Know Your Overhead to Keep Your Business Under Control
Updated: Jan 20
Many small business owners and independent contractors out there think they are profitable, but make one simple mistake that brings their business to a halt within only a few years of starting up:
DO NOT PAY YOURSELF OUT OF YOUR BUSINESS PROFIT.
But Ryan, you ask, if I’m not paying myself out of my profit, how am I going to pay my bills? OK, let’s get more specific. You DO need to pay yourself. However, your salary needs to come out of overhead- not profit. For those who just felt the static buzz feeling start to wash over your brain, hang in there. We’re going to break it down in a way that’s easy to understand and calculate, so that you can make sure you are charging enough for your labor, and keeping yourself in business for years to come.
Getting on the Same Page
First, we need to go over some definitions so that we can all get on the same page while we are talking about the numbers. So… what exactly is overhead?
Overhead is basically the cost of your company existing. Your overhead costs are things you need to pay for that don’t vary from month to month, or job to job. These are bills that your business is going to have to pay regardless of whether you are bringing in money or working on a project at the moment. Do you pay for any of the following?*
Rent for your office space
Website / URL
Licenses or State Registration Fees
*This is not a comprehensive list. It should give you a general idea of what you are looking for when calculating overhead.
Project/ Job Costs:
Confusingly enough, some people call these “Project Overhead” or “Job Overhead”. Whatever language works best for you, these are the things you will pay for on a project by project basis, or costs that change depending on the project you do. Things like:
Supplies and Materials (lumber, cleaning products, fabric, paint, etc.)
Gas (the further a project is away, the more gas you will need)
*Some businesses put their labor in as a part of overhead. Some estimate labor on a project by project basis. This is highly dependent on your industry, and how you want to run your business.
In our examples below, we are generally assuming that your business lists these costs as separate line items on your estimates when you are bidding on a project.
Revenue is the total amount of money that is coming in from your project or projects- BEFORE you take out the cost of actually completing the project. Businesses can bring in a lot of revenue, but if their overhead costs or the cost of the job were too high, they may not actually be making any money!
Profit is the total amount of money (if any) that you made from a project. In simple terms, it’s what your client paid you, minus what you paid to do the job. In a successful, thriving business, this should be a positive number.
Doing the Math
Now that we have vocabulary out of the way, time for a quick math lesson. Calculating your overhead is important for two reasons:
Figuring out what to charge for your time.
Figuring out if you have actually made a profit.
The first thing you are going to want to do as a business owner is collect information on all of your business’ regular bills. You might know a lot of this off-hand, or be able to easily find it in your Quickbooks account. Make a list of all of the regular, non-changing expenses that you have throughout the year (or, update last year’s list).
As an example, let’s take a look at Nic, who owns a small custom craft carpentry business called “Nic Builds Stuff”. Every year, Nic pays the following bills regularly:
Nic can figure out how much the bills he pays monthly cost him for the year by multiplying the monthly expense by 12. He can also figure out how much his yearly bills cost him monthly by dividing the yearly amount by 12. He fills in the whole chart for reference.
Next, because Nic has followed our advice, and pays himself, and his employee, who is learning craft carpentry from him, a yearly salary- which he counts in his overhead expenses- he is going to add his payroll expenses to this same chart:
Now, to calculate his overhead, Nic is going to break down these numbers even farther, to be able to see how much each of these bills cost him per week, per day, and per hour.
Important Note: Nic believes that taking time to rest and refresh is important to mental health and work life balance. He also recognizes that life isn’t perfect, and stuff is going to come up for both himself and his employee. No one is capable of working every single day of every single month of every single year. So, instead of dividing his yearly cost by 52 weeks per year, he’s going to divide by 48 weeks. This allows for 4 whole weeks of vacation time, personal time, sick days, mental health days, or “oops, life happened and I can’t make it in” days for both himself and his employee to be budgeted into his overhead calculations up-front. Allowing for everyone to take time for themselves and not having to stress when illnesses or accidents happen is one big step in helping your business thrive.
Nic calculates daily rates dividing his weekly calculations by 5 work days in a week, and hourly rates dividing his daily calculations by 8 hours in a day, because that is a reasonable estimate of a healthy schedule for himself and his employee. If you use a different work schedule, perhaps your business is open 4 days per week, but has more employees and shifts, and is open 12 hours per day, or maybe you work 5 days per week, but only 6 hours per day, you may need to adjust your calculations accordingly.
Once Nic has figured out how much each of his overhead expenses costs per hour, he can add that column up to figure out his minimum hourly rate. To make sure that all of his overhead costs are covered, Nic now knows he needs to charge at least $68.78 per hour for any of his projects. This is before any project materials or other job costs, and remember, all this does is break even- he is not yet making a profit!
If you are finding that your hourly rate doesn’t cover your overhead costs, you may need to be charging more per hour. If your hourly rate is not covering your overhead costs, but you cannot charge more per hour, you may need to find ways to cut costs when it comes to your overhead expenses.
That’s a Lot - Is There A Shortcut?
For those who are not so interested in putting together spreadsheets of all of their bills, or perhaps your business is new and you are uncertain how much your bills will be, you can estimate overhead costs and profit by charging a percentage of the job cost of each of your projects. This method isn’t as precise, however, and does have the potential to lead to un-profitable projects.
Using a percentage for your overhead and profit is commonly referred to as a profit margin. Be careful when you are marking up your estimates- the math is a little more complicated than just adding percentages!
Let’s go back in time to when Nic was just starting out… he decided he was going to mark up his estimates by 20% - 10% for overhead, and 10% for profit. Nic’s first project was a custom built ornamental shelf, which he determined would cost $1000 to build (because that’s an easy number for us to do math with). He put in a markup of $200. Do you see where Nic’s math led him astray?
Because Nic only marked up his costs by 20%, his profit margin was only 17%. If he kept making this mistake, his business would have felt it over time. Nic chose to go with the more precise method of calculating his overhead we detailed above, however, if you are a huge fan of percentages, you can use a profit margin chart like this one to calculate what your markup will need to be to get the profit margin you are looking for. If Nic had checked the chart before making his estimate, he might have noticed that for a profit margin of 20%, he actually needs a mark-up of 25%.
Thanks, Thrive! What’s Next?
One of the best ways you can properly determine your overhead starts with making sure your bookkeeping is accurate and up to date. We can help with that- schedule some time to talk now!
We’ll also be taking a deeper dive into methods for managing (and guaranteeing) profits in our newsletter this month, so don’t forget to sign up today!