Understanding Overhead Costs
Overhead costs are ongoing expenses that support business operations but aren’t directly linked to producing a specific product or delivering a service. They’re the costs that keep the lights on—literally and figuratively.
Overhead costs are different from direct costs, which are tied to output: raw materials, labor, or any expense you can trace back to a particular product or project. Overhead includes everything else that keeps the business running behind the scenes. It doesn’t generate revenue on its own, but it’s essential to ensuring that the rest of the operation can do so effectively.
Common examples of overhead costs include:
- Office rent and utilities
- Administrative salaries
- Equipment depreciation
- Software subscriptions
- Insurance premiums
There are also different types of overhead to consider. Fixed overhead stays steady month to month—think rent or full-time administrative staff. Variable overhead changes based on activity, like electricity costs or shipping. Product-based businesses also must account for manufacturing overhead, which includes things like equipment maintenance or factory lighting. On the services side, overhead might show up as general administrative or selling expenses.
When you know what kind of overhead you’re dealing with, you can make smarter decisions about how to manage it effectively and reduce it when possible.
How to Calculate the Overhead Cost
Before diving into the numbers, it’s important to establish a solid foundation for calculating overhead. A structured approach helps finance teams bring clarity to spending and uncover meaningful insights. Here’s a step-by-step way to begin.
Step 1: List and Categorize Your Indirect Expenses
Start by pulling together all the costs that support your business operations but aren’t directly tied to delivering a product or service. As mentioned, these might include things like rent, software subscriptions, office supplies, administrative salaries, insurance, and professional fees. Once you’ve gathered these together, organize them into logical categories such as:
- Administrative costs
- Facilities
- IT and systems
- HR and compliance
Categorizing costs upfront makes it easier to analyze spending patterns, allocate expenses appropriately, and identify areas for optimization later on.
Step 2: Add Up Your Total Overhead Costs
After categorizing your expenses, calculate the total for each category and then sum them together. This gives you your total overhead cost for the period you’re measuring—typically monthly, quarterly, or annually.
Be sure to exclude any costs already captured under direct expenses, like material costs, so you don’t double count. Accuracy here is essential, as even small errors can compound and mislead future planning.
Step 3: Apply the Overhead Rate Formula
Now, convert your raw overhead cost into a usable rate. To calculate the overhead rate, use the formula:
Overhead Rate = (Total Overhead Costs ÷ Total Direct Costs or Labor Hours) × 100
This overhead percentage tells you how much overhead you incur relative to your most relevant cost driver. Some teams use direct labor dollars, others use hours worked, and some use total production cost—it depends on your business model.
For example, if you spend $100,000 on overhead and your direct labor costs are $250,000, your overhead rate is 40%. That means for every dollar spent on direct labor, you’re spending 40 cents on overhead.
Step 4: Calculate Total Manufacturing Overhead (If Applicable)
If your business produces physical goods, you’ll want to isolate manufacturing overhead—a subset of your total overhead. This includes factory utility bills, maintenance on production equipment, quality control costs, and indirect labor like supervisors or custodial staff.
To calculate it, add up these indirect production-related expenses over the period you’re measuring. Knowing this number helps you price products accurately, improve cost control on the factory floor, and refine margins.
Step 5: Avoid Common Pitfalls
Even with the right overhead calculations in place, overhead cost management can go sideways if you don’t watch for common trouble spots. These include:
- Scattered data: Without a unified source of truth, teams waste time reconciling inconsistencies and questioning the numbers.
- Manual processes: Spreadsheets might work at a small scale, but they become a liability when the business grows or complexity increases.
- Lack of real-time visibility: Outdated data makes it harder to make timely decisions or spot red flags early.
Catching these issues before they cascade is essential. The more proactive you are in addressing them, the more confident you’ll be in the accuracy and impact of your overhead insights.