In simple terms, overhead is the cost of keeping your business afloat. Overhead is a summary of the costs you pay to keep your company running, and appears on your monthly income statement.
When you track and categorize your overhead, you can plan around expenses, get an accurate picture of your profit margin, and find new ways to save your business money.
What costs factor into my overhead?
Overhead is what you pay to keep your business in business. However, that doesn’t include what you spend to produce goods or provide services, typically on raw materials and direct labor. These expenses are called COGS (cost of goods sold) and COS (cost of services), respectively.
When you buy ingredients for the croissants at your bakery, that expense is included in COGS. When you pay insurance for your bakery’s delivery van, that’s COS. Both these expenses are directly related to your business—you incur them in the process of making money.
However, rent for the bakery, business insurance, the cost of hiring an accountant, assorter administrative costs—all of these are overhead. These costs are not directly related to the way your bakery makes money, but they do keep your business running.
Overhead vs. operating expenses
When it comes to categorizing the ways you spend money, there’s an important distinction between overhead and operating expenses.
While overhead covers everything required to stay in business, operating expenses includes both overhead and COGS/COS. Operating expenses is a broad category, encompassing everything you spend in the course of running your business. In other words, overhead is a type of operating expense.
Overhead vs. G&A
G&A (general and administrative) expenses are expenses that apply to the whole company, and don’t necessarily have anything to do with essential business activity—the product or service the business creates. For example, the business might have general liability insurance, a business license, HR employees, office supplies, accounting and legal fees, bank fees, etc. The business has to pay these indirect costs even if they aren’t currently working on any projects.
Overhead expenses relate directly to the product or service the business produces, but not to one specific project. For example, a construction company might have a manager that oversees all of the projects the company is currently working on. Her salary would be overhead. Theoretically, if the company didn’t have any projects in the works, they could let her go and not incur the expense.
Fixed, variable, and semi-variable overhead
There are three types of overhead: fixed costs, variable costs, or semi-variable costs.
The rent for your bakery is the same amount every month. No matter how your business is performing, or what kinds of crazy market forces are at work, you’ll pay the same amount for rent every single month.
Rent is an example of fixed overhead. Fixed overhead includes:
- Property tax
- Business insurance
- Interest on mortgage payments
- Regular janitorial services
- Web hosting
- Bookkeeping services
- PO box rental
- Phone plan
Variable overhead costs are costs you incur on a regular basis with costs that fluctuate. For example if you’re running a bakery and you use gas ovens, you likely use a different amount of gas every month—it fluctuates depending on how much you need to bake. That means that, month to month, your gas bill is different.
Gas bills are an example of variable overhead. Other examples of variable overhead include:
- Vehicle maintenance
- Building or equipment repairs
- Hiring seasonal support staff
- Staff events
As expected, semi-variable overhead covers scenarios where costs fall somewhere between variable and fixed overhead. For instance, your business phone has a regular monthly rate. But when you travel internationally, or go over your data limit, you’re charged extra fees. So even though your phone plan costs a fixed monthly minimum, there’s some fluctuating cost on top of that.
This is an example of semi-variable overhead. Think of the expense as being split into two parts: the fixed overhead (the monthly cost of your phone plan) and the variable overhead (the fees for data overage and/or international travel).
Types of semi-variable expenses include:
- Staff bonuses—awarded at different times each year, such as the busy season, or near the end of the year
- Traditional bookkeepers—they charge a monthly minimum, and the rest is based on how much bookkeeping you need done
- Janitorial services—in addition to their regular duties, you may have to hire cleaners for extra messes
Further reading: Fixed vs Variable Costs (with Industry Examples)
How to categorize overhead expenses
Whatever bookkeeping solution you use, you should make sure your overhead costs are categorized. That way, you keep accurate business records, produce accurate financial statements, and see where your money is going.
Overhead is either general, or falls into a specific category. General overhead affects the whole business—rent is a good example of a type of general overhead.
Specific overhead categories apply to specific parts of your company. For instance, some of your overhead is indirectly connected with creating your product—such as the cost of kitchen utilities. Other specific overhead is a result of back office tasks—like accounting, payroll, and general business administration.
The exact categories you use for your overhead will depend on your business; to figure out which ones fit the needs of your business, your best bet is to chat with a bookkeeper.
However, the most common overhead categories include:
Selling overhead: the cost of marketing your business (e.g., online advertising, signage, and agency fees)
Administrative overhead: what it costs you to run your back office (e.g., bookkeeping, accounting, payroll, scheduling, and human resources)
Research overhead: the cost of researching new products or markets (e.g., consultant fees, prototyping, research, and diagnostic software)
Transportation overhead: the cost of travel not directly related to your product or service (e.g., gas mileage for commuting to work, travel to conferences, or meetings)
Manufacturing overhead: the cost of running your manufacturing facilities, such as rent, janitorial services, and equipment maintenance
How to calculate overhead rate
Your overhead rate is how much money you spend on overhead compared to how much revenue you generate. For instance, you may have an overhead rate of 14%—meaning that, for every dollar your business brings in, you pay $0.14 in overhead.
Why bother calculating overhead rate?
Say you run a lemonade stand. You already know that for every $5.00 glass of lemonade you sell, you’re spending $2.00 on ingredients and labor. That’s your COGS for each glass.
You may be tempted to believe you’re earning $3.00 income for every glass sold. But that doesn’t take into account the cost of electricity (to run your top-of-the-line juicer), or the monthly rate for your accountant (who specializes in the cold beverage industry). Those are both part of overhead. And unless you factor them in, your profit will be lower than your profit projections.
The formula for overhead rate
Luckily, overhead rate is quite simple to calculate. This formula handles it:
Overhead Cost / Sales = Overhead Rate
For the formula to work, you need to use numbers from a single period, like one month.
If you make $13,000 in sales in a typical month and you spend $1,600 on overhead, you get the following calculation:
1,600 / 13,000 = 0.123
Your overhead rate is 12.3%, or about 12 cents overhead for every dollar earned.
Finding your average overhead and sales
If you run a lemonade stand year-round, you probably make fewer sales in December than in August.
And, since some of your overhead is variable and semi-variable—such as the electricity bill—your overhead will be variable, too.
This is when comprehensive financial records are useful. Looking at your past overhead and sales numbers for a defined period—say, the previous financial year—you can calculate your average sales and overhead per month.
In this example, you’d add up all the sales figures for your lemonade stand the previous year, and divide that number by 12 (for 12 months). Then, do the same for overhead.
When you plug these numbers into the overhead rate formula, you’ll get a fairly accurate picture of how much you spend on overhead, versus how much you earn. The larger the time period you use to calculate your average, the more accurate your average overhead rate will be.
Overhead tax deductions
You may think keeping track of your overhead—the cost of staying in business—is a pain. The good news? Some of that money can probably be deducted from your taxes.
Keeping track of tax deductions quickly becomes routine, once you’re familiar with what can and can’t be deducted. Crunch the numbers with help from our guide on small business tax deductions.
Overhead is the cost of staying in business—not including COGS and COS, which (respectively) each go directly into the product or service you offer. The sooner you figure out your overhead, and see how it relates to your revenue, the sooner you get a realistic portrait of your business—and the info you need to start planning for the future.