On my last Creative Accounting post, I talked about all those pesky hidden expenses (called “overhead expenses”) that your small biz encounters. I concluded that discussion by saying that it’s important to recover a little piece of your overhead expenses every time you sell a product or service, so you should be including these expenses in your pricing formula.
Today, we’ll get into the details of exactly how to do this! This process can get a little complicated and depends a lot on the specific products or services you provide. So feel free to ask for help in the comments!
So let’s review from last time – overhead expenses are those indirect costs that go into creating my product. They are expenses that I cannot assign to an exact product. Things like glue, thread, the electricity I use to keep my sewing machine on, craft show fees, etc. I am spending real money on these things, but since I can’t allocate them to a specific product or line of products, I might forget to take them into consideration when I price my products. Remember, pricing is all about trying to recover all the expenses it cost to make that product, plus earn some profit.
Here’s an example of a typical pricing formula:
The “overhead rate” piece is what we’re discussing today. How exactly do we come up with a number to put in this part of your pricing formula?
Let’s start by tallying your estimated overhead expenses, either on a monthly or annual basis, whatever is easiest for you. That includes the following types of expenses:
If you’re having trouble estimating your monthly or annual overhead expenses, it might help if you think of all the expenses you expect to pay for your business in one month or year. Then determine which of them are not directly allocable to your products. You’re left with an estimate of all your overhead expenses.
Once you have your estimate, you need to find a way to include a piece of this total sum in your pricing formula(s). This little piece is called your “overhead rate”. It can be either a dollar amount or a markup percentage.
There are lots of ways to calculate your overhead rate. Here are just a few possibilities:
- Based on estimated products created – Estimate how many products you will create this year. Take your total overhead expense number and divide it by the number of items. Add that number to the sales price of each item you list for sale. For example, $1000 in annual overhead divided by making 350 items this year means I need to increase the price of each item by $2.85 or so to recoup a chunk of overhead in every sale I make.
- Based on estimated products sold – Same method as above, but instead of estimating your total items produced, estimate the total number of items you hope to sell this year. That way you are getting closer to truly recouping that overhead expense back with each and every sale.
- Markup percentage – Instead of adding a flat “fixed” overhead dollar amount to each sale price, you can use a percentage markup instead. Once you know the cost of direct materials and labor that went into creating a specific product, you can multiply that amount by a specific overhead percentage (determined based on what feels sensible to you). For example, if these earrings cost me $6 to create and my overhead percentage is 20%, then I’m saying these earrings required about $1.20 of overhead expense to make, and really cost me $7.20 total to create.
Each overhead rate calculation method has its pros and cons. Experiment with the different methods and see what calculates a price that you feel most comfortable with.
To refine your formula further, you can even have multiple categories of overhead with their own rates. For example, your different product lines might have their own different overhead rates, and then you might have an overall “general business” overhead rate that you apply to all of your products.
Calculating your overhead rate and pricing formula depends on what makes most sense to you. My most important takeaway lesson is that you do something to include your overhead costs in your prices in some way, shape, or form. If you fail to include these costs in your price, then you are much less likely to ever recover them via your sales. At the end of the day, your business will make less real profit than you might think.
What questions do you have about overhead expenses for your creative biz?
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