The three components of cost are material, labor and overhead. Because many business owners don’t understand how to calculate overhead, or how to incorporate it into their analysis, I see a lot of business owners eliminating overhead from their cost calculations, which can lead to operating losses and cash flow problems.
If you are confused as to how to calculate overhead, the easiest way to do so is as a percentage of sales. Take all of the projected overhead expenses for the period (a month, a quarter, or a year) you want to analyze, and divided these projected expenses by the amount of projected sales. Going forward, if your projections are higher or lower than your sales by 10% or more you should recalculate the overhead rate based on your new projected sales, and you need to do the same thing if your projected expenses are off (because they’re higher or lower than they should be) by 10% or more. The sales dollars associated with each transaction or quote needs this percentage applied to them, or you need to perform the same calculation with last year’s actual results for overhead and sales on actual results instead of projected results. I myself prefer using projected results. There are other options for calculating overhead that also use labor hours and dollars, but I find using sales is the best option (unless the business is in the trades, such as a plumber or electrician, or it’s a manufacturing business, in which case I like to use labor hours, which makes more sense for these types of businesses because you simply assign overhead costs per direct labor hour and all you need do to know your costs is estimate the labor hours for a job).
When it comes to the calculation of overhead and incorporating overhead in cost calculations, there are many schools of thought. There are some people who avoid accounting for overhead altogether by saying, “The overhead will begin to be paid anyway, no matter how much the sales price exceeds material and labor, and that’s the only objective.”, and to them I say:
First of all, if sales aren’t actually high enough for you to employ this school of thought you are guaranteeing that you will NOT be profitable. You will eventually have to pay for all the fixed overhead, even if sales exceed material, labor, and variable overhead* by a few dollars, BUT the sales must be high enough and that is a HUGE risk.
Secondly, although an argument can certainly be made that any sale that covers some overhead is better than no sale at all, are you absolutely SURE there is no other sale that you could make that covers more or even all of your overhead that you’re not bothering to find because you justify just giving away your products and services as long as it covers some overhead?
*The business owner sometimes calls expenses which can be considered overhead but are actually expenses which are variable to sales overhead. These are things like credit card fees or gas fees if you need to travel to perform a service, and they need to be identified as variable overhead and incorporated as part of the expense component deducted from the selling price to determine profit before fixed overhead.
Every business owner really should know what the overhead component of their product or service is so that they have a grasp on what their true bottom line is on each and every transaction or quote. Knowing that bottom line on your every transaction, unless your expense or revenue projections are way off, will set you at ease by ensuring that all your costs are accounted for. At the end of the day the business owner can use their own discretion as to whether a sale that does not entirely cover fixed overhead is worth making. If it were me I must be extremely confident that there is no other sale to make that will give me a better return before I would accept a sale that only partially covered fixed overhead. For example let’s say you know with reasonable certainty that your business is in a state of low demand maybe due to seasonality or economic conditions. If I am convinced there is no other sale out there that is going to give me a better return or if I think the customer is worthwhile to keep because the customer will give me long term potential at higher profit margins then I would make the justification that I am at least covering some fixed overhead.