Overhead costs can represent a significant portion of small business expenses and have a direct impact on profitability. Learn how to effectively manage these costs.
By Cleveland SCORE
Overhead costs are those that support the business activity but are not directly influenced by the cost of goods and services sold. These costs may be borne monthly, quarterly, or annually whether or not the business produces and sells products/services. Overhead costs can be segmented into three groups: fixed, variable, and semi-variable. Fixed costs make up a large portion of overhead and remain constant over a specified period. Variable costs can fluctuate and may not occur on a monthly basis. By their nature variable costs, therefore can be more difficult to budget. Factors such as pandemics, seasonality and economic downturns can impacted these costs. Semi-variable costs reoccur monthly but may be different values each time. These may also be influenced by some of the same factors as variable costs.
Below are examples of costs within the three categories.
|Fixed Overhead||Variable Overhead||Semi-Variable Overhead|
• Loan payment/interest on loans
• Insurance premiums
• Property taxes
• Software subscriptions
• Administrative salaries
• Asset depreciation
• Office supplies
• Legal fees/ consulting fees
|• Hourly overtime|
• Sales salaries
• Travel expenses
• Company car expenses
All categories of overhead cost have a direct impact the overall profitability and therefore, should be reviewed periodically to determine where there is potential for efficiencies. In addition to impact on profitability, overhead also provides valuable information on product/services pricing. When overhead is underestimated, product pricing may be set too low thus adversely impacting profits. Overestimating may price the product too high thus adversely impacting sales and potentially inventory turn-over rates.
As a result of these impacts, business owners should calculate, monitor, and manage overhead costs with the metric Overhead Rate. Calculating the overhead rate is not difficult and can be set up on excel through a simple formula and data collection spreadsheet. Begin by listing down all expenses and categorizing them based on their direct or indirect impact on the cost of goods sold. Once the categorization is complete, total all expenses determined to be overhead costs. From this the overhead rate will be easily calculated. A target rate may be around 35%, however, this is dependent on the current level of profit margin and the industry norm Overhead Rate. For businesses with a low net or operating profit margin the target for overhead could be as low as 10% or less. The optimal goal would be to keep within the industry range.
Due to the dependency of the Overhead Rate optimal goal on profit margins, information on the net profit margin will be needed. There are three important metrics related to profit margins: Gross Profit Margin, Operating Profit Margin and Net Profit Margin. Gross profit margin provides the business owner with remaining income after accounting for cost of goods sold. Operating profit margin provides information on the remaining income after accounting for expenses required to keep the business running on a day-to-day basis. This may include some overhead expenses but not all. Finally, Net profit margin reflects remaining income after all expenses have been accounted for. Therefore, understanding the impact on Net Profit Margins along with the overhead rate will allow business owners the best metrics for determining when changes are needed.
In reviewing overhead expenses, the following expense categories may provide fertile ground for potential reductions.
• Office supplies – specifically, paper and ink. Review usage and identify areas where you can effectively go paperless. Review all office supply expense and determine the need and volume is appropriate.
• Travel expenses – while travel may be necessary for business growth try to incorporate usage of airline miles, discounts, loyalty programs where possible. In today’s environment the use of on-line virtual meetings, training seminars and presentations is a good way to travel to a minimum.
• Utilize expense tracking tools – this provides an easy way to get information on expenditures and supports tax preparations.
• Lease equipment when possible – allows for more current equipment upgrades as well as reducing or eliminating equipment maintenance costs.
• Market to existing customers – the existing customer base is an effective marketing tool. Focus on improving their customer experience. Brand recognition is also an important part of this marketing aspect. Word of mouth is a powerful marketing tool.
• Reduce advertising costs – utilize social media, email, websites where possible. These can reduce costs for printing and mailing of advertising materials. If you have company vehicles, use vehicle wraps to turn them into billboards.
Small business owners are responsible for many functions that keep the business up and running. From an overhead perspective, this posses a risk should the business owner become disabled. To reduce this risk, business owners can acquire Business Overhead Insurance (BOI). A periodic review of the Overhead Rate should include consideration of BOI. This may cover expenses such as administrative employee wages and salaries, taxes, principal and interest payments, utilities, and other overhead expenses. It should be noted that insurance companies may differ in the manner in which they define and cover overhead expenses. You should work with your insurance company to determine if a BOI is needed and if so the best policy and coverage.
Identifying and reviewing your overhead expenses and BOI needs may be the time to bring in the support of a SCORE mentor. A SCORE mentor has business experience and access to the best resources to help you along the way.
The Cleveland Chapter of SCORE was founded in 1965 to foster and support the small business community in Northeast Ohio through mentoring and education. There are currently 80 volunteers with experience in the fields of business ownership, managers, accountants, attorneys, and other business fields that are ready to share their knowledge through mentoring. For more information about our services for small business visit the website at cleveland.SCORE.org or call (216) 503-8160.
In addition to mentoring services, there are also webinars available. Registration for these is found on our website. Following are upcoming events in February:
Net Profit Series 4: Grant Writing Basics 2/23/2022 4 – 5:30 PM
How do Emerging Trends Impact Your Small Business 2/24/2022 4 – 5:30 PM
Funded in part through a Cooperative Agreement with the U.S. Small Business Administration. All opinions, conclusions, and/or recommendations expressed herein are those of the author(s) and do not necessarily reflect the views of the SBA.
1 To calculate Overhead Rate, divide total overhead expenses by monthly sales and multiply by 100 to get a percent.
2 Net Profit Margin calculation is (Revenue – Cost of Goods Sold – Operating Expenses – Other Expenses – Interest – Taxes)/Revenue. To get percentage multiply by 100.