As my day job I manage an SBA loan program where we help small businesses with funding and then business coaching before and after the loan. I am becoming increasingly convinced of the importance of understanding your breakeven as a small business owner. To define breakeven, it is basically the point at which your sales match your expenses. If you sell anything less than your breakeven amount, you are losing money. I just wrote a more detailed blog post on how to determine if your business is breaking even here, but today I am going to focus on an important component of calculating your breakeven, that is – your overhead costs.
What are Overhead Costs?
First we should define overhead costs so that we are all on the same page. According to Investopedia:
“Overhead is an accounting term that refers to all ongoing business expenses not including or related to direct labor, direct materials or third-party expenses that are billed directly to customers. Overhead must be paid for on an ongoing basis, regardless of whether a company is doing a high or low volume of business.”
Examples of Overhead Expenses
I think it is helpful to list some examples of expenses that are considered overhead:
- Wages and salaries for sales, management, and administrative staff
These are all expenses that will be the same for you each month whether you sell 1 unit or 100 units.
Examples of Expenses that are Not Overhead
I also think it can be helpful to list some expenses that you should not count as overhead such as:
- Material costs to make your product
- Labor cost to make your product
These expenses are often considered your Cost of Goods Sold.
How to Calculate Your Overhead Costs
Step 1 – Categorize Every Expense as Overhead or Cost of Goods Sold
This seems pretty straightforward right? Basically you just need to categorize each expense and ask yourself the following question:
“If I didn’t sell anything next month would I still have this expense?”
If the answer is “Yes” then that expense is probably overhead.
Cost of Goods Sold expenses tend to be tied directly to production of a product or service. So if you have a manufacturing company then the labor expense for those working on the assembly line would be cost of goods sold because if you didn’t have any orders to produce next month, you would not have the labor expense.
Step 2 – Are some Expenses part Overhead, Part Cost of Goods Sold
In step 1 I bet you will run into some weird situations where you feel like an expense is part overhead and part cost of goods sold. For example, let’s say you own a plumbing company. Your plumbers make $15 per hour and they work 8 hours per day. On the average day you have them doing billable work 6 hours per day, but you still pay them for 8 hours. There is 2 hours where they are really more of an overhead expense to you, and the 6 billable hours they are more like cost of goods sold.
So you might want to consider breaking out 1 expense into X% overhead and X% cost of goods sold.
Step 3 – Consider all Cash Outflows
Finally, you might have some other cash outflows that are not technically expenses, but for most small businesses should probably be considered when thinking about overhead. The best example is a Loan Payment.
A loan payment is split between interest and principal. Technically the principal portion is not an expense, but when you are trying to determine what your monthly overhead costs are, you might as well include the entire loan payment so that you know exactly how much cash you need to bring in to break even.
If you have any specific questions about whether an expense should be counted toward your overhead or not, I would be happy to help. Email me at firstname.lastname@example.org