How to Calculate the Overhead Rate for a Business

An overhead rate allows businesses to allocate indirect costs that support operations but are not directly tied to producing a specific product or service. This financial tool helps companies understand the full cost of their offerings, beyond just direct materials and labor. Calculating this rate provides valuable insights for making informed decisions about pricing, budgeting, and overall financial management.

Identifying Your Overhead Costs

Overhead costs encompass all expenses necessary to run a business that are not directly involved in the creation of a product or service. These indirect costs are incurred regardless of production volume and are essential for day-to-day operations. Examples include rent or mortgage payments for office space, utility bills, and premiums for business insurance. Administrative salaries, office supplies, depreciation on office equipment, professional services, and marketing expenses are also common overheads.

These costs can be categorized as fixed, remaining constant regardless of activity (e.g., rent), or variable, fluctuating with business activity (e.g., some utilities or office supplies). Accurately identifying and summing these indirect expenses for a specific period is the foundational step in determining a business’s total overhead.

Selecting an Allocation Base

An allocation base serves as a specific measure used to distribute indirect overhead costs to particular cost objects, such as products, services, or departments. The purpose of this base is to logically link the overhead incurred with the activity that drives those costs. Businesses choose an allocation base that best reflects how overhead expenses are consumed or incurred.

Common allocation bases include direct labor hours, which are suitable for labor-intensive operations. Direct labor costs can also serve as a base, particularly for service businesses. For highly automated or machine-dependent processes, machine hours often provide a more appropriate measure. Other bases might include the number of units produced or sales revenue, which can be simpler but less precise for cost allocation. The chosen base should logically correlate with the incurrence of overhead to ensure accurate cost assignment.

Calculating the Overhead Rate

Once total overhead costs and a suitable allocation base have been identified, calculating the overhead rate involves a straightforward formula. The overhead rate is determined by dividing total overhead costs by the total amount of the chosen allocation base. This yields a rate representing the overhead cost associated with each unit of the allocation base.

For instance, consider a business with total annual overhead costs of $120,000. If this company chooses direct labor hours as its allocation base and expects 20,000 direct labor hours, the calculation is $120,000 divided by 20,000 hours. This results in an overhead rate of $6 per direct labor hour, meaning $6 of indirect overhead costs are incurred for every hour of direct labor performed.

Using Your Calculated Rate

The calculated overhead rate offers several practical applications for businesses. One primary use is in product or service pricing, where incorporating the overhead rate ensures that selling prices cover not only direct costs but also a fair share of indirect expenses, contributing to profitability. For example, if a product requires two direct labor hours, an overhead rate of $6 per hour means an additional $12 in overhead cost should be factored into its price.

Businesses also utilize this rate for job costing, assigning indirect costs to specific projects to determine their true total cost. The overhead rate is a valuable tool for budgeting and forecasting, allowing companies to estimate future overhead expenses based on projected activity levels, aiding in financial planning. Finally, analyzing the overhead rate over time helps in performance analysis, enabling businesses to monitor efficiency, identify cost control opportunities, and make adjustments to improve operational effectiveness.