Calculating the Overhead Rate: A Step-by-Step Guide (2023)

Knowing your overhead rate is important for businesses of all sizes. Learn how to calculate your overhead rate and what the results mean.

The overhead rate, sometimes referred to as the standard overhead rate, is the cost that a company allocates to production to get a more complete picture of product and service costs. The overhead rate is calculated by adding the indirect costs and then dividing that cost by a specific measurement.

While this is a necessity even for larger manufacturing companiessmall businessescan benefit from the calculation of their overhead rate.

Overview: What is the overhead rate?

Overhead rates are calculated by adding up the indirect or overhead costs your business incurs and allocating those costs based on a specific metric. Indirect costs are part of doing business, but they are not directly related to production and do not generate revenue.

Overhead, or the overhead rate, is never directly related to revenue generation. Image source: author

The measures used to calculate overhead rates include machine hours or labor costs, with these costs being used to determine how much indirect overhead is expended in producing products or services.

To properly calculate your overhead rate, you must first add up all of your indirect business expenses. Overhead costs are overhead costs that are not directly related to the manufacturing or service process. Some examples of indirect costs are:

• To rent
• Utilities
• maintenance
• equipment
• Insurance
• advertising and marketing
• Steer

If you useaccounting softwarefor your company, you can retrieve this information directly from your annual accounts or other system reports. If not, you'll need to add your indirect expenses manually to calculate your overhead rate.

To fully understand the overhead rate, you should first be familiar with the following accounting terms.

• Direct costs: Any cost that can be directly linked to the production of a product or service is considered a direct cost. The majority of the direct expenses that impact your business include direct labor, direct materials, and manufacturing materials.
• indirect costs:indirect costsare costs incurred by your business that are necessary for the normal running of the business but cannot be directly linked to the cost of producing a product or service. Indirect costs are the costs used to calculate your overhead rate.
• fixed costs: Fixed costs are costs that do not change depending on the level of production. For example, rent is a fixed price because the amount of rent paid monthly is the same whether the level of production increases or decreases.
• Variable costs: Not howfixed costs, variable costs will increase or decrease with production. For example, both direct materials and direct labor are considered variable costs and will increase when production increases and decrease when production decreases.

Overhead Rate vs Direct Cost: What's the Difference?

While both the overhead rate and direct costs can affect the end product cost, along with yoursbalance sheetAndproof of income, Those are two different things.

The overhead rate is calculated by adding up your indirect costs and then dividing them by a specific quantity such as machine hours, sales totals, or labor costs. Direct costs are those costs that directly affect production, such as B. direct labor, direct materials, and manufacturing materials.

Examples of overhead measures

Before you calculate the overhead rate, you must first determine which allocation key figure to use. An attribution metric is something you use to measure your overall total cost.

1. Direct work

Direct workingCosts are the wages and salaries of your production workers. Direct labor is a variable cost and is always part of your cost of goods sold. If you want to compare your indirect costs to direct labor costs, you would divide your total indirect costs by your direct labor costs.

For example, if Joe's manufacturing facility had indirect costs of $175,000 and direct labor costs of $145,000 in August, the overhead rate would be calculated as follows:

175.000 $ ÷ 145.000 $ = 1,21 $

This means that for every dollar of direct labor, Joe's manufacturing business incurs $1.21 in overhead.

2. Machine hours

Machine hours are the time that production machines are running for the period for which the overhead rate is calculated. Let's assume that Joe's machines ran a total of 10,000 hours in August. To calculate the overhead rate using machine hours, perform the following calculation:

175.000 $ ÷ 10.000 = 17,50 $

This means that Joe's overhead rate using machine hours is $17.50, so for every hour that the machines are running there is $17.50 in indirect costs.

3. Sale

Joe decides to compare his indirect costs to total sales. This measurement can be especially helpful when he's creating a budget, as he can estimate revenue for the budget period and then calculate indirect costs based on the overhead rate.

If Joe's sales for the month were $325,000, he would calculate his overhead rate as follows:

175.000 $ ÷ 325.000 $ = 0,54 $

This result shows that for every dollar earned, Joe's manufacturing company spends $0.54 in overhead.

To get the percentage of any of these overhead rates, simply multiply the results by 100. For example, if Joe wanted a percentage for his sales calculation, he would simply do the following calculation:

(175.000 $ ÷ 325.000 $) x 100 = 53,84 %

That means 53.84% of Joe's sales dollars are spent on overhead.

How to calculate the overhead rate

Once you've decided which activity drivers - such as B. direct labor, revenue or cost per hour - you can go ahead and calculate your overhead rate. The standard overhead formula is:

Indirect Cost ÷ Activity Factor = Overhead Rate

Let's say your company had $850,000 in overheads in 2019, with direct labor costs totaling $225,000. To calculate your overhead rate, do the following:

$850,000 ÷ $225,000 = $3.78 = overhead rate

The overhead rates are always calculated in dollar amounts, but if you want to calculate overhead as a percentage, you can easily change the formula:

Indirect Cost ÷ Activity Factor x 100 = Overhead Percentage

You can use your income statement to see the total cost of indirect costs for the period. Image source: author

Calculating the overhead rate is important for your business

Calculating the overhead rate is important for any business. Even small business owners benefit from knowing what their indirect costs are and how they are affecting the business.

A simple calculation is enough to determine your overhead rate. But this simple calculation can benefit many facets of your business, from initial product pricing to bottom-line profitability.

Taking a few minutes to calculate the overhead rate can help your business identify strengths and weaknesses and give you the information you need to stay profitable.