What Is the Overhead Rate?
The overhead rate is a way to allocate indirect (overhead) costs to products, services, departments, or projects. Overhead costs are expenses that support operations but cannot be traced directly to a specific product or service (for example: rent, utilities, administrative salaries, insurance, and general maintenance). The overhead rate spreads those indirect costs across production using a chosen allocation measure (direct labor dollars, machine hours, labor hours, etc.) so companies can more accurately determine product cost and set prices.
Key Takeaways
– Overhead rate = Indirect (overhead) costs / Allocation measure.
– Allocation measures (activity drivers) include direct labor dollars, direct labor hours, machine hours, or any relevant cost driver.
– The rate may be expressed as a dollar-per-unit (e.g., $/machine-hour) or as a percentage (e.g., overhead per $1 of direct labor).
– Use a consistent time period for both overhead costs and the allocation measure.
– Overhead rates are useful for pricing, cost control, budgeting, and profitability analysis but have limitations (accuracy depends on the allocation base and company structure).
Overhead Rate Formula and Calculation
Basic formula:Overhead rate = Indirect (overhead) costs / Allocation measure
Two common presentations:
– Dollar-per-unit: $ overhead per machine hour = Total overhead ÷ Total machine hours
– Percentage: Overhead rate (%) = (Total overhead ÷ Total direct labor dollars) × 100
Example calculations (illustrative):
– If overhead = $20,000,000 and direct labor = $5,000,000, overhead rate = 20,000,000 ÷ 5,000,000 = 4.0 → $4 of overhead for every $1 of direct labor (or 400%).
– If overhead = $500,000 and machine hours = 30,000, overhead rate = 500,000 ÷ 30,000 = $16.67 per machine hour.
Using the Overhead Rate — Step-by-Step Practical Process
1. Define the period
– Choose a consistent period (month, quarter, year) and use overhead and allocation measures for the same period.
2. Identify and total overhead costs
– Include rent, utilities, indirect wages, insurance, maintenance, administrative expenses, and other indirect costs. Exclude costs that can be traced directly to products.
3. Choose an appropriate allocation base
– Pick the cost driver that best correlates with consumption of overhead: direct labor hours/dollars, machine hours, number of setups, floor space, etc. The better the correlation, the fairer the allocation.
4. Measure the allocation base for the period
– Sum total direct labor hours, direct labor dollars, machine hours, or chosen driver for the same period.
5. Compute the overhead rate
– Apply the formula: overhead ÷ allocation base = overhead rate (dollar/unit or percentage).
6. Apply the rate to products/services
– Multiply the rate by each product’s usage of the allocation base to allocate overhead to that product (e.g., overhead per unit = overhead rate × machine hours per unit).
7. Review and adjust
– Compare budgeted vs. actual, review allocation base relevance, and adjust periodically. Many companies use a predetermined overhead rate for pricing and budgeting (budgeted overhead ÷ budgeted allocation base).
Direct Costs vs. Overhead (Indirect) Costs
– Direct costs: can be traced directly to a product (direct materials, direct labor, manufacturing supplies used on the product).
– Indirect costs (overhead): cannot be traced cleanly to a single product (factory utilities, factory rent, administrative salaries).
Correct classification is essential: misclassifying costs can misstate product cost and profitability.
Examples of Overhead Rates
Example 1: Costs in Dollars
– Overhead: $20,000,000
– Direct labor: $5,000,000
– Overhead rate = 20,000,000 ÷ 5,000,000 = 4.0
Interpretation: For every $1 of direct labor spent, allocate $4 of overhead (or 400%).
Example 2: Cost per Hour
– Overhead: $500,000 (month)
– Machine hours: 30,000 (month)
– Overhead rate = 500,000 ÷ 30,000 = $16.67 per machine hour
Interpretation: Each machine hour used by a product should be charged $16.67 of overhead.
Applied unit-cost example:
– Product consumes 2 machine hours, direct materials $10, direct labor $5.
– Overhead per unit = 2 × $16.67 = $33.34
– Total cost per unit = $10 + $5 + $33.34 = $48.34
Use that total cost as a basis for pricing and margin calculations.
Limitations of the Overhead Rate
– Choice of allocation base matters: a poor base produces misleading costs.
– Overhead rates assume a stable relationship between the base and overhead consumption; this may not hold for complex operations.
– Large companies with many corporate functions will naturally show higher overhead rates than small operations — comparisons should be industry-specific.
