The ultimate guide to understanding and calculating your overhead costs

What are overhead costs?

Overhead costs are the indirect, ongoing expenses required to operate a business that are not directly attributable to creating a specific product or service. Think of them as the costs of keeping the lights on. While the raw materials and direct labour needed to build a chair are direct costs, the rent for the workshop, the electricity that powers the tools, and the salary of the accountant who manages the books are all overhead costs.

These expenses are sometimes referred to as "overhead expenses," "operating expenses," or "indirect costs." Regardless of the name, their defining characteristic is that they support the overall business rather than a single revenue-generating activity. You can't run a business without incurring these costs, making them a crucial component of any financial plan. Failing to account for and manage overhead effectively can lead to inaccurate pricing, poor cash flow, and reduced profitability.¹

Types of overhead costs

Overhead costs are not monolithic. They can be categorised into three primary types based on how they behave in response to changes in business activity. Understanding this distinction is crucial for accurate forecasting and budgeting.

Fixed costs

Fixed costs are expenses that remain constant regardless of the level of business activity or production output. Whether your company produces 100 units or 10,000 units in a month, these costs do not change. This predictability makes them easier to budget for but also means they can become a significant burden during periods of low sales.²

Examples of fixed costs include:

• Rent or mortgage payments for office or factory space
• Annual insurance premiums
• Salaries for administrative, HR, and management staff
• Property taxes
• Depreciation of assets (like buildings and equipment)
• Annual software subscriptions

Variable costs

Variable costs are expenses that fluctuate in direct proportion to business activity. As production or sales volume increases, these costs rise; as volume decreases, they fall.

You need to distinguish between variable overhead costs and direct variable costs. Direct variable costs, like raw materials, are part of the Cost of Goods Sold (COGS). Variable overhead costs are the indirect costs that change with business activity.²

Examples of variable overhead costs include:

• Shipping and packaging supplies
• Office supplies that are consumed based on activity levels
• Consumption-based utilities for production machinery
• Wages for temporary staff hired during peak seasons

Semi-variable costs

Semi-variable costs, also known as mixed costs, contain both fixed and variable components. They typically include a baseline fixed cost that must be paid regardless of activity, plus an additional variable cost that changes with usage. These can be more complex to forecast but represent a common type of business expense.²

Examples of semi-variable costs include:

• Utility Bills: A monthly electricity bill often has a fixed base service fee plus charges based on the kilowatt-hours consumed.
• Company Vehicles: There is a fixed cost for insurance and registration, plus variable costs for fuel and maintenance that depend on mileage.
• Salesperson Compensation: A salesperson might have a fixed monthly salary plus a variable commission based on their sales figures.

Overhead cost examples

To provide a clearer picture, here is a comprehensive list of common overhead costs categorised by business function. Most businesses will incur a variety of these expenses.³

Administrative Overheads:

• Salaries and benefits for administrative, executive, HR, and accounting staff
• Legal and professional fees (e.g., lawyers, accountants, consultants)
• Office supplies (pens, paper, printer ink)
• Bank fees and charges
• Business licenses and permits
• Depreciation on office equipment (computers, printers, furniture)

Facility Overheads:

• Rent or mortgage for office or factory space
• Property insurance
• Utilities (electricity, water, gas, internet)
• Property taxes
• Maintenance and repair costs for the building
• Janitorial and cleaning services

Sales & Marketing Overheads:

• Salaries and commissions for the sales team
• Advertising and promotional expenses
• Website hosting and maintenance costs
• Marketing software subscriptions (e.g., CRM, email marketing tools)
• Travel and entertainment expenses for client meetings

How to calculate overhead cost

Calculating your total overhead cost is a straightforward but essential process for understanding your company's financial health. It involves summing up all indirect costs over a specific accounting period (e.g., monthly, quarterly, or annually). ⁴

Here's a simple three-step process:

1. Define the Period: Choose the time frame you want to analyse, such as a single month.
2. List All Indirect Expenses: Go through your business's financial records (your income statement or general ledger) and identify every expense that is not a direct cost of producing goods or services. This includes all the examples listed above—rent, utilities, administrative salaries, insurance, etc.
3. Sum the Costs: Add up all the identified indirect expenses. The resulting sum is your total overhead cost for that period.

The formula is simply: Total Overhead Costs = Sum of all Indirect Costs

Accurate bookkeeping is the foundation of this calculation. You can use accounting software to properly categorise every expense, making this process significantly faster and more accurate.

What is the overhead rate?  

While knowing your total overhead cost is useful, the overhead rate provides deeper, more actionable insight. The overhead rate is a calculation used to allocate a portion of total overhead costs to a specific cost object, such as a product, project, or service.⁵

Its primary purpose is to help you understand the full cost of production. By adding direct material costs, direct labour costs, and the allocated overhead costs, you can determine the true cost of bringing a single product to market. This information is critical for:

• Pricing Strategy: Setting prices that cover all costs and generate a profit.
• Budgeting: Creating more accurate financial forecasts.
• Performance Analysis: Determining the profitability of individual products or services.

