What Is Overhead Cost & How Can You Reduce It?

Expenses and operating costs are inevitable parts of running a business. But if you don't have a detailed process for categorizing and tracking your expenses, they can quickly get out of hand, putting your business at risk in the future.

Overhead expenses can be especially difficult to track and evaluate their impact on your business because they are not directly correlated to sales. As a business owner or manager, it is vital to the health and stability of your organization to understand overhead cost and how it can affect your business.

What Is Overhead Cost?

Overhead costs are the expenses associated with simply having functioning business. These are the costs you will incur before you ever sell a single product or service (although you will continue to incur overhead at regular intervals throughout the operation of your business).

Overhead costs include things like rent and utilities, business licenses, accounting fees, advertising expenses, and payroll. These costs are fairly predictable and constant, whereas direct costs, such as raw materials or packaging supplies, are directly correlated to the product or service you provide. As your sales increase, your direct costs will increase proportionately.

Overhead costs can be referred to by many names, including:

• Overhead expenses
• Operating costs
• Indirect costs
• Administrative overhead

What Are the Types of Overhead Costs?

Overhead costs generally fall into one of three categories: fixed, variable, or semi-variable. Fixed overhead costs are the same from period to period, regardless of how your business or the industry performs. The most common example of fixed overhead is building rent.

Variable overhead costs will vary from period to period, but the cost fluctuations are not directly tied to your sales. For example, the electric bill will change from month to month, but it typically changes due to seasonal weather patterns rather than increases or decreases in your sales.

Finally, semi-variable overhead costs will include both a fixed and a variable component. If your company has a contract with a marketing agency, you can expect to be billed a regular monthly fee for services plus an additional amount for any advertisements you ran that month.

What Are Examples of Overhead Costs for Businesses?

While there are no hard and fast rules about how overhead costs are categorized, here are some examples of overhead costs and where you might find them on a business expense report.

Fixed Cost Examples

• Rent
• Property taxes
• Insurance costs
• Cleaning services
• Accounting services
• Landscaping

Variable Cost Examples

• Electricity
• Equipment repairs and maintenance
• Office supplies
• Overtime wages
• Legal expenses

Semi-Variable Cost Examples

• Vehicle usage
• Marketing services
• Water, gas, and utilities
• Trash pickup

How Do You Calculate Overhead Cost?

Since overhead costs are not directly proportional to your sales, it can be harder to determine how your overhead costs are affecting your bottom line or whether those costs are getting out of hand. Comparing your actual overhead to your sales can help you evaluate how well you are managing your business overhead cost.

Calculating this as a percentage, known as overhead rate, can help you track rising overhead costs over time. The simple formula for overhead rate is calculated as:

Total overhead cost for the period / Total Sales for the period = Overhead Percentage Rate

Evaluating the overhead rate from month-to-month or quarter-to-quarter can help you quickly determine when costs are rising. If you notice that overhead costs have been steadily increasing for the past several periods, it may also be helpful to calculate your overhead percentages by category (fixed, variable, and semi-variable) to determine where the increases are occurring.

How To Reduce Overhead Cost

To keep costs low, there are several simple steps you can take to better manage your business overhead.

Look for Shared Office Space

To minimize overhead, many startups begin as home-based businesses. As profits ramp up and your business outgrows a home office, sharing office space with other businesses can help you minimize overhead costs. Rather than committing to a large space that won't be fully used every day, look for opportunities to occupy space that is shared by multiple startups. Co-working spaces are also a great way to have a professional office presence while keeping rental costs in check.

Negotiate Favorable Lease Terms

When negotiating a lease for your business space, work with a landlord to find mutually beneficial ways to lower costs. Signing a longer-term lease may hold down rent expenses or limit future increases. Negotiating other lease contracts, such as those for office equipment, may also present an opportunity for cost savings with favorable terms.

Reduce Paper Consumption

Environmental awareness has made businesses and consumers highly conscious of paper usage, but the reduction in overhead costs is another good reason to reduce paper in the workplace. Emailing invoices can save money on both paper and postage. Scanning, rather than copying, documents is another way to cut paper usage.

Going paperless can yield other savings by reducing the need to purchase expensive printers, copiers, and fax machines and by lowering utility bills that would otherwise be driven up by these machines. Paperless files also require less storage space in the office — possibly saving you money on rent for additional square footage. (Note: It is essential to understand and honor federal state and local record retention laws. If the regulations allow and you decide to store records electronically, ensure you will be able to retrieve those records for the required length of time.)

Consolidate Vendor Services

You could also save money by consolidating paid vendor services as much as possible. Bundling services with one vendor can often yield significant cost savings through loyalty discounts or tiered price breaks.

Use Cloud-Based Software

Rather than pay for expensive data storage and systems stored on in-house servers, use cloud-based software to secure important company information while improving cash flow. An online accounting system, for example, gives you all the benefits of traditional accounting software, but for a low monthly subscription fee rather than a large upfront purchase cost and additional charges whenever new features and functionality is added. Cloud software can also potentially save data recovery costs and limit system downtime, which can add expenses to your bottom line.

Automate for Efficiency

Businesses may be able to reduce overhead by automating tedious administrative processes. By using an online accounting system, staff members responsible for finances may spend less time on the manual bookkeeping processes. Automated payroll processing can save time and also reduce manual errors that can be costly and time-consuming for staff to research and correct.

Understanding Overhead To Help Your Business Succeed

Overhead costs can significantly affect your company's bottom line. Knowing how to accurately track and manage overhead costs can help save your business thousands of dollars every year. By keeping control of your overhead costs before they get out of line, your business will be better positioned for growth and sustainability, even when sales patterns fluctuate.