How to Calculate Overhead for Your Service Business

One of the biggest financial challenges of running a service business is calculating overhead costs. 

Understanding overhead will help you budget and make better-informed decisions about hiring, purchasing and pricing. When you know what your overhead is, you can take steps to increase your profit margins and enhance your bottom line. 

Let’s take a closer look at the essential components of overhead — from how to calculate it to the best strategies for managing it — so that you can run a more profitable business.

What Expenses Count as Overhead?

Overhead costs are the expenses that keep your business running but aren't directly tied to delivering a specific service to a client. You incur these costs regardless of how much business you do each month. 

Unlike direct costs, which fluctuate based on the number of clients or services provided, overhead costs tend to be fixed and don’t change. However, some overhead costs (such as utilities and office supplies) may be semi-variable, which means they include a fixed cost as well as a variable cost.

Examples of Overhead Costs

Here are some examples of the most common fixed and semi-variable costs, as well as direct business expenses that are not included in overhead. 

Fixed Overhead Costs

• Rent and Utilities: The cost of maintaining your office, warehouse or business location.
• Indirect Labor Payroll: Salaries for employees who perform work that supports the company’s ability to perform services, such as administrative staff.
• Office Equipment: Costs for computers, printers and other office tools.
• Insurance Premiums: Health, liability and other types of necessary insurance.
• Marketing and Advertising: Costs to promote your services.
• Administrative Costs: General costs for running the business, including software subscriptions and office supplies.
• Accounting Expenses: Fees for bookkeeping, tax preparation and financial consulting.
• Travel Expenses: Costs related to business travel, such as airline tickets and hotel expenses.
• Legal Fees: Any legal costs the business incurs.

Semi-Variable Overhead Costs

• Utilities: Some utility costs are fixed, but others may vary based on usage (e.g., electricity).
• Office Supplies: Office supply costs can vary from month to month, but tend to be predictable overall.

Direct Expenses (Not Included in Overhead)

• Labor Costs: The salaries and wages you pay to employees, contractors and fee-based service providers.
• Raw Materials: Materials that are necessary to provide a service, like lumber for contractors or cleaning supplies for cleaning companies.

These costs influence your profitability. Understanding the implications of different types of overhead costs is one of the fastest ways to increase your bottom line.

For example, Thrive Digital used Accelo to streamline their workflow, save time and increase profits, creating a 40% jump in profitability.

Client Success Story: "Busy Agency Sees a 40% Jump in Profitability"

How to Calculate Your Overhead Costs

Not sure how to start or what calculation to use? Thankfully, calculating your monthly overhead costs is simple. All you need to do is add up your monthly indirect expenses. 

The sum of your indirect expenses represents the total dollar amount it takes to operate your business each month. This amount will always be the same, no matter how many services you perform or payments you collect.

Example Calculation: Let’s say your monthly indirect expenses include:

• Rent and utilities: $5,000
• Indirect labor payroll: $10,000
• Office equipment: $500
• Insurance premiums: $1,000
• Marketing/advertising: $2,000
• Administrative costs: $1,500

Your total overhead cost would be $20,000 per month.

By balancing your project expenses with your overhead, you can set up your business for success. 

How to Calculate Your Overhead Rate

The overhead rate (or overhead percentage) helps you understand how much of your revenue goes toward covering overhead costs. 

Use it to price your services accurately and stay profitable.

Method 1: Calculate Overhead Rate Based on Sales

1. Total Monthly Sales: Calculate the total sales for the month.
2. Divide Overhead by Sales: Divide your total overhead costs by your monthly sales.
3. Multiply by 100: Convert this figure to a percentage.

Example: If your monthly overhead is $20,000 and your monthly sales are $50,000, your overhead rate is:

• $20,000 ÷ $50,000 = 0.4
• 0.4 × 100 = 40% 

This means 40% of your revenue goes toward overhead.

Method 2: Calculate Overhead Rate Based on Labor Costs

1. Total Monthly Labor Costs: Calculate the total labor costs for the month.
2. Divide Overhead by Labor Costs: Divide your total overhead costs by your monthly labor costs.
3. Multiply by 100: Convert this figure to a percentage.

