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.
Table of Contents
How to Calculate Overhead Costs
The fewer overhead costs there are, the more profitable a business is likely to be – all else being equal.
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 paying these overhead costs is necessary for the business to continue operating, these sorts of costs are not directly associated with the generation of revenue.
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 costs cannot be attributed to one specific revenue-producing business activity, the term “overhead costs” is often used interchangeably with the term “indirect expenses”.
By quantifying the dollar value of overhead costs – 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 overhead consists of three-steps:
- Identify Each Overhead Cost: The first step is to identify each overhead cost and the associated amount for the specific time period.
- Add Overhead Costs: The next step is to add all the overhead costs together to arrive at the total overhead cost.
- Calculate Overhead Rate: The final step is to divide the overhead costs 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 overhead costs is as follows.
Overhead Cost Formula
- Overhead Costs = Indirect Materials + Indirect Labor + Indirect Expenses
Overhead costs can be categorized as indirect materials, indirect labor, and 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.
Overhead Cost Examples
The list below contains some of the more common examples of overhead costs:
- Administrative Costs
- Office Supplies
- Marketing and Advertising
- Telephone Bills
- Accounting and Legal Fees
- Property Taxes
Something important to note is that an overhead expense in one industry could be a direct cost for another, so context must be considered in all cases.
Overhead Costs vs. Direct Costs
Certain costs such as direct material (i.e. inventory purchases) or direct labor must be excluded from the calculation of overhead costs, 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.
Types of Overhead Costs
Overhead costs can be segmented into three distinct types:
- Fixed Costs → Fixed costs remain constant irrespective of the number of units produced and sold in the period, e.g. rent.
- Variable Costs → Variable costs fluctuate based on the number of units produced and sold in the period, e.g. AWS server hosting fees.
- Semi-Variable Costs → 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, truck fuel.
Overhead Costs Calculator – Excel 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 costs 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 determined its overhead costs as the following:
- 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.
- Overhead Costs = $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 costs 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 costs.