Knowing your overhead rate is important for businesses of any size. 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 a company allocates to production to get a more complete picture of product and service costs. The overhead rate is calculated by adding the overhead costs and then dividing those costs by a specific measure.
Although a necessity for large manufacturing companies, even small businesses can benefit from calculating their overhead rate.
Overview: What is the overhead rate?
Overhead rates are calculated by adding the indirect or overhead costs incurred by your business and allocating those costs based on a specific metric. Indirect costs are part of doing business, but they are not directly associated with production and do not generate revenue.
Metrics used to calculate overhead rate include machine hours or labor costs, these costs are used to determine how much indirect overhead is spent to produce products or services.
To correctly calculate your overhead rate, you must first add up all of your indirect business expenses. Indirect expenses are overhead costs that are not directly involved in the production or service process. Here are some examples of indirect costs:
- Advertising and Marketing
If you use accounting software for your business, you can get this information directly from your financial statements or other system reports. Otherwise, you’ll have to manually add your indirect expenses to calculate your overhead rate.
To fully understand the overhead rate, you must first be comfortable with the following accounting terms.
- Direct costs: Any cost that can be directly associated with the production of a product or service is considered a direct cost. The majority of direct expenses that impact your business include direct labor, direct materials, and manufacturing supplies.
- Indirect costs: Indirect costs are costs incurred by your business that are necessary for normal business operations but cannot be directly associated with 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 with production levels. For example, rent is a fixed cost since the amount of rent paid each month will be the same whether production levels increase or decrease.
- Variable costs: Unlike fixed costs, variable costs will increase or decrease with production. For example, direct materials and direct labor are considered variable costs and will increase when production increases and decrease when production decreases.
Overheads vs direct costs: what’s the difference?
Although overhead and direct costs can impact the cost of the final product, as well as your balance sheet and income statement, they are two different things.
The overhead rate is calculated by adding your indirect costs and then dividing them by a specific metric such as machine hours, sales totals, or labor costs. Direct costs are costs that have a direct impact on production such as direct labor, direct materials, and manufacturing supplies.
Examples of Overhead Metrics
Before calculating the overhead rate, you must first identify the allocation metric to use. A breakdown metric is something you use to measure your total overall costs.
1. Direct work
Direct labor costs are the salaries and wages of your production employees. Direct labor is a variable cost and is always part of your cost of goods sold. If you want to measure your overhead against direct labor, you need to take your total overhead and divide it by your direct labor cost.
For example, if Joe’s manufacturing plant had overhead 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 amount of time the production machines have been running during the period for which the overhead rate is calculated. Let’s say 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 Joe’s overhead rate using the machine hours is $17.50, so for every hour the machines run, $17.50 of overhead is incurred.
Joe decides to measure his indirect costs against total sales. This metric can be especially useful when creating a budget, as it will be able to estimate sales for the budget period and then calculate indirect expenses 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 indicates that for every dollar that Joe’s manufacturing business earns, he spends $0.54 on overhead.
To get the percentage of one of these overhead rates, simply multiply the results by 100. For example, if Joe wanted a percentage for his sales calculation, he would simply perform the following calculation:
($175,000 ÷ $325,000) x 100 = 53.84%
This means that 53.84% of Joe’s sales dollars are spent on overhead.
How to Calculate the Overhead Rate
Once you’ve decided which activity factor – like direct labor, sales, or cost per hour – you want to use, you can go ahead and calculate your overhead rate. The standard overhead formula is as follows:
Indirect Cost ÷ Activity Driver = Overhead Rate
Say your business had $850,000 in overhead for 2019, with direct labor costs totaling $225,000. To calculate your overhead rate, follow these steps:
$850,000 ÷ $225,000 = $3.78 = overhead rate
Overhead rates are always calculated in dollars, although if you want to calculate overhead as a percentage, you can modify the formula slightly:
Indirect Cost ÷ Activity Driver x 100 = Overhead Rate Percentage
Overhead costs directly impact your financial performance and profit margin. Knowing your overhead rate can help you estimate budgeted overhead, price products or services accurately to ensure profit, and know how much it costs your business to keep its doors open every day.
It depends on the questions you want answered. If you are looking to measure machine efficiency, it may be best to use machine hours to calculate your overhead rate.
If you are looking to effectively price your products, using total sales or even labor costs may be a better allocation metric for your business to use.
Many small businesses find that calculating their overhead rate annually is sufficient. However, companies with an active manufacturing component may find it helpful to calculate their overhead rate quarterly to make more timely adjustments if needed.
There are lots of things you can do to reduce your overhead, starting with a thorough review of your monthly expenses.
While you can’t change fixed costs like rent and insurance, you can certainly consider expenses like administrative salaries, maintenance costs, and office supplies.
You may even want to reassess your current office/warehouse space to see if it’s still a good fit for your business. Assessing utility costs can also be a good first step in reducing overhead.
Overhead calculation is important for your business
Calculating overhead is important for any business. Even small business owners will benefit from knowing their overhead costs and their impact on the business.
A simple calculation is enough to determine your overhead rate. But this simple calculation can benefit many facets of your business, from the initial price of the product to the ultimate profitability.
Taking a few minutes to calculate the overhead rate will help your business identify strengths and weaknesses and give you the information you need to stay profitable.