‘Overheads’ will not be a new term to most Business Owners. You see them each month or year when you print out a Profit and Loss report from your accounting system. Some accounting systems by default calls Overheads ‘Expenses’.
It’s a listing of what you have spent money on over a period e.g. Bank Charges, Rent, Salaries etc. These expenses are different to Cost of Sales in that COS mostly only happen when you sell something, whereas Overheads occur whether you sell anything or not.
‘Overheads %’ is a percentage, rather than just a number. A total of expenses is a useful figure for the Taxman to determine tax deductibility and it is also part of the equation in determining profitability i.e. Gross Profit – Overheads = Net Profit.
A percentage is a more meaningful indicator of financial health for a business owner/manager, because it measures Overheads in relation to Revenue. e.g. if you have Revenue of $1,000,000 and Overheads of $800,000 this looks OK, because it means you made a $200,000 profit.
How to increase profit margin
If your Revenue is $2,000,000 and your Overheads are $1,800,000, this may still look OK because again it means you made a $200,000 profit.
If you were measuring Overheads %, the first scenario shows a result of 80%, whereas the second scenario shows a result of 90%. This means you have more expenses relatively in the second scenario, even though you are making the same amount of profit.
The point is, that it’s taking up more resources to make the same amount of profit in the second scenario and undoubtedly more headaches for the business owner.
Perhaps it would be better to decide on an acceptable Overheads % and strive for that, rather than just focusing on Revenue and ending up with less profit for more headaches.
The aim in business is to make more profit with the resources you have. Aiming for efficiencies and economies of scale should be the objective i.e. making more money with the same amount of resources. This is what makes a business more profitable and more valuable.
If Overheads % is an important indicator of financial health how can you improve it?
The place to begin, is knowing what your Overheads are. For every accounting period you need to know what your Overheads will be, so that you can budget and project what your profit and cash position will be.
Planning Overheads is generally part of budgeting and forecasting. I have often heard business owners say they can’t do a budget because they have no idea what they will sell in the future.
This may be true, but most business owners have a fair idea of their overheads e.g. Rent, Salaries etc. This is a great place to begin budgeting, because once you know your Overheads and Costs you are then in a position to determine how much Revenue you need to cover both.
This is called Break-even i.e. the amount you need to sell to make neither a profit nor a loss. Once you know your Break-even point, you can then plan what you need to do to make a profit or avoid a loss.
Once you know your Overheads you can enter them into whatever accounting system you are using as a Budget. It’s a good idea to enter them for each month, so that when it gets to the end of each month you can compare your actual results to the budget.
This will enable you to see very quickly where variances are occurring and take quick action to correct the situation or alter the budget if you’ve miscalculated.
Managing Overheads is one of the absolute keys to business financial survival.
Once you have a budget that’s great but what next? As well as measuring the variance between budget and actual monthly, what else can you do to manage Overheads?
Purchase Orders!
A Purchase Order is a simple document that all staff must complete prior to spending any of the company’s money. This is then handed to a director who authorises it prior to the order being placed. Sounds like a simple concept doesn’t it? So why don’t all businesses do it?
Not having a Purchase Order system in place is like giving staff an open credit card.
You as business owner are usually in the best position to know your financial position, as well as many other important factors in the business operations. For example a staff member may not know that something they are about to order will shortly become obsolete, whereas you may know that.
If they just go ahead and order it you get stuck with it. If they had asked you to sign a Purchase Order you could have avoided the wastage. It may sound like a bit of a pain but believe me it’s worth it. I have saved our business many $thousands this way.
Once staff get the message they can’t just spend the company’s money at will, it’s amazing how much more careful they will be. This simple tactic can have a huge impact on the Overheads % result and ultimately the value of your business.
This is just one tactic for managing Overheads, there are many others.
