How to Calculate Overhead Cost With 100% Accuracy?

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📝Key Takeaways:

  • Calculating overhead costs accurately and reducing the ones that you can do without will help you increase revenue and reduce cash flow problems.
  • Not all overhead costs can be removed. Some are necessary to run your business.

If you are not sure how to calculate overhead cost, here is a comprehensive guide to achieve 100% accuracy and estimate the project better.

Overhead costs are an important part of running a company since they help identify the expenses that are required to manage day-to-day business operations.

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Because overhead costs can never be eliminated, it is critical to understand them in order to cut expenses and turn a profit.

In this blog, we’ll learn how to calculate overhead costs and reduce them to boost profitability.

What Are Overhead Costs?

Overhead costs, also known as recurring expenses, keep your business running but do not add to revenue. These expenses are frequently referred to as indirect costs because they are not part of business operations that generate revenue and boost net profit.

Overhead costs are categorized into three types: fixed overhead costs, variable overhead costs, and semi-variable overhead costs.

1. Fixed overhead costs

Fixed overhead expenses remain constant every month. 

Here are some examples:

  • Payments for rent or mortgage
  • utility bills
  • Taxes on real estate
  • Insurance

2. Variable overhead costs

Business operations influence variable overhead costs. These types of overhead costs rise in accordance with increased business operations. 

Variable overhead expenses include the following:

  • Shipping
  • Materials
  • Advertising
  • Maintenance of office equipment

3. Semi-variable overhead costs

Semi-variable overhead costs vary significantly from month to month based on usage. These are some examples of overhead costs:

  • Utility bills
  • Salaries (including overtime)
  • Business vehicle usage
  • Maintenance and repairs of tools and equipment

When calculating overhead costs, these categories become less significant. However, understanding the differences is critical to the functioning of your organization.

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Importance of overhead costs

Based on your business operations, overhead expenses make up a big amount of dollars bills that you spend every month. Understanding and managing them properly might play a crucial part and make a difference in your company’s profit and loss.

The following are some benefits you gain when you calculate overhead costs:

  • Helps you determine prices for your products or services in order to make a profit.
  • Calculates the amount of money needed to break even.
  • Provides you with information about your bottom line (net profit)
  • Identifies expenses that can be worked on to reduce

Now that you know what overhead costs are and why they are significant, let’s move on to understanding how to calculate and reduce them.

How to Calculate Overhead Cost?

To determine your overhead costs, follow the steps discussed below:

1. List your expenses

Make a detailed list of indirect business expenses such as rent, utilities, taxes, office equipment, equipment maintenance, etc. These expenses are your overhead costs. Overhead costs do not include direct costs associated with the production of goods, such as labor costs and costs for raw materials.

List your expenses

Remember that some things cannot be assigned to a specific category when categorizing direct and overhead costs. Some business expenses can be considered as overhead costs for others, but they are direct costs for your company.

2. Add in the overhead costs

Calculate the monthly overhead costs to find the total overhead cost. This is the amount of money required to run your business.

3. Determine the overhead rate

The overhead rate, often known as the overhead percentage, is the amount of money a company spends on manufacturing a product or offering services to its clients. To determine the overhead rate, you need to divide your indirect costs by direct costs and multiply the amount by 100.

If your overhead rate is 30%, it suggests that your company spends 30% of its income on manufacturing goods or offering services. A reduced overhead rate means increased profits and productivity of the business.

4. Compare with sales

You will have to know what percentage of a dollar is assigned to overheads when determining prices and creating budgets. Divide your monthly overhead cost by monthly sales and multiply the amount by 100 to calculate the percentage of overhead costs to sales.

how to calculate overhead cost per unit

For instance, a company with $200,000 in monthly sales and $80,000 in overhead costs has ($80,000/$200,000) x 100 = 40% overheads.

5. Compare with labor cost

Determine the overhead cost as a percentage of the labor cost to assess the efficiency with which company resources are used. The lower the percentage, the more efficiently your company is using its resources.

To calculate it as a percentage, divide the total overhead cost by the total labor cost for the month and multiply the result by 100.

Why Is Reducing Overhead Costs Important?

It is unsustainable for your organization to be constantly operating at a loss. While you cannot totally remove expenses, there are numerous techniques to reduce your overhead costs. 

Additionally, you can boost your profitability, prevent critical cash flow issues, and keep your company afloat even during recessions and low sales seasons.

8 Ways to Reduce Overhead Costs

1. Hire an accountant

Hire an accountant

While hiring an accountant can appear to be an extra cost in addition to your overhead costs, it is one of the simplest techniques to save money in the long run. Not only will you enhance your efficiency and prevent unnecessary financial mistakes, but your accountant can also assist you in identifying potential tax deductions that may raise your take-home pay.

2. Rent rather than purchase

Purchasing equipment or tools to run your business is a significant investment for your company. If you don’t want to spend the money, you can lease or rent it instead. This enables you to use the equipment without having to worry about upfront fees, repairs, or maintenance.

