Updated: Sep 15, 2020
In the line of work that I’m in I hear lots of people mention overhead percentages. But that is usually not followed by what exactly they mean when using those words. It can mean very different things to different people.
It is almost always expressed as a percentage, but a percentage is useless if you do not know what you are applying that percentage against. Let’s call this the overhead base.
So let’s go through a few methods to use overhead percentages. This primarily comes down to what your overhead base, or denominator in the equation, is.
APPLIED AGAINST SALARIES ONLY
In this method you take your overhead costs and create a percentage by dividing those overhead costs over only the salary costs. This will result in the highest percentage because it uses the smallest base, or denominator.
APPLIED AGAINST SALARIES AND BENEFITS ONLY
This is similar to the above method except now the overhead base is higher because it also includes benefits, with a resulting lower percentage.
APPLIED AGAINST TOTAL COSTS
In this method the overhead base includes salaries, benefits, and now all operating expenses. This method is more complicated because you may need to make adjustments to the operating expenses to remove certain large pass-through or contract items. If you leave in these items it will skew the overhead percentage too low and not fairly represent the amount of work needed. This method also results in the lowest percentage of any of the methods, and is therefore the most politically popular.
A different way of looking at the same picture is to take all costs (benefits, operating expenses, and overhead costs) and dividing those costs over the salary costs. This is a simple way to calculate and recover all of your costs, and is a more widely used yardstick in the private sector.
DON’T APPLY OVERHEAD AGAINST OVERHEAD
For all of these methods, when determining the overhead base, or denominator, you want to make sure that you don’t include any overhead costs. The reason for this is logical and mathematical. If you apply overhead costs on top of overhead costs, it means that your original overhead costs are now higher, because they have had overhead applied against them. This then creates an infinite loop as the original overhead costs keep getting higher as you apply overhead costs against them.
So the first thing to do whenever anyone gives you an overhead percentage is to ask, “A percentage of what?”