What are overhead costs?
Overhead costs are all the continuing expenses of running the business, excluding the direct costs of developing a product or providing a service.
Whether all of your specialists are assigned to projects or half of them sit on the bench, you need to pay overhead cost for all of them. Knowing what your overhead costs are is essential for estimating your project’s profitability.
What costs are included in overhead?
Here are a few examples of overhead costs:
- Office rent and utilities
- Office supplies
- Hardware and software licenses
- Accounting and legal expenses
- Marketing and sales expenses
- Government fees and licenses
- Property taxes
Notice that overheads are not a part of direct costs resulting from the labor itself - in general, they are all the costs that support the labor itself. But are there some salaries that are an overhead cost? Read about it in our article.
What is contribution to overhead?
Departmental contribution to overhead costs is the amount of money available to a single department after all of the direct expenses are paid to contribute to the overhead of your business. In other words, these are all the indirect costs that do not cover the labor expenses.
In larger companies, departments often share overhead expenses and divide their indirect costs between them. And since they all benefit from office rent or insurance, it makes sense that each one contributes to pay overhead cost.
How to calculate the departmental contribution to the overheads, or the indirect costs?
Revenue of the department - Direct expenses = Departmental contribution
This calculation assumes that all of the indirect expenses at your company are considered as overhead.
What are the different types of overhead?
We can divide overhead costs into three categories:
1. Organization overhead
All the expenses at the level of the organization (for example, office rent and utilities). The overhead costs for this type of expenses will be part of the overhead expenses for every project realized by your software company. They are the most common indirect costs in any business.
Note: You can divide organizational overheads further - for example, into HR, management board, marketing, and sales, etc. Adding these costs separately gives you an opportunity to analyze how the project’s profitability and where your cost optimization efforts should be focused.
2. Project overhead
Overhead cost associated with a specific project (for instance, software licenses or access to cloud resources). These expenses are only relevant for this particular project and don’t apply to others.
3. Employee overhead
You can approach calculating the overhead at a more granular level by calculating the overhead rate per employee. By assigning employees to a project, you’ll instantly know what the overhead costs are.
I shared more insights and formulas here: How do you calculate overhead cost per employee?
Overhead costs and profit margin degrees
I already mentioned the profit margin and how important calculating overhead cost is to get it right. As the overhead absorption rate specifies, these costs impact the profit margins later on.
But how do you actually apply these expenses to the profit margin? It’s all about different margin degrees:
- First-degree margin - this margin is related to all the expenses that generate your revenue directly (for example, the salaries of software developers in your team).
- Second-degree margin - this one can be based on additional project costs, including overhead cost and indirect costs.
- Third-degree margin - this is when you subtract administration expenses from your revenue.
- Fourth-degree margin - now subtract the costs of marketing and sales,
- Fifth-degree margin - this is when you subtract the final overhead cost: the cost of management.
Naturally, every software company defines these margins differently. But most of them aim for at least 30% profit margin. Regardless of the case, overhead costs always affect those results.
Why is calculating overhead cost so important?
It makes no difference what kind of software company you manage.
You need to know your overhead costs - whether you're a body leasing company, a boutique software development firm, or a large provider of IT services. Why?
Without overhead, you can’t calculate how much your project actually costs you.
You also have no idea about what margin you need to impose to preserve the projected profitability per project/group of projects - or even the entire company!
Understanding your expenses is easier once you calculate overhead cost.
The process also helps in breaking down expenses for internal usage. And it’s your best tool in determining the hourly price that will maintain your projects profitable and help you reach your target profit margin.
If you don’t calculate your overhead cost, you don’t really know how much one hour of your employees’ time costs.
Setting the hourly price for your clients without this knowledge is, to put it mildly, pretty dangerous.
How to calculate overhead cost?
1. List and categorize your expenses
To calculate overhead costs of your software company, start by categorizing each overhead expense of your business. Always do it for a specific time period - your expenses might change with time, and you’re interested in making sure that your project is profitable within the next 3 or 6 months. Therefore, the overhead cost for this period should be included here, too.
Sometimes it looks like a sine wave.
The best way to deal with overhead expenses is to break them down by month. While all your indirect costs are overheads, be extra careful when categorizing them. You need to be sure that they don’t contribute to production in any way - if they, they’re direct costs, not overheads.
2. Add the costs up
Once you’ve categorized your costs, it’s time to bring all these expenses together. This is how you’ll get the total overhead cost for the period for which you’re calculating.
Example scenario for May 2021:
- Administrative costs - €10,000
- Sales & Marketing spends - € 40,000
- Non-billable people salaries - €100,000
In total €150,00 in May 2021.
3. Calculate overhead rate
Now you’re ready to discover the overhead percentage as a percentage of sales. What is an overhead percentage? It a rate that shows you how much your company spends on overhead and how much on building software or delivering IT services.
