What is Overhead Cost? A Simple Guide for Small Business

Overhead costs are the costs of running your business that you can't trace to one specific product, job or client. Rent, insurance, utilities and the wages of staff who don't work directly on jobs are overhead. Materials used on a job and the hours your team spends on it are direct costs. To price a job so it covers everything, you assign a share of overhead to it, for example with an overhead rate.

OpenStax's open textbook Principles of Accounting, Volume 2: Managerial Accounting defines manufacturing overhead as "costs incurred in the production process that are not economically feasible to measure as direct material or direct labor costs; examples include indirect material, indirect labor, utilities, and depreciation" (OpenStax, chapter 2 key terms, opened October 29, 2026). For service businesses, the same book uses "operating overhead," which it defines as an "overhead account used for service industries" (chapter 4 key terms).

Overhead and direct costs

OpenStax explains: "Overhead consists of indirect materials, indirect labor, and other costs closely associated with the manufacturing process but not tied to a specific product" (section 6.1).

• Direct costs can be traced to a job: the materials used on it and the hours worked on it.
• Overhead supports every job but can't be traced to one: rent, insurance, utilities, equipment depreciation, and the time of staff who don't work on the jobs themselves.

Which costs go where is a judgment call for your business, so agree on the categories with your accountant. Cost accounting covers how businesses assign all their costs to products and jobs.

How to calculate an overhead rate

OpenStax says: "A predetermined overhead rate is calculated at the start of the accounting period by dividing the estimated manufacturing overhead by the estimated activity base." It defines the activity base as an "activity that has been considered to be a primary driver of overhead costs and for which, traditionally, direct labor hours or machine hours were used" (chapter 6 key terms).

Overhead rate = Estimated overhead for the year ÷ Estimated activity base for the year

Then apply it to each job: Overhead applied = Overhead rate × the job's units of the activity base

Using one rate for all jobs is the traditional method. Activity-based costing uses several cost drivers instead; OpenStax notes that ABC "has advantages over the traditional allocation method, which assigns overhead using a single predetermined overhead rate," but that "Those advantages come at a cost, both in resources and time."

Sample overhead rate and job cost

This is a sample with invented figures for a fictional service business, Elm Street Plumbing, which uses direct labor hours as its activity base.

Estimated overhead for the year

• Rent: $18,000.00
• Insurance: $6,000.00
• Utilities: $4,800.00
• Office administrator's wages: $21,200.00
• Total: $18,000.00 + $6,000.00 + $4,800.00 + $21,200.00 = $50,000.00

Estimated direct labor hours for the year: 2,500

Overhead rate: $50,000.00 ÷ 2,500 hours = $20.00 per direct labor hour

Cost of one job

• Materials: $310.00
• Direct labor: 12 hours × $45.00 = $540.00
• Overhead applied: 12 hours × $20.00 = $240.00
• Total job cost: $310.00 + $540.00 + $240.00 = $1,090.00

Pricing this job at less than $1,090.00 wouldn't cover its share of the year's estimated overhead. Because the rate is based on estimates, the overhead you apply over the year can differ from actual overhead; compare the two at year-end with your accountant.

Where Billed fits

Billed's expense tracking page says an expense "records who you paid, when, how much and which category it belongs to," and that "Billed's expense report can group your expenses by category." Record rent, insurance, utilities and other overhead costs under categories of their own, then add up each category when you estimate next year's overhead.

Related Articles

• What Is Cost Accounting?
• What Is Activity-Based Costing (ABC)?
• What is Gross Profit?
• What is Marginal Cost?
• Break-Even Calculator

Frequently Asked Questions

What are examples of overhead costs?

OpenStax gives indirect material, indirect labor, utilities and depreciation as examples of manufacturing overhead. In a small service business, rent, insurance, utilities and the wages of staff who don't work directly on jobs are overhead.

How do you calculate an overhead rate?

Divide your estimated overhead for the year by your estimated activity base for the year, such as direct labor hours. In the sample on this page, $50,000.00 of estimated overhead divided by 2,500 direct labor hours gives a rate of $20.00 per hour.

What is the difference between overhead and direct costs?

Direct costs belong to one job or product, like the materials it uses and the hours spent on it. Overhead keeps the whole business running without belonging to any single job, so you spread it across jobs with an overhead rate.

What is the difference between traditional overhead allocation and activity-based costing?

The traditional method applies one predetermined overhead rate to every job. Activity-based costing uses several activities as cost drivers. OpenStax says that brings advantages, but at a cost in resources and time.