Spending money is an integral part of running a business. Business owners spend a lot on producing and creating products and services. This cost is known as direct costs. These expenses are directly associated with building the product and services. However, the expenses which are not associated directly with building a product/service, are known as an overhead cost.
If the business owner doesn’t take care of overhead cost, it can quickly drain the business revenue. The business owners need to take out time and figure out how to calculate the overhead cost. But before going any further, let us first discuss what the overhead cost is.
What is Overhead?
Overhead cost is that cost which is associated with running a business. But it is not directly attributed to product/service, business activity, and a portion of the company’s income. The example of this cost is:
- Professional expenses, such as legal or accounting services
- Administrative costs
- Licenses and permits
- Property taxes
- Office equipment
The cost is critical for a business, but it does not lead to the generation of profits.
Additionally, this cost is fixed. For example, the rent for the office stays the same every month. Notably, the direct cost is different from overhead cost. Direct cost includes direct labour and material associated with the production of products and services. Direct cost is variable cost, whereas overhead is fixed. The total cost of the small business is calculated by adding direct and overhead expenses.
How to Calculate Overhead cost for Small Businesses?
As a small business owner, you should know the overhead cost formula and how to calculate the overhead cost. The most common way to calculate it is to take a percentage of sales and labour costs. Your goal should be to keep the overhead cost as low as possible. It would mean that a high percentage of the expenses are going towards the production of goods and services.
A low overhead cost will also mean that you can offer your products at better prices, making them a better option for competition. Furthermore, a small overhead would also increase profit margins and boost the bottom line.
To calculate business overhead, you need first to specify your business activities and make a list of your expenses; it should be thorough. You can look through your financial statement in order to make sure that you have to pinpoint every cost. Once all the business expenses are identified, sort them into two categories, namely direct and indirect expenses. Then ask yourself, does this expense impact the production of goods?
Once the expenses are sorted, add all the direct and indirect expenses for the month. Then look at the company’s income statement to ascertain monthly sales. Once the monthly sales are determined, calculate the overhead ratio in the following way:
(Monthly overhead ÷ monthly sales) x 100 = percentage of overhead cost to sales
The overhead cost can also be measured by comparing it to the labour cost:
(Monthly overhead ÷ monthly Labour cost) x 100 = percentage of overhead cost to labour
Now let’s take a look at how to lower down the overhead costs for a small business in India.
How to lower down overhead costs?
If you realise that the overhead expenses are taking a toll on your revenue, you should immediately look for ways to lower down the cost. Below, you will find ways to reduce the cost:
Review Everything Thoroughly
Determine the expenses that you can consider as an indirect cost. However, these expenses can fluctuate over time, based on the activities of the business. You need to review the expenses monthly to ensure there are no drastic changes.
You should anyway go through all your business expenses monthly. Mark the items as:
- No longer necessary for business
- Open to efficiencies
- Too high in price
If you have a high overhead percentage, don’t look for a magic bullet. Cutting down on a single expense will not fix the problem. The process requires you to have patience and realise the most significant cost saving that can bring down overhead.
Re-evaluate third-party Contracts
If you rent machinery or equipment, you can re-evaluate the cost by looking for current deals and see if they still fit your needs. You can look for better and cost-efficient deals as well. However, this process is critical if the contractors or vendors are older.
Brainstorm the Employees
You can take the input of your employees regarding where you can save money. Depending on the size of the organisation, you can even offer incentives for the employee that provides the most innovative concept. Notably, if you brainstorm with the team, you are more like to get better ideas.
Clear out Storeroom
There are chances that your office is filled with non-working or outdated technology, like printers, computers, etc. Take time to review the technology expenses and cut out those that are no longer required to save cost. Compare different service providers in your locality and avail services from the one that offers better rates.
There’s a chance that your one or two employees may be underperforming. Laying off employees hurts, but keeping the underperforming employee on board won’t do any good for the company either. It undoubtedly is a drain on your resources.
Designate one person to purchase everything for your organisation. This person should be in charge of things like negotiating with the suppliers and getting the best deals and offers.
The above mentioned points will help you by cut your overhead expenses. You just need to carefully evaluate the current position of your expenses and come up with a saving strategy.