What Are Overhead Costs & How Can You Lower Them?

Running a business is expensive; that is true, but people often forget about the costs of “keeping the lights on,” i.e., the overhead costs. If business owners aren’t careful, overhead costs can quickly drain their revenue. Business owners need to spend some time understanding their overhead and how they can reduce it. Typical overhead varies from industry to industry. For restaurants, overhead should be about 35% of sales, while professional services firms may have overhead costs as high as 50% of sales. No matter your business type, there are many ways to manage these “non-productive” costs and get ahead effectively.

What Is Overhead?

Overhead costs are those that are associated with running your business but that you can’t directly attribute to a product, service, business activity, or portion of the company’s revenue. 

Overhead costs include things like: 

  • Professional expenses, such as accounting or legal services
  • Administrative costs, such as the salaries for your marketing employees 
  • Insurance
  • Depreciation
  • Licenses and permits
  • Property taxes
  • Manufacturing overhead, such as lease payments 
  • Office equipment
  • Utilities

Although overhead costs are critical to business operations, they do not directly lead to the generation of profits. While having a place to conduct work is great, the building itself and its costs are not what makes you money. These costs are, however, usually fixed, i.e., stay the same over time. 

On the flip side, direct costs, including direct labor and direct materials, are associated with creating a product or service, but they vary.

How To Calculate Overhead

Before trimming your overhead costs, you must understand how to calculate overhead. The most common way to calculate overhead costs is as a percentage of sales or labor costs.

Your goal as a business owner should be to keep your overhead proportion as low as possible. The equation looks like this: 

(Monthly Overhead ÷ Monthly Sales) x 100 = Percentage of Overhead Cost to Sales

You can also measure your overhead costs compared to your labor costs to get an idea of how rising wages affect your overhead. The equation for that looks like this: 

(Monthly Overhead ÷ Monthly Labor Cost) x 100 = Percentage of Overhead Cost to Labor

How To Lower Overhead Costs

Reducing overhead costs doesn’t have to mean laying off employees or forgoing coffee in the mornings; there are many practical ways to trim the fat, which we’ll outline below.

Look At Your Contracts

If you’ve been using the same printer rental company for decades, chances are you’re overpaying. Dust off some of your oldest contracts with equipment vendors and see if you could save by switching to a new company or simply revamping your current agreement. Additionally, if you have contracts for things you don’t use very often, terminate them.

Clear The Clutter

Does your storage closet look like a morgue for outdated computers, monitors, keyboards, and desk chairs? It may be time to evaluate whether or not you need these items. Keeping outdated items just takes up space and costs you money every time you need to call IT to fix them. Ditch the storage closet dust bunnies and invest in new technology when you need it.

Change Your Marketing

Digital advertising is expensive. Advertising on Google, Facebook, and Instagram can cost thousands of dollars or more per month. While marketing is essential, you can reduce the cost of paid advertising by switching up your strategy. Word-of-mouth marketing is still one of the best referral forms. Try using your current, happy customers as brand ambassadors. Ask for testimonials, referrals, or even offer discounts for their time recording a video “ad.”

Reign In Purchasing Power

Office supply orders can feel like a pen, folder, or mousepad free-for-all if you don’t have the proper oversight. If possible, designate one person to handle all purchasing, including negotiating contracts and placing office-supply orders. Ideally, the person wouldn’t be shy to ask for discounts either. By putting one person in charge of purchasing, this person can dedicate their time solely to finding you the best vendors and best deals. It will also eliminate overspending by multiple employees or departments.

Downsize Or Digitize

If COVID taught us anything, it’s that people can work from home and do it well. If you’re drowning in overhead costs, it might be time to give up your office space and move to a work-from-home (WFH) model. If WFH isn’t possible, consider location as well. It may be better to relocate to any area with cheaper leases. Finally, consider downsizing to smaller office space if changing locations or doing WFH isn’t ideal. 

You should also utilize accounting software designed for small business owners like QuickBooks or Xero, which can quickly track direct and indirect expenses. Doing so will allow you to identify your overhead ratio and reduce costs.
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