Overhead Margin Analysis ExplainedScott Williams
Overhead Margin relates to Overhead Costs, which are the costs in your business that do not change directly with a change in your Revenue and/or a change in your Cost of Goods Sold (COGS).
They include such things as:
- Rent, insurance.
- Salaries of permanent staff.
- Administration costs in general; telephone, office costs.
- Some elements of the sales process that are not directly related to your Sales Revenue.
These Overhead Costs tend to grow over time and may lead to inefficiencies in your business. This is due to activities no longer being relevant to your business but remain as a cost. 12Faces has several tools for helping to remove these “barnacles” that detract from your Operating Profit. Yellow Belt
Accounting Terminology can be different around the world and even between accountants.
If you are not familiar with the term “Operating Costs” go to the article: Accounting Terminology Translator
When to Use
The analysis of your Overhead Margin is useful when you want to:
- Strip away unnecessary overhead costs that may have grown up over time.
- Check on the efficiencies of groups of staff costs – e.g. sales and marketing staff – to ensure that their efficiency is not reducing.
- Check on the productivity of staff in general to ensure that your business is not becoming “top heavy” with the cost of additional staff not contributing proportionally to an increase in Revenue and Profit.
The main terms you will be dealing with here are:
- Revenue (Income)
- Overhead Costs
- Operating Profits
If any of those terms are not familiar to you check alternative phrases in our article: Accounting Terminology Translator
The Overhead Margin is one of many ratio analyses that can measure the health trends of your business.
- The change in one aspect of your business (a variable) compared to another one.
- They show performance trends over time.
Overhead Margin = Overhead Costs / Revenue X 100
An increase in this number means your business efficiency has worsened as overhead growth has exceeded revenue growth.
- Figures last year were: $200,000 Overhead Costs / $1,000,000 Revenue = 20% Overhead Margin
- Figures this year: $250,000 Overhead Costs / $1,000,000 Revenue = 15% Overhead Margin
- The Overhead Margin has increased from 20% to 25%.
From the example above, you can see:
- Overhead Margin has increased (worsened) from 20% to 25%. This is due to an increase in Overhead Costs.
- Revenue has not changed.
- All the increase in Overhead Costs will be charged to Operating Profit, which will therefore fall by the $50,000 that Overhead Costs have gone up by.
- Assuming there is no change in the Gross Margin %, since Revenue has not changed, your Operating Profit would have been reduced by the increase in Overhead Costs.
This is a penalty to Profits of $50,000.
For more on Gross Margin %, go to the article: How Gross Margin Analysis Boosts Profit Explained
What Is a “Good” Overhead Margin
There is no single “good” figure for Overhead Margin. It will vary widely, depending on the nature of your business.
- Labour intensive industries, like many services (e.g. accounting, law), tend to have a large percentage of their total costs in Overhead Costs.
This is due to the cost of their Labour falling in the Overhead Costs category.
- A retail business in a high foot traffic area, where rents are high, may have substantially higher rental costs.
- Other types of retail business may have proportionally less Overhead Costs but higher Costs of Goods Sold.
They spend a lot of money on Inventory for sale which falls in COGS.
Much of the interpretation of “good” Overhead Margin might relate to measuring how it changes over time.
Ideally, we want the Overhead Margin to fall, meaning it is steadily improving over time.
This means that, even if Revenue and Costs of Goods Sold are going up, your Overhead Costs are not increasing as fast. You are becoming more efficient in the use of Overhead Costs.
Acceptable Increases In Overhead Margin
There are circumstances where increases in your Overhead Margin are understandable; and perhaps even necessary.
If your business is in a growth phase, you will likely be committing money to:
- Rent for new space for your business.
- Hiring staff, in advance of them earning back what they cost to hire due to the income they generate when first employed.
- Possible other administrative expenses like legal fees, fund raising and similar in order to fund your growth.
In these circumstances:
- You are likely to see a weakening in your Overhead Margins until such time as these new expenses start to pay back for themselves.
- An increase in Overhead Margin in a growing business might be a perfectly acceptable situation.
- Over time however, you would expect the Overhead Margin to begin to fall again as the new investments earn their keep.
1: Your goal is to keep the Overhead Margin at least constant to Revenue and preferably falling as Revenue increases.
This means that you are becoming increasingly efficient at managing your Overhead Costs as your business grows.
2: You can research “normal” Overhead Costs for your industry and use them as a benchmark for your own business.
If you are below benchmark, it might mean you are below the average operating efficiency.
So, although your Overhead Costs are steady, maybe you should be setting your sights higher. That should lead to better Operating Profit.
You can Google Overhead Costs benchmarks.
If this analysis turns up anything of interest:
- Continue monitoring the figures in the future. The 12Faces TrendBoard is designed to make monitoring easy
- Spot good changes and take advantage of them.
- Spot bad changes and take prompt action to limit their effect.
Your Overhead Costs are made up of several contributing costs like:
- Permanent wages
There are separate 12Faces analyses you can use to measure the contribution impact of each of these different types of Overhead Costs.
You can subscribe to our more powerful analysis tools like TrendBoard to have these calculated for you.
Or you can calculate them yourself using the information in the article: Critical Business Financials Explained
- Other versions of our TrendBoard tools explain other profit boosting analysis for you.
- Overhead Costs 12Faces search: Overhead Costs
Refresh your screen to update the list.