What Does It Mean?
When we talk about an Overhead Rate, we’re talking about a firm’s Total Indirect costs (non-project labor and expenses) in relation to its Direct (project) Labor costs.
Overhead is sometimes called Indirect Expense, but for clarity, it should be used to refer to non-labor expenses.
Our Overhead Rate simply tells us how many dollars we are spending on overhead stuff for every dollar we spend on project work (labor). Think of it as the burden every hour of project labor must carry on its back in order to generate a profit for the firm.
Because Overhead is a necessary cost of running a firm, its costs must be spread across all projects evenly and fairly. This is done by assigning a dollar share of Overhead to every dollar of salary spent on our projects.
To fully understand our Overhead, we need to split the firm’s Labor (salary) costs into two separate camps. The Direct portion of our labor costs is spent directly on projects, and typically assigned to a specific project number. The Indirect portion is everything else, also referred to as Non-billable Labor. This latter portion becomes part of our Overhead.
The Simple Math
The simple equation for getting to our Overhead Rate looks like this:
(Indirect Labor + Indirect Expenses) / Direct Labor = Overhead Rate
It is essential that we identify and track every item of Indirect Expense, or we won’t have an accurate calculation.
Here’s what it consists of:
Indirect Labor: As we said above, all the labor not directed at project work. This is probably our largest indirect expense item.
Office Occupancy Expense: Includes all the things that relate directly to occupying an office, even if it’s transient or virtual. Of course, a virtual office won’t incur many expenses.
New Business Development, Marketing, and PR Expenses (also known as Promotional Expense): Includes all such items that relate to seeking and winning new work, and advertising and marketing the firm.
Staff Benefits Expense: Includes all the things that the firm spends on behalf of the individual employee.
Insurance & Tax Expense: As the name suggests, it includes all insurance and tax items. We may need some help with this one, perhaps from our accountants or bookkeeper.
Miscellaneous Expense: All the items that don’t fit neatly into the other categories, such as legal and accounting fees, depreciation, etc.
The Big Idea
Once our Overhead Rate is clearly understood and tracked monthly, we can begin to deal with it. If it’s too high, the firm will have difficulty making a profit. If it’s too low, the firm may not be investing enough in marketing, staff development, benefits, technology, or other things that drive the practice forward.
Knowing our Overhead Rate allows us to better understand our Net Fee Multiplier and to set our ideal hourly billing rates.
The formula for calculating Overhead gives us some clues about managing it. Increasing our Indirect Expenses and Indirect Labor will increase our Overhead, while increasing Direct Labor will decrease Overhead.
One of the interesting things about Overhead is that, everything else remaining the same, adding project staff will actually lower Overhead.