What Is an Overhead Ratio?
Let me explain what an overhead ratio really is. It's a straightforward measurement of your business's operating costs compared to the income you're bringing in. If you keep this ratio low, it means you're doing a good job minimizing those expenses that aren't directly tied to producing your goods or services.
The Formula for the Overhead Ratio
You calculate the overhead ratio by dividing your operating expenses by the sum of your taxable net interest income and your operating income. Put simply, it's Operating Expenses divided by (TII + Operating Income), where TII stands for Taxable Interest Income. This formula gives you a clear picture without any fluff.
The Basics of Overhead Ratios
Overhead expenses are the costs that come from your normal, everyday business operations. Think office rent, advertising, utilities, insurance, depreciation, or machinery—these are all part of it. But remember, when we calculate overhead, we exclude anything directly related to producing your goods or services.
For example, in a toy factory, the skilled workers making the toys and their tools aren't overhead. However, your marketing department employees and the materials they create for promotions definitely count as overhead costs. This distinction keeps the focus on indirect expenses.
Key Takeaways
- An overhead ratio measures operating costs against company income.
- A low ratio indicates effective control of non-production expenses.
- Calculating it helps evaluate business costs relative to generated income.
How Overhead Ratios Are Used
You can use the overhead ratio to evaluate your business costs against the income you're generating. Generally, aim for the lowest operating expenses possible, but don't sacrifice the quality or competitiveness of what you offer.
Track your overhead ratio to compare it with others in your industry or the industry average. If yours is higher than the competition, you might need adjustments or at least a solid explanation—like how keeping headquarters in a high-cost city like Manhattan could inflate it compared to a rival in a cheaper location like Omaha.
Cutting expenses improves your overhead ratio, but you have to balance that with any potential harm to your products or services. It's about making smart, informed decisions.
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