What Is the Overhead Rate?
Let me explain the overhead rate directly: it's a cost you allocate to producing a product or service. Overhead costs are those expenses not directly linked to production, like the corporate office bills. To handle these, you apply an overhead rate to the direct costs of production, spreading out the overhead based on specific measures.
For instance, you might apply overhead at a set rate using the machine hours or labor hours needed for the product.
Key Takeaways
- Overhead rate is a cost allocated to the production of a product or service. Overhead costs are expenses that are not directly tied to production such as the cost of the corporate office.
- By analyzing how much it costs in overhead for every hour the machine is producing the company's goods, management can properly price the product to make sure there's enough profit margin to compensate for its indirect costs.
- A company that excels at monitoring and improving its overhead rate can improve its bottom line or profitability.
Overhead Rate Formula and Calculation
You can calculate the overhead rate in various ways, but here's the basic formula: Overhead rate = Indirect costs / Allocation measure.
Remember, indirect costs are the overhead or expenses not directly tied to producing a product or service. The allocation measure is whatever measurement is needed for production, such as direct labor hours or machine hours for a product or period.
This calculation is based on a specific period. If you're figuring indirect costs for a week, total your weekly overhead costs. Then, measure what's used in production for that week, like total direct labor costs. Divide the indirect costs by that measure to get the overhead per dollar of direct labor for the week.
Using the Overhead Rate
You use the overhead rate to add indirect costs to the direct costs of production, giving a clearer view of each product's profitability. In complex scenarios, you might combine several cost drivers to estimate overhead.
Overhead expenses are usually fixed, incurred regardless of production levels—like rent, utilities, insurance, supplies, maintenance, administrative salaries, and other fees under selling, general, and administrative expenses. If a cost isn't directly tied to a revenue-generating product or service, it's overhead or an indirect expense.
It's tough to pinpoint exactly how much overhead goes to each production process, so you estimate using the overhead rate per cost driver or activity. Include these indirect costs in pricing to avoid losses—if prices are too low to cover overhead, your business won't profit.
Direct Costs vs. the Overhead Rate
Direct costs are those directly linked to producing a product or service, easily traced to cost objects like goods, services, departments, or projects. These include direct labor, materials, manufacturing supplies, and production wages.
The overhead rate, in contrast, allocates indirect costs to these direct costs by spreading them based on direct cost dollars, total labor hours, or machine hours.
Limitations of the Overhead Rate
The overhead rate isn't perfect for companies with low overhead or costs mostly tied to production. Also, compare it only to similar companies in your industry—a large firm with a corporate office and HR will have a higher rate than a smaller one with fewer indirect costs.
Examples of Overhead Rates
The overhead rate equation is indirect costs divided by direct costs or your chosen measure. Direct costs could be labor, machine costs, or materials, all in dollars, and each is an activity driver or allocation measure.
Example 1: Costs in Dollars
Suppose a company has $20 million in overhead for a period and $5 million in direct labor costs. Divide $20 million by $5 million to get an overhead rate of $4, meaning $4 in overhead per dollar of direct labor.
Example 2: Cost per Hour
If overhead is $500,000 for a month with 30,000 machine hours, divide to get $16.66 per hour. This shows $16.66 in overhead per machine hour, helping you price products to cover indirect costs plus direct ones like labor, electricity, and materials. Excelling at this improves profitability.
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