Example: If your labor costs are $30,000 and your overhead is $20,000, your overhead rate is:

• $20,000 ÷ $30,000 = 0.67
• 0.67 × 100 = 67% 

This means 67% of your labor costs are needed to cover overhead.

The better you manage your overhead, the easier it will become for your business to support recurring projects. Bang Digital used Accelo’s Retainers product to efficiently track time and automate their billing, which turned their one-off projects into steady, recurring revenue.

Client Success Story: "The Secret to Growth? Recurring Work!"

Getting an accurate picture of your overhead rate can streamline your operations, allowing your business to achieve greater financial efficiency.

Likewise, fine-tuning your billing process can make your overhead calculations more accurate. It's important to regularly review and adjust your billing and utilization practices.

How to Determine Your Overhead Absorption Rate

The overhead absorption rate is the part of your overhead costs that goes toward providing your business’s actual services. 

Depending on your business model, there are a couple of different ways to calculate this figure.

Method 1: Based on Direct Materials

1. Divide Overhead by Material Costs: Divide your total overhead cost by the total cost of materials used.
2. Multiply by 100: Convert this figure to a percentage.

Example: If your material costs are $10,000 and your overhead is $20,000, your absorption rate is:

• $20,000 ÷ $10,000 = 2
• 2 × 100 = 200% 

This means for every dollar spent on materials, you allocate $2 toward overhead.

Method 2: Based on Prime Cost

1. Add Labor and Material Costs: Calculate the sum of direct labor and material costs.
2. Divide Overhead by Prime Cost: Divide your overhead by this sum.
3. Multiply by 100: Convert this figure to a percentage.

Example: If your prime cost is $40,000 and your overhead is $20,000, your absorption rate is:

• $20,000 ÷ $40,000 = 0.5
• 0.5 × 100 = 50% 

This means 50% of your prime costs are allocated to overhead.

Method 3: By Labor or Machine Hours

1. Calculate Total Labor Hours or Machine Hours: Total the billable hours for labor and/or hours worked by machines.
2. Divide Overhead by Hours: Divide your overhead by the total hours.
3. Calculate Cost per Hour: This gives the dollar amount spent on overhead per hour.

Example: If your overhead is $20,000 and your total labor hours are 1,000, your absorption rate is:

• $20,000 ÷ 1,000 = $20 per hour 

This means you spend $20 in overhead for every labor hour.

Examining your overhead based on direct materials, prime cost and labor or machine hours can reveal opportunities for your business to make adjustments. Use this approach to make better-informed decisions that improve client satisfaction and business outcomes.

More Ways to Calculate and Analyze Overhead

Basic overhead calculations are always useful, but analyzing overhead costs at a more granular level — such as by employee or service project — can provide deeper insights into your business's financial health, such as:

• Hiring Decisions: Determine if you can afford to hire additional employees.
• Project Cost Management: Identify if project expenses are eating into profit margins.
• Pricing Strategy Adjustments: Refine your pricing strategy so that you can stay competitive while covering all of your costs.

3 Media Web used strategies like the ones described above to significantly reduce their overhead, saving 20 hours per week through Accelo's integrated solutions.

Client Success Story: "Award-Winning Agency Saves 20 Hours Per Week"

Conclusion: Business Owners Need to Know Their Overhead

Overhead is unavoidable, but understanding how to manage them can make it easier for your business to budget and improve its bottom line. 

Get an accurate calculation of your operating expenses to help you make smarter decisions about every aspect of your business, from setting prices to hiring employees.

Accelo can empower you to grow your business by streamlining your business processes. It seamlessly integrates with your accounting software to generate powerful and insightful reports that help you analyze expenses, earnings and more. 

Ready to take control of your overhead? Schedule a demo today.

This guide draws on insights from a variety of authoritative sources to provide a comprehensive look at calculating overhead for your service business. For further reading, you can explore resources from FreshBooks, Vintti, Skynova and QuickBooks.