How Is Overhead Rate Calculated for a Business?

An overhead rate represents the proportion of a business’s indirect expenses compared to a specific allocation base. Understanding this rate is fundamental for businesses to grasp their actual operational costs. The overhead rate helps in making informed decisions regarding pricing and overall financial health. It provides insight into how much is spent on “keeping the lights on” versus direct production. Monitoring and improving this rate can directly impact a business’s profitability.

Identifying Overhead Costs

Overhead costs are expenses not directly linked to the production of a specific product or service, yet they are necessary for business operations. These are often referred to as indirect costs. Accurately identifying these expenses is the initial step in determining an overhead rate. These costs represent the expense of simply staying in business, regardless of sales levels.

Direct costs, in contrast, are expenses directly traceable to the creation of a specific product or the delivery of a service. Examples include raw materials, such as steel and bolts for a car, and direct labor wages for employees actively involved in production. These costs often fluctuate with production levels.

Indirect costs, or overhead, support the overall functioning of the business but are not directly attributable to a single product or service. Common examples include rent for the office or factory space, utility bills like electricity and water, and salaries for administrative staff. Depreciation of equipment, insurance premiums, property taxes, and general office supplies also fall under overhead expenses. These costs are generally more stable, often being fixed or semi-fixed.

The Basic Calculation Process

Calculating the overhead rate involves a straightforward process once indirect costs are identified and summed. First, aggregate all overhead expenses for a specific period, such as a month or a year. This total represents the numerator in the overhead rate formula.

Next, choose an appropriate allocation base. This base is a measure of activity believed to drive or relate to overhead costs, and it should logically reflect how overhead is consumed. Common allocation bases include direct labor hours, machine hours, or direct labor costs.

Finally, the overhead rate is determined by the formula: Overhead Rate = Total Overhead Costs / Total Allocation Base. For instance, if a manufacturing company has total overhead costs of $10,000 for a period and its total direct labor hours are 1,000, the overhead rate would be $10 per direct labor hour. This means that for every hour of direct labor, $10 in overhead costs are allocated.

Different Allocation Bases and Calculation Methods

The selection of an allocation base depends on the business’s nature and which activity most significantly drives its indirect costs. Using the correct base helps ensure a more accurate allocation of overhead to products or services.

One common method uses direct labor hours, suitable for labor-intensive businesses. The overhead rate is calculated by dividing total overhead costs by total direct labor hours. For example, if total overhead is $50,000 and direct labor involves 5,000 hours, the rate is $10 per direct labor hour. This means that each product requiring one direct labor hour will have $10 in overhead allocated to it.

Another method employs machine hours, often preferred in automated production environments. This calculation divides total overhead costs by total machine hours. If a company’s overhead is $75,000 and machines operate for 15,000 hours, the overhead rate would be $5 per machine hour. This rate helps allocate overhead based on machine usage.

Using direct labor cost as an allocation base is a simple and widely adopted method. The overhead rate is calculated by dividing total overhead costs by total direct labor costs, often expressed as a percentage. If total overhead is $60,000 and direct labor costs amount to $100,000, the rate would be 60% of direct labor cost.

For material-intensive production, direct material cost can serve as an allocation base. The overhead rate is determined by dividing total overhead costs by total direct material costs. If a business has $40,000 in overhead and $80,000 in direct material costs, the rate is 50% of direct material cost.

Sales revenue or units produced can also serve as broader allocation bases for overall or specific product costing. For sales revenue, the overhead rate is total overhead costs divided by total sales revenue. If overhead is $20,000 and sales are $100,000, the rate is 20% of sales revenue. Alternatively, dividing total overhead by the total number of units produced provides an overhead cost per unit.