Overhead Costs: How to Calculate an Overhead Rate and Price
Overhead costs explained: types and examples, three ways to calculate an overhead rate, and how to include overhead in pricing, with a job-costing example.
Quick answer: Overhead costs are the indirect expenses of running a business, such as rent, insurance, office wages, software and depreciation, that cannot be traced to a single job or product. To price for them, calculate an overhead rate (total overhead / an allocation base such as direct labour hours) and add that rate to the cost of every job before adding profit.
Many small businesses lose money not because their prices are far too low, but because overhead costs never make it into the price at all. This guide explains the types of overhead, three ways to calculate an overhead rate, and a full job-costing example that shows how to include overhead in pricing. Once your rates are right, an online invoice generator makes it easy to bill them consistently.
What counts as overhead costs
The test is simple: can you trace the cost directly to one job, product or client? If yes, it is a direct cost. If it supports the business as a whole, it is overhead.
| Overhead type | Examples | Usual behaviour |
|---|---|---|
| Facility | Rent, property tax, utilities, repairs, cleaning | Mostly fixed; utilities partly variable |
| Administrative | Office staff, accounting and legal fees, bank charges, software | Mostly fixed |
| Selling and marketing | Advertising, website, trade shows, sales salaries | Fixed or discretionary |
| Equipment | Depreciation, leases, maintenance on shared tools and vehicles | Fixed, with step changes |
| Production or shop | Supervisor wages, consumables, small tools, shop insurance | Semi-variable |
| Insurance and compliance | Liability insurance, licences, permits | Fixed |
Most overhead is fixed in the short term, but not all of it. Electricity in a workshop and consumables such as sandpaper rise with activity, so they are semi-variable. The SBA's startup cost guide lists rent, salaries, property taxes, insurance, interest and depreciation as typical fixed costs, which is a good starting checklist. For the line-by-line accounting treatment, our guide to operating expenses covers where each cost sits on the income statement, and fixed vs variable costs covers cost behaviour.
Manufacturing overhead vs selling and admin overhead
Product businesses often split overhead into two groups. Manufacturing or production overhead, such as workshop rent, production supervisors, machine depreciation and factory utilities, supports making the product. Under standard accounting it becomes part of inventory cost and reaches the income statement through cost of goods sold when the product is sold. Selling, general and administrative overhead, such as office staff, marketing and accounting fees, is expensed in the period it occurs. For pricing, both groups must be recovered, so many small businesses use one combined rate. For financial statements, keep them in separate accounts so your gross margin is calculated consistently.
Overhead vs direct costs
Direct costs are materials and labour you can list against a job: the timber for a cabinet, the hours your carpenter spent building it, a subcontractor for that job. Overhead is everything that keeps the doors open whether or not that job exists. The same cost can switch categories depending on the business. A delivery van is overhead for a cabinet shop but closer to a direct cost for a courier.
Three ways to calculate an overhead rate
An overhead rate spreads indirect costs across your work so each job carries its fair share. Choose a base that actually drives your overhead.
| Method | Formula | Best for |
|---|---|---|
| Per direct labour hour | Total overhead / direct labour hours | Trades, workshops, agencies, consultants |
| Percentage of direct labour cost | Total overhead / direct labour cost × 100 | Firms with crews on different pay rates |
| Percentage of sales | Total overhead / revenue × 100 | Retail and quick benchmarking |
Per-hour rates work well when time is what you sell. Percentage of sales is useful for tracking but weak for pricing, because it assumes every sale uses overhead in proportion to its price, which is rarely true.
How to calculate your overhead rate step by step
- Pull last year's expenses from your profit and loss statement, or this year's budget if costs have changed.
- Remove direct costs: materials, direct labour and subcontractors charged to specific jobs.
- Add up what is left. That is total overhead. Include depreciation and a fair cost for anything you use but do not pay for monthly, such as annual insurance.
- Choose an allocation base, usually direct labour hours.
- Estimate the base realistically. Use billable hours, not paid hours. Holidays, training, travel, quoting and rework all reduce billable time.
- Divide overhead by the base to get your rate.
- Review the rate at least once a year, and whenever rent, staffing or equipment changes significantly.
Worked example: a cabinet shop's overhead rate
Oak and Line Joinery has three cabinetmakers and one part-time office manager. Annual overhead:
| Overhead item | Annual cost |
|---|---|
| Workshop rent | $42,000 |
| Office manager wages | $31,000 |
| Equipment depreciation | $12,000 |
| Utilities | $9,600 |
| Delivery van costs | $8,400 |
| Insurance | $7,800 |
| Marketing and website | $6,000 |
| Accounting and legal | $4,200 |
| Software and phone | $3,600 |
| Shop consumables | $3,400 |
| Total overhead | $128,000 |
Each cabinetmaker is paid for about 2,080 hours a year but, after holidays, sick days, cleaning and maintenance, realistically spends around 1,500 hours on client jobs. So direct labour hours are 3 × 1,500 = 4,500. Their loaded wage, including payroll taxes, averages $32 an hour, so direct labour cost is 4,500 × $32 = $144,000.
