If you’re here, you probably want to get better at calculating your project’s profitability.
Calculating your overhead correctly and adding it at the right moment when planning your project is crucial as anything that goes wrong will have an impact on your profit margin.
But don’t worry — you’ve come to the right place. Keep reading to find out how to do it and achieve your desired profitability.
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 must pay overhead costs. Knowing your overhead costs 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
What is departmental contribution to overhead?
Departmental contribution to overhead 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 larger companies, departments often share overhead expenses. Since they all benefit from things like office rent and insurance, it makes sense that each one contributes to pay overhead costs.
How do you calculate departmental contribution?
Revenue of the department – direct expenses = departmental contribution
This calculation assumes that all of the indirect expenses at your company are considered overhead.
What are the different types of overhead?
We can divide overhead costs into three categories:
- Organization overhead: All the expenses at the level of the organization (for example, office rent and utilities). These costs will be part of the overhead expenses for every project your professional services company realizes.
- Project overhead: Costs associated with a specific project (software licenses or access to cloud resources). These expenses are only relevant to this particular project and don’t apply to others.
- Employee overhead: You can calculate the overhead at a more granular level by calculating the overhead rate per employee. You’ll instantly know the overhead costs by assigning employees to a project.
Overhead Costs and Different Profit Margin Degrees
We already mentioned profit margin and how important calculating overhead costs is to get it right.
But how do you 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 employees on your team).
Second-degree margin: This one can be based on additional project 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: When you subtract the final overhead cost, the management cost.
Why is calculating overhead cost so important?
Without overhead, you can’t calculate how much your project actually costs you. You also have no idea what margin you need to impose to preserve the projected profitability of a project or group of projects — or even the entire company!
Understanding your expenses is easier once you calculate overhead costs. The process also helps in breaking down expenses for internal usage. It’s your best tool in determining the hourly rates that will keep your projects profitable and help you reach your target profit margin.
If you don’t calculate your overhead, you don’t really know how much one hour of your employees’ time costs. Setting the hourly rate for your clients without this knowledge is very risky.
How do you calculate your overhead costs?
List and Categorize Your Expenses
To calculate the overhead costs of your professional services company, start by categorizing each overhead expense of your business. Always do this for a specific period — your expenses might change with time, and you’re interested in ensuring your project is profitable within the next 3 or 6 months.
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 ensure they don’t contribute to production in any way — if they do, they’re direct costs, not overheads.
Add the Costs Up
Once you’ve categorized your costs, it’s time to combine them. This is how you’ll get the total overhead cost for the period for which you’re calculating.
Calculate Your Overhead Rate
Now you’re ready to discover the overhead rate as a percentage of sales. What is an overhead percentage? An overhead percentage is the proportion of indirect costs incurred by a business relative to its total expenses, typically expressed as a percentage of direct costs.
To calculate it, divide the total overhead costs 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.
Suppose your company pays $10,000 in overhead costs each month. But things are going well, and you’re generating $40,000 in sales.
$10,000 / $40,000 = .25 (or 25%)
overhead costs / sales = overhead rate
What does this mean? That you spend 25 cents on overhead for every dollar you make. That’s good to know, right?
Discover Your Resource Utilization
Another interesting finding from calculating overhead is checking what percentage of labor cost it represents. This can help you estimate your resource utilization. The lower the percentage, the more effectively your business utilizes its resources.
Let’s start with defining direct labor costs — these are the wages and salaries of your employees involved in production.
To measure your overhead against direct labor costs, divide the total overhead by the direct labor cost for a given period.
For example, if your company has overhead costs of $10,000 and direct labor costs (based on billable hours) amounting to $70,000 in June, here’s how you calculate the overhead rate:
$10,000 / $70,000 = 0.14 (or 14%)
overhead costs / direct labor costs = overhead rate
How do you calculate overhead cost per hour?
Calculating the overhead allocation rate is easy. Just divide the total overhead 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 finish a project.
If you don’t know how much it costs to finish a project, how can you set a good rate for the client?
The total overhead for 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 to the price of your billable hours?
To add overhead to the hourly rate you’ll be charging the client, you need to know the hourly rates of employees allocated to the project.
Once you have that number, just add the overhead rate to it. This is how you get your billable hour price.
Your overhead for 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 will break even in June. But you don’t want to only break even — you’re here to make a profit. Most companies aim for profit margins of 30%.
So, why not add 30% to that billable hourly price to get your business what it needs to succeed? It’s so easy to keep your projects profitable now.