Why You Need to Consider
Overhead costs is a term that covers all of the operating costs of a business that are not directly part of the labor or materials necessary to make an item—all of those additional cost which you may not even think about in estimating the wholesale price of an item.
Overhead costs are generally fixed, monthly expenses. You will have these costs whether or not you make or sell anything. Your rent, insurance premiums, telephone bills and utilities still have to be paid whether you are away at craft shows or working all night to finish an order. This is a very neglected area in most home businesses, and if you fail to take overhead into consideration, it can eat up your profits.
Keeping track of theses expenses and assigning them to the work you produce can be complicated, but it's necessary if you are to make a profit from your business; that is, take in more money than you spend. If you have been in business at least a year, it will be fairly easy for you to pull all these overhead figures together to arrive at an average monthly cost. But if you are just starting, you will have to so some fancy guessing and estimating.
Before developing a formula to calculate overhead costs, you should be aware of what is involved in it. Following are some of the easily identifiable costs of doing business that contribute to your overhead:
- Rent. Overhead involves the cost of a place to work, including percentage of mortgage interest/or rent and utilities. If you are using your own home, you still should add in a cost for rent because you are actually using a certain percentage of your living space for your business and should therefore take a percentage of the cost as overhead.(Up to a maximum or 25%).
For example, if you live in a six room house and you use one room exclusively for your jewelry business then you would calculate 1/6 or your rent or 1/6 or your mortgage interest into your overhead. Or if you live in a 1600 square foot house and you use 320 sq ft for your business then you would calculate 20% of your rent or mortgage interest into your overhead.
- Utilities. Heat, light, gas, water, trash removal, etc—figure the same percentage as you took for the rent unless you can figure these costs exactly. Note that if your particular jewelry making techniques uses an excess of a particular utility, perhaps electricity, then you should take this into consideration when you are figuring out these costs.
- Telephone. If you don't have a separate business phone line, estimate the percent of calls you make, in and out, that pertain to business, and multiply by the monthly bill. Be sure to take the total cost of any long distance calls you make for business purposes.
- Equipment Purchase. The tools and equipment you use in the manufacture of your goods will not last forever. They represent an investment. A portion of these capital goods costs should be included in your overhead each year as a very real cost of manufacture. You may depreciate or take a certain percentage of the costs of these each year over the useful life of the machine or equipment. You may also have tools which must be replaced at certain intervals.
- Equipment Repair. Maintenance and repair of any equipment or computers is an expense needed to keep production going.
- Office Supplies. You will certainly need office supplies to carry on your business—envelopes, letterhead stationery, business cards, packing slips, pens, pencils, computer paper, printer cartridges, software, disks, and any other consumable supplies and tools. Also any cleaning supplies to keep your office and work area clean All of these are overhead.
- Shipping and Packaging Materials. You must also consider all your shipping and packaging materials such as boxes, tape, labels, tissue, bags, etc.
- Postage and Shipping. Stamps, UPS, FEDEX, Parcel Post for correspondence and shipping orders. Unless charged separately to customers, it is not included in the materials cost and should be included here.
- Wholesale Selling Costs. If you sell your products strictly wholesale then you must also calculate your selling costs into your wholesale price. Such as, advertising and promotion, booth fees for trade shows, cost of materials for your booth, signs, and display items.
If you sell your products retail then these costs would be included in your retail price. (For more information on the costs of selling see Selling Costs You Need to Include in Your Retail Prices.)
- Travel Expenses. If you are away from home overnight or longer for sales, education, promotion, or for a conference, include your food and housing expenses and admission fees.
- Dues and Publications. Membership in organizations for either educational or promotional purposes, and subscriptions to related magazines, or books you add to your library.
- Professional Fees. Payment for the services of an accountant or lawyer, tax preparation fees, and any other consultants.
- Bank Charges and Interest. The monthly charges the bank makes to maintain your account and any overdraft charges. If you have borrowed money to set up your business and to buy the initial equipment or upgrade equipment, then the interest cost is another overhead expense. The principal of the loan is not considered an expense, since you've already spent the money and the payment comes out of your profit.
- Automobile Expenses. If you use your car or van to deliver merchandise, pick up supplies, and/or going to and from craft shows then the cost of your gas and mileage is also an overhead expense.
- Insurance Premiums. Cost of any special business coverage such as: property and inventory coverage, business interruption, legal liability, etc. See the article on The Importance of Home Business Insurance
- Nonproductive Service Time. One essential overhead is the cost of your labor in doing all the non-productive work involved in running a business. You must seek sources of supplies, place orders, pay bills, keep track of your paperwork, time spent in talking to customers or potential buyers, and locating and applying for craft shows. If you find yourself spending a long time with such chores, they could add significantly to the price of your products.
Calculating Overhead Costs
To determine overhead costs, make a list of all your overhead items and indicate next to them the total amount you spend—or expect to spend—for that item in one year. You will probably find certain amounts easy to identify, while others may have to be estimated based on previous experience or some specific plans you have made
Once you have carefully calculated all the items in your list, you should have a total of your annual overhead expenses. Your next step is to divide this total by twelve to arrive at a monthly figure. Suppose, for example, that your total overhead amounts to $3,360 for a year, your monthly overhead expense would therefore be $280.00.There are two methods to figuring your overhead cost into a specific jewelry item.
- Determine how many hours you work per month on your business. Divide these total hours into your monthly overhead expenses to get an hourly overhead figure.
To illustrate how your hourly overhead figure fits into your pricing scheme, let's assume that your monthly overhead expenses total $280, and you're working 140 hours per month on your business. This means your hourly overhead rate is $2.00 per hour.
That means a product that takes an hour to produce must have $2.00 included in its price to account for overhead. If a project takes ten hours to complete, then overhead of $20.00 must be included in its wholesale price. Of course the more you can produce in an hour the less hourly overhead rate per piece would be added to the cost of each item. So, if you can make four items in an hour, then your hourly overhead rate would be divided by four. In this example you would add fifty cents to each of the four item's price for overhead.
- The second method you could use is based on the total cost of labor plus materials. You then add a specific percentage to each dollar spent to account for overhead.
Your first step is to determine how much you expect to spend on labor and materials, based on previous experience and future plans, then divide this production-cost figure into your total overhead for the year. Again, illustrating how this works using the example above, let's say you expect to spend around $16,250 this year for production costs, you then divide this amount into your overhead expense of $3,360. You will find that your overhead costs will be equivalent to 20 percent of your production costs.
That translates to $0.20, which is the amount that should be added to every dollar of production costs on an item. So if an item costs $18.50 in labor and materials, you would add 20% of this figure ($3.70) for overhead, increasing the total cost to $22.20.
You may find your actual overhead costs much higher or lower than that shown in the example. Start now to document all your overhead costs, by keeping accurate records and you will be able to determine your actual overhead costs for the year. These actual overhead costs can be important for three main reasons; the first of course is for tax purposes, the second so that you can compare with the estimates you used, and the third to use as a basis for next year's estimates.
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