What are overhead costs?

Overhead costs are costs associated with running a business. But they’re not direct costs that can be attributed to things like product innovation, creation of services, or running specific business activities. Those are operating expenses.

An overhead cost is something that provides support for a business, like rent, for example. 

Something that falls into a company’s overheads will not generate any income.

One of the big reasons why eCommerce is booming is thanks to the low overhead costs associated with running a business online.

While every business will incur some overhead costs, a lot of overheads are expenses for physical things, like property and office facilities. 

So taking everything online can be hugely beneficial, especially for a small business.

Types of overhead cost

Just like direct costs for product or service creation, people split indirect costs into many different types of categories. 

It can help businesses to categorize their overhead costs in really granular ways, for example as administrative expenses, production costs, and sales. 

For clarity though, overhead costs can easily fall into three main, overarching categories.

Fixed overhead

You guessed it: a fixed overhead stays the same every month.

Regardless of business revenue, fixed costs remain consistent and companies must pay the same regular amount.

Variable overhead

These overhead costs are generally monthly costs that vary depending on business activity.

Similar to the bills you get at home for gas and electricity, variable overhead costs will increase and decrease in accordance with use.

Semi-variable overhead

These overhead costs are somewhere between fixed and variable.

If a fixed monthly bill sometimes increases with business activity, like a phone bill with international roaming charges, it is semi-variable.

Examples of overhead costs

Here are some of the most common overhead costs associated with running a business.

Rent

The big one. Business rent can be the most significant overhead for a company. 

Rent is payable monthly, quarterly, or annually, depending on the agreement a business strikes with its commercial landlord. This is a fixed overhead.

Depending on the industry it’s in, a business might end up having a whole property portfolio to manage rent overhead expenses for. 

Even if a company owns an office, there are property taxes to factor into overhead costs – those expenses will just keep adding up.

Chain restaurants and cafes must pay rent for every location. Retailers have warehouses and stores to pay for, as well as a central office location. 

Luckily for entrepreneurs looking to open stores, there are ways to keep rent overhead costs down:

• Only have an online store. It’s easy to make your eCommerce store look amazing and feel interactive.
• Opt for dropshipping. It’s a great way of fulfilling orders and keeping costs low.
• Use a flexible shared office space. Have your face-to-face team meetings occasionally to minimize expenses.

Utilities

Maybe the most hidden cost of running a business, the overhead for utilities is something that every office-based organization has to commit to.

Utility costs are variable or semi-variable expenses, depending on what they’re for, who’s billing you, and what deals you manage to negotiate.

That’s right: you can often negotiate utility costs for a business, particularly if you’re looking to scale the company and use multiples of a particular service.

As with rent, companies can cut back on these overheads by running as an online-only enterprise, if it suits the business model.

Some examples of the utilities you’ll need to cover as a business include:

• Internet
• Phone service
• Electricity
• Water
• Gas

Salaries and wages

Depending on the employee’s role, contract type, and other factors, their pay could be categorized as an overhead in different ways.

Generally speaking, though, a salary is a fixed overhead and one of those indirect costs that must be covered. A business has to pay each employee every month without fail. 

Wages are more variable than salaries. They can fluctuate depending on hours worked, commission earned, or if a company penalizes employees for being late or sloppy with their work.

A happy team equals a better business, though, so don’t go deducting wages if you can help it. 

For salaried workers, their pay could be categorized as semi-variable if:

• They receive bonuses directly related to performance
• They’re incentivized to make on-top earnings, like sales commission
• They get a pay rise midway through the year

Office supplies

This one might make you think twice about taking notepads home or using milk from the office fridge in your daily bowls of porridge.

Any office manager can attest to having to buy a lot of stuff every month to keep businesses running smoothly.

Stationery, toilet paper, and any products or services you get to share with your coworkers are all directly related to an overhead cost. 

These things keep employees happy and fulfilled, so they’re worth doing, but the cost of office supplies can sometimes get out of hand. This is a variable cost.

It’s definitely possible to cut back on overhead expenses without banning snacks – which most office workers would agree is an essential perk.

Businesses could try to:

• Become paperless offices. There’s no excuse to use reams of paper anymore, and it’s bad for the environment as well as your income statement.
• Invest in technology over stationery. Products like interactive whiteboards and tablets are longer-lasting than pens and paper.
• Stop operating out of offices to eliminate these costs. It won’t work for everyone, but working remotely is on the rise and it’s easier than ever to pull off. 

How to calculate an overhead rate

Businesses need to calculate their overhead rate to check how much they’re spending on overheads compared to how much revenue they’re gaining.

It’s important for a business to be aware of its overhead rate so that it can accurately forecast their profit margins. 

Without considering all those overhead expenses – rent, utilities, salaries – the profit projections will be incorrect, and way too ambitious.

So, how is it done?

The formula for calculating overhead rate is pretty simple:

• Overhead rate = overhead cost/sales

Multiply the result by 100 to get your overhead rate as a percentage. For the formula to work out, take numbers from one period at a time.

For example, if your business made $84,000 in a month and your overhead costs totaled $9,500, your overhead rate is 11.3%, or around 11 cents for every dollar earned:

$9,500 / $84,000 = 0.113 x 100 = 11.3%