How to Calculate Overhead Costs: 3 Types of Overhead Costs

Overhead costs, also known as overhead and indirect costs, are expenses incurred by a business as part of its day-to-day business operations. Operating expenses—also known as direct costs/direct expenses—and overhead costs are the two main business expenses for business owners. While operating expenses vary according to the nature of the business, monthly sales, and other factors, overheads are more or less fixed in terms of cost and are often referred to as fixed costs.

Some companies may choose to break overhead costs into separate categories, such as administrative costs or manufacturing overhead, and then determine the overhead allocation rate by dividing the overhead cost by an allocation measure, like the number of direct labor hours or direct machine hours. In doing so, a company can determine whether to allocate expenses to different projects or services.

Overhead costs do not include operating expenses generated to create a product or service, such as raw materials or labor costs, classified as cost of goods sold (COGS) and cost of services (COS), respectively.

Businesses of all sizes need to track overhead costs because they directly impact profitability, as detailed on their balance sheets. Overhead costs are a major component in determining a company’s net income, or its bottom line, which is determined by its expenses—both overhead and operating—from its net revenue, or income generated from sales of its products or services.

There are three types of overhead costs in business:

1. 1. Fixed overhead costs: Fixed overhead costs are expenses that do not change in a given period (usually month-to-month), regardless of a business’s activity level. Examples of fixed overhead costs include full-time employee salaries, rent for office space, business insurance, property taxes, interest on mortgage payments, depreciation of assets, and government licenses. The company typically reports these expenses on its income statement.
2. 2. Semi-variable overhead costs: Semi-variable overhead costs involve an expense that has a fixed element, such as a baseline cost, and a variable aspect that changes based on business activity levels. Semi-variable costs may include everything from commissions and bonuses to janitorial services.
3. 3. Variable overhead costs: As their name suggests, variable costs are overhead expenses that fluctuate according to business activity levels. Variable overhead costs include certain utilities, consulting and legal expenses, office equipment and associated repairs, administrative costs, office supplies, and hiring seasonal or temporary support staff.

To calculate overhead costs, you’ll need to refer to your financial statements for a single year.

• Add your sales figures. Add up all of your sales figures over a 12-month period.
• Add your overhead costs. Next, add up your monthly overhead costs.
• Divide the figures. Divide both figures by 12 to account for all 12 months in that given year. Using those figures, divide your monthly overhead costs by your monthly sales.
• Convert the decimal to a percentage. The resulting figure will give you a decimal figure. Multiply that figure by 100 to arrive at a percentage that will help you determine how many cents of each dollar of sales goes toward overhead.

There are several differences between overhead and operating expenses, including:

• Impact: One of the key differences between overhead and operating expenses is what happens if the company stops manufacturing its product. If the expense would no longer show up on the balance sheet, it’s an operating expense. If it would remain after manufacturing stopped, it’s an overhead expense.
• Permanence: Businesses can lower overhead expenses by cutting back or changing business practices. Operating expenses are permanent and unalterable because a company must make these payments to manufacture its goods or services.
• Purpose: The primary difference between overhead and operating expenses is how a business incurs these costs. Overhead expenses relate to a business’s general functions like accounting, payroll, facility rental, or office expenses. Operating expenses help keep the business running, such as direct labor costs, material costs, and equipment required to manufacture goods and services.

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