– Overhead often includes fixed costs; as production volume changes, per-unit overhead varies, which can distort short-term decision-making.
– For companies with diverse products/processes, single-rate allocation can hide true product profitability; activity-based costing (ABC) may be more accurate.
Practical Steps to Improve Overhead Measurement and Control
– Use the right allocation base: test correlation between candidate drivers and overhead consumption; consider multiple drivers for different overhead pools.
– Consider activity-based costing (ABC) if overhead is large, complex, and not driven by a single activity. ABC allocates overhead to activities, then to products based on activity consumption.
– Use a predetermined overhead rate for quoting/pricing to avoid volatility and to support budgeting. Reconcile budgeted to actual to adjust future estimates.
– Monitor overhead KPIs: overhead per unit, overhead as a percentage of revenue, overhead per labor hour. Track trends and investigate deviations.
– Reduce controllable overhead: renegotiate leases, consolidate facilities, automate office processes, outsource noncore functions, cut unnecessary subscriptions.
– Price products to cover direct costs, allocated overhead, and desired profit margin—regularly validate pricing with updated overhead rates.
When to Use Alternatives
– If overhead is small or costs are nearly all direct, a simple direct-cost approach may suffice.
– Use ABC when overhead costs are significant, indirect cost drivers are diverse, and product mix is complex.
Conclusion
The overhead rate is a fundamental costing tool that allocates indirect costs to products or services using a chosen activity driver. Calculated correctly and reviewed frequently, it helps ensure product pricing covers not just direct costs but a fair share of overhead. Choose relevant allocation bases, consider multiple drivers or ABC for complex operations, and use predetermined rates for budgeting and quoting while reconciling to actuals for accuracy.
Source
– Investopedia, “Overhead Rate,” Madelyn Goodnight. https://www.investopedia.com/terms/o/overhead-rate.asp (accessed for content summary)
Additional Methods to Calculate Overhead Rate
There are several practical ways to calculate and apply an overhead rate depending on the complexity of your operations and the accuracy you need:
– Single (Plantwide) Overhead Rate: One rate applied company-wide. Formula: Overhead rate = Total indirect costs / Total allocation base (e.g., direct labor dollars, direct labor hours, or machine hours). Simple but can distort costs when products use resources very differently.
– Departmental Overhead Rates: Compute a separate overhead rate for each department (e.g., machining, assembly, finishing). Formula for each department: Department overhead rate = Department indirect costs / Department allocation base. More accurate than a single rate when departments use different mixes of resources.
– Activity-Based Costing (ABC): Breaks overhead into activity cost pools and allocates them using activity drivers (e.g., setup hours, inspection hours, number of purchase orders). ABC gives the most accurate product-level overhead but requires more data and maintenance.
Practical Steps to Calculate Your Overhead Rate
1. Define the period. Choose the period for which you’ll measure costs (monthly, quarterly, annually).
2. Identify indirect costs. Sum all overhead costs for that period: rent, utilities, supervisory salaries, maintenance, insurance, depreciation, office expenses, etc.
3. Choose an allocation base (activity driver). Common bases: total direct labor dollars, direct labor hours, machine hours, or a set of activity drivers if using ABC.
4. Measure the allocation base for the same period. Collect the total direct labor hours, machine hours, or direct labor dollars for the period.
5. Compute the overhead rate. Overhead rate = Total indirect costs / Total allocation base.
6. Apply the rate. Multiply the overhead rate by the activity consumed by a product, job, or department to allocate overhead to cost objects.
7. Review and update. Recompute the rate each period or whenever major changes occur in capacity, product mix, or cost structure.
Example 3 — Departmental Overhead Rate
Scenario:
– Machining Department indirect costs (annual): $600,000
– Machining department machine hours (annual): 40,000 hours
– Assembly Department indirect costs (annual): $400,000
– Assembly department direct labor hours (annual): 50,000 hours
Calculations:
– Machining overhead rate = $600,000 / 40,000 machine hours = $15.00 per machine hour
– Assembly overhead rate = $400,000 / 50,000 direct labor hours = $8.00 per labor hour
Application:
If Job A uses 120 machining hours and 80 assembly labor hours:
– Machining overhead allocated = 120 × $15 = $1,800
– Assembly overhead allocated = 80 × $8 = $640
– Total overhead allocated to Job A = $2,440
Example 4 — Activity-Based Costing (ABC) Example
Suppose a company identifies three activity cost pools:
– Machine setups: $150,000; driver = number of setups (3,000 setups)
– Inspections: $90,000; driver = inspection hours (9,000 inspection hours)
– Purchase orders: $60,000; driver = number of purchase orders (6,000 orders)
Activity rates:
– Setup rate = $150,000 / 3,000 = $50 per setup
– Inspection rate = $90,000 / 9,000 = $10 per inspection hour
– Purchase-order rate = $60,000 / 6,000 = $10 per purchase order
If Product X requires 10 setups, 15 inspection hours, and 2 purchase orders:
– Overhead for Product X = (10 × $50) + (15 × $10) + (2 × $10) = $500 + $150 + $20 = $670
How to Use the Overhead Rate
– Pricing and Product Profitability: Add allocated overhead to direct costs when setting prices to ensure full cost recovery and acceptable margins.
