Overhead costs typically include expenses such as rent, utilities, salaries for non-production staff, and other indirect expenses that are necessary for running a business but not directly tied to producing goods or services. Consequently the overhead ratio is an important indicator of the financial health of a business, as it provides a measure of how much of it’s revenue is going towards non-productive expenses.
Overhead Ratio Formula
The ratio is calculated by dividing overheads by revenue as shown in the formula below.
The items used in the overhead ratio formula are as follows.
- Firstly overheads are found in the income statement. Overheads are the indirect recurring costs of running a business such as administration, selling, and premises expenses. Additionally overheads are often referred to as operating expenses.
- Secondly revenue is also found in the income statement. Additionally it may be called sales or turnover.
How to Calculate the Overhead Ratio
To illustrate suppose a business has the income statement shown below.
|Cost of sales
|Income before tax
The business has overheads of 30,000 with revenue of 100,000, so the overhead ratio is calculated as follows.
Overhead ratio = Overheads / Revenue Overhead ratio = 30,000 / 100,000 x 100% = 30%.
In the example above, the ratio shows the percentage of revenue (in this case 30% of revenue) that is needed to pay for the overhead operations of the business. It is generally accepted that overhead is not income generating, so 30% of all income is used in non-income producing activities.
The Business Expands
However suppose the business grows and takes on more employees. For example it might move to larger premises and incur larger overheads as a consequence, in the example below overheads have increased to 40,000.
Initially the ratio will increase (as shown in the middle column below), however, eventually if the move has been a correct one, the revenue will increase as a consequence of the move and the ratio will return to its previous level or lower.
Overhead Ratio Meaning
In contrast, a low overhead ratio can indicate that a business is operating efficiently, with a focus on minimizing expenses and maximizing revenue.
- The overheads ratio will vary from industry to industry, so it is important to make comparisons to similar businesses in your industry sector. If your overheads ratio is substantially different from other businesses within your sector it will need investigation to ascertain why.
- Overheads tend to increase as a business gets larger but unfortunately do not tend to decrease if the business starts to get smaller. It is important therefore to keep overheads in proportion to the size of the business as it grows by monitoring the ratio. Ideally the ratio should be declining as the business grows.
- The aim is to get the overhead ratio as low as possible. This could be achieved by either increasing revenue while maintaining the same level of overhead or by reducing overhead itself.
- Increasing values of the ratio over time can indicate declining productivity and efficiency. Consequently it can be a warning sign that the business is spending too much on non-productive expenses and not enough on activities that generate revenue. In contrast, a low overhead ratio can indicate that a business is operating efficiently, with a focus on minimizing expenses and maximizing revenue.
- Even when the business is doing well, an increasing ratio can indicate that your overheads are rising unnecessarily.
- The overhead cost ratio will normally be in the 15% to 30% range depending on the industry.
In conclusion, the overhead ratio is an important financial metric that provides insight into how efficiently a business is operating. Consequently by keeping overhead costs under control and minimizing non-productive expenses, businesses can improve their bottom line and maintain a healthy financial position. While there are many factors that can impact the ratio, a focus on reducing waste, streamlining operations, and negotiating favorable pricing with suppliers can help businesses to keep their expenses in check and maximize revenue.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.