An Entrepreneur’s Guide to Overhead Costs for Small Businesses
Running a business costs money. The various expenses required to keep a company operating are known as overhead costs, and it’s important for small business owners to manage these closely each month. In this article, we’ll cover everything there is to know about overhead costs for small businesses, specifically the different types, as well as tips and strategies for reducing them, and calculating your overhead rate.
What are Overhead Costs?
Overhead costs are business expenses that support a company’s operations but do not directly generate revenue for the company. In other words, they are indirect costs and they are incurred no matter how much profit the company makes.
Some of the most common examples of overhead costs include:
- Rent for office spaces, warehouses, etc.
- Utilities like electricity bills, gas, water, internet, etc.
- Office supplies
- Insurance for vehicles, employees, and properties
- Lawyer fees
- Loan interests
- Business licenses and permits
- Marketing and advertising materials
Why Is It Important to Know your Overhead Costs?
Even though overhead costs are not revenue-generating, they absolutely affect a company’s bottom line. Businesses need to pay their overhead costs using a percentage of their sales each month, but the expenses don’t vary based on what you make. The higher your overhead, the more it will eat into your profits
Miscalculations of overhead costs can also lead to mistakes when pricing your products or services. If you aren’t properly factoring your overhead expenses into the manufacturing of your product, one of two things could happen. 1.) you could price it too low, which would result in a loss of profit, or 2.) you could price it too high which would lead to slow inventory turn-over. Particularly if you’re selling perishable products, a slow turn-over rate could result in inventory spoiling which would also lead to a loss of profit.
Proper management of overhead expenses certainly helps with budgeting. If you have a month or quarter where they are higher than normal, you’ll know you need to make reductions.
3 Types of Overhead Costs
Overhead costs are divided into three categories: fixed, variable, and semi-variable. Fixed costs are ongoing, meaning they reoccur each month, so they are relatively easy to track. However, variable and semi-variable costs can vary and cause influxes on any given month. Here we’ll break down how each category works.
1. Fixed Overhead Costs
The majority of your overhead expenses will fall under the fixed cost category. These types of overhead expenses remain the same each month, regardless of how much profit your company was able to generate in that month. For example, if you own a retail clothing store and you pay $1,500 in rent for the store space each month, you will still owe that $1,500 whether your store makes $5,000, $10,000 or $15,000 worth of profit in a given month. As the name implies, it’s a fixed cost that does not change.
Other general examples of fixed costs include:
- Loan interest rates
- Business insurance
- Property taxes
- Payroll costs
- Software Subscription Fees
2. Variable Overhead Costs
Variable costs are overhead expenses that vary or change from month to month. Depending on your business’ activities, you may or may not incur variable costs every month.
Some general examples of these costs include:
- Advertising and marketing expenses
- Shipping costs
- Legal expenses
- Consultation fees
- Office Supplies
- Commissions (if applicable)
Variable costs can be hard to predict, and some may very well be out of your control. For instance, when the COVID-19 pandemic hit, businesses had to start investing in PPE for employees which was an unforeseen cost. To the best of your ability, adjust your variable costs when there is an economic downturn. When you know your business is heading into a slow season, you can be more cognizant of your spending on items or services the company doesn’t truly need during that slower period.
3. Semi-Variable Overhead Costs
Costs like utilities are considered a semi-variable expense. That’s because they reoccur each month, but the actual cost amount will vary from one month to the next. Take your office’s electricity bill, for example. Electricity is a monthly cost, but in the summer months when you need to increase the use of air conditioning, this cost will increase.
General examples of semi-variable overhead costs include:
- Travel expenses
- Hourly wages
- Company vehicle expenses (i.e., gas)
3 Steps to Calculating Your Overhead Rate
Your overhead rate is one of the most significant metrics in your business. It measures or calculates the portion of your sales that will need to be put towards paying your overhead. It also determines the costs that are not directly tied up to the production of goods or the delivery of your services, helping you come up with a better price for your products or services.
