every business, regardless of the industry, should portray a smaller percentage.
However, the bad news is that with the increasing inflation in 2022, fixed, variable, and semi-variable expenses may increase significantly. Although, as a business owner, you may increase the prices of the goods and services, it is not a guarantee that your average sales will remain the same or increase during this time.
Overhead costs for small businesses are necessary for the smooth running of a small business. However, as discussed, you should diligently track and manage all your expenses to avoid reducing your sales revenue.
If your overhead costs exceed 35%, consider following the tips to help adjust your expenses and boost your business in the long run.