One of the most common reasons that companies end up going out of business is due to a poorly developed internal system of operations. More specifically, poor financial management often leads to the downfall of many small companies within only a few years after they’re founded. Company overhead cost, in particular, is something that many entrepreneurs and small business owners fail to optimize, and it’s easy to run into financial issues through long-term overspending.

Operating expenses are a major part of financial management and include many costs not directly tied to production.

But what is overhead cost exactly? Not everyone is sure of the answer. Rent, for example, is a common business expense and can often be deducted for tax purposes.

Not sure where to start? Don’t worry. We’ve got you covered. Let’s take a look at everything you need to know.

So… What Is Overhead Cost?

The term “overhead” in a business context is an ongoing cost that is not associated with manufacturing or providing a product or service. However, understanding this concept has many different crossroads, and in most cases, you will need to build your knowledge before you can manage these costs effectively.

For example, if you have a clothing company and you are buying blank T-shirts, you would consider this a direct cost. However, rent or utilities? These would be classified as an overhead expense, and this is where many business owners find themselves confused.

Overhead is an important figure that you need to consider since it will directly influence your pricing when it comes to your company’s goods and services.

Why is this so critical?

It is critical because indirect expenses like rent, administrative costs, and administrative salaries are not directly related to production, but they must be covered if you want to generate profit.

When you have a significantly high overhead cost, what happens?

You will find yourself in a situation where you need to charge your customers more so that you can generate the profit you want to generate. This is something that many business owners struggle with.

To help clarify this concept even further, overhead could be thought of as a sort of “operational cost” – but only if this expense is required to run your business. Simply put, operating costs include both direct and indirect costs for your small business, and you need to understand the difference.

Understanding and managing overhead costs will help you ensure better budgeting and strategic decision-making.

What Are Common Types of Overhead Costs?

There’s a large handful of different overhead costs that you may encounter, and these will vary from industry to industry. However, if you want to succeed in managing your business finances, you need to understand what these costs look like.

What are some examples of overhead and common overhead costs? They include administrative expenses, legal fees, administrative salaries, legal expenses, office rent, insurance, and monthly costs like utilities. Yes, these are the costs that you will always have, regardless of whether you sell one product or one thousand products.

But here’s something important that you need to know: a few business overhead costs are relatively consistent among different types of businesses. Because of that, it becomes important to track all the costs involved in your operations. Total fixed costs, for example, include rent, administrative salaries, and other indirect costs that you cannot avoid.

Let’s explore a few of the most noteworthy such costs, because understanding these will help you in the process of better financial management.

Rent

Premises or office rent is likely one of the most significant fixed overhead costs and a major monthly cost that you’ll encounter. As a non-variable expense, office rent remains consistent regardless of your business activity levels.

Depending on the size and location of your office space, you may even spend thousands per month just to have a location for your business to operate out of.

Some facilities also charge other fees in addition to rent, such as for security cards, access to the building after business hours, monthly janitorial services, etc. If these expenses aren’t explicitly listed as separate costs by your landlord, they’re likely included in your rent and could be a contributing factor behind a rent payment that’s exceptionally high.

Utilities

Utilities are considered overhead costs for businesses because they are indirect expenses necessary to keep the business running, but are not directly tied to producing a specific product or service.

Utility costs typically include electricity, water, heating, cooling, and sometimes internet or phone services used in the office, warehouse, or production facilities. These costs are often semi-variable overhead expenses, meaning they have a fixed base charge plus a variable component that fluctuates depending on usage.

For example, a business pays a minimum monthly fee for utilities regardless of production levels, but the total cost can increase if more electricity or water is consumed during busier periods.

As you can see, utilities are essential for maintaining business operations, but since they do not directly contribute to profit generation, they fall under overhead costs.

Business Insurance

In order to protect yourself from lawsuits, you’ll need to purchase business insurance. Insurance premiums are a regular fixed overhead cost that your business must pay to remain operational. These insurance costs are often overlooked but are crucial to include in your financial planning and cost calculations.

Since this cost is required in order for your company to operate safely and efficiently, it can be considered as an overhead expense.

Depending on what industry you’re in, you may need to purchase a different type of insurance than someone you know who operates in a different field. For example, someone who works in event entertainment will have different obligations than a person who runs an athletic apparel company.

Property Tax

Yet another unavoidable cost for many people, property taxes are a form of overhead that anyone who owns a house, building, etc., has to pay. But, these taxes never change (without government intervention) depending on the level of production the business exhibits, making them completely fixed from payment to payment.

Property taxes are included in the total fixed costs a business must budget for, as they are part of the sum of all fixed expenses that impact profitability.

It should be noted, though, that owning an overly large office building or production facility will result in you paying more in taxes than you need to.

Administrative Costs

Administrative expenses are those indirect costs incurred for all managing and administrative purposes in your business. For example, administrative office rent and utilities, administrative staff salaries and benefits, office supplies, and office equipment depreciation are all considered administrative expenses.

