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Expenses aren’t as fun to think about as sales, but they are an essential part of your business. Even if you are the sole proprietor of and only worker in a service-based business, you will still have business expenses. Unlike a W-2 employee who gets to keep their entire salary—less taxes, of course—you won’t be able to keep every dollar you earn in your business.
Some of the expenses you must manage in your business are those you incur to make your product or deliver your service. Other expenses go into keeping your business running. And still other expenses aren’t expenses at all, at least not from an accounting perspective.
Part of doing business is managing the expenses that go into operating your business. But not all expenses are created equal. In this article, we will take a look at the expenses that take up the most space on your profit and loss statement: overhead expenses.
Overhead expenses are the costs of running your business. Overhead expenses differ from direct costs—or cost of goods sold—because overhead expenses don’t tie directly into the production of a product or delivery of a service. Direct costs will vary based on your sales volume, but overhead expenses typically remain about the same each month, regardless of your business’s income.
For example, let’s say you own an advertising agency. You have dozens of expenses each month, like rent, payroll, your accounting software subscription, media buy for clients, talent costs, printing, and—unavoidably—taxes.
The expenses that go into the delivery of your service—media buy, talent costs, and printing—are all direct costs. These expenses are reported as Cost of Sales (COS, or sometime COGS for Cost of Goods Sold) on your P&L. Rent, payroll, accounting software subscriptions, and (in some cases) taxes are considered the cost of doing business, operating costs, or overhead expenses.
On the other hand, let’s say you own an accounting firm. You have dozens of expenses every month, too, like rent, payroll, accounting software subscriptions, printing costs, and, naturally, taxes.
Printing costs probably aren’t part of delivering your service to your clients, or if they are, they aren’t a large part of it. Those would be considered overhead expenses for your business. However, accounting software subscriptions do go into delivering your service. In this case, your accounting software subscriptions would be reported as Cost of Sales, and rent, payroll, printing costs, and (possibly) taxes would be considered overhead expenses.
In other words, there is no hard-and-fast rule about what is a direct cost and what is an overhead expense. The definition will vary from business to business. The important thing for you and your accountant to determine in order for you to get meaningful financial statements is which expenses in your business directly relate to the production of your product or the delivery of your service, and which ones go into operating your business.
What does stay the same across all businesses is where each of these types of costs are reported. Direct costs—whatever those might be for your particular business—are reported in the Cost of Sales section of your profit and loss report, right under income. They are subtracted from your total revenue to determine your gross profit. Gross profit, then, is the profit your business has after paying for the materials and/or labor that goes into producing your product or delivering your service.
Overhead expenses take up most of the rest of your profit and loss statement. Reported after gross profit, overhead expenses—sometimes called operating expenses, or just expenses—are subtracted from your gross profit to show you your net profit, net income, or bottom line.
Even among business overhead expenses, not all expenses are equal. Overhead expenses can be divided into three main categories. Knowing these different categories—and what overhead expenses go into each—can help you create a meaningful budget for your business.
Fixed overhead expenses are the expenses that don’t change from month to month. If a fixed overhead expense does change, it typically happens on an annual basis and during a renewal period.
Some examples of fixed overhead expenses include:
Fixed overhead expenses are the easiest to budget and plan for, because you know they will be the same every month. At the same time, these can be the hardest expenses to reduce in response to decreased sales or restricted cash flow, because they are typically “locked in” by a contract or some other agreement.
Variable overhead expenses are affected by business activity, but not necessarily by sales. Some examples of variable overhead expenses include:
Although office supplies expenses will likely increase as a result of increased sales, they are not directly tied to the production of a product or delivery of a service, and so they aren’t direct costs. There is no guarantee that office supplies will respond to changing sales volume; your office manager probably won’t know sales are down when she needs to reorder office supplies, and so she probably won’t take that into consideration when she is deciding what to order.
Similarly, advertising expenses might increase during a downturn in sales in an attempt to bring sales levels back up. And legal expenses and repairs and maintenance expenses can happen at any time (and often when you can least afford them).
