Overheads are the ongoing costs required to run your business. However, they do not link directly to one product, service or job. Simply, these costs support your business as a whole. You should still pay them even if sales slowed down for a period.
When a bakery needs flour to make cakes, that cost links directly to each other. Therefore, it counts as a direct cost. However, the same bakery also pays rent and insurance. These costs keep the business operating every day, so they count as overheads.
The Three Types of Overheads
Fixed Overheads
A fixed overhead stays broadly the same each month. They do not change significantly when sales rise or fall.
This can include:
- Rent or lease payments
- Business insurance premiums
- Website hosting fees
- Some software subscriptions
- Salaries for administrative staff
These costs are predictable, which makes budgeting easier. However, they can create pressure during quieter periods.
Variable Overheads
A variable overhead changes depending on business activities. As your business becomes busier, these costs often increase.
This can include:
- Electricity usage
- Water usage
- Office supplies
- Certain marketing costs
- General travel expenses
For instance, a restaurant may use more energy during busy periods. Therefore, its utility bills will increase as customer numbers grow.
Semi-Variable Overheads
A semi-variable overhead contains both fixed and variable elements. This can be something like a phone contract. You pay a fixed monthly fee, but you also pay extra if you exceed usage limits.
This can also include:
- Utility bills with standing charges
- Software plans with tiered pricing
- Maintenance contracts with additional fees
These costs can be predictable at first, but rise as your business expands.
Direct Costs vs Overheads
A direct cost links to a specific product, service or job. Whereas, an overhead supports the business more generally.
For instance, a cake business may have these direct costs:
- Ingredients for a customer order
- Packaging for the order
- Delivery of the order
The same business may also have these overheads:
- Rent for the bakery
- Insurance cover
- Website hosting
- Accounting software
- Broadband and phone services
A simple way to differentiate is to ask one question: would you still pay this cost without that specific job or sale? If the answer is yes, it is likely to be an overhead.
Where Wages Fit In
Overheads can include wages, however, it depends on the role of each employee.
Wages for administrative staff, finance teams, HR staff and office managers usually count as overheads. These roles support the business as a whole. In contrast, wages for staff who deliver a specific product or service may count as direct labour.
For example: A chef in a catering business may form part of the cost of sales.
Small businesses may need to split costs carefully. For instance, a sole trader may divide time between client work and admin tasks. In this case, part of their time may count as a direct cost, while the rest counts as an overhead.
How to Calculate Overhead Costs
Calculating your overheads helps you understand your true business costs. It also supports better pricing and budgeting decisions.
Start by listing all regular costs that do not link to a specific sale or job. Next, remove direct costs such as material or project-based labour. Then group your overheads into categories, such as:
- Premises
- Utilities
- Software
- Insurance
- Administration
After that, add your overheads for a set period. Most businesses use a monthly figure to support cash flow management.
Overhead Rates
An overhead rate shows how much indirect cost supports your products or services.
You can calculate it using this formula: Overhead Rate = Total Overheads / Allocation Measure
The allocation measure could include:
- Labour costs
- Labour hours
- Machine hours
- Turnover
The most suitable option depends on how your business operates.
For example: A business has £10,000 of overheads and £2,500 of direct labour costs. £10,000 / £2,500 = 4. This means every £1 spent on labour carries £4 of overhead cost.
How Overheads Affect Your Profit
Overheads appear on your Profit and Loss Statement. They reduce your profit once you deduct them from your income.
High overheads can:
- Reduce net profit
- Put pressure on cash flow
- Make pricing less competitive
- Limit funds available for growth
- Increase financial risk during quiet periods
However, very low overheads do not always mean success. Some overheads support growth, quality and customer service.
Reducing Taxable Profit
Many overheads can reduce your taxable profit, if they qualify as allowable business expenses. This means they are “Wholly and Exclusively” for business use.
This may include:
- Rent and business rates
- Insurance costs
- Accounting and legal fees
- Office and administration expenses
However, each cost must relate to your business activities. You should also keep accurate records, receipts and invoices.
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This article is for general informational purposes only and does not constitute legal or financial advice. While we aim to keep our content up to date and accurate, UK tax laws and regulations are subject to change. Please speak to an accountant or tax professional for advice tailored to your individual circumstances. Pi Accountancy accepts no responsibility for any issues arising from reliance on the information provided.