What Is Overhead? What Small Businesses Need to Know
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Overhead is a term used to describe business expenses that aren’t directly linked to creating a product, service or any other activity that contributes to a company’s income. While some business overhead is unavoidable, reducing these indirect expenses will help widen your profit margin.
Every business incurs some overhead expense, although some businesses (for example, a large retail department store) have much higher overhead costs than others (such as a freelance graphic designer working exclusively from home). A wide range of business expenses are typically considered overhead, including:
Advertising and marketing.
Utilities like electricity, climate control, water, phone and internet.
Accounting, legal and other professional services.
Business travel and meals.
Compensation for employees not directly involved in product production such as administrative or janitorial staff.
Office supplies and equipment.
Business rent or mortgage.
Licenses and fees.
Subscriptions to services like Zoom or Expensify.
Employee perks such as company swag, gym memberships, team-building activities and retreats, company cars, coffee and snacks.
Types of overhead
Overhead expenses generally fall into one of three major categories:
Fixed overhead: These are business expenses that remain stable from month to month such as rent, insurance, subscriptions or internet service.
Variable overhead: These costs rise or fall depending on how busy your business is. Variable expenses might include your shipping costs, which increase when you sell and ship more product and decrease when you sell less — falling all the way to zero if you haven’t made any sales during a particular period.
Semi-variable overhead: Overhead costs that you pay some portion of year-round, but that increase as you get busier, are considered semi-variable. Your electric bill might be an example of semi-variable overhead since you always pay something for this utility, but your electricity consumption may increase during busy times, causing this cost to fluctuate.
Some businesses find it useful to fine-tune their accounting analysis even further by dividing their overhead expenses into sub-categories like labor overhead, administrative overhead and selling overhead.
Calculating your overhead ratio
Knowing your overhead ratio provides a clear picture of how overhead impacts your business. In general, it’s good to aim for an overhead ratio of less than 35%. To figure out yours:
Examine all your business expenses incurred during a set time period (typically a month), carefully determining which of these expenses aren’t directly linked to your product or service, and therefore qualify as overhead.
Add up all of these indirect expenses to get your total overhead expense figure.
Determine your total sales income for the period you’re working with.
Finally, apply the following formula: (Monthly overhead / monthly sales) x 100 = Percentage of overhead cost to sales.
For example, if you spent $10,000 on overhead during the month of May, and took in $40,000 in sales during that same period, your overhead ratio would be (10,000 / 40,000) x 100 = 25%.
Part of any business’s accounting responsibility is to maintain good records of overhead costs. Whether these costs are fixed, variable or semi-variable, they should be entered on your company’s profit and loss statement and on its balance sheet.
Profit and loss statement: Also known as a P&L, this statement shows what your company is earning versus what it’s spending and provides insight into your cash flow, company risk and overall performance.
Balance sheet: This is a financial statement that presents a quick snapshot of your company at a specific point in time by showing assets, liabilities and shareholder equity. Overhead costs are entered as current liabilities on your balance sheet.
Tips to reduce your overhead
Since overhead takes away from your net profit without contributing anything directly to creating your product or service, it makes sense to keep these costs as low as you possibly can without harming your business. Here are some easy ways to reduce yours:
Select your team carefully
Smart hiring choices keep labor overhead costs under control and reduce the need for painful terminations over time. Choose team members with skill sets, aptitudes and work styles that fit your company, and invest in training that gives your employees the necessary knowledge and skills to master the work your company needs done. When hiring, keep in mind that not all functions need to be performed by regular W-2 employees. For seasonal or occasional tasks, it may be more cost-effective to outsource and use independent contractors.
Work with an accountant
While this may feel like an additional expense initially, bringing a skilled accountant into the mix can save you big money in the long run. You’ll discover tax deductions you’d never even considered, maintain more accurate financial records and avoid mistakes that could cost your business a bundle. Investing in good accounting software that tracks income and expenses is another way to keep your bookkeeping accurate and up-to-date, whether or not you also decide to work with an accountant.
Bookkeeping and accounting software
QuickBooks Online $30 per month and up. Read Review.
FreshBooks Accounting $17 per month and up. Read Review.
Sage 50cloud $48.17 per month (when paid annually) and up.
Wave Financial Free (add-ons available).
Xero $13 per month and up.
Zoho Books $0 per month and up.
Have employees work from home
Commercial rent or mortgage is one of the largest contributors to overhead expenses. Allowing some of your staff to work from home could significantly reduce your square footage requirements, which gives you the choice between downsizing or sub-leasing excess space to offset your costs. If you decide to relocate, you may be able to find a neighborhood with more affordable commercial real estate if leaving your current area won’t hurt your bottom line.
Sending out physical invoices, statements and notifications — and retaining hard copies of files — contributes significantly to your paper, ink, postage, electric and storage space expenses. Send digital correspondence and back up important stored records to a hard drive and/or the cloud. To further reduce your paper consumption, consider replacing paper towels with electric dryers in company restrooms and paper cups with reusable mugs in the break room.
Cut costs on recurring charges
Overhead expenses like phone, internet, equipment rentals, service retainers and supplies may be unavoidable, but there’s no reason to pay top dollar for them. See if you can renegotiate your contracts or switch to providers and suppliers with lower rates. Converting from a traditional PBX office system to a phone-over-internet model may reduce your phone bill significantly, for example. Take stock of your current software subscriptions and see if there are any that you could downgrade to a more affordable service tier or cancel altogether.