How to Understand Your Overhead Costs
The saying goes, “You have to spend money to make money.” It is a common statement you will hear when you’re running a company. From renting a warehouse to hiring employees, your business will generate overhead costs that you have to account for to ensure everything you spend contributes to making profits. In this article, we’ll help you understand your overhead costs and how to calculate them. That way, you can identify areas of excess spending, manage your cash flow more effectively, and decide better on pricing and other important business aspects.
Key Takeaways of Understanding Your Overhead Costs
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What Are Overhead Costs?
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Overhead costs are essential yet indirect expenses for running a business, like rent, utilities, and administrative salaries. These are crucial for daily operations but not directly tied to profit generation.
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Types of Overhead Costs
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Overheads include fixed costs (like rent), variable costs (like utility bills), and semi-variable costs (a mix of fixed and variable elements), each impacting your business finances differently.
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How to Calculate Overhead Rate
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To determine the overhead rate, divide total monthly overhead costs by total monthly sales and multiply by 100, providing insight into the proportion of each revenue dollar spent on overheads.
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How to Handle Your Overhead Costs Better to Gain a Lower Rate
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Regularly review ongoing expenses, adopt efficient technology, optimise space, outsource non-core activities, implement energy-saving measures, and consider borrowing options for better overhead management.
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What Are Overhead Costs?
Overhead costs are the ongoing expenses associated with running a business that aren’t directly tied to creating a product or service. These costs are essential for the day-to-day functioning of a business but do not directly generate profits. They may include a wide range of expenses such as rent or lease payments for business premises, utility bills like electricity and water, administrative costs including office supplies and equipment, and salaries of non-production staff.
In the context of B2B companies, overhead costs might also encompass expenses related to marketing and advertising, legal and professional fees, insurance and travel expenses. These costs are typically fixed and recur regularly, making them a critical factor in budgeting and financial planning for any business.
Overhead costs can often go unnoticed, especially when your attention is primarily focused on direct business expenses like raw materials and manufacturing processes. Yet, these costs are among the first that should be scrutinised when looking to optimise expenses. When you keep a close eye on these expenses, you can identify areas where cost-saving measures can be implemented without compromising the efficiency or quality of your operations. In other words, understanding these overhead costs and effectively managing them is crucial for maintaining a healthy bottom line and ensuring the sustainability of your business.
Types of Overhead Costs
Here are the key types of overhead costs in business that you should be aware of:
- Fixed Overheads: These costs remain constant regardless of your business activity levels. They include expenses like rent or mortgage payments for your office space, insurance premiums, and administrative staff salaries. For instance, examples of fixed costs for a civil engineering firm might include monthly rental fees for equipment storage facilities.
- Variable Overheads: Unlike fixed overheads, these costs fluctuate with the level of business activity. Examples include utility bills, which can vary from month to month, and the cost of office supplies, which might increase with more projects. Focusing on B2B industries, what are overhead costs in a manufacturing business that are considered variable? These could include equipment maintenance costs or consulting fees that vary based on multiple factors.
- Semi-variable Overheads: These costs have both fixed and variable components. For example, a business might have a base rate for utilities (fixed) plus a variable rate that depends on usage. For instance, in the context of a labour-hire company, this might manifest in the form of a basic telecommunications package (fixed) with additional charges based on usage (variable).
How to Calculate Overhead Rate
Calculating the overhead rate is a fundamental process for any business, particularly in B2B sectors where managing finances is crucial. This rate helps you understand the proportion of overhead costs in relation to your sales. Here’s how you can calculate it:
- 1. Identify the Total Monthly Overhead Costs: Begin by summing up all your overhead costs in a month. This includes fixed and variable expenses such as rent, utilities, administrative salaries, and other costs indirectly tied to production or service delivery.
- 2. Calculate the Overhead Rate: First, identify your total monthly sales. Next, divide your total monthly overhead costs by your total monthly sales, then multiply the result by 100 to get a percentage. For instance, if your business generates monthly sales of $50,000 and incurs monthly overhead costs of $12,500, the calculation formula would be as follows: ($12,500 / $50,000) x 100, resulting in an overhead rate of 25%. This means that for every dollar earned, 25 cents is spent on overhead costs.
A lower overhead rate usually indicates more profits and better efficiency. So, knowing your small business’s overhead costs and overhead rate is a critical step to recalibrating your budget and pricing to manage your finances more effectively.
How to Handle Your Overhead Costs Better to Gain a Lower Rate
Reducing your overhead rate can help boost your business’s profitability. Here are some strategies to manage and lower your overhead costs effectively:
Review Ongoing Expenses Regularly:
Assess ongoing expenses like utilities, subscriptions, and rental fees periodically. Doing so will help you identify areas where you can cut back or negotiate better prices.
Innovate & Adopt Relevant Technology:
Using the right technology can streamline processes and reduce manual labour costs. For instance, using accounting software can minimise the need for extensive administrative staff.
Optimise Space Utilisation:
Evaluate your physical space requirements. If possible, consider downsizing or moving to a less expensive location. Alternatively, if your business model allows, shift some of your team members to a remote working model to save on administrative office space costs.
Outsource Non-Core Activities:
Outsourcing tasks not central to your B2B company, such as cleaning or IT services, can be more cost-effective than maintaining in-house teams.
Go Green:
Implementing energy-efficient practices can significantly reduce utility bills. Simple changes like switching to LED lighting or optimising heating and cooling systems in your manufacturing facilities can lead to savings.
Consider Borrowing Options:
When evaluating your fixed and variable overhead costs, it’s wise to explore various business financing options that could help manage these expenses more effectively.
Consider Borrowing Options:
For example, if your business is burdened with outdated machinery that frequently breaks down, leading to high repair and maintenance costs (an example of variable overhead costs), consider investing in new equipment through equipment financing solutions. Additionally, various business loan products can provide a much-needed cushion for short-term cash flow challenges, allowing you more flexibility as you work towards reducing your company’s total overhead costs.
Darkhorsefinanical.com.au Can Help You
Get in touch with us if you need expert guidance on using commercial lending solutions to handle your business’s overhead costs and cash flow better. Our seasoned brokers are ready to sit down with you to identify your needs, assess your company’s financial situation and connect you to a lender that best suits you.
