For many small and midsize businesses, persistent inflation, elevated interest rates, and volatile energy costs continue to tighten profit margins. Price increases, however, are not always the right answer or necessary. Price increases could cause some customers to begin searching for lower cost providers in today’s competitive market. Disciplined cost controls is where sustainable pricing decisions should start and managing overhead costs are a broad area that’s great to target for operational inefficiencies.

Learn What Counts As Overhead

Overhead costs are a part of every business. These accounts frequently serve as catch-alls for any expense that can’t be directly tied to revenue-generating activities, including:

• Equipment maintenance and depreciation
• Rent and building maintenance
• Administrative and executive salaries
• Insurance
• Utilities

 
These are sometimes called indirect costs because they support your operations as a whole. Generally, these costs are fixed over the short run, meaning they won’t change appreciably as your revenue ebbs and flows. However, some overhead costs can rise with increased activity levels, energy usage, or staffing demands.

For many small businesses, overhead grows gradually over time. And, because it isn’t directly tied to a single product, job, or service, you may underestimate how much these costs affect your overall profitability.

Choose An Allocation Method That Fits Your Business

The key to controlling overhead — and unlocking hidden profit potential — lies in allocating these costs to your products, services, projects, or clients. Overhead allocations are typically associated with manufacturers. But a thoughtful approach, even if it’s informal, can help many businesses evaluate profitability. For instance, construction companies can assign equipment, supervision, and office expenses to projects, restaurants can assign operating costs across menu items or locations, and professional service firms can assign administrative costs across client engagements.

The challenge is deciding how to allocate these costs using a relevant overhead rate. The rate is typically determined by dividing estimated overhead expenses by estimated totals in the allocation base (for example, direct labor hours) for a future time period. Then you multiply the rate by the actual number of direct labor hours for each product, project, or service line to determine the amount of overhead to apply.

In some businesses, the rate is applied across all products. But if your operations are more complex, you may use multiple overhead rates to allocate costs more accurately. If one department is machine-intensive and another is labor-intensive, for example, multiple rates may be appropriate. In some situations, activity-based costing methods can improve accuracy by assigning overhead to activities that drive costs, such as machine setups, shipping volume, or employee time supporting clients.

Cost allocations provide insight into which customers, services, or business segments are the most profitable. This can help you identify underperforming products or services, evaluate expansion opportunities, and make better-informed pricing decisions.

Review Overhead Regularly

There’s one problem with managing overhead costs: Variances from actual costs are almost certain. Fortunately, you can reduce the chance of overhead anomalies and improve the reliability of your financial reporting by:

• Conducting independent reviews of adjustments to overhead accounts
• Studying significant overhead adjustments over different periods of time to spot anomalies
• Evaluating your existing overhead allocation methods and updating them when needed

 
Allocating costs more accurately won’t guarantee that you make a profit. However, it can provide a stronger foundation for planning and budgeting.

You should also periodically revisit allocation assumptions as labor costs, supply chain expenses, technology investments, and business operations evolve. Allocation methods that worked several years ago may no longer be relevant for your current operations.

Need Guidance?

Accurate overhead allocation can provide valuable insight into profitability, pricing, and operational efficiency. We can help you evaluate your current costing methods, strengthen internal controls, and develop practical strategies to manage rising expenses. Contact us to learn more.