Overhead cost refers to the ongoing expenses, excluding direct costs, required to operate a business day-to-day. Properly tracking and managing overhead is crucial for maintaining profitability.
What Qualifies as Overhead?
Overhead costs include recurring expenses like:
- Employee salaries and benefits
- Rent and utilities
- Insurance premiums
- Office supplies and equipment
- Marketing, advertising and PR
- Accounting and legal fees
- Repairs and maintenance
- Inventory storage and shipping
One-time or irregular expenses like lawsuit settlements would not be considered overhead.
Overhead vs. Cost of Goods Sold
Overhead should not be confused with cost of goods sold (COGS), which refers to the direct costs of manufacturing or purchasing products for resale. COGS and overhead make up a company’s total operating costs.
For example, a retailer would classify the wholesale prices paid to suppliers as COGS. Rent for the retail space would be overhead.
Calculating Overhead Cost
Overhead expenses are totaled for a specific period of time, such as a month or year. The formula is:
Total Overhead = Sum of All Overhead Expenses
Overhead Percentage = Total Overhead / Total Revenue x 100
For example, a company has $500,000 in overhead costs and $2 million in revenue over a year. Its overhead percentage is:
$500,000 / $2,000,000 x 100 = 25%
This metric helps determine profit margins and operational efficiency over time. Lower overhead as a percentage of revenue indicates improving efficiency.
Example Calculation of Overhead Cost
For example, let’s say we know the following about Company ABC:
To calculate our overhead, we would add up all the expenses that relate to our normal course of business. That’s everything below revenue, except COGS and legal judgment. Accordingly, our overhead in this example is $460,000.
As a percentage of revenue, 46% of every dollar the business earns goes to overhead.
Benefits of Knowing Overhead Cost
Knowing how many cents of every dollar goes to overhead allows businesses to measure their profitability and efficiency. It helps them notice when things are getting out of control or when they’re cutting back too much. Ultimately, keeping overhead as low as possible is a competitive advantage, but as the saying goes: you can’t manage what you don’t measure.
In summary, managing overhead costs is an essential practice for achieving profitability goals and maintaining a healthy business. Tracking overhead against revenues highlights areas for potential reduction.