What is the Overhead Ratio?
The overhead ratio is the overhead costs of the business expressed as a percentage of the revenue (sales).
Formula for Overhead Ratio
The ratio is calculated by dividing overheads by revenue as shown in the formula below.
- Overheads are found in the income statement. Overheads are the indirect recurring costs of running a business such as administration, selling, and premises expenses. Overheads are often referred to as operating expenses.
- Revenue is also found in the profit and loss statement. It may be called Sales or Turnover.
How do you Calculate the Overhead Ratio?
Using the example income statement below. The business has overheads of 30,000 with revenue of 100,000, so the overhead ratio is 30,000 / 100,000 x 100% = 30%.
|Cost of sales||45,000|
|Income before tax||10,000|
What does the Overhead Ratio show?
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.
As the business grows and takes on more employees, 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.
Useful tips for Using the Overhead Cost Ratio
- The overheads ratio will vary from industry to industry, so it is important to make comparisons to similar businesses in your 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 overhead 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 overhead ratio over time can indicate declining productivity and efficiency.
- Even when the business is doing well, an increasing overhead 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.
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.