How to Calculate Overhead

Overhead is a way of measuring indirect expenses, or those expenditures that are necessary for and contribute to the continuing well-being of your business, but don’t contribute directly to profits. Examples of indirect expenses include rent, utilities and maintenance costs for your work facility, insurance fees for employees, fines and licensing fees. Often, a business owner will calculate the ratio of indirect expenses versus direct expenses. Direct expenses are the cost of labor and materials that go directly toward producing a profit-making product or service. The resulting ratio of indirect versus direct expenses is known as an overhead rate, and may also be figured as an overhead percentage.

Steps

Calculate Expenses

1. Make 3 lists of all indirect expenses. One list should be calculated on a monthly basis, another quarterly and the last one yearly. If all you want to calculate is your overhead expenses, you’re done.
2. Make 3 lists of direct expenses, which are materials and labor that go directly toward producing products or services. These lists should also be calculated monthly, quarterly and yearly. This list will be of use if you’re trying to calculate your overhead percentage, or the relationship between profit-producing (direct) and non-profit-producing (indirect) expenses.

Calculate Your Overhead Rating or Percentage

1. Divide indirect costs by direct costs. Make sure you’re using the same measure of time for both cost calculations. In other words, if you’re using quarterly indirect cost figures, your direct cost figures must be computed quarterly as well. Likewise, yearly or monthly cost figures must be computed in relation to cost figures measured across the same time period.
2. Compare the resulting figure -- known as the overhead rate -- against typical overhead rates for other companies in your industry sector. If your overhead rate is lower than the typical overhead rate, or than the overhead rate for a specific company, you have a competitive advantage.
3. Convert the overhead rate to an overhead percentage. Simply multiply the overhead rate by 100. So if you have an overhead rate of .50 (which would result if your indirect costs for a given time period were half as much as the direct costs), your overhead percentage, calculated as .50 * 100, would be 50 percent.

Tips

• Tracking overhead rates over time--that is, monthly, quarterly and yearly--helps to normalize variances caused by seasonal considerations, consumer buying pattern and availability/cost of raw materials.
• If you’re calculating overhead for a past time period, you can use actual facts and figures from company records for your calculations. If you’re estimating overhead for a future time period, you’ll need to use average figures to estimate costs. To calculate future indirect costs, for example, you might examine several past time periods and calculate an average cost for each indirect expense that will be in effect at your business during the future time period you wish to estimate. Likewise, for future direct expenses, you can estimate average costs based on past records and current figures. For example, direct labor can be calculated by multiplying the average hourly wage for direct labor workers at your company by the average number of hours worked by direct labor in a certain time period. The resulting figure may not be exactly what ends up being paid out in said time period, but it’ll be a close estimate.

Sources and Citations

• http://www.inc.com/articles/2000/05/18841.html
• http://www.wisegeek.com/in-business-what-is-overhead.htm
• http://www.missouribusiness.net/docs/calc_overhead_percentage.asp

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