- Overhead rate per direct labour hour: $128,000 / 4,500 = $28.44 an hour
- Overhead as a percentage of direct labour cost: $128,000 / $144,000 = 88.9%
- Overhead as a percentage of last year's $380,000 revenue: $128,000 / $380,000 = 33.7%
How to include overhead in pricing
Now price a kitchen job that needs $6,200 of materials and 120 hours of cabinetmaker time.
| Cost element | Calculation | Amount |
|---|---|---|
| Materials | From supplier quotes | $6,200.00 |
| Direct labour | 120 hours × $32 | $3,840.00 |
| Overhead | 120 hours × $28.44 | $3,412.80 |
| Full cost | $13,452.80 | |
| Profit at 20% markup on cost | $13,452.80 × 20% | $2,690.56 |
| Price | $16,143.36 |
A 20% markup on cost equals a 16.7% margin on price ($2,690.56 / $16,143.36). If you think in margins rather than markups, our markup vs margin guide has a conversion table. This is the cost plus pricing method with overhead built in properly.
What happens if overhead is left out
Suppose the shop prices the same job as materials plus labour plus 20%: ($6,200 + $3,840) × 1.20 = $12,048. That looks profitable, but the full cost including overhead is $13,452.80, so the job actually loses $1,404.80. On a labour-heavy job, a markup on materials and labour alone rarely covers the overhead the hours consume.
Turning the rate into an hourly charge-out rate
Many trades quote an hourly rate instead of a job price. For Oak and Line, labour $32 + overhead $28.44 = $60.44 of cost per hour. With a 20% markup, the charge-out rate is about $72.53, which the owner might round to $73 or $75. Materials are then billed separately with their own markup. Our guide to labor and materials invoices shows how to lay that out.
Allocating overhead more precisely with two rates
A single shop-wide rate is fine for most small businesses. It becomes unfair when one type of work uses a cost that other work never touches. At Oak and Line, the $8,400 of van costs relate only to installation visits, which take about 600 of the year's 4,500 hours. Splitting the overhead gives two rates:
- Workshop overhead: ($128,000 - $8,400) / 4,500 hours = $119,600 / 4,500 = $26.58 per hour, applied to every hour.
- Installation overhead: $8,400 / 600 installation hours = $14.00 per installation hour, applied on top for site work only.
| Job | Hours | Single rate ($28.44) | Two rates |
|---|---|---|---|
| Kitchen with 24 hours of installation | 120 | $3,412.80 | 120 × $26.58 + 24 × $14.00 = $3,525.60 |
| Freestanding bookcase, collected by client | 40 | $1,137.60 | 40 × $26.58 = $1,063.20 |
With two rates, the kitchen carries $112.80 more overhead and the collected bookcase $74.40 less. The shop's total overhead is unchanged; it is just charged to the work that causes it. This is a simple form of activity-based costing, and it matters most when your jobs vary a lot in how much of a particular cost they use. Do not overdo it: two or three rates are plenty for a small business.
Under-recovered and over-recovered overhead
The overhead rate is a prediction. If the shop bills the planned 4,500 hours, the overhead built into prices is 4,500 × $28.44 = $127,980, which is within rounding of the $128,000 actually spent. But if a slow quarter means only 3,600 hours are sold, prices recover just 3,600 × $28.44 = $102,384, leaving $25,616 of overhead unpaid by customers. That comes straight out of profit.
Ways to manage the risk:
- Set the rate on a cautious estimate of billable hours, not a best case.
- Compare actual overhead recovered with actual overhead spent each quarter, using a budget vs actual review.
- Fill quiet periods with work that at least covers direct costs and makes some contribution to overhead. The contribution margin of the job shows whether it does.
Overhead for freelancers and solo service businesses
Freelancers have overhead too: software, equipment, insurance, a co-working desk, accounting, marketing, and the unpaid hours spent on admin. Suppose a freelance consultant spends $10,000 a year on these and bills 1,200 hours. Overhead per billable hour is $10,000 / 1,200 = $8.33. If the target pay is $60 an hour, the rate before profit is $68.33, before any allowance for taxes and time off. Overhead is a bigger share of a freelancer's costs than it first appears, because the main overhead is often time rather than money. If the same consultant spends 10 hours a week on admin, sales, proposals and invoicing, that is around 450 to 500 hours a year that nobody pays for directly. Those hours are why 1,200 billable hours is a realistic target for many solo businesses, not 2,080. Our guide to how to set freelance rates walks through the full calculation, and self-employed tax deductions covers which of these costs reduce your tax bill.
How to reduce overhead without hurting the business
- List every recurring charge from bank and card statements and cancel unused subscriptions.
- Renegotiate fixed contracts such as rent, insurance and phone plans at renewal.
- Raise billable utilisation. More billable hours on the same overhead lowers the rate per hour without cutting anything.
- Automate admin. Templates for quotes and invoices, saved client details and automatic invoice numbering reduce the hours spent on paperwork.
