Overhead expenses are the operating costs of a business that do not directly produce a profit. It includes indirect expenses, such as electricity and equipment repairs, that are not immediately associated with making a product or providing a service. While these costs do not add revenue to your bank account, they are necessary for your business.
Understanding business overhead expenses will not only keep your finances on track, it will also help you to establish prices that will turn a profit.
Direct and indirect expenses
As a small business owner, you have many costs to cover. Some costs refer to purchases that directly relate to producing goods or delivering services. These are called direct expenses. Raw materials can be traced to a specific good, and are physically present in the final product, so they are classified as direct costs. For example, if you own a construction company, the cost of the lumber you purchase for a project is considered a direct expense.
Overhead costs, on the other hand, includes all of the indirect expenses that do not relate to profit making processes. These are often fixed, ongoing expenses that do not change with fluctuating monthly sales.
Here is a list of common indirect costs:
- Rent/mortgage payments
- Office supplies, equipment maintenance, and tools
- Depreciation on equipment and buildings
- Legal fees, advertising, and consulting services
- Fixed supervisor salaries
Though these costs do not directly contribute to your company’s revenue, indirect expenses are an essential part of operating your business.
Calculating overhead expenses
To get started on finding your company’s overhead rate, first decide whether or not each expense is a fixed cost. Like most overhead expenses, if the item’s amount does not fluctuate, or it changes very minimally, from month to month it is a fixed cost.
You must also decide if the cost is directly related to creating a product or performing a service. If it is not, then it can be called an overhead expense. If the expense is directly involved, it is included in the cost of goods sold (COGS) and not considered while finding the overhead rate. Learn more about how to calculate COGS.
After your expenses are classified, you can determine your company’s overhead rate by dividing the total monthly overhead costs by the total monthly sales.
For example, a business has $7,500 in monthly overhead costs and earns $50,000 in monthly sales. Divide $7,500 (monthly overhead) by $50,000 (monthly sales) to get 0.15. By multiplying this number by 100, you can see the business’s overhead rate is 15 percent.
Looking at this calculation in terms of dollars, the company above spends 15 cents on overhead costs for every dollar it earns. You can do this calculation for your business to determine how much you are spending on overhead expenses. The lower the rate of overhead in business, the higher your company’s revenue will be.
Knowing your overhead rate and break-even point will help you decide competitive prices for your products or services. By understanding these numbers, you can also determine how well you are utilizing your resources. Examine your overhead expenses to see if improvements can be made to your spending, such as going paperless or purchasing fewer supplies.
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