How to calculate the overhead rate

The overhead rate is calculated by dividing the total overhead costs for a period by a chosen allocation base. An allocation base (also known as a cost driver) is a measure of activity that is believed to be the primary driver of overhead costs.⁵

The formula is:

Overhead Rate = Total Overhead Costs/Allocation Base

Common allocation bases include:

• Direct Labour Hours: Total hours worked by production employees.
• Machine Hours: Total hours that production machinery was running.
• Direct Labour Cost: Total wages paid to production employees.
• Sales Revenue: Total revenue generated.

Steps to calculate the Overhead Rate:

1. Calculate Total Overhead: Sum all indirect costs for the period.
2. Choose an Allocation Base: Select an allocation base that has a strong correlation with your overhead costs. For a labour-intensive business, direct labour hours are a good choice. For a highly automated factory, machine hours may be more appropriate.
3. Calculate the Allocation Base Total: Sum the total units of your chosen allocation base for the same period.
4. Divide: Divide the total overhead by the total of the allocation base to find your overhead rate.

Examples of overhead cost and overhead rate

Let's put this into practice with a hypothetical example. Consider a company, "Precision Parts Inc.," that manufactures custom metal components.

Step 1: Calculate monthly overhead cost

The company's finance department compiles the following indirect costs for the month of July:

• Factory Rent: HK$8,000
• Utilities (Electricity & Water): HK$2,500
• Supervisor Salaries: HK$12,000
• Equipment Depreciation: HK$3,000
• Factory Insurance: HK$1,500
• Maintenance Supplies: HK$1,000
• Total Monthly Overhead Cost: HK$28,000

Step 2: Choose and calculate the allocation base

Precision Parts is a machine-heavy operation, so they decided that machine hours are the most logical allocation base. In July, their production machinery ran for a total of 4,000 hours.

Step 3: Calculate the overhead rate

Using the formula:

Overhead Rate = HK$28,000 (Total Overhead) / 4,000 Machine Hours = HK$7 per machine hour

This means for every hour a machine is running, the company incurs HK$7 of overhead cost.

Step 4: Apply the overhead rate

Now, let's say the company receives an order for a custom part that requires 5 machine hours to produce. The direct costs for the part are HK$50 in raw materials and HK$ 80 in direct labour. To find the total cost, they must also allocate the overhead:

• Allocated Overhead: 5 Machine Hours * HK$7/hour = HK$35
• Total Cost of Product: HK$50 (Materials) + HK$80 (Labour) + HK$35 (Overhead) = HK$165

Without calculating and applying the overhead rate, the company might have priced the part based only on the HK$130 of direct costs, leading to a significant underestimation of the true cost and a potential loss on the sale.

How to reduce overhead costs

Reducing overhead is a powerful way to increase profitability without needing to increase sales. You need to implement a systematic and ongoing effort to identify and eliminate waste and inefficiency. Here are several effective strategies:⁶

• Conduct regular expense audits: Don't "set and forget" your expenses. Schedule quarterly or semi-annual reviews of all overhead costs. Scrutinise every line item on your income statement and ask if it's necessary and if the cost can be lowered.
• Embrace technology and automation: Modern software can automate time-consuming administrative tasks like payroll, bookkeeping, and invoicing, reducing the need for manual labour. Going paperless by using cloud storage can save on supplies and physical storage space.
• Renegotiate with suppliers and vendors: Your relationships with suppliers are not static. Regularly shop around for better deals on insurance, internet services, and raw materials. Don't be afraid to ask your current landlord or vendors for better terms, especially if you are a long-term, reliable client.
• Optimise your workspace: The rise of remote and hybrid work models has proven that a large, centralised office isn't always necessary. Downsizing your physical office space or subletting unused portions can lead to massive savings on rent and utilities.
• Streamline internal processes: Look for bottlenecks and inefficiencies in your workflows. Can communication be improved? Can meetings be made more effective? Eliminating wasted time is a direct way to reduce costs, especially those related to salaries.
• Focus on high-ROI marketing: Analyse your marketing spend to determine which channels provide the best return on investment. Shift your budget away from underperforming strategies and toward more cost-effective digital marketing avenues like content marketing, SEO, and targeted social media ads.
• Consider outsourcing: For non-core business functions like IT support, human resources, or accounting, outsourcing to a specialised firm can often be more cost-effective than maintaining an in-house department.

Manage your overhead costs efficiently with Aspire Expense Management

We understand that manually tracking these various costs and claims, as well as seeking budget approvals, are precisely the time-consuming administrative tasks that a dedicated platform is designed to eliminate. Aspire's Expense Management platform simplifies the process with powerful automation and real-time control.

With Aspire, you can:

• Stay in control of your expenses by creating budgets at the client, team, or project level
• Process and disburse reimbursements faster with the Aspire mobile app
• Save up to 50% of time on manual accounting tasks with smart automation
• Eliminate 100% of manual data entry through real-time syncing with Xero and QuickBooks
• Gain real-time visibility into business expenses and invoice statuses
• Reduce bottlenecks and maintain compliance with multi-approval flows
• Simplify cross-border payments and international transactions with detailed, upfront invoice documentation