When it comes to running a business, there are several costs that you need to be aware of- but they don’t all fall into the same bucket. One of the costs is overhead- which is all expenses not related to the production of your product/service. Your business incurs these expenses whether you make anything or not. Things like insurance, rent, and utilities fall into this group.

As a business owner, it’s critical to understand your overhead costs as well as the expenses related to production to establish your break-even point. This is also a key strategy for determining where you streamline your business to save money.

Defining Overhead

Overhead is the fixed expenses incurred by your business that are not related to production and will not vary. In other words, even if your business stopped producing right now, you still have to pay things like salaries, rent, insurance, and utilities.

Overhead is critical for several reasons. First, these costs can’t be avoided by slowing or stopping production. Second, determining these costs is required to find the break-even point of your business. These costs can be factored into your prices to ensure that you’re not losing money.

It’s also important to understand overhead costs because this is one of the first places you can look for cost savings. You should be reviewing your bills regularly to find out if you can get better deals to reduce overhead costs.

Fixed vs. Variable Overhead

As mentioned, overhead typically refers to fixed expenses, such as rent and insurance, which remain constant regardless of production/sales. That being said, there are some variable overhead expenses to consider. These costs are tied to production, such as utilities for running equipment and raw materials for production.

The primary difference is that you must pay fixed expenses whether you are producing or selling anything or not. You can find ways to be more efficient and increase profit margin in this category.

However, it’s important to note that both fixed and variable are required for your business to run, and both must be calculated to determine your profitability point.

Types of Overhead Costs

There are several types of overhead costs:

• Rent/mortgage: must be paid whether your business is running or not
• Utilities: must be paid whether or not your business is open on any given day. In some cases, costs are fixed, while others fluctuate
• Insurance: coverage must be active, even when the business is closed
• Administrative costs: salaries of those who are not involved in the production, whose pay does not change with production/sales
• Sales/marketing: not related to production, must be paid no matter what

Things like office supplies, professional services, and property taxes are also considered overhead and can vary from one industry or company to another. You also need to be aware of what is not considered overhead, not just variable production costs, but investments in assets, such as renovating your facility. These are not fixed, but one-time expenses used to increase the value of your business.  

Calculating Overhead Costs

To calculate overhead expenses, you need to determine the fixed costs that are not related to production. Once that is done, use the following equation:

Facilities cost + Utilities+ Sales/Marketing+ Licensing + Administrative Fees + Insurance = Overhead

Pay attention to the things that are not included in this formula, such as labor- which is directly related to production and not considered overhead.

This process is a lot easier when you use accounting software because it can sort out relevant expenses and automatically total them over various periods.

Calculating overhead is also necessary for budget planning. If you don’t understand your fixed costs, it’s much harder to forecast revenue and expenses, as well as make key decisions about investing in your business.

Allocating Overhead Costs

Allocation is the process of breaking down total overhead costs into a per-hour/per-unit basis. Here is the formula for that:

(Facilities cost + Utilities+ Sales/Marketing+ Licensing + Administrative Fees + Insurance) ÷ Hours/Units = Overhead per unit

Again, this process is much easier when you have the right tools.

Why is Allocation Important?

Allocating overhead costs allows you to see how much profit is required per unit/hour to cover your fixed costs. It also breaks down overhead into tangible numbers. When you attach the costs to something that isn’t abstract such as hours/units.

Finally, allocation will help you manage your costs and demonstrate the importance of finding ways to increase efficiency- cut costs and increase profits.

Do You Need Funding for Your Overhead Expenses?

If you need additional help with your overhead expenses or funding to cover those expenses, contact First Class Lending. We can help you with your financial needs.