Table of content
1. What are overhead costs?
In a software company, overhead costs are all the ongoing expenses of operating the business, excluding the direct costs of developing a product or delivering a service.
You pay for overhead expenses regardless of whether you engage all your specialists in projects or half of them end up on the bench.
Here are some example overhead costs for a service-based business:
- If you have an office, your overhead costs are rent, utilities, equipment, and insurance cost.
- Support staff cost (administrative and marketing costs).
- Material cost (materials used to provide services like hardware and software).
- Management board expenses.
- Car leasing cost.
Business overhead vs. project overhead
Note that you can differentiate between business overhead and project overhead cost. For example, buying a software license required to deliver work on a specific project is a project overhead that doesn’t apply to the entire company.
Of course, you can later use such software used for other purposes, and in that case it’s worth considering whether you’ll treat it as a cost attributed to the project or to the entire organization.
What is the difference between those approaches? In the first case, all the billable projects chip in to pay for this cost, so it affects their profitability at the level of 3 profit margins. If we assign this cost to a specific project, then only this project needs to cover 100% of this cost - so, it can be included in the second-degree margin.
Ok, I used the magic words “margin” and margin “degree”.
- Right now it’s important that you understand the first-degree margin as related to expenses that generate income directly - for example, work of software developers.
- The second-degree margin may be based on additional project costs.
- The third-degree margin is the costs of administration.
- The fourth-degree is marketing and sales, and the fifth-degree margin is the cost of management.
Of course, different companies define these margins differently.
- Learn more about how you can divide expenses, set margin levels, and what profitability level is considered as healthy for most companies in this article: How to set the margin level?
What are labor project costs?
As opposed to overhead rates, direct project costs are the costs you bear for the work of your employees. In other words, they’re labor costs.
For example, if a project involved 5 employees whose work costs $75 per hour, and they all worked 10 hours on the project, the direct project costs are as follows:
5 employees x $75 x 10 = $3750
Now you can add the income rate to it. For the sake of simplicity, let’s assume that you’re charging your client 100$ per hour.
You can easily calculate the planned first-degree margin as 25%.
But how to calculate the real work costs? You need to calculate overhead costs.
2. Why calculate overhead costs?
It doesn’t matter what type of software business you run.
Whether you’re a body leasing firm or a boutique custom software development business, you need to know your overhead. Why?
Without this information, you won’t be able to count how much your project really costs you, and what margin you should impose to maintain the assumed profitability per project / group of projects - or even the entire company.
Calculating overhead costs is an integral part of understanding your expenses.
It also helps you to break costs down for your internal use and set the right rates to keep your projects profitable and achieve the desired profit margin.
If you have no idea what your overhead expenses are, you don’t know how much one hour of your employee really costs.
Setting the hourly rate for your clients without that information is risky, to say the least.
Ok, so how do I calculate overhead per employee?
3. How do you calculate overhead rate per employee?
In the case of a contractor:
If you hire a contractor, calculating how much they cost you is a piece of cake.
$60 x 20 hours = $1200
But things become tricky once you hire part-time or full-time employees and use a lump-sum settlement with them.
In the case of an employee:
It all starts with calculating capacity:
- Every month has a different number of working days,
- An employee might have different capacities in different months due to holiday leaves, taking days off because they’re sick or just beacuse of different contract terms
- What's more, you can also take into account any non-billable activites, e.g. internal workshops, meetings, lunches, etc.
So, depending on your approach, and the granularity level that you will take into account your overhead rate per employee can be totally different and makes a huge difference.
By choosing 8 hours per day as your benchmark, your capacity changes by a lot - not mention the employee cost.
This capacity impacts not only the utilization rate but also the employee cost.
Learn more about how to calculate your employee capacity and utilization rate in this article: What is the utilization rate formula for software companies?
How do you calculate employee cost? [Example]
How much does 1 hour of Mark’s work on the project cost in January 2021?
To calculate that, you first need to know Mark’s capacity during this period.
So, if you assume that Mark works 8 hours per day and he worked for 20 days in January, his capacity amounts to 160 hours.
This is how you calculate how much 1 hour of Mark’s time costs:
$5000 / 160 = $31.25
But what if Mark takes a 1-hour lunch break every day?
Then his daily capacity is actually 7 hours. When multiplied by 20, this gives you 140 hours of work per month. And this is how you calculate Mark’s hourly rate:
$5000 / 140 = $35.7
Quite a difference, isn’t it?
Setting a realistic capacity is an essential step to calculating the direct costs of assigning an employee to a project and moving on to calculating the applicable overhead cost.
Note: What if an employee gets a promotion while the project is running?
In Primetric, this works automatically. When you assign a person to a project, the system applies the cost of that employee to the estimations.
It also stores all the information about your contract with the employee on a timeline.
When the employee gets a raise or moves to part-time work while the project is running, this will be reflected in the project cost estimations.
Ok, so how to calculate the overhead cost per employee? [Instruction]
1. Select a time period for calculating costs and workload of your people
Let's analyze February 2021.
During that month, 7 software developers worked on 7 different projects, and each person dedicated 100% of their time to one project.
2. Start by defining your overhead costs
That February, all of your costs added up to $10,000.
Overhead costs are all the costs that aren’t directly related to the project cost. They are the sum cost of running your business that you have to pay during a given time period.
For example, let’s say that in February 2021, you hired 10 employees.
7 of them are software developers working on a project, and 3 of them are administrative and marketing roles. The cost of hiring these 3 people is your overhead. This can also be another type of cost (indirect cost), for example:
- Office materials cost,
- Office rental
- Car leasing,
- Marketing budget,
- Payroll taxes,
- Health insurance,
- And other activities for business running.
