What Counts as Overhead?
Overhead is every cost your business incurs that is not directly tied to producing a specific product or delivering a specific service. The key distinction is between direct costs and indirect costs:
- Direct costs can be traced to a specific job, project, or product. Materials for a construction job, labor hours for a consulting engagement, ingredients for a restaurant meal—these are direct costs.
- Overhead (indirect costs) support the business as a whole but cannot be assigned to a single job. Rent, utilities, office staff, insurance, accounting, vehicle leases, software licenses, marketing, and the owner's salary all fall into overhead.
A common mistake is treating owner compensation as a direct cost or ignoring it entirely. If you work in the business but do not allocate your salary as overhead, your job costs look artificially low and your margins look artificially high.
Why Service Businesses Must Allocate Overhead to Jobs
This is where most service businesses get into trouble. They quote a job based on materials and labor, add a markup, and call it profitable. But they never account for the overhead that the job must help cover. Here is a concrete example:
Suppose you run a plumbing company. A job uses $200 in materials and 4 hours of labor at $45/hour ($180). Total direct cost: $380. You charge $600 and celebrate a $220 “profit.” But your monthly overhead is $15,000, and you complete about 80 jobs per month. That means each job must absorb $187.50 in overhead. Your real profit on that job is $32.50—not $220. And if the job takes even 30 minutes longer than planned, you are losing money.
According to the SBA, failure to properly allocate overhead is one of the most common financial management mistakes among small business owners. It leads to chronic underpricing and the illusion of profitability right up until the business runs out of cash.
Industry Benchmarks for Overhead Rates
Overhead rates vary significantly by industry. Data from the Bureau of Labor Statistics Industry at a Glance and SCORE industry guides provide these general ranges:
- Construction and trades: 10–20% of revenue. These businesses are labor- and materials-heavy, so overhead is a smaller share of total revenue. However, the overhead rate as a percentage of direct labor is often 50–80%, meaning for every dollar spent on field labor, another $0.50–$0.80 goes to overhead. Contractors who do not apply this multiplier to their bids are systematically underpricing.
- Professional services: 25–40% of revenue. Law firms, accounting firms, consulting companies, and agencies have higher overhead because their primary cost is skilled labor that spends significant time on non-billable activities like business development, training, and administration.
- Manufacturing: 15–25% of revenue. Factory overhead includes facility costs, equipment depreciation, quality control, and production management. Manufacturers with high automation tend toward the lower end; those with complex custom production run higher.
- Retail: 20–35% of revenue. Rent, staffing, shrinkage, and marketing are major overhead categories. Location-dependent businesses like restaurants and shops often have overhead at the higher end due to lease costs.
- Technology and SaaS: 30–50% of revenue. High overhead from engineering salaries, hosting infrastructure, and customer support. These businesses accept high overhead because gross margins on software are typically 70–85%.
How to Reduce Overhead
Reducing overhead is not about penny-pinching—it is about ensuring every dollar of overhead generates a return. The SCORE business planning guides recommend the following approach:
- List every overhead expense. Pull three months of bank and credit card statements. Categorize every expense that is not directly tied to a specific job or product. Most owners are surprised by at least 3–5 subscriptions or recurring charges they forgot about.
- Rank by size, then by necessity. Sort overhead expenses from largest to smallest. For each one, ask: would I sign up for this today if I were starting fresh? If the answer is no, cut it or renegotiate it.
- Renegotiate your top 5. Your five largest overhead items typically represent 60–70% of total overhead. Even a 10% reduction on these five items can lower total overhead by 6–7%.
- Consolidate vendors and tools. Many businesses pay for overlapping software, redundant insurance policies, or multiple vendors providing similar services. Consolidation reduces both cost and complexity.
- Convert fixed overhead to variable. Where possible, switch from fixed costs to variable costs. Coworking instead of a lease. Contractors instead of full-time admin staff. Usage-based software instead of flat monthly fees. This lowers your break-even point and gives you flexibility during slow periods.
The Overhead Allocation Trap
There is one final nuance that trips up even sophisticated business owners. When you allocate overhead using a percentage of direct labor, you are assuming that all jobs consume overhead at the same rate relative to labor hours. That is rarely true.
A complex custom project that requires extensive coordination, project management, and office support consumes more overhead per labor hour than a simple repeat job. If you use a single blended overhead rate, you are overcharging on simple jobs and undercharging on complex ones. This is why many businesses find that their “best” clients (the ones with the biggest, most complex projects) are actually their least profitable.
The fix is activity-based costing: allocating overhead based on the actual activities that drive it, not just a flat percentage. This is more work but gives you a far more accurate picture of true job profitability.
Sources
- U.S. Small Business Administration — Manage Your Finances — Financial management guidance for small businesses
- Bureau of Labor Statistics — Industries at a Glance — Industry cost structure and employment data
- SCORE — Templates & Resources — Free overhead analysis worksheets and financial planning tools