– Job Costing and Bidding: Use the overhead rate(s) to estimate total job costs for quotes and bids.
– Budgeting and Forecasting: Project overhead costs and allocation bases to forecast product costs and profitability under different scenarios.
– Performance Measurement: Track overhead per unit of activity (e.g., overhead per machine hour) to measure efficiency improvements over time.
– Make-or-Buy and Capacity Decisions: Understand the full cost impact (including allocated overhead) when evaluating outsourcing or capacity investments.
Strategies to Reduce or Control Overhead
1. Right-size facilities and workforce: Match fixed-cost commitments (office/factory space, salaried headcount) to realistic demand.
2. Improve utilization: Increase machine or labor utilization to spread fixed overhead over more units (reduces overhead per unit).
3. Automate or invest in efficient equipment: Upfront costs may increase depreciation but lower variable overhead and labor costs.
4. Consolidate functions or vendors: Reduce duplicate admin functions or negotiate better procurement terms.
5. Outsource non-core activities: Consider outsourcing HR, payroll, or IT if it reduces overhead cost per unit of activity.
6. Cut wasteful spending: Regularly review subscriptions, utilities, and service contracts for savings.
7. Implement ABC or time-tracking: Gain visibility into high-overhead activities and target them for improvement.
Monitoring, Reporting, and Benchmarking
– Update rates regularly: Recompute overhead rates when costs, output, or product mix changes significantly (at least annually).
– Use dashboards and KPIs: Examples include overhead as a percentage of sales, overhead per machine hour, or overhead per unit.
– Benchmark vs. peers: Compare your overhead percentage to industry averages and similar-sized firms to spot outliers. Note that larger firms often have higher overhead due to corporate functions; compare within your industry and size category.
– Variance analysis: Investigate variances between budgeted and actual overhead to identify controllable drivers.
Common Pitfalls and Limitations
– Misleading allocations: Using a single allocation base (e.g., direct labor dollars) can over- or under-allocate overhead to products that don’t consume that base in proportion to resources.
– Ignoring capacity: Calculating rates using current (possibly low) production can inflate per-unit overhead. Consider using normal capacity or practical capacity for more informative unit costs.
– Seasonal distortions: If activity fluctuates seasonally, compute seasonal rates or use annualized bases to avoid misleading monthly or quarterly rates.
– Overly complex systems: ABC improves accuracy but may be costly to implement and maintain; weigh benefits vs. cost.
– Not including all indirect costs: Omitting relevant overhead items understates product costs and profitability impacts.
FAQ (Short)
– Should overhead be allocated to all products? Yes — if you want full-cost pricing and profitability measurement; however, allocate in a way that reflects resource usage.
– When is ABC worth it? When overhead is large or diverse, and products consume overhead activities in very different proportions.
– Can overhead be negative? No — overhead is a collection of costs; however, allocation bases can change and cause rates to decrease or increase.
Concluding Summary
The overhead rate is a foundational tool for allocating indirect costs to products, jobs, and services so that management can accurately price offerings, assess profitability, and make resource decisions. Simple plantwide rates are easy to compute and may be sufficient for homogeneous operations. Departmental rates and activity-based costing provide greater accuracy for diverse production environments but require more data and effort. To use overhead rates effectively, define the measurement period, identify all relevant indirect costs, choose appropriate allocation bases, compute and apply rates consistently, and update them when business conditions change. Regular monitoring, benchmarking, and targeted cost-control actions can reduce overhead per unit and improve overall profitability.
References
– Investopedia, “Overhead Rate,” Madelyn Goodnight. Source: https://www.investopedia.com/terms/o/overhead-rate.asp
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