Reduce Overhead Costs : A Step-by-Step Guide (2023) - Shopify (2024)

Overhead costs are the ongoing expenses that keep a business running—separate from the direct costs of creating a product or providing a service.

This guide contains a detailed look at these costs, complete with overhead examples, to help you better understand and manage your business finances.

What are overhead costs?

Overhead costs are ongoing business costs that aren’t directly linked to producing a product or service. They are expenses a business incurs to stay in business, regardless of its sales volume or activities.

In other words, overhead costs represent all the costs on a company’s income statement, except those that can be traced to a specific business activity, such as manufacturing or executing a service.

For example, the rent for a studio where a potter creates ceramics is an overhead cost, because the potter pays rent regardless of how many products they make or sell.

On the other hand, a potter’s clay and potting wheel are not overhead costs, because they are directly related to the products the business produces.

💡 Businesses account for overhead costs to determine net income. You need to know your net income to price products and generate a profit.

Fixed vs. variable overhead costs

Overhead costs are often categorized by how likely they are to change. This categorization is helpful for budgeting.

Overhead costs can be classified as:

• Fixed costs
• Variable costs
• Semi-variable costs

Fixed overhead expenses are the same every month, no matter the activity levels of a business. Think rent, licenses, property taxes, and other fees.

Variable overhead expenses increase or decrease depending on how busy a business is. Variable costs include wages for certain employees, storage space, pay-per-click advertising fees, or equipment maintenance.

Semi-variable overhead expenses occur regardless of activity levels but can change as business activities increase. For example, an accountant might spend more on printer ink during tax season.

Types of overhead costs

Another way to break overhead costs down is to categorize them by type. Most businesses will pay three main types of overhead costs: administrative costs, selling costs, and manufacturingcosts.

Administrative overhead costs

Administrative expenses are the costs that keep the wheels of a business turning—and keep a business in good standing with external stakeholders. They form a substantial part of a company’s overhead and come from diverse sources.

Examples of administrative overhead costs

• Office supplies: This includes everything from stationery to subscriptions for project management tools like Asana or Trello.
• Legal expenses: These are the costs related to compliance, such as retaining a legal consultant to ensure the company is up to date with all industry-specific regulations.
• Insurance: Businesses maintain various insurance policies to protect against unforeseen circ*mstances. This might include professional liability insurance, workers’ compensation, and auto insurance for company vehicles.
• Employee perks: Many companies offer benefits to their employees, such as wellness programs and company-sponsored events. These costs are administrative overheads, as their impact on the production of goods or services is indirect.

Selling overhead costs

Selling overheads are the costs of marketing a company’s products and convincing potential customers to purchase.

Examples of selling overhead costs

• Sales commissions: These are performance-based payments made to sales staff. The more they sell, the more they earn. Commissions are variable costs because they fluctuate based on the sales team’s success.
• Advertising and marketing: Marketing channels such as pay-per-click advertising campaigns are also variable costs, because they change depending on the traffic an ad generates. Businesses may spend on selling overheads such as content marketing and attending industry events.

Manufacturing overhead costs

A manufacturing overhead is an indirect cost incurred during the production process.

Examples of manufacturing overhead costs

• Rent: This is the cost a business pays for the space where it produces its goods. If a business owns property, it will need to account for depreciation.
• Utilities: These are the essential services that keep a business running, including electricity to power machinery, water for restrooms, and internet services for an office.

How to calculate overhead costs

Calculating overhead expenses is a straightforward process. First, you need to analyze your income statement to define your overheads. Then, you can divide your overheads by your sales.

Organize monthly expenses

Begin by identifying and categorizing each overhead expense your business incurs over a specific period—usually a month. Take time to ensure that included expenses are genuine overheads and are not directly related to your business’s product or service.

Calculate overhead rate

Add up these expenses to get the total overhead cost for that period. You can then calculate your overhead rate, which is the percentage of your sales that goes toward overhead costs.

Divide total overhead costs by the total sales for the same period, and multiply the answer by 100 to produce a rate.

For example, if your total monthly overhead costs are $5,000 and your total sales for the same month are $20,000, your overhead rate is:

$5,000 / $20,000 = $0.25
0.25 x 100 = 25%

Based on that month’s income statement, your business spends 25¢ of every dollar made on overhead expenses and has a 25% overhead rate.

10 ways to reduce overhead costs

If you feel that your overhead rate is too high, it’s often possible to find savings within your business operations. Here are 10 overhead-reducing tips:

1. Adopt a hybrid work model

By allowing employees to work from home sometimes, you can reduce the need for large office spaces and reduce rental costs.

2. Negotiate contracts

Regularly renegotiate contracts with your vendors to ensure you get the best possible prices. Consider multi-year contracts for additional savings.

3. Use group purchasing organizations (GPOs)

By joining a GPO, you can leverage collective buying power to secure discounts on supplies and services.

4. Implement lean-startup tactics

By using a lean startup approach to identify and eliminate inefficient activities, you can reduce waste and lower overhead costs.

5. Optimize software subscriptions

Regularly review your software needs and cancel unnecessary subscriptions. Consider using open-source alternatives where possible.

6. Go paperless

Transition to a digital-first approach for administrative tasks. This can reduce costs associated with paper, printing, and storage.

7. Outsource tasks

Consider outsourcing tasks that aren’t central to your business, such as accounting or HR, to reduce the need for full-time staff and associated costs.

8. Implement energy-saving measures

Invest in energy-efficient appliances and encourage employees to conserve energy for cumulative savings on utility bills.

9. Encourage virtual client meetings

Cutting travel costs by encouraging teleconferencing for client meetings is one way to reduce variable costs.

10. Invest in training

Investing in training can increase employee efficiency and reduce the need for costly external consultants.

Overheads: The bottom line

Overhead costs are necessary and unavoidable. But if you don’t keep tabs on overheads, they can eat into profits and destabilize your business.

Regular monitoring of indirect operating expenses is crucial, even when starting out as an entrepreneur. A rented office space might make your start-up feel more legitimate, but an assessment of your finances might show that your overhead spending and profit margins just don’t match.