How to calculate overheads

Sort costs by what they relate to. A direct cost belongs to a particular product, job or sale: stock for resale, materials used on a job, a subcontractor working for a client, or the wages of staff whose time is billed. An overhead supports the business as a whole: rent, insurance, office wages, phone and internet, software, marketing, utilities, bank fees and accounting fees.

Some costs straddle the line, such as a vehicle used on jobs and for errands, or a staff member who splits time between client work and admin. Split them on a sensible basis, such as kilometres recorded for each use or timesheets, agree the method with your accountant and use it every period.

Overheads are one kind of expense. Every overhead is an expense, but direct costs are expenses too, and they aren't overheads. business.gov.au's glossary defines cost of goods sold as the total direct costs of producing a good or delivering a service, which is where stock for resale, job materials and billed labour end up.

On a profit and loss statement the two sit in different places. business.gov.au's profit and loss guidance lists sales, cost of goods sold and gross profit first, then expenses such as advertising and marketing, rent and rates, utilities and insurance, and then net profit. Direct costs usually sit above the gross profit line and overheads below it, though your accountant may place some production costs differently, so once anything that is really a direct cost has been moved up into cost of goods sold, the expenses section comes close to your overhead total.

Take the expense lines from the profit and loss statement. A full financial year is the most reliable base, because it picks up costs that arrive once a year, such as insurance premiums and subscriptions. For a shorter period, use that period's own activity rather than a year-to-date balance.

• On accrual books, include bills for the period that arrived late, and costs used but not yet billed.
• Leave out drawings by a sole trader or partner, loan principal repayments and transfers between the business's own accounts. Ask your accountant which equipment costs belong in expenses for the period.
• Check nothing counted as a direct cost also appears in overheads.

The electricians' own wages are not in the list. Their time is billed to customers, so in this business it is treated as a direct cost.

A total on its own is hard to act on. Dividing it by a measure of activity for the same period turns it into something you can price from and track. Pick the measure that matches how you charge: billable hours for time-based work, jobs or units for set-price work, or sales for a quick comparison over time. Whatever you divide by must be above zero.

Each figure says the same thing in a different unit: every billable hour, every job or every sale has to contribute that much towards running the business before it contributes anything to profit.

business.gov.au's glossary describes overheads as the fixed costs of operating a business, and defines a fixed cost as one that isn't part of producing a good or service. Most overheads are fixed in the everyday sense too: rent, insurance, software subscriptions and the bookkeeping fee arrive at much the same amount whatever the month brings. A few move with activity, such as card fees that rise with takings, fuel for driving out to quote, or power in a workshop that runs longer hours in busy months. Some sit in between, like a phone plan with a set monthly charge plus usage.

The split matters because fixed overheads don't shrink in a quiet month. When work falls away, each hour or job has to carry more of them.

Total overheads fell by a tenth in the quiet month, yet each grooming hour had to carry half as much again. A rate worked out from a busy month understates what the quiet months cost, which is one more reason to build it from a full year. The table also shows where trimming costs goes furthest: a lower fixed overhead reduces the cost of every hour, all year, while a lower variable one helps mostly in the busy months.

business.gov.au's pricing guidance describes adding up what it costs to supply a product or service, with materials, labour and overheads all included, before adding a markup or margin. A quote built from direct costs alone relies on its markup to cover rent and insurance, so the overhead figure per hour or per job is a useful check that it does.

business.gov.au's budgeting guide sorts costs differently, into fixed costs (insurance, rent and car leases are its examples) and variable costs (wages, utilities and supplies). That split is about how costs behave, so it cuts across the overhead and direct split. Both views are useful; just don't mix them in one calculation.

An overhead rate turns the year's overheads into an amount per hour that every quote can carry. Base it on the last full year's overheads, adjusted for changes you already know about, such as a rent increase, and divide by the billable hours you expect over the coming year, which must be above zero.

Step by step: work out the rate from the year's overheads and hours; price the job's direct costs, with materials at supplier prices and labour at what an hour of the joiners' time costs the business; charge the job's 64 hours at the overhead rate; then add profit as a markup on the full cost.

Leave out the overhead line and the same markup on the direct costs alone gives a price of 12,213.60. That looks like 2,035.60 of profit, but once the job's 2,176.00 share of overheads is paid, it leaves the business 140.40 short. Some trades quote overhead and profit as one loading on top of direct costs; splitting it as above shows how much of the loading is really profit.

business.gov.au's quoting tips say to quote for profit, not just to win the job, by including all the costs and adding a margin on top.

The rate also shows what an overrun really costs. Every extra hour on the kitchen fit-out costs 52.00 of labour and recovers none of the 34.00 of overheads it should carry, so 10 hours over the quote leave 860.00 of cost uncovered before any extra materials.

Hours aren't the only base. Some businesses charge overheads as a share of direct labour cost instead: here, 88,400.00 divided by the year's expected labour cost of 135,200.00 (2,600 hours at 52.00) gives 0.65, so each job carries 0.65 of its labour cost in overheads. Use whichever base most closely follows how jobs use the business's time and space.

It means the work done in a period carried less overhead, at the rate you set, than the business actually spent on overheads. A rate fixed at the start of the year from expected overheads and expected hours is often called a predetermined or absorption rate. The overhead charged to jobs at that rate is the overhead absorbed, or applied, and at the end of the period you compare it with what was actually spent.

Under-absorption has two causes, and this example has both. The larger part came from working 250 fewer billable hours than planned, which points to workload and scheduling. The smaller part came from overheads running above the plan. The opposite, more hours or lower spending than planned, can leave overheads over-absorbed, meaning jobs carried more overhead than the business spent.

Unless your books build overheads into job or stock costs, this is a check on the rate, not an entry in the books: the profit and loss statement shows what was actually spent either way. If overheads come out under-absorbed year after year, the rate is too low, and so is every quote built on it.

Overheads tend to creep. Put each line side by side with the same period last year, and ask about any that has grown faster than sales. business.gov.au's cash flow guidance suggests checking costs often while they are climbing, cutting any the business can manage without, and switching energy, banking or insurance providers where a better deal is available.

• Recalculate the per-hour or per-job figure when a big overhead changes, such as a new lease.
• Check whether billable hours or job numbers have fallen, because the same overheads then weigh more on each one.
• Keep the totals and workings with the period's records so next year's figure is built the same way.

Group the overhead accounts together in your chart of accounts, or in the layout of your profit and loss report, and keep direct cost accounts in a group of their own. The overhead total then becomes one line you can read off for any period, instead of a sum you rebuild by hand, and a cost posted to the wrong group stands out when periods are compared.

In a spreadsheet, list each overhead down the rows with the 12 months across, plus a row for billable hours or jobs. A rolling 12-month total for each line, divided by the rolling hours, keeps the rate current without waiting for the year to finish. A check that leaves the rate blank when hours are zero stops a month with no work from producing a meaningless figure.

If your software can tag income and costs by job, the costs tagged to a job are its direct costs. As long as every direct cost is tagged, the untagged expenses give a quick view of overheads to check against the profit and loss statement.