What are Overhead Costs?
Overhead Costs represent the ongoing, indirect expenses incurred by a business as part of its day-to-day operations.
An overhead cost is a recurring expense necessary to support a business and allow it to continue operating, but these indirect costs are not directly tied to revenue generation.
How to Calculate Overhead Costs (Step-by-Step)
Overhead costs are the ongoing costs paid to support the operations of a business, i.e. the necessary expenses to remain open and to “keep the lights on”.
However, while overhead expenses are necessary incurrences for a business to continue operating, these sorts of costs are not directly associated with the generation of revenue.
The fewer overhead costs there are, the more profitable a business is likely to be – all else being equal.
An overhead cost, contrary to a direct cost, cannot be traced to a specific piece of a company’s revenue model, i.e. these costs support operations, as opposed to directly creating more revenue.
Since overhead cannot be attributed to one specific revenue-producing business activity, the term is often used interchangeably with the term “indirect expenses”.
By quantifying the dollar value of a company’s overhead – i.e. how much it costs a business to stay open and operate – management can determine how many units it needs to sell in order to break even, as well as how much must be sold in order to meet its profit targets.
The process of calculating a company’s overhead consists of three steps:
- Step 1: Identify Each Overhead Cost: The first step is to determine each cost that meets the criteria and the associated amount for the specific time period.
- Step 2: Add the Total Overhead: The next step is to add all the costs deemed “overhead” to arrive at the total overhead cost.
- Step 3: Calculate Overhead Rate: The final step is to divide the overhead by sales to arrive at the overhead rate, which facilitates analysis of year-over-year (YoY) trends, as well as to be able to make comparisons to industry peers.
Overhead Costs Formula
The formula for calculating a company’s overhead is as follows.
An overhead cost can be categorized as either indirect materials, indirect labor, or indirect expenses.
- Indirect Materials → Material costs that do not qualify as direct materials, such as the cost of cleaning supplies in a factory.
- Indirect Labor → Labor costs for employees not directly involved with the production process, such as compensation for the janitor or security guards.
- Indirect Expenses → A catch-all term that encompasses any operating expense that is not a direct cost, such as utility bills and rent.
Indirect Cost vs. Direct Cost: What is the Difference?
Certain costs such as direct material (i.e. inventory purchases) or direct labor must be excluded from the calculation of overhead, as these costs are “direct costs”.
In order to measure the overhead of a business correctly, any direct costs associated with creating revenue must be excluded.
The list below contains some of the more common examples of indirect costs:
- Administrative Costs
- Office Supplies
- Marketing and Advertising
- Telephone Bills
- Accounting and Legal Fees
- Property Taxes
However, something important to note is that each industry has a different definition for overhead, meaning that context must be considered in all cases.
Types of Overhead Costs: Fixed vs. Variable vs. Semi-Variable Cost
An overhead cost can be segmented into one of the three distinct types:
- Fixed → Fixed costs remain constant irrespective of the number of units produced and sold in the period, e.g. rent.
- Variable → Variable costs fluctuate based on the number of units produced and sold in the period, e.g. AWS server hosting fees.
- Semi-Variable → Semi-variable costs – a hybrid between fixed and variable costs – are incurred regardless of the output, but there is also another component that can cause some variance contingent on the specific circumstances, e.g. a monthly telephone bill, or truck fuel.
Overhead Costs Calculator – Excel Model Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Overhead Costs Business Calculation Example
Suppose a retail company is attempting to determine its total overhead for the past month.
For our hypothetical scenario, we’ll assume that the company operates multiple store locations and generated $100k in monthly sales.
- Month 1 Sales = $100,000
In Month 1, the company has identified the following costs are “overhead”:
- Rental Cost of Stores = $8,000
- Indirect Employee Salaries = $6,000
- Marketing and Advertising = $4,000
- Office Supplies and Utilities = $1,000
- Insurance and Property Taxes = $1,000
After adding together all the overhead expenses of our company, we arrive at a total of $20k in overhead costs.
- Monthly Overhead = $8,000 + $6,000 + $4,000 + $1,000 + $1,000
As a standalone metric, the $20k in overhead is not too useful, which is the reason our next step is to divide it by the monthly sales assumption to calculate the overhead rate (i.e. overhead divided by monthly sales) of 20%.
- Overhead Rate = $20k / $100k = 0.20, or 20%
In our example scenario, for each dollar of sales generated by our retail company, $0.20 is allocated to overhead.