Running your own business can be challenging. You have to look after several different factors to make sure everything is going as smoothly as it should. One of the most important things a business owner or contractor must know how to do is calculate overheads and profit. In this guide, we will cover:

  • What overhead costs are
  • Why you need to track overhead costs
  • Examples of overhead costs
  • How to track overhead costs
  • How to calculate overhead costs
  • How to calculate profit

What are overhead costs?

As a contractor, you are going to have a lot of different expenses. Some will be costs that aren’t directly linked to the creation of products or services but have to be taken into account on an ongoing basis. These costs are known as overhead costs.

Knowing your overhead costs is essential for budgeting purposes and tracking your finances. In addition, they are one of the most important factors to consider when pricing your products or services so that you can make some profit. 

Why track overhead costs?

Overhead costs and operating expenses need to be tracked separately for several reasons. 

  1. Accurate cost accounting

Companies use ‘cost accounting’ to understand the actual cost of producing your product or service. That includes every part that goes into creating the product. To be even more accurate, some people prefer to break down the cost of each unit produced. 

By understanding these costs, you can control them better and find ways to improve your cost-saving measures. It’s also helpful to understand which services are most profitable and this can help you to make better business decisions. 

  1. Better pricing

When you price your products or services, you will need to consider the cost of inventory, labour and the materials that go into them. Usually, it’s pretty easy to identify these. However, knowing your overhead costs is also vital to pricing your products. 

If you price your products or services too low, you might not profit from them. Or you could price them too high, which might result in inventory going unsold. Either way, you’re losing money.  

  1. Compliance with financial accounting rules

Many companies use accounting to report externally to shareholders and HM Revenue & Customs about the business’ taxes, income and expenses. Overhead costs appear on the company’s income statement, where they are deducted from profit.  

  1. Knowing your bare minimum

Since overhead costs generally have to be paid monthly, you must know your total minimum monthly cost. How much you need to keep your business going. This is because no business can operate on this level for very long. It becomes even more critical when your company is impacted by unexpected events or natural disasters. 

Examples of overhead costs

Overhead costs are one of the most fundamental parts of the total cost of running a business. They are generally made up of ongoing fees that must be paid and taken into account regardless of how well or poorly your business is doing. 

Direct labour costs, sourcing materials and direct costs don’t count as overhead costs. 

Some of the most common overhead costs include:

  • Renting and maintaining a property 
  • Repairing, replacing and maintaining tools you need
  • Insurance
  • Stationery
  • Accounting
  • Taxes
  • Human Resources (only salaries for administrative employees that handle tasks like hiring, onboarding, etc. Does not apply to non-HR staff.)

All of these costs have to be paid, whether your business is going well or not. Therefore, most organisations find it beneficial to divide overhead costs into two different sub-categories: Administrative and Manufacturing. 

The advantage of splitting them up is that it allows the company to allocate manufacturing costs to works-in-progress or finished products. Separating the manufacturing overheads makes it possible for businesses to conduct a more thorough analysis of their profitability. 

Admin costs can’t be changed without significant changes to the business’ infrastructure (e.g. reducing the number of employees). However, manufacturing overhead costs might be more changeable if a more in-depth analysis of the costs is measured versus the direct labour and material costs. 

How to track overhead costs

Being able to define and categorise overhead costs is the most important thing when it comes to tracking. The system is usually completed through the process of ‘cost accounting’. When everything is completed, the accountant really only needs to know if the cost in question is a fixed cost. 

Overhead costs generally aren’t related to company revenue, so they shouldn’t change a lot. Rent, salaries and depreciation are all expenses that remain the same every month. One fixed cost that will vary slightly every month is the cost of utilities. The time of year can also impact the cost of utilities, for example there may be more need for heating during winter months. However, it shouldn’t have too much of an impact on the overall running of your business. 

Another great way to categorize your overhead costs is to question whether the costs are directly or indirectly related to producing a good or service. Any cost that isn’t in the direct category should be labelled as an indirect cost. 

When you divide the indirect cost by allocation measure (any type of measurement necessary to make the product or service), you get your overhead rate. Overhead allocation rate is determined by dividing total overhead costs by the number of direct labour hours. 

Calculating overhead costs

Once all of your overhead costs are correctly allocated, you can figure out your business’ overhead as a percentage of sales. This is done by adding up all of the overhead costs, then breaking them down by month and dividing them by the total monthly sales. 

Calculating profit

Calculating profit is pretty straightforward. The formula to calculate profit is Total Revenue – Total Expenses = Profit. Profit is determined by subtracting indirect and direct costs from all of the sales made.  

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The app also provides automatic expense categorisation and a receipt capture tool, so you can make sure your accounts are always accurate. And with automated invoicing, you can save time and get paid faster. Find out more here and sign up for free.