The good thing about variable expenses is you can often immediately adjust them if you experience a downturn in income. The bad thing about variable expenses is they can often be difficult to predict, which makes budgeting for them more difficult than budgeting for fixed overhead expenses.
Some overhead expenses aren’t exactly the same from month to month, but they also aren’t completely unpredictable, either. These expenses are called semi-variable overhead expenses, and they include:
When planning for semi-variable overhead expenses, you can often get an idea of how much to budget by looking at previous years’ spending in each category.
Earlier in this article, we alluded to taxes “sometimes” or “possibly” being overhead expenses. This is one of the tricky parts of accounting, which can be confusing to many business owners.
Not every outlay of cash in your business is an expense from an accounting perspective. Items that appear on your balance sheet—like many income tax payments, owner’s draws, loan payments, and dividends—are not technically included in overhead expenses on your P&L. However, you must still be aware of these expenses, especially when you are budgeting, managing your cash flow, and calculating your overhead rate.
You might have heard of burden rate, burden cost, or burdened overhead. Burdened overhead costs are costs that can be partially attributed to direct costs and partially to pure overhead expense.
We don’t recommend being overly concerned with burdening overhead expenses. Burden rate and fully burdened costs typically won’t be reflected on a small business’s financial statements. Knowing your burden rate and fully burdened costs can help you make sound managerial decisions about your business, but when you are managing your overhead expenses, spending too much effort determining burden rates can actually cloud your decision making.
One of the most powerful metrics you can know in your business is your overhead rate. Your overhead rate tells you exactly how much of each sale you make goes into overhead expenses.
To calculate your overhead rate, add up all your overhead expenses, and then divide that number by your sales. The formula is:
Overhead Rate = Overhead Expenses / Sales
You will want to calculate overhead rate for a specific time period. For example, let’s say your total overhead expenses for the first quarter of the year were $50,000. Your total sales were $500,000.
Overhead Rate for Q1 = Q1 Overhead Expenses / Q1 Sales
Overhead Rate for Q1 = $50,000 / $500,000
Overhead Rate for Q1 = $0.10, or 10%
In other words, for every dollar your business earned in sales, $0.10 went to operate the business. Depending on your business model, this can mean you either ran really lean, or it could mean you need to curb some expenses. Especially if you have a low profit margin in your business, a 10% overhead rate could be much too high.
The important thing to keep in mind is every dollar you spend on overhead expenses is a dollar subtracted from your bottom line, so the lower your overhead rate, the better.
Unlike direct costs, overhead expenses typically can’t be tied directly to sales. They don’t usually respond to changes in sales without some intervention on your part. This makes keeping overhead expenses in check very important to the financial health of your business. If your overhead expenses are too high, a slow sales month could mean trouble for your business.
The best way to keep your overhead expenses in check is by creating and maintaining a budget for your business. Knowing the different types of expenses and how they respond to your business activity will help you do this. A high number of fixed overhead expenses might make budgeting easier, but having a lot of money tied up in fixed overhead can also make it more difficult for you to reduce overhead expenses in response to a downturn in sales. A high number of variable or semi-variable expenses make budgeting trickier, but these types of overhead expenses can be quickly adjusted. Regardless of your business’s mix of overhead expenses, strive to keep a reserve of three to six months’ worth of overhead expenses in the bank to help weather slow sales months.
Beyond affecting your cash flow, overhead expenses also impact the overall profitability of your business. The lower your overhead expenses, the more profit you get to keep in your business or distribute to yourself or other stakeholders in the business. You will have to pay taxes on this profit, though, so work with your accountant to make sure you have an effective tax strategy in place for your business (and for you, personally).
Finally, calculating your overhead rate will help you measure your business’s performance against other businesses similar to yours. The overhead rate metric can help you quickly determine if your business is performing above average, or if you need to reduce your overhead expenses to help keep your business competitive and attractive to potential investors or buyers.
As always, if you need help determining, analyzing, or managing your overhead expenses, your accountant or bookkeeper will be happy to help.