When conducting business, there are two main types of expenses that small business owners need to track to understand pricing, budgeting, reporting, and profitability.
Operating expenses are costs that are directly related to the production of a product or delivery of a product or service—and to producing revenue. These include raw materials, parts, labor, and equipment, and can vary according to business activity.
Overhead expenses are what it costs simply to stay in business—your day-to-day business operations. These include costs such as:
- Rent and utilities
- Repairs and maintenance
- Office space and office equipment
- Certain taxes
- Management salaries
Overhead costs don’t vary much with business volume. Utility bills may vary seasonally and you may have more repairs one month than another, but these business expenses are more or less fixed. In fact, they are sometimes referred to as fixed costs.
How can you tell the difference between an operating cost and business overhead? One way is to think about which bills you’d have to pay even if you stopped making your product or delivering your service for a while. You wouldn’t have to buy parts, pay your service delivery people, or advertise, but you’d have to keep making your rent, utility, and insurance payments.
Why track overhead and operating costs?
Overhead costs and operating expenses should be tracked separately for a number of reasons.
Accurate cost accounting
Companies use cost accounting internally to figure out the true cost of production. That includes every last component that goes into producing the product, freight, labor hours per unit, etc. To be totally accurate, some amount of overhead expense has to be allocated to each unit of production. Understanding your true costs allows your business to control costs and figure out where you may be able to save money. It helps you know which products and services are most profitable, and it helps you make better decisions.
When you price your products or services, you take into account the cost of inventory or the labor and materials that go into them. Usually, it’s pretty clear what those are. But it would be a mistake to just look at those costs and add markup. You also have to include your overhead costs in your pricing. Not knowing your overhead costs could result in you pricing your products too low and not making a profit. Or, you might price them too high, resulting in unsold inventory and a hit to your bottom line.
Compliance with financial accounting rules
Companies use financial accounting to report externally to shareholders (if your company has them) and tax authorities on the income, expenses, and profitability of the business. Overhead costs appear on the company’s financial statements, specifically on the income statement where they are deducted from profit. In a manufacturing business, generally accepted accounting principles (GAAP) require overhead to be included on your balance sheet as part of inventory. It also must be included in the cost of goods sold on the income statement.
Knowing your bare minimum
Since overhead costs generally have to be paid monthly, you must know your total minimum monthly cost—how much money you need to make just to stay in business. That’s simply because no business can operate for long at this level. It becomes even more important should your business be impacted by factors beyond your control, such as a natural disaster or global pandemic.
How to track overhead costs
All of this tracking should be relatively easy to do with proper accounting software. But exactly how you categorize overhead costs will differ from business to business.
Although most overhead costs are fixed, your business may also have variable overhead, such as shipping or office supplies. These costs fluctuate from month to month and could even be zero at times. You may also have semi-variable costs, such as utility bills that change with the seasons, sales salaries where commission is variable, and overtime.
Some organizations find it helpful—and sometimes necessary—to split overhead costs into two different subcategories: manufacturing and administrative. The benefit of keeping them separate is that it allows the organization to allocate manufacturing costs to works in progress or finished products.
By separating manufacturing overhead from other types of overhead costs, it’s possible for the business to conduct a more thorough examination of its profitability. This gives you more knobs and levers to turn to adjust.
For example, administrative costs cannot be easily adjusted without significant changes to the business’s infrastructure (i.e., reducing your workforce). Manufacturing overhead, however, might be adjusted by being more proactive with maintenance to avoid repair costs. Or, you could find a faster way to do things so that machines can consume less power.
How to calculate overhead costs
Once all costs are properly classified, you can figure out your business’s overhead rate as a percentage of sales. This is done by adding up all overhead costs, breaking them down by month, and then dividing that total by monthly sales. The formula is below:
(Overhead ÷ monthly sales) x 100 = overhead percentage
Here’s an example:
- Company A, a consulting company calculates they have $120,000 in monthly overhead costs.
- They make $800,000 in monthly sales.
- Company A’s overhead percentage would be $120,000 divided by $800,000, which gives you 0.15.
- Multiply that by 100, and your overhead percentage is 15% of your sales.
This means that at Company A, for every dollar the company makes, 15 cents goes to pay overhead. When you consider that the average profit margin for most companies is 10%, 15% is a significant percentage. This is why it’s very important to have a handle on your overhead costs.
It’s also beneficial to calculate the overhead percentage in relation to labor cost. This is called the overhead allocation rate. In that case, the monthly overhead costs are divided by the monthly labor costs and multiplied by 100. The formula is as follows:
Total overhead ÷ total labor hours = overhead allocation rate
Here’s how that would look if Company A had 700 labor hours per month:
$120,000 ÷ 700 = $171.42
This means that for every hour spent consulting, Company A needs to allocate $171.42 in overhead.
In both these cases, the lower the percentage, the more effective a business is at using its resources.
There’s no getting over overhead
While overhead costs are simply part of the “the cost of doing business,” no business can afford to ignore them. Getting a handle on your overhead expenses gives you a real appreciation of your cash flow needs and your overall financial position. It helps you set prices optimally, see where there may be an opportunity to cut costs, and make better business decisions overall.
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