Spending money is a necessary part of building a business. Business owners can attribute many costs to producing or creating a product or service. These are known as direct costs. The expenses that are not associated directly with building a product or service are known as overhead costs or indirect costs.
If business owners aren’t careful, overhead costs can quickly become a drain on business revenues. Business owners will want to take the time to figure out how to calculate overhead costs. Once they figure out how to do so, they should look into ways to cut back on these expenses.
What is overhead?
Overhead costs are those that are associated with running your business but that you can’t directly attribute to a:
- Business activity
- Portion of the company’s income
These indirect costs commonly include things like:
- Professional expenses, such as for accounting or legal services
- Administrative costs, such as the salaries for your employees who are not involved with producing a product
- Licenses and permits
- Property taxes
- Manufacturing overhead, such as rent payments for a building or piece of equipment
- Office equipment
Although overhead costs are critical to business operations, they do not lead to a generation of profits. Additionally, overhead costs tend to be fixed. For instance, your rent payment tends to stay the same from month to month.
Overhead costs are notably different from direct costs. Direct costs, which can include direct labor and direct materials, are ones associated with the creation of a product or service. Direct costs are variable costs. By adding direct expenses and overhead costs on the income statement, you’ll see the total costs for your business.
How to calculate overhead
As a small business owner, you should know how to calculate overhead costs. The most common way to calculate overhead costs is as a percentage of sales or labor costs.
Your goal as a business owner should be to keep your overhead proportion as low as possible. A small overhead proportion means that a high percentage of your expenses go directly toward the production of a good or service. Lower overhead ratios provide business owners with a competitive advantage.
A low overhead rate will allow you to better price your products, making you a more attractive option than your competition. Furthermore, a small overhead could also allow you to increase your profit margins, boosting your bottom line.
To calculate business overhead, you’ll need to first comb through every specific business activity, listing all of your expenses. You’ll want your list to be thorough. Look through your financial statements to ensure that you pinpoint each one of your costs. Once you’ve identified all of your business expenses, you’ll want to sort them into two categories: direct and indirect expenses. When doing so, ask yourself, “Does this expense result in the production of a good or service?”
Once you’ve sorted your expenses, add up all of the indirect costs for the month. Then look at the company’s income statement to determine your monthly sales. Once you’ve figured out your monthly sales, you can calculate your overhead ratio with the following equation:
(Monthly Overhead ÷ Monthly Sales) x 100 = Percentage of Overhead Cost to Sales
You can also measure your overhead costs compared to your labor costs. The Bureau of Labor Statistics indicates that the average U.S. wage increased by 3% between March 2018 and March 2019. With labor costs rising so rapidly, you’ll want to cut back on overhead expenses. The equation to do so is:
(Monthly Overhead ÷ Monthly Labor Cost) x 100 = Percentage of Overhead Cost to Labor
Knowing how to calculate overhead will put your business in a much better position to succeed. Owners who routinely consider overhead are more efficient when managing company finances.
How to lower overhead costs
If you look at your business finances and realize that overhead expenses are taking a significant chunk of your revenue, it may be time for you to reevaluate. Below, you’ll find 12 ways to reduce your overhead expenses.
1. Review everything thoroughly
The first time that you pull your overhead costs, you’ll determine which expenses you can consider indirect. However, these expenses could fluctuate over time, based on the activity level of your company. You should review overhead costs monthly to make sure there are no drastic changes. Furthermore, you should pour through your list of business expenses each month. You should mark items that are:
- No longer necessary
- Too high in price
- Open to efficiencies
It’s always a good idea to get a handle on your costs before you try to make sweeping changes. Consider cutting back on a couple of your expenses to see how they impact your overhead costs.
2. Don’t look for a magic bullet
There likely isn’t one single solution to your high overhead percentage. Cutting one expense isn’t going to fix your problem instantly. Have patience throughout the process and realize that your most significant cost savings might come from a series of small cuts.
3. Brainstorm with your employees
If you have a staff, ask for their input on where the company can save money. Depending on the size of your organization, you might even want to offer incentives for the idea that saves the most or the concept that is the most innovative. You’ll find more success brainstorming as a team than you would have going at it alone.
