The short answer. Overhead is too much when your gross margin dollars no longer cover it, plus debt service, with room to spare. That is fixed obligation coverage: monthly gross margin dollars divided by total fixed monthly obligation. Percent-of-revenue rules miss it. As coverage falls toward 100 percent, a single slow month turns into a loss.
Why Percent-of-Revenue Rules Mislead
The common advice says overhead should stay under some percent of revenue. Twenty, thirty, thirty-five, depending on who you ask. The problem is that revenue does not pay overhead. Gross margin dollars do.
Two businesses at $3 million each, with identical overhead at 25 percent of revenue. One delivers a 45 percent gross margin, the other 30. The first carries its overhead easily. The second is one bad quarter from trouble. Same rule. Opposite outcomes.
Fixed Obligation Coverage
Every month, the business owes its fixed weight whether it sells anything or not. Overhead plus debt service. That is total fixed monthly obligation, and it is the number Fixed Cost Capacity is measured against.
Divide monthly gross margin dollars by total fixed monthly obligation. That ratio is fixed obligation coverage. Above 100 percent, gross margin carries the weight and something is left. At 100 percent, nothing is left. Below 100, the business is consuming cash to stay open.
A Worked Example
A business produces $95,000 a month in gross margin dollars. Overhead runs $68,000. Debt service is $14,000. Total fixed obligation is $82,000.
Coverage is $95,000 divided by $82,000, about 116 percent. That looks fine until you ask how far it can fall. A drop of about 14 percent in gross margin dollars, from one lost customer or one slow month, puts coverage below 100. The overhead did not change. The cushion was just thinner than anyone knew.
Overhead Moves in Steps
Overhead does not rise in a smooth line. It jumps. One more office hire, one more truck, one more square foot of lease. Each step raises fixed obligation the day it is signed, and the gross margin to cover it arrives later, if it arrives at all.
Before any step, restate fixed obligation coverage with the new cost in it. If coverage falls into a range where one bad month breaks it, the step is premature. See When Should I Hire My Next Employee? for how a single hire moves breakeven.
What to Cut, and What Not To
If coverage is too thin, you have two levers: raise gross margin dollars or lower fixed obligation. Overhead that does not protect margin, deliver capacity, or collect cash is the first place to look. Unused software, idle space, vehicles nobody drives, subscriptions nobody opens.
Overhead that protects margin is different. The estimator who keeps quotes accurate and the coordinator who keeps technicians billable are not overhead problems. Cutting them lowers fixed obligation and gross margin at the same time. See Should I Cut Costs or Raise Prices?
Frequently Asked Questions
Does debt service really count as overhead?
For this test, yes. Debt service is a fixed monthly obligation that has to be paid out of gross margin whether the month was good or bad. Leaving it out makes coverage look better than it is.
How often should I check coverage?
Monthly at minimum, weekly if margins are thin. Use current gross margin dollars, not last quarter's average. It is a leading read only if it is current.
My overhead is low but I am still short on cash. Why?
Coverage is one test. You can have strong coverage and still run a Working Capital Gap or underfund Minimum Mandatory Profit. Check those next.
Is owner pay overhead?
Owner compensation at market rate belongs in the cost structure. If you pay yourself below market, your overhead looks lower than it really is, and so does your floor.