If you are running a small business, then it is very important to track and calculate overhead costs because while managing the business, there are values and expenses that are not directly correlated to producing products or services but still, we have to pay on a continuous basis.
These types of costs are called “overhead costs”. This costs not only very beneficial for budgeting accurately and tracing finances, but also very important for analyzing the actual costs of goods or services so that the business can adapt a profit.
Some examples of overhead costs:
Overhead costs are the managing costs that need to be paid regardless of the company’s current business volume. General overhead costs include:
- Rent and Utilities
- Repairs and Maintenance
- Office Supplies
- Human Resources
How to Track and calculate Overhead Costs
Tracking Overhead Cost
Overhead costs are not correlated to the revenue of the company and also not vary. The examples of overhead costs are Rent, salary, and reduction that persist the same from month to month not vary continuously.
Fixed costs that may reflect minor monthly changes are utilities. Maybe seasonality can easily affect this cost (i.e use of air conditioning in summer, running with skeletal staff over the holidays). However, the effect of seasonality on your expenses should be so slight that it does not actually affect accounting calculations.
The other best possible way to accurately classify overhead costs is to ask if costs are directly related to the production of a good or service. Every cost that can be classified in this way is an indirect cost and as a result, must be classified as overhead.
5 Steps to Calculate Overhead Cost
If you want to calculate the overhead costs of business then you have to add all business expenses that manage your business running but keep in mind you have not add to the revenue generation process. These are indirect costs such as administrative expenses, sales and marketing costs, and production expenses.
Regularly calculating and recording overhead costs helps you to save money and also get a better price for your products and services, and allow you to streamline business operations.
List The Expenses
Make a complete list of indirect business expenses like rent, taxes, services, office facilities, maintenance, etc. These costs are overhead costs. Remember, direct expenses associated with the production of goods and services, like labor and raw materials are not involved in overhead costs.
When classifying direct and overhead costs, make sure that some items cannot be assigned to a specific category.
Add the overhead cost
The total cost of monthly overhead to calculate the total overhead cost. This is that amount of money that you need to drive your business.
Calculate the overhead rate
The overhead rate or overhead percentage is the value of your business that contributes to building a product or providing services to the customers.
Calculate the overhead rate by this formulae: Divide the indirect cost / the direct costs and (*) multiply by 100.
For eg: if your overhead rate is 30% then it indicates your business spends 30% of its revenue on manufacturing goods and providing services. A lower overhead rate shows the efficiency and higher profits.
Compare to sale
While fixing prices and creating a budget, it is important to know the percentage of a dollar that is allotted for overheads. To calculate the ratio of overhead cost to sales:
Monthly overhead cost / monthly sales (*)100.
For example: A business with monthly sales of $200,000 and overhead costs is $40,000 has ($40,000/ ($200,000) x 100 = 80% overheads.
Compare to labor cost
To estimate the efficiency with which business resources are being used, measure overhead costs as a percentage of labor costs. The lower the percentage of labor cost, it means the more active your business is using its resources.
Formula to express it as a percentage: Divide the total overhead cost / the total labor cost for the month (*) 100.
How to calculate the overhead absorption rate
The amount of indirect cost that is allotted to goods and services is known as overhead absorption. Indirect costs are not immediately available. External financial reporting requires overhead absorption by both GAAP and IFRS.
Overhead is assigned to the product or service based on direct labor hours, machine hours, direct labor costs, etc. The overhead absorption rate is determined to add overhead in the cost of production of goods and services. It defines the amount to be debited for indirect labor, material and other indirect expenses for work in production to work in progress.
Different Methods to calculate the Absorption Rate
Percentage on Direct material Method
Direct material cost is the main component of the product cost. In this method, the absorption rate depends on the direct material cost. Formula to calculate direct material method:
Divide the overheads / Estimated or actual direct material costs (*) 100.
Direct Labor cost method
The expected or actual cost of labor is calculated by: Dividing overhead / direct wages and expressed (multiply by 100 if you want to be expressed in %).
Prime Cost Percentage Method
It is the total of direct labor and direct material expenses of a business. To calculate the prime cost percentage: Divide factory overhead / prime cost. (multiply by 100, if you want to express in percentage)
Labor Hours Method
The formula to calculate the labor hour rate: Dividing the factory overhead / direct labor hours.
Machine Hour Rate
The formula to calculate the machine hour rate is: Dividing the factory overhead / machine hours.
Sale Price Method
The formula to calculate Sale Price: Overheads/Sale Price of Production Units.
How to calculate the overhead rate per Employee
Follow the below steps to calculate the overhead rate per employee.
- Calculate the labor cost that includes not only weekly or hourly pay, but also health benefits, holiday pay, pensions, and employer-paid retirement benefits.
- Calculate the complete overheads of the business.
- Distribute the overhead cost by the number of billable hours. For example, if you have six technicians in your business, the overhead cost is split between them.
- Calculating labor costs for overhead costs and billable hours gives you that employee’s net cost per hour of business.
By reducing the ratio of overhead, a business can gain a competitive advantage, either by increasing profit margins or pricing its products more competitively.
Hope, you like to read this article and understand the steps to track and calculate overhead costs in QuickBooks. In case, you are still getting any issue or problem, don’t worry, Wizxpert is here to help you with all your queries. You just need to dial +1-855-441-4417 this toll-free and get connect with our Intuit certified ProAdvisor and feel free to discuss all your queries.