Calculating overhead rate and percentages for a small business simply involves taking the company's indirect expenses and dividing them by the company's direct expenses. Once the company understands its overhead costs, it is in a much better position to determine what price it should charge for its product and ultimately, what it must do to reduce those costs in order to remain competitive. In this case, it’s about determining the overhead rate and percentage and then determining their impact on the product’s price. So, what are the steps to calculating overhead rate and percentage for small businesses?
When looking to calculate overhead rate and percentage, it’s important to sum up both of your company’s direct and indirect expenses. When thinking of direct expenses, think of the direct labor and material needed in the manufacturing of your product. In this case, if your company manufactured widgets, then your direct expenses would be the material needed in manufacturing and the labor costs for each and every production employee involved in making those widgets. In a sense, direct expenses can be seen as variable expenses. Some months you'll produce more than others and as such, your direct expenses will fluctuate as a result.
When looking at indirect expenses, think of those support roles within your company that you must cover as salaries and your company's general expenses. These support roles could include your accounting, sales and customer service departments, marketing, engineering and design, maintenance, as well as general expenses of taxes, insurance, rent etc. Indirect expenses are often referred to as overhead expenses and include all those costs on your income statement, except of course your direct expenses of material and labor (mentioned above).
The above video explains how to come up with an hourly rate for a small business and shows how to calculate overhead rate and percentage. It is taken from the post: Determining Hourly Rates for a Contractor or Small Business
Overhead Rate Calculation: Indirect Expenses / Direct Expenses
Overhead Percentage: Overhead Rate X 100 = %
Direct Expenses: These are the direct labor and material costs in manufacturing the product. They are essentially variable expenses that fluctuate with demand or production volumes. Again, some months you'll produce more, with higher direct expenses, and others you'll produce less, with have lower direct expenses.
Indirect Expenses (Overhead Costs): I’ve put overhead costs in parenthesis because one should think of indirect expenses as costs that are “over and above” or “in addition to” a company’s direct expenses. These costs are associated with a company’s support roles of sales and customer service, marketing, accounting, engineering as well miscellaneous expenses of rent, insurance, utilities etc. These are indirect expenses that can’t be attributed to any one product, or volume of product, but that are essential in running a business.
Let’s assume you’ve summed up all your indirect expenses and direct expenses from the prior month.
- Your indirect expenses were $35,000.00
- Your direct expenses were $60,000.00
- Overhead rate = $35,000.00 / $60,000.00 = .58
- Overhead percentage = .58 x 100 = 58%
In this current month, your company was awarded a significant contract. As a result of this new contract, you had higher direct expenses than the previous month. This is because you purchased more material and parts, and paid out more salary to production workers, in order to manufacture the larger volume contract. Therefore, this month’s direct expenses jumped to $70,000.00 However, your indirect costs remained the same, or fixed, at $35,000.00
- Overhead rate = $35,000.00 / $70,000.00 = .50
- Overhead percentage = .50 x 100 = 50%
For this month, your overhead rate or overhead percentage, decreased because your company essentially spread out its indirect expenses (overhead costs) over a larger portion or value of direct expenses. Most companies track their overhead by quarter and by year, but some service companies may track their overhead costs by month or even by week. This is up to you.
Why is Determining Overhead Important?
Simply put, it allows companies to track the value of those expenses that don’t directly contribute to a product or service’s profit, but who are nonetheless important to the company’s operations. After all, a company must cover its costs relating to employee salaries, rent, insurance, taxes etc. In addition, it must cover these costs and still include a profit in the product's price. Ideally, this overhead percentage must be used in order to cover the company's cost of operations. However, something else must be added to secure healthy profit margins.
Let’s assume that a company had direct expenses of $15.00 (labor & material) in producing one widget. In order to cover the company’s indirect expenses, the company should charge $7.50 ($15.00 x 50% overhead percentage = $7.50) in addition to its labor and material costs. This new cost of $22.50 would allow the company to cover its direct expenses of $15.00, and its indirect expenses of $7.50 or its overhead. To determine a price, it might include using gross profit on sell price. Using gross profit on sell price is preferred because it is the same reporting method on company income statements. Now, if the company wanted to make 30% gross profit on sell price, it would take this cost of $22.50 and divide it by .70 (100% - 30% = 70% or .70). This would mean the company would then have product selling price of $32.14 per unit.
- Direct expenses = $15.00
- Overhead = Overhead % * Direct Expenses = .50 * $15.00 = $7.50
- Total Cost = Direct expenses + Overhead = $15.00 + $7.50 = $22.50
- Gross Profit on Sell Price = $22.50 / .70 = $32.14 per unit
Check the math: Take the sell price and multiply it by 30%. Take that amount and deduct it from the sell price to confirm the total original cost.
- $32.14 x 30% = $9.64
- $32.14 - $9.64 = $22.50 - correct.
When companies calculate their overhead costs, they are in a much better position to understand what impact these costs have on the business and what role they should play in their product’s price. If too high, then the company must put plans in motion to reduce their overhead. If low, then the company is in good position to steal business and grow market share. For the most part, companies should review their overhead costs on a monthly, bi-monthly or quarterly basis and should only do so in order to capture any rising costs over these periods.
While I am a proponent of capturing a company’s overhead costs, I am not in favor of adjusting prices every time costs change. The impetus should be on monitoring overhead over time, and not merely matching a competitor’s price without first understanding what matching that price does to the company’s costs and its gross profit.
To read about how overhead impacts a company's restocking fees on product returns, please see: B2B Restocking Fees: Three Simple Steps to Covering Carrying Costs