What is Overhead Ratio and How to Calculate it
Overhead costs are expenses to your business that are not directly related to the production of goods or services. Although what is considered overhead sometimes depends on the industry. A few common examples are rent, utilities, office supplies, insurance, etc. Controlling your overhead ratio can provide you with a significant competitive advantage over your competitors; however, before being able to control your ratio, you need to understand how to calculate your overhead cost.
This simple four step guide below will help you determine which costs can potentially be counted as overhead and show you how to calculate your overhead ratio. Don't take its simplicity for granted, the information obtained can invaluable.
Start off by gathering a comprehensive list of all your expenses including rent, utilities, labor costs, etc. You don't need to categorize them just yet, but make sure all your expenses are listed. You can use any time-frame that you feel suits your business, but you have to remain consistent throughout the calculation.
Categorize: Overhead or Not
Next step is to identify if a cost is directly related to goods or service production or if it is overhead. A good way to determine this is to ask, "Will I have to pay for this even if my business does not generate any sales?" If the answer is "yes", then it is very likely an overhead expense and not directly a result of goods or service production. A few examples that are considered overhead are: banking fees, accounting fees, legal fees, rent, utilities, administrative staff salary, office supplies, internet and phone bills and stationeries. This, of course, is not an exhaustive list of all overhead costs.
Once all your costs are categorized, add up the total for each category. You should have a total for your overhead costs and a total for cost of goods and services.
Knowing your total overhead cost is valuable in itself; however, a real advantage is gained when you can determine the proportion of overhead to sales.
Overhead to Percentage of Sales – Overhead Ratio
To calculate the overhead ratio you divide the overhead cost, as calculated earlier, by the total sales for the same period and multiply it by 100. Knowing this ratio is fundamental to maintain a successful business. You want to keep overhead ratio as low as possible, without affecting the quality of service or product. You can compare your ratio to your competitors to determine if you have a competitive ratio or perhaps it’s lagging behind. A lower ratio is better.