4. Reevaluate your third-party contracts
If you rent equipment or pay service retainer fees, you can find cost savings by evaluating your current deals to see if they still fit your needs. The evaluation process is especially crucial if the contracts are older. Chances are your business has changed since you first signed the contract, so it’s worth looking into the contract again.
5. Clear out your storeroom
There’s a chance that your storage room or empty office space is filled with non-working or outdated technology, including older computers, printers, fax machines, and phones. Take time to review your technology expenses, and cut out those that you no longer need. Compare service providers in your area to see if you can get a better rate as well.
6. Assess your staff
Chances are there are one or two members of your team who are underperforming. Laying someone off hurts, but keeping an underachieving employee on staff doesn’t do anyone any good. It’s a drain on your resources and employee morale. It also doesn’t give the employee a chance to find something new or different that might be better suited to his or her skills. Eliminating someone from your team could allow other members to work more efficiently.
7. Leverage your current client base to save on promotions
Even in the digital age, word-of-mouth is still one of the best forms of referral. Scale back your advertising and marketing budget by using your current, happy customers as brand ambassadors. Here are a couple of ways to do it:
- Offer an incentive: (i.e., a restaurant gift card, a percentage off future services, premium items, etc.) to clients who refer others to your business. These incentives do not have to be pricey, but they should be valuable.
- Ask for testimonials: Ask current clients for a one- or two-sentence testimonial. You can use the testimony on your website, in email newsletters or as part of any other advertising. You should also ask the customer to post a positive review on Yelp or other social platforms like Facebook or Twitter.
8. Go paperless
While you may not be able to eliminate office supplies from your business, you can cut back on things like how much paper and ink you use. Backup all of your documents to the cloud or a drive, and shred any unnecessary files so that you don’t have costs related to document storage.
9. Use credit cards that work for you
As a business owner, you probably have at least one credit card for business expenses. Make sure that you’re using a card that gives you the most benefits, including:
- Miles or points for travel
- Other rewards
You can also evaluate your cards based on annual fees and interest rates. Make sure the card you use is designed for small business and not individual consumers.
10. Control purchasing
If possible, designate one person in your organization to handle all purchasing. This individual should be in charge of things like negotiating contracts and placing office-supply orders. Ideally, the person in charge of purchasing would have shrewd negotiating skills and should not be afraid to ask for a discount. Think of things like, “If we pay the total balance in eight months instead of 12, can we get a 3% discount?”
By putting one person in charge of purchasing, this person can dedicate his or her time solely to finding the best prices and bargains. When a purchaser has multiple responsibilities, he or she may end up placing orders with a familiar vendor instead of shopping around for the best offer. Paying one person to handle purchasing will create a salary expense. But if the person is good at the job, your investment will pay off quickly thanks to the money you’ll save in other areas.
11. Sublease your office space
If you own your office space, you might find there are a group of rooms — or even floors of a building — that you don’t use. Sublease this space to other small businesses and use the rent to subsidize your mortgage payments.
12. Consider how much space you need
Depending on your organization’s size, it might be time to give up your office space and move to a work-from-home model. Consider location as well. Do you really need to be paying rent for a high-priced office in the middle of the city?
Consider what you use your office for, how often you’re there, and why you have it. If you feel you still need an office, consider downsizing or look into office rental alternatives like shared coworking spaces.
Cut your overhead costs and improve your business finances
If you commit to cutting your operating expenses, you will need to carefully evaluate your current situation to come up with a savings strategy. Remember that results will not come overnight. Unless you do something drastic like cut administrative expenses by firing employees, your cost-saving endeavors will be fluid and ongoing.
Keeping costs down should be a year-round effort. There should be a method to your cost-cutting. Take time to learn more about where not to cut corners when it comes to your startup’s finances.
You should also utilize accounting software designed for small business owners. QuickBooks can track direct and indirect expenses quickly. Doing so will allow you to identify your overhead ratio and craft a strategy to reduce costs.