Administrative fees, such as those for office management or support services, are also considered overhead and should be tracked as part of total operating expenses.

Variable Overhead Costs

Variable overhead costs are the expenses that change directly with your business activity or production levels.

Unlike fixed overhead costs that stay the same no matter what, variable overhead costs rise and fall depending on how much you produce or sell. Consider shipping fees, packaging materials, or specialized equipment maintenance that increases as your production volume grows.

For instance, if you get more customer orders, you’ll probably see your shipping and packaging costs climb right along with them.

Keeping a close eye on variable overhead costs is key to maintaining healthy profit margins, especially when demand increases.

That’s why strategies like just-in-time inventory management and fine-tuning your supply chain can make a big difference in cutting waste and controlling these costs. By doing this, you’ll help your business stay flexible and cost-effective as it expands.

Managing Overhead Costs: How to Calculate Overhead Costs and Rates to Measure

In order to calculate your company’s overhead costs, you can start by adding up all the indirect costs (both variable costs and fixed costs) your business incurs. Look at some of the above costs we have mentioned. However, check again all your bills to see if there is something else you must add.

What to Look for in Your Bills to Classify Your Overhead Expenses?

To classify costs as overhead costs, you should look for expenses that are indirect and not directly tied to the production of goods or services.

Here are the key points to consider when you want to find all costs in order to calculate overhead costs:

1. Indirect Nature

Overhead costs are indirect costs, meaning they cannot be traced to a specific product, project, or service. For example, rent for office space is an overhead cost because it supports the business generally, not a particular product or production process.

2. Not Directly Related to Production

Costs directly involved in producing a product or service, such as raw materials and direct labor, are not overhead. Overhead includes costs such as administrative costs, office supplies, utilities, and insurance.

3. Ongoing Business Expenses

Overhead costs are ongoing expenses necessary to keep the business running, regardless of your production levels. For example, rent and insurance premiums typically remain constant even if the production level varies.

4. Fixed Costs, Variable Costs, or Semi-Variable Costs

Overhead costs can be fixed costs (e.g., rent), variable costs (e.g., some utility costs that increase with business activity), or semi-variable costs (having both fixed and variable components).

5. Support Functions

Costs related to administrative functions, management, office maintenance, legal fees, and other support services usually fall under overhead.

In summary, if a cost is essential for running the business but is not directly tied to producing goods or services, it is likely an overhead cost. Identifying these costs correctly helps in budgeting, pricing, and managing profitability.

Once you have your total overhead costs, you can allocate them by dividing this figure by the number of units produced or hours worked, giving you an overhead cost per unit or per hour. This calculation helps you set accurate prices, determine your desired profit margins, and identify areas where you might need to cut costs.

Calculate Total Overhead Costs Incurred

To better understand how to calculate overhead costs, let’s go through a practical example. Suppose your company has the following indirect expenses (types of overhead) for a month:

Now, let’s say your direct costs (such as raw materials and direct labor as variable costs) for the same period amount to $42,000.

Step 1: Calculate Total Overhead Expenses

Add up all indirect overhead expenses: 3,000 + 500 + 400 + 4,000 + 300 + 200 = $8,400

Step 2: Calculate Overhead Rate

Use the formula:

• Overhead Rate = (Total Overhead Expenses / Total Direct Costs) × 100
• Overhead Rate = (8,400 / 42,000) × 100 = 20%

This means that for every dollar spent on direct costs, your company incurs 20 cents in overhead costs.

Step 3: Allocate Overhead Costs per Unit Produced

Now, if your company produced 10,000 units in that period, the overhead cost per unit would be:

• Overhead Cost per Unit = Total Overhead Expenses / Number of Units Produced
• Overhead Cost per Unit = 8,400 / 10,000 = $0.84 per unit

By calculating overhead costs in this manner, you can establish pricing strategies that encompass both direct and indirect expenses, thereby ensuring profitability.

Understand Your Overhead Rate

As you have seen from the above example, your overhead rate is an important metric that shows how much your business spends on overhead costs compared to direct costs.

This rate, presented in the form of a percentage, will help you better understand the efficiency of your business operations and guide your pricing and profit margin decisions.

So, monitoring your overhead rate over time can show some specific trends and highlight areas where your business incurs unnecessary costs.

Simply, a high overhead rate might signal inefficiencies or excessive spending, while a lower rate suggests your business is managing its resources well.

How Can You Reduce Your Overhead Costs?

Cutting costs and especially reducing overhead costs is crucial for improving your company’s financial position, as it directly impacts profitability and long-term stability. So, one important question that will always be present in every business is “How to cut costs incurred?”

Let’s cover several ideas where you can look for opportunities to reduce your different types of overhead costs.

1. Current Office Space

Downsizing your current office space is one of the most efficient ways you can reduce your overhead. Oftentimes, new business owners splurge on an overly large office complete with amenities, superfluous decoration, etc.

