How To Calculate Overhead Costs in 6 Steps

By Indeed Editorial Team

Updated June 7, 2022 | Published October 9, 2020

Updated June 7, 2022

Published October 9, 2020

Overhead costs are a fundamental element of operating a business and reflect the expenses companies have that are needed to run day-to-day operations. Since you can never get rid of overhead costs, it's essential to understand them so you can reduce expenses to make a profit. In this article, we'll take a look at what overhead costs are, why you should know your overhead costs and how to calculate your overhead costs.

What are overhead costs?

Overhead costs are continuing expenses that support your company but do not generate profit for your business.

Overhead costs are indirect expenses that are not related to business activities that make the company money—payment of overhead costs is required, no matter what, even when business is slow. Companies will have overhead costs to keep the business operating during these periods.

Related: Why Budgeting Is Important (plus 7 Benefits of Budgeting)

Why you should know your overhead costs

There are benefits to understanding your overhead costs.

Knowing your overhead costs can assist you with setting prices for products and services that result in profits. By factoring overhead costs into the total cost to operate your business, you can forecast the total amount of funds that will be required for success.

You can determine your net profit by using your overhead costs by taking your gross profit and subtracting all expenses, counting overhead, to figure out your net profit. The net profit will explain if your business is making money or if expenses are more than your revenue.

Knowing your overhead costs will help you find ways to reduce them. You can examine ways to save money by seeing what large expenses are generated over time and coming up with solutions that will help reduce your overhead costs and increase your net profit.

Related: Forecast vs. Budget: Differences and Steps to Forecast Budget

How to calculate overhead costs

Keeping an organized and complete record of your overhead costs will benefit your business and help you establish the best price for your product or service. Accurate record-keeping will help you see where you can save money and help you find ways to streamline your business model. Here are six easy steps to calculate overhead costs:

1. List all of the expenses

Prepare a complete list of your business costs. Your list should be thorough and incorporate things like rental space for your business, utilities, taxes and building upkeep. These are examples of overhead costs. Other expenses like stock, materials and labor are not overhead costs.

2. Categorize each expense

Calculating your overhead costs is more straightforward when organized. Categorize each item on your list of the expenses for the goods or services your business provides. For example, labor for a house build and the raw materials for the house are direct costs. The direct costs are related to when the house is in construction.

It's important to remember that some items don't fall easily into one category or the other, so you must make some judgment calls. For example, most businesses classify legal costs as overhead. The law firm and the lawyer's cost of services is a direct cost since it's connected to providing legal assistance, which is the law firm's service.

Overhead costs follow the protocols for the provided industry and list expenses as direct or overhead costs.

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3. Add the overhead costs

Add the month-to-month overhead costs to calculate the annual total overhead expense. Typically the sum is what you require for running your business.

4. Calculate the overhead rate

The overhead rate or percentage is the sum your organization spends on making an item or providing services to its clients. Calculating the overhead rate can be done by dividing the indirect costs by the direct costs and multiplying by 100.

If your overhead rate is 40%, it implies the enterprise spends 40% of its revenue on making a good or providing a service. The lower your overhead rate is, the more efficient and profitable your company may be.

5. Compare to sales

When setting costs and making budgets, you should know the percentage of funds dedicated to overheads. To calculate the overhead costs compared to sales, divide the monthly overhead cost by monthly sales, and then multiply by 100.

For example, an organization has monthly sales of $200,000 and overhead costs of $50,000.

($50,000/$200,000) x 100 = 25% overhead

6. Compare to labor cost

To determine the efficiency of how a business is using its resources, calculate the overhead cost as a percentage of labor cost. The lower the percentage is, the more efficient a company is using its resources.

Divide the monthly overhead cost by the monthly labor cost and multiply by 100 to represent it as a percentage.

Related: Balanced Budget: What It Is and How To Create It

Overhead costs and formulation calculation

While there are a lot of ways to calculate the overhead costs, here is a simple formula to follow:

Overhead cost = Allocation measure/ Indirect costs

Overhead expenses are the indirect costs that are not specifically tied to creating an item or service.

Allocation measure is any estimation that's essential to producing the product or service. It can be the number of direct labor hours or machine hours for a specific item or a period.

The calculation of the overhead cost has a foundation based on a specific period. For example, if you wanted to determine the indirect costs for a month, you would total your monthly indirect or overhead costs. You would then take an analysis of what goes into production for the same period.

By measuring the total direct labor cost for the month, the denominator would be the total monthly cost of direct labor for production that month. Ultimately, you would divide the indirect costs by the allocation measure to reach how much overhead expenses are for every dollar spent on direct labor for the month.

A company that exceeds expectations by observing and improving its overhead costs can progress the business's productivity and profit.

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