3. Reduce your staff count

Salaries for employees are another key contributor to your total overhead costs. Downsizing is often a preferred alternative, particularly if you’ve discovered that you can lower the number of employees without affecting productivity or efficiency.

However, the ideal strategy to reduce staffing costs is to make better recruitment decisions in the first place. You should constantly look for employees with a diverse set of skills and experiences or invest in training programs to bridge gaps internally.

4. Go green

If you’re not careful, your utility expenses can quickly add up. 

how to calculate overhead costs for manufacturing

Going for more sustainable alternatives such as LED bulbs and energy-saving power outlets may have a higher initial cost, but they will result in cheaper utility bills in the long run. To save money on paper, printing, and power, think about going paperless as well.

5. Outsource experts

It is not important to accomplish everything in-house. Specific responsibilities can be outsourced to help you replace staff shortages without needing to pay full-time compensation. It also means you’ll save money on office supplies and other overhead costs.

Furthermore, if you need to cut back, you can simply discontinue using third-party services. Just be careful when hiring vendors and only outsource jobs that suit themselves well to freelancing, such as bookkeeping or marketing.

6. Empower your brand ambassadors

Marketing is a necessary business activity, particularly in highly competitive industries, but it can consume a significant portion of your money. Reduce advertising costs by utilizing your most valuable marketing strategy: your loyal clients.

You can offer incentives, discounts, and bonuses for referrals to persuade clients to become your company’s brand ambassadors. Many customers will gladly help you with free advertising in exchange for something valuable, especially if they are already strong supporters of your brand.

7. Review your contract agreements

If you’ve been in the industry for a while now, reviewing and renegotiating your contract agreements might be a smart way to cut costs. 

Your business has most likely grown, as have your relationships with your suppliers or third-party vendors. You should cancel any contracts that no longer fit your requirements and renegotiate the ones that do to acquire better business deals.

8. Look for the best credit card for business

Company owners should always keep a credit card for business expenses on hand. Therefore, you should not use a personal card. Look for a card that is a good fit for your company, particularly in terms of available credit, rate of interest, and charges.

There are cards designed especially for small business owners that give excellent incentives such as money back, discounts, and possibly points that can be used for business-related trips.

What is the Difference Between Overhead Costs and Operating Expenses?

While some people wrongly assume that the terms “overhead costs” and “operating expenses” are synonymous, there are actually a few significant differences between the two.

Operating expenses, also known as direct costs, are the expenses involved in your day-to-day operations that are required to run your business. 

This comprises costs for manufacturing, selling, and advertising your products and services. It also covers direct materials, labor costs, equipment, manufacturing overhead, packaging, and other expenses.

On the other side, overhead costs are also expenses involved with running a business. 

However, this term primarily refers to recurring costs for general business operations or charges that must be paid even if you do not manufacture or sell anything for a timeframe. This covers rent, bookkeeping, software, insurance, administrative expenses, and other basic necessities.

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Frequently Asked Questions
  1. What is overhead absorption rate?

    Overhead absorption is the percentage of indirect expenses that are allocated to goods and services. The indirect expenses are not easily quantifiable. Both GAAP and IFRS need overhead absorption for external financial reporting.
    Overhead is assigned to a product or service based on direct labor hours, direct labor cost, machine-hours, etc. The overhead absorption rate is estimated to include overhead in the cost of producing goods and services. It is used to determine the amount to be debited for material, indirect labor, and other indirect expenses for the manufacturing process.


  2. How to determine overhead rates per employee?

    Follow the steps below to determine the overhead rate per employee:

    • Calculate the labor cost, which includes not only the hourly pay but also the medical benefits, paid holidays, retirement, and pension benefits.
    • Calculate the overall business overheads.
    • Subtract the overhead costs from the billable hours. For instance, if your company employs five technicians, the overhead charges are split among them.
    • Adding direct or overhead costs and labor costs to billable hours yields the net cost of that employee per hour.

    By reducing the percentage of expenses, a company can acquire a competitive advantage by raising the profit margin or selling its products by pricing them more competitively.

Scale Your Business with InvoiceOwl!

We hope our blog helped you understand how to calculate your overhead costs and reduce them to increase profitability. 

But as we’ve mentioned earlier, overhead costs cannot be eliminated altogether. Some of them are necessary to run a business, such as a software solution.

A software like InvoiceOwl can streamline several of your work processes with automation, help you save time and money, and increase revenue as well.

InvoiceOwl is one of the finest invoicing software for contractors and field service technicians. 

With InvoiceOwl, you can create invoices anywhere with accurate details and send them to your clients. 

You can also create error-free purchase orders and estimates, manage your client details and generate analytical reports to make informed business decisions.

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Author Bio
Jeel Patel
Jeel Patel
Founder

Jeel Patel is the Founder of InvoiceOwl and is the main curator & writer of the content found on this site. With ideals of quality, commitment, and perseverance, he believes in creating lasting business relationships with the clients.

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