If you have a business, you have overhead costs. Whether you work alone or have a staff of 50, overhead expenses are a part of doing business. Learn what overhead costs are, the different types of overhead your business may have, and how you or your bookkeeper can learn to easily calculate them.
Overview: What are overhead costs?
Overhead costs are the costs necessary to run your business. Overhead costs are not directly related to any specific product or service, and unlike items such as materials, do not directly generate a profit. However, overhead costs are still part of doing business and should be accounted for properly.
Calculating overhead costs isn’t an option for manufacturing businesses, since GAAP rules state that manufacturing overhead costs must be included in progress inventory and finished goods inventory on your balance sheet and included in the cost of goods sold on your income statement.
While that may sound intimidating, the process is fairly routine if you’re using accounting software, but those of you still recording transactions using manual ledgers will have to spend a little time calculating your overhead costs.
In order to understand overhead costs, it can be helpful to understand the difference between direct and indirect costs:
• Direct costs are any expense that your business incurs that is directly related to the production of goods or services. Direct labor and materials are considered direct costs.
• Indirect costs are not directly related to production costs, but are still necessary in order to run your business. For example, building rent is necessary to run your business, but is not directly related to the production process.
Once you understand the difference between direct costs and indirect costs, it becomes much easier to recognize and calculate overhead costs.
Types of overhead costs for small businesses
There are three types of overhead costs that can directly affect your small business. While the first two, fixed costs and variable costs are fairly easy to track, there is also a third category, semi-variable that small businesses may incur as well.
1. Fixed costs
Fixed costs are the easiest overhead expenses to manage. Fixed costs are the same each month and are not affected by an increase or decrease in production activity. Examples of fixed expenses include general operating costs such as:
• Mortgage payments
• Property taxes
• Asset depreciation
• Administrative salaries
For example, let’s say you own a small manufacturing business that makes wooden picture frames. You currently lease a building that houses both administrative staff and a small manufacturing area.
The rent on the building is $3,500/month. In May, you produced and sold $10,000 worth of frames, but broken equipment in June decreased output, so you only manufactured and sold $2,000 worth of frames. Regardless of the level of manufacturing output in May and June, your rent expense remained $3,500.
2. Variable costs
While the majority of your overhead costs will be fixed costs, there are some variable overhead costs that need to be calculated as well. Unlike fixed costs, you may or may not have variable costs for a particular month. Variable costs include:
• Office supplies
For example, since you manufacture and sell picture frames, you incur shipping costs for each month you ship orders. However, if there’s a month when your business doesn’t sell any picture frames, you will not have any shipping expenses.
The same principle applies for any month in which no office supplies are purchased or no advertising is bought.
3. Semi-variable costs
Most of your overhead costs will fall into the fixed or variable cost category, but there are times when semi-variable costs will be used. These include:
• Sales salaries
• Hourly overtime
While costs such as utilities are incurred each month, the amount varies from month to month, putting them squarely in the semi-variable category.
How to calculate overhead costs
Once you understand the various types of overhead, you’re ready to calculate business overhead costs. One of the most important things to remember when calculating overhead is to not include any direct expenses, such as products and materials purchased that are used for resale, or direct labor.
Direct expenses should always be calculated in your cost of goods sold; including them in your overhead costs would increase your expenses.
The easiest way to calculate overhead costs is to add up your expenses for a specific period of time. Most businesses find it most helpful if they calculate their overhead expenses monthly.
For example, let’s say your manufacturing business had the following expenses for the month of May:
• Rent: $1,100
• Insurance: $300
• Property taxes: $160
• Shipping: $250
• Office supplies: $90
• Utilities: $175
Adding the totals, the overhead expenses for your business totaled $2,075 for the month of May.
How to calculate overhead rate
To get the most benefit out of calculating your overhead costs, the next step would be to calculate your overhead rate. In order to calculate your overhead rate, you’ll use the following formula:
Overhead Costs ÷ Sales = Overhead Rate
In this example, let’s say that you had $32,000 in sales for May. In order to calculate your overhead costs, you would take your overhead costs, which are $2,075 and divide them by your sales for the period, which total $32,000.
$2,075 ÷ $32,000 = .06 or 6%
This result means that for every dollar you earn, you spend $0.06 in overhead.
How do you allocate overhead costs?
There’s one more calculation you can perform using overhead costs: the overhead allocation rate. Similar to calculating the overhead rate, the overhead allocation rate helps you determine how much overhead needs to be allocated to produce a product or service. The calculation for allocating overhead is:
Total Overhead ÷ Total Labor Hours = Overhead Allocation Rate
For example, let’s say that your business had 140 direct labor hours for the month of May. We already know that the overhead cost for the month was $2,075. The calculation would be:
$2,075 ÷ 140 = $14.82
This means that for every labor hour spent manufacturing picture frames, you’ll need to allocate $14.82 in overhead.
You can also choose to use machine hours rather than labor hours when calculating your overhead allocation, replacing the number of labor hours with the number of machine hours in your calculation.
Why knowing your overhead costs is important
Overhead costs directly impact both your balance sheet and income statement, but perhaps even more important, not knowing or incorrectly calculating your overhead costs can result in decreased profits from inaccurate product pricing.
Not including your overhead costs when pricing a product or service can result in a significant loss of profit if a product is priced too low. Conversely, an incorrect estimate of overhead costs might cause you to overprice your products, resulting in sluggish inventory movement and obsolete stock gathering dust on a shelf.
Knowing your business overhead expenses also helps you be more proactive in managing your business. For example, if you have high overhead, you can take the necessary steps to reduce it. If your overhead in business is low, it may be a good time to consider adding an additional product to your current line.
Taking a few extra minutes to calculate your overhead costs can pay off both short term and long term. You’re in business to make money, and managing your overhead costs will help you do just that.
Original source: The blueprint