So, start by defining your overhead costs and adding them up.
3. Divide the sum of overhead by the number of hours worked this month
In February, you had 7 projects covered by 7 employees equally.
Now, each employee worked 160 hours on the project in that month. In total, that’s 1120 hours. Here’s calculate the overhead hourly rate:
$10,000 / 1120 hours = $8.9 per hour
This is how much you need to add to each hour worked by the employee to make sure that your project is profitable.
4. Multiply the hourly overhead by the number of hours worked by your employee
So, if an employee worked 160 hours that month, all you need to do is multiply that rate by the number of hours:
160 hours x $8,9 = $1424
This is your overhead rate per employee in February 2021.
- This might be interesting for you as well: How to calculate a full-time equivalent employee
But wait, is this the only and best way to calculate your overhead?
4. How do you calculate overhead cost per hour?
To get started, you need to know how many hours employees worked on each project.
When counting the hours, it’s important to differentiate the hours you planned vs. the hours actually worked.
This is why time tracking is so important.
It helps you understand how many hours each employee really worked on each project to which they were assigned.
By equipping your employees with an intuitive time tracking tool, you’ll get more accurate results.
To learn more about time and performance tracking, read this article: How to track employee performance: expert guide
So, how do you calculate the overhead rate per hour?
Here’s an example scenario:
In January 2021, you employed 14 people who worked on 7 projects. Half of them worked 160 hours in their projects and half worked part-time - 80 hours. Another 80 hours they spent on internal activities.
The total number of hours worked this month was as follows:
(7 employees x 160 hours) + (7 employees x 80 hours) = 1680 hours
Your overhead costs this month amounted to $25,000. Now divide your monthly overhead rate by the total number of hours.
$25,000 / 1680 hours = $14.88
This is your overhead hourly rate in January 2021.
5. Why it’s better to calculate overhead rate per hour than employee cost
To keep your projects profitable, you need to add the overhead costs to the billable hours worked by each employee. Non-billable projects like workshops or hackathons don’t count here.
That’s why it’s smarter to calculate your hourly overhead worked by employees in a given project than by per employee.
Here are a few good reasons:
- Each employee is probably engaged in non-billable work on a regular basis.
- They might also work on several projects per month. In some companies, one employee might be working on two or more projects per day!
- Moreover, knowing the overhead employee cost doesn’t really help you in estimating project cost and setting the best rate for the client.
6. What is the typical overhead cost for an employee?
You probably know what I’m about to say here:
Every business calculates overhead costs differently.
Most of the time, software companies calculate overhead costs by taking the total number of billable hours in all projects in a given period and divide their total overhead costs by that number.
This is how they get the overhead rate per hour.
Now they know how much money they need to add to every hour worked on projects to their estimations to keep their projects profitable.
Why keep overhead costs apart when calculating costs per hour?
For some software companies, the initial project margin where you only calculate the direct project cost against estimated revenue isn’t important at all.
What they do instead is setting one hourly rate for every employee in the business.
They add up all of their costs per month - including overhead and direct labor costs. Everything.
Then they add up all the billable hours per month to calculate how much one hour costs.
Let’s say that all the costs for Q1 2021 amounted to $50,000. Your employees worked 900 hours during that period.
$50,000 / 900 = $55.55
This is the cost of each hour in Q1 2021.
This approach makes calculating costs and project margins easier. You can get away with an Excel spreadsheet.
But you lose important data in the process.
For example, if a project is carried out by a senior developer whose hourly rate is $100, your estimation won’t be accurate if you base it on the company’s average hourly cost.
7. What if you calculate your overhead rate wrong?
Software companies often make this mistake:
Imagine that you hire 5 contractors and each costs $50 per hour. So you bill your client for $75 per hour. You earn $25 per every hour billed on that project.
But what if your overhead costs are very high?
If your overhead cost per hour is more than $25, then you’re going to lose money in that project.
As you can see, knowing your overhead cost is critical for smart finance management at your software business.
8. Bonus tip: Use overhead costs as a key part of your forecasts
Primetric gives you mechanisms for long-term budgeting of overhead expenses. These values go through statuses like Settled and Not settled. automatically or manually (which makes sense to use if your costs are different every month).
You can then use this information to compare your plans to what was actually realized.
When doing long-term planning, you can move several months ahead to see what the planned cost and revenue for this month are - and act accordingly when setting rates for clients. You can later track how these estimations are realized.
In the screenshot above, you can see all the costs lumped together. The margin is calculated with these costs in mind.
But you can go down to the level of individual projects to check their profitability.
Let’s say that you’re running a project and want to check the costs vs. profits ratio. Take a look at Primetric - you will see two profit margin columns and one revenue column.
The first margin is the margin you get after subtracting the direct costs of work from the planned revenue. The second margin combines direct project costs and overhead expenses to give you a more realistic view into your project’s profitability.
You need this type of business intelligence software to run your business smoothly and make sure that all your projects have the profit margin you need.
When calculating overhead costs, you’re probably looking to learn how a given project performed in the context of the entire company and its costs.
This information is really valuable when you negotiate rates with clients. By having full clarity about your overhead expenses, you can set rates that give your business the profit margin it needs to grow.
This is why it’s better to calculate overhead per hour, not per employee.
And the good news is, you don’t need to resort to multiple spreadsheets to keep all of this information at hand.
Try Primetric instead. Sign up here and gain full control of your overhead and make sure that your projects are always profitable.