Financial metrics
Overheads
Overheads are the ongoing business expenses that support your daily operations but cannot be directly traced to the creation of a specific product or service.
What is Overheads?
Overheads represent the indirect costs you incur just to keep your business open, regardless of how much you sell. Unlike direct costs, such as raw materials or direct labour, overheads cannot be easily traced to a specific unit of production or a specific service you provide. You must pay these expenses even if your revenue drops to zero for the month. Common examples include office rent, utility bills, administrative salaries, software subscriptions and insurance premiums. Understanding your overheads is essential for setting accurate prices, because every item you sell must contribute a portion of profit to cover these indirect costs. If you fail to account for them properly, you might sell products at a gross profit but still lose money overall, threatening your long-term survival.
Total Overhead Costs / Allocation Base
This rate tells you how much indirect cost to add to each unit of your allocation base. For example, if your base is direct labour hours, the result shows the overhead cost applied for every hour worked.
How Overheads works
Managing overheads begins with identifying all your business expenses and separating them into direct and indirect costs. You first record every bill, payroll run and subscription fee in your accounting system. Next, you classify the indirect costs into fixed, variable or semi-variable overheads. Fixed overheads, like rent, stay the same each month. Variable overheads, such as office supplies, fluctuate with your general business activity. Once categorised, you total these indirect costs over a specific period, usually a month or a year. Finally, you allocate this total across your products or services using a chosen base, such as direct labour hours or machine hours. This allocation ensures that the final price of your goods covers both the direct materials and a fair share of the operational upkeep.
- Identify all business expenses and separate direct costs from indirect costs.
- Record every indirect expense in your general ledger under the correct account.
- Classify each overhead cost as fixed, variable or semi-variable for better tracking.
- Calculate the total overhead costs incurred during your chosen accounting period.
- Allocate the total overheads to your products using a consistent allocation base.
Worked example
Oasis Furniture Manufacturing wants to calculate its overhead rate for the month. The business incurs 12,000 in factory rent, 3,000 in utilities and 5,000 in administrative salaries, totalling 20,000 in overhead costs. The manager decides to allocate these costs based on direct labour hours. This month, the factory workers log a total of 4,000 direct labour hours. To find the overhead rate, the manager divides the total overheads (20,000) by the total direct labour hours (4,000). The result is an overhead rate of 5 per direct labour hour. When costing a new table that takes 10 hours to build, Oasis will add 50 in overhead costs to the direct material and labour costs.
Why it matters for your business
Monitoring your overheads is crucial for maintaining a healthy net profit margin. If your indirect costs creep up unnoticed, they will consume the profits generated by your sales, leaving you with less cash to reinvest or distribute. High overheads also increase your break-even point, meaning you must sell more goods just to avoid a loss. By keeping a close eye on these expenses, you can identify areas to cut waste, such as renegotiating a lease or switching utility providers. Paper & Pen helps you organise this data, as Sales and Invoicing is free forever and it posts journal entries automatically. Keeping overheads lean makes your business more resilient during economic downturns.
Questions
Common questions
What is the difference between overheads and direct costs?
How do I reduce my business overheads?
Are overheads the same as operating expenses?
Related terms
- Cost of goods sold Cost of goods sold is the total direct expense incurred to produce or purchase the items that a business successfully sells during a specific accounting period.
- Gross margin Gross margin is a financial metric that reveals the percentage of revenue remaining after subtracting the direct costs of producing the goods or services sold by a business.
- Net profit margin Net profit margin is a financial ratio that shows the percentage of revenue remaining after all operating expenses, taxes and interest have been deducted from your total sales.
- Break-even point The break-even point is the exact moment when a business generates enough revenue to cover all its fixed and variable costs, resulting in neither a profit nor a loss.
- General ledger A general ledger is the master accounting record of a business, containing all financial transactions categorised by account to track assets, liabilities, equity, revenue and expenses.
- Amortisation Amortisation is the accounting practice of gradually writing off the initial cost of an intangible asset over its useful life to match expenses with generated revenues.