- Check that cuts do not cost sales. Marketing is overhead, but cutting it can reduce the hours you sell and push the rate up.
Tracking overhead each quarter
An overhead rate set once a year can drift out of date quickly. A short quarterly review compares three things: what you spent on overhead, what your prices recovered, and overhead as a share of sales. Here is Oak and Line's first three quarters at the $28.44 rate:
| Quarter | Actual overhead | Hours billed | Overhead recovered (hours × $28.44) | Over / (under) | Overhead as % of sales |
|---|---|---|---|---|---|
| Q1 | $31,200 | 1,050 | $29,862.00 | ($1,338.00) | 35.5% of $88,000 |
| Q2 | $32,100 | 1,180 | $33,559.20 | $1,459.20 | 31.8% of $101,000 |
| Q3 | $33,900 | 1,090 | $30,999.60 | ($2,900.40) | 35.3% of $96,000 |
Two patterns stand out. Billed hours in Q1 and Q3 fell short of the 1,125 hours a quarter the rate assumes (4,500 / 4), so overhead was under-recovered. And overhead spending itself rose each quarter, from $31,200 to $33,900. Either the shop needs more billable hours or it needs a higher rate. Catching this in October gives the owner time to adjust quotes for the next season instead of discovering a profit shortfall at year end. A small business budget with an overhead section makes this comparison easy.
Common overhead mistakes
- Using paid hours instead of billable hours, which understates the overhead rate.
- Forgetting non-cash costs such as depreciation, so equipment replacement is never funded.
- Adding overhead as a separate invoice line in normal commercial work. Build it into rates instead.
- Never updating the rate after moving premises or hiring staff.
- Leaving the owner's time out of the cost base entirely.
Price with overhead built in
Overhead costs are real costs, and every price you quote should recover its share. Calculate your overhead rate once a year, add it to every job or hourly rate, and check recovery each quarter. When the work is done, bill it clearly with the free invoice generator, using a tidy layout such as the classic invoice template. Download the result as a PDF invoice you can email, print or upload to a client portal.
Frequently asked questions
What are overhead costs?
Overhead costs are the ongoing expenses of running a business that cannot be traced directly to a specific product, job or client. Examples include rent, utilities, insurance, office staff wages, accounting fees, software, marketing and depreciation on shared equipment. They are sometimes called indirect costs or burden. Direct costs, by contrast, are the materials and labour that go into a particular job and can be listed against it.
How do you calculate an overhead rate?
Divide total overhead for a period by an allocation base that drives work in your business. Common bases are direct labour hours, direct labour cost or sales. For example, $128,000 of annual overhead divided by 4,500 direct labour hours gives an overhead rate of about $28.44 per hour. You then add that rate to the cost of every job based on the hours it uses.
What is a good overhead rate?
There is no universal good overhead rate, because it depends on the allocation base and the industry. A workshop with expensive equipment and rent will carry a higher rate than a remote consultant. More important than the absolute number is whether your prices recover it in full and whether it is creeping up faster than revenue. Track overhead as a percentage of sales each quarter and investigate rises.
Are overhead costs the same as operating expenses?
They overlap but are not identical. Operating expenses is an accounting category on the income statement covering all costs of running the business outside cost of goods sold. Overhead is a costing idea: any cost that is not direct to a job. Some overhead, such as factory rent or production supervisors, can sit inside cost of goods sold, while selling and admin overhead sits in operating expenses.
How do I include overhead in my prices?
First calculate an overhead rate, usually per direct labour hour for service and trade businesses. When pricing a job, add materials, direct labour, and overhead (the rate times the job's hours) to get the full cost. Then add your profit margin or markup on top. If you only mark up materials and labour, you are hoping the markup also covers overhead, which often fails on labour-heavy jobs.
What happens if I sell fewer hours than planned?
Your overhead is under-recovered. The rate assumes a certain number of billable hours, so if you sell fewer, the overhead included in your prices falls short of what you actually spend. For example, a rate based on 4,500 hours that only recovers 3,600 hours leaves about a fifth of overhead uncovered. Be realistic about billable hours when setting the rate and review it at least yearly.
Should freelancers calculate overhead?
Yes. Freelancers often price only for their time and forget software, equipment, insurance, accounting fees, marketing and unpaid admin hours. Add up those annual costs and divide by realistic billable hours to get an overhead amount per hour. Add it to your target hourly pay. Even a modest $10,000 of annual overhead adds about $8.33 an hour if you bill 1,200 hours a year.
Can I show overhead as a line item on an invoice?
Usually you should not show overhead as a separate charge. Most clients expect it to be built into your rates and prices, and a separate overhead line often invites argument. The exception is cost-plus or government contracts, where the agreement may require costs to be broken out and an approved indirect rate applied. In normal commercial work, include overhead in your hourly rate or job price instead.
Invoice Creator Editorial Team
Guides on invoicing, cash flow and small-business finance from Invoice Creator, operated by Next Software Development Company. Content is reviewed for accuracy against the fields our own invoice generator produces.
Try the invoice generator