While these are great assets to have once your company is well established and successful, they’re often unnecessary and impractical for smaller companies. So, consider your rent payment and how much of your current space you’re actually using for business purposes— you may find it logical to downsize.

2. Incorporate Remote and Hybrid Work Models

One of the most impactful ways to reduce your overhead costs is by implementing remote work policies.

Today, 52% of remote-capable businesses in the United States offer hybrid work options, and 27% offer fully remote positions while 21% on-site.

Research from Global Workplace Analytics suggests that remote work could save organizations approximately $11,000 per employee annually.

The benefits when it comes to reducing different types of overhead costs of remote work include:

• Reduced office space requirements
• Lower utility bills for lighting, internet, and HVAC systems
• Decreased cleaning and maintenance costs
• Elimination of office bonuses like coffee and snacks

3. Leveraging Technology and Automation to Lower Overhead

Using technology and automation is a powerful way to reduce administrative overhead costs and streamline operations.

For example, with accounting software, you can automate routine tasks such as invoicing, payroll, and expense tracking, which not only reduces labor costs but also minimizes the risk of human error.

Automation can also help you optimize resource allocation, cut down on unnecessary expenses, and improve overall efficiency.

For example, cloud-based project management tools and customer relationship management (CRM) systems can centralize information and improve overall collaboration in your company, further reducing administrative overhead.

4. Energy Efficiency and Utilities

Small businesses that invest strategically in energy efficiency projects can cut utility costs anywhere from 10% to 30%. Remember that energy costs rank among the top three business expenses for about one-third of small businesses.

Experiment with different approaches, and you can start with the following simple energy-saving measures:

• Adjust heating by one degree: This simple change can slash heating bills by as much as 10%
• Switch to LED lighting: Focus on efficient lighting systems across your business
• Turn off equipment: Switch appliances off when not in use and avoid leaving equipment on standby
• Optimize heating schedules: Turn on the heating an hour before employees arrive and turn it off an hour before they leave

When it comes to industry-specific energy solutions, here are some recommendations you can implement to reduce overhead expenses:

• Retail overhead reduction: Focus on efficient lighting (LEDs), optimized heating and cooling, and energy-efficient refrigeration.
• Manufacturing overhead reduction: Implement smart meters, upgrade machinery to energy-efficient models, and consider heat recovery systems
• Office-based overhead: Reduce standby power, use smart lighting systems, and ensure proper insulation.

5. Avoid Unnecessary Purchases

Avoiding unnecessary purchases is also a great way to reduce your business’s overhead. Expensive computers, office furniture, and brand-new company cars will only serve to further burn a hole in your company’s bank account. Also, there can be a space for reduction when it comes to office supplies.

So, analyzing overhead costs regularly can help identify areas where you can save and improve cost control.

6. Outsourcing Non-Core Tasks

Outsourcing allows you to delegate non-core functions—such as payroll processing, IT support, or benefits administration—to specialized providers, which can significantly reduce labor costs and overhead expenses. This approach enables your team to focus on core business activities that drive revenue.

7. Negotiate with Suppliers and Vendors

Negotiation, on the other hand, involves working with suppliers and service providers to secure better rates, terms, or discounts.

Vendors and suppliers are often willing to help small business clients by offering discounts or adjusted terms to retain loyal customers. Every inefficiency can eat into your margins, making vendor negotiation crucial for small businesses.

There are many strategies you can try; however, in my experience, the best results we have achieved through following effective negotiation strategies:

• Build strong relationships: The best deals are saved for reliable and trusted partners who pay invoices on time
• Share growth forecasts: Suppliers are more open to negotiating when they see long-term potential from working with your business.
• Research benchmark pricing: You must understand industry averages before you even think about negotiating prices with your suppliers and vendors.
• Request volume discounts: Consider bulk purchasing so you can get discounted prices from your vendors.

3. Go Paperless

Additionally, having your company go paperless is a great way to avoid unnecessary spending on printer ink (and of course paper) while also increasing productivity by eliminating the need to wait for documents to print or copy.

Instead, you can take advantage of cloud storage to archive your company’s sensitive data and have a centralized location for employees to access anything relevant to their role that they need to. It also has the added benefit of positively impacting the environment.

Related: Things to Consider Before Expanding Your Business and Running a Restaurant: Five Ways to Reduce Costs, Improve Customer Satisfaction, and Increase Your Profits

Reducing Overhead Cost Can Seem Difficult

But it doesn’t have to be.

When budgeting, it’s important to consider all project costs, including direct expenses and overheads (variable, semi-variable, and fixed overhead). In such a way, you can allocate costs more accurately, especially when using activity-based costing,which ensures that overhead expenses are distributed properly across activities.

Using accounting software to allocate overhead costs can further improve financial management.

With the above information about ‘what is overhead cost’ in mind, you’ll be well on your way to ensuring that you never spend a dollar more than you need to when it comes to ongoing expenses.