To calculate it, divide the total overhead cost of your business in a given period (for example, a month) by the sales made during this period.
Multiply the number by 100 to arrive at your overhead rate.
Let’s say that your company pays $150,000 in overhead costs each month. But things are going well, and you’re generating some $250,000 in sales.
$150,000 / $250,000 = .60 (or 60%)
Overhead costs / Sales = Overhead rate
What does this mean? It means that you spend 60 cents on overhead cost for every dollar you make. It’s good to know that, right?
4. Discover your resource utilization
Another interesting finding from calculating overhead is checking what percentage of labor cost it represents. This is helpful for estimating your resource utilization (note: this and employee utilization rate aren't one and the same thing) and it can help you allocate overhead costs properly. The lower the percentage, the more effective your business is utilizing its resources.
Let’s start with defining direct labor costs - these are the wages and salaries of your employees involved in production. So, software developers, DevOps engineers, and QA specialists - but not office assistants, sales reps, or marketing specialists.
To measure your overheads against direct labor costs, divide the total overhead by the direct labor cost for a given period.
For example, if your software company has overhead costs of $150,000 and direct labor cost (based on billable hours) amounting to $200,000 in June, here’s how you calculate the overhead rate:
$150,000 / $200,000 = 0,75 (or 75%)
Overhead costs / Direct labor costs = Overhead rate
How to calculate overhead rate? Formula
Calculating the overhead allocation rate is easy. Just take the total overhead costs and divide it by the number of direct labor hours during a given period.
Now that you have your overhead allocation rate, you can multiply it by the number of direct labor hours required to realize a project - for example, develop a mobile application. By doing so, you can allocate overhead costs accurately.
If you don’t know how much it costs to build this app, how can you set a good rate for the client?
The total overhead for the month of June is $10,000. Employees assigned to a project will work for 550 hours in total. So, the overhead allocation rate is:
$10,000/550 = $18.18
Total overhead / Total labor hours
This means for every hour required on this project you need to allocate $18.18 worth of overhead to it.
How do you add overhead costs to the price of your billable hours?
To add overhead to the hourly rate you’ll be charging the client, you need to know one thing: the hourly rates of employees who are allocated to the project and the amount of the direct labor their contribute to the project (also known as the number of billable hours).
Once you have that number, just add the overhead rate to them. This is how you get your billable hour price.
Your overhead for the month of June is $10,000. People assigned to the project will work for 550 hours that month. Let’s say that you set the hourly rate of your employees at $55.
($10,000 / 550 hours) + 55$ = $73.18
(Monthly overhead / Monthly direct labor hours) + Hourly rate of your employees = Billable hour price
If you charge the client $73.18 per hour, you’re going to break even in June. But you don’t want to only break even - you’re here to make a profit. Most software companies aim for profit margins at 30% after including overhead costs and direct labor cost.
So, why not add 30% to that billable hourly price to get your business what it needs to succeed? I know, it’s so easy to keep your projects profitable now.
Can you automate all of this?
As you can see, including overhead costs in the price of your billable hours is quite complex. And what I’ve shown you so far was for a limited time period.
How to calculate the right hourly rate if you’re running a long-term project where both the overhead costs and direct labor might change from one month to the other?
This is where Professional Services Automation comes in.
Find a solution that supports you at every step of project planning and allocation by connecting the dots and automatically calculating your overhead rate to help achieve the profit margin you want.
Just to give you an idea of how it works, here’s what the process looks like in Primetric.
1. Create project estimations
Develop a rough project quote based on professional services project life cycle. Define how many hours are required to deliver the entire project or its specific phase. And identify the skills you need to do it.
At this point, you can consider the hourly cost you don’t want to exceed in the project and make your first estimations of the project revenue.
2. Get the people for the job
When picking the team members who will be getting this project off the ground: skills, experience, level of seniority, soft skills, geographical location, and time zone. Use our skill management module in Primetric to do this within minutes.
But you also need to consider their hourly rate, or a direct labor cost. This is how you keep your project profitable and achieve the profit margin your company needs.
3. Add overhead costs
Next, include the organization overhead costs for the period when the project is running. You can keep on adding different overhead costs to arrive at different profit margin estimations.
Primetric takes into account any changes happening in your overhead and allocation. For example, your overhead expenses might change a lot during the project if you decide to rent a part of your office while your employees are working from home.
Allocation will also look different depending on whether a team member takes time off in a given month or the number of public holidays.
Calculating all of that manually is just hard.
Why juggle several spreadsheets and spend time worrying that you didn’t count one public holiday when you can have BI reporting software do all the grunt work for you?
Try Primetric to have full control over your profitability.
Sign up for a demo and get started.