Here are the three steps for calculating your overhead costs:
1. List Down All Your Overhead Expenses
Before you can calculate your overhead expenses, you need to identify what they all are. Remember, all overhead expenses are indirect costs – whether they are fixed, variable, or semi-variable. To determine which of your expenses are considered overhead costs, examine whether that expense directly influences the production of goods or services. You may have bought a desk or desk chair to do your work, but those items will not directly generate any profit for you, so they are an overhead cost. Raw materials, on the other hand, are a direct cost because they physically make up the products that your company sells for a profit. This means they are not an overhead cost.
2. Add Up All the Overhead Expenses
Once you’ve completed your list of overhead expenses and associated costs, add them all up to get your total for the month.
3. Calculate the Overhead Rate
To calculate your overhead rate, you divide your total overhead costs by your total monthly sales and multiply the quotient by 100.
Overhead Rate = (Total Overhead Costs per month / Monthly Sales) x 100
For example: if your overhead costs add up to $7,500 per month and your monthly sales total is $30,000, your overhead rate would be 25%.
Overhead Rate = ($7,500 / $30,000) x 100% = 25%
In this specific example, the overhead rate tells us that 25% of every dollar earned from your product must be put towards paying for the overhead costs of your business.
You should always try to keep your overhead rate of less than 35%. For businesses with a low-profit margin, an overhead rate of 10% could be too heavy for their business so they should work on reducing their overhead costs to keep their business thriving.
4 Ways to Reduce Your Overhead Costs
The lower your overhead rate, the more profit you will be able to keep. If you find yourself going over the ideal 35% rate, or simply want to reduce your overhead expenses, here are five strategies for lowering those indirect costs:
Continuously having to resupply paper and ink adds up. Not only is paperless cost-effective, but it’s more environmentally friendly as well. Invest in software or a cloud-based system that lets you store all important company records electronically. The software cost will be significantly less than the ongoing cost to continue purchasing unnecessary supplies. Going digital also eliminates clutter and allows business owners to be more organized. Be sure to have all your documents backed up in the event of any computer or software glitches.
Budget your Travel
Travel can eat up a good chunk of your company’s budget but is often necessary for business growth. Be proactive and make a budget for each trip you take so you have an allotted limit you have to adhere to. This will motivate and encourage you to be more savvy. You can use airline miles you’ve accumulated for flights, stay in business hotels, and apply for their loyalty programs to obtain discounts on future stays. You should also evaluate the necessity of a trip before booking any travel accommodations. If a virtual meeting could just as well suffice, opt for that.
Invest in Expense-Tracking Tools
There are a lot of software options available today that help business owners to track any unnecessary spending or highlight areas where overspending is taking place. Using such tools can provide insights as to where businesses can cut costs when it comes to overhead expenses. Plus, when tax season comes, having a reliable accounting tool will make it easier for accountants to spot any tax-deductible expenses which lead to more savings for the company.
If you’re spending too much of your company’s money on office equipment like computers, photocopy machines, and other office essentials every year, consider leasing these items instead. Renting allows you to upgrade more easily to the latest versions of computers and other equipment. Additionally, costs like equipment repairs and maintenance will also be lowered if not eliminated when leasing.
Market to Your Existing Customers
One of the best ways to reduce your marketing costs is to focus on improving your customer’s experience with your company and brand. Satisfied customers are more likely to recommend your products or services to friends and family, and word of mouth remains the most powerful marketing tool. You can also encourage your current customers to promote your brand via social media and through online reviews or testimonials. Potential customers are more likely to trust organic promotion via their peers than paid advertising.
Overhead Costs for Small Businesses: Bottom Line
Overhead costs are part of running a business. Business owners who are diligent in tracking and managing these expenses will be able to make adjustments when necessary to ensure that their business is maximizing its profits and improving the company’s bottom line. The more you save on your overhead costs, the more of your profits you’ll be able to keep.