If you've started a business, the idea is to be profitable so you want to be sure you're considering your overhead costs and how you're going to cover them. Here's a little more info on what is considered an overhead expense, the different types and how to cover them in your handmade business.
What are overhead costs?
Overhead costs can be defined as the indirect expenses related to operating a business. In other words, any cost that is not directly related to the manufacturing of a product or delivery of a service.
There are fixed overhead expenses that generally stay the same from month to month. For example:
- rent for your studio space
- utilities for that space
- wages you have to pay to your employees
- accounting fees
- memberships or subscriptions
And then there are variable overhead expenses that may change each month. For example:
- telephone bills
- office supplies
- marketing efforts
Determining Total Overhead Expenses
Fixed expenses are relatively easy to add up each month as they're pretty cut and dry. You'll have to do a bit of guesstimating for your variable expenses but in general you can get a good average number by looking at your variable expenses for the past few months. Once you have this figured out, add your fixed and variable expenses together to get your total overhead costs for a month.
How to Cover Overhead Costs
PRODUCT PRICES (Absorbed Pricing)
The easiest way to cover these overhead costs is to include a fraction of them in each of your product's prices. To do this, take your total overhead costs for the month and divide it by the total amount of products you plan on making.
If your overhead costs for the month are $150 and you buy enough materials to make 25 items each month:
150 divided by 25 = 6
You'll want to add $6 onto the price of each of your items
If you sell a variety of products, all at varying prices, you may want to distribute those $6 a bit differently among your products as adding $6 to a smaller item may make it overpriced.
The other way to cover these costs is to leave your product prices as is (without overhead costs included) and focus on selling more quantity and hitting a specific sales goal. This may be an easier model to follow if you can produce high volumes and you have the outlets to sell them through. You can have a minimum order requirement when selling wholesale or create bundles that encourage customers to buy more than one product or service for you.
This is part of the reason larger companies can lower their prices as they grow. The retail store I worked for always used this analogy for covering overhead costs for each store:
Say in a shipment you received a box with 10 shirts to sell
Profit from the sale of shirt #1 - covers the cost it took to get that shipment to you
Profit from the sale of shirt #2 - covers the cost of the store (electrical bills, rent, etc)
Profit from the sale of shirt #3 - covers costs of advertising that shirt
Profit from the sale of shirt #4 - covers employees wages who are hired to sell that shirt
Profit from the sale of shirt #5 and beyond is all PROFIT
They used this analogy to stress the importance of selling those last couple shirts. They weren't items to be hidden behind other shirts because there were only one or two left. They were the products you wanted showcased to ensure that shirt was profiting and not just covering costs.
Going by this model, you need to find your breakeven point. This is calculating how many sales (in dollars or units) you need to make to cover all your expenses. Once you reach that breakeven point, the rest is profit!
Here's a simple formula to determine how many units you need to sell:
Total overhead costs ÷ profit = breakeven point
- First, add up your overhead expenses
- Next, determine your product's profit. Take the retail price and subtract the cost of materials and labor.
- Finally, divide your overhead expenses by your product's profit.
Let's say your overhead costs for the month are $50 and your products cost $40 with $10 dollars of that covering production costs.
$150 (overhead costs) ÷ $30 (price $40 - production costs $10) = 5After you sell 2 units, your costs are covered and the rest is profit.
For example, if your overhead costs are $50 and you sell each of your products for $20 with $10 of that covering materials and labour costs, you would even out after selling 5 items and anything after that would be profit.
Sale of product #1 = $30 towards overhead
Sale of product #2 = $30 towards overhead ($60 total)
Sale of product #3 = $30 towards overhead ($90 total)
Sale of product #4 = $30 towards overhead ($120 total)
Sale of product #5 = $30 towards overhead ($150 total - your overhead expenses are now paid off
Sale of product #6 = $30 profit
Sale of product #7 = $30 profit ($60 total)
Sale of product #8 = $30 profit ($90 total)
Sale of product #9 = $30 profit ($120 total)
Sale of product #10 = $30 profit ($150 total)
If you had $150 in overhead costs and sold 10 items at $40 each you would make $150 profit that month. If selling 10 items in a month doesn't seem feasible, incorporating your overhead costs into your prices may be the better option.SELLING WHOLESALE
Also keep in mind that if you're selling your products through wholesale or consignment, your profit goes down. Each agreement is different however wholesale prices are generally 50% of your retail price meaning your profits go from $30 to $10. And the units you would need to sell in order to break even would be 15 instead of 5 ($150 (overhead expenses) ÷ $10 (profit) = 15)
When you break it down, you can see how important it is to account for your overhead expenses and make sure you're getting that money back from somewhere. All of a sudden the $100 profit you thought you had for the month is cut down to $50 when you account for overhead.