How is Overhead Rate Calculated

Overhead Rate Calculator

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Rent, utilities, administrative salaries, insurance, etc.

$

The driver used to assign costs (e.g., Total Direct Labor Costs).

$

Enter the direct cost of a specific job to calculate its overhead burden.

Please enter valid positive numbers for Indirect Costs and Allocation Base.

How Is Overhead Rate Calculated?

Calculating the overhead rate is a critical accounting process that allows businesses to allocate indirect costs to the products or services they produce. Unlike direct costs (like raw materials or labor specifically for a product), overhead costs cannot be traced directly to a single unit of output. The overhead rate bridges this gap.

The Basic Formula

To calculate the overhead rate, you divide the total indirect costs by a specific allocation measure (often called the allocation base) for a set period. The standard formula is:

Overhead Rate = Total Indirect Costs / Total Allocation Base

Step-by-Step Calculation Process

1. Identify Total Indirect Costs (Numerator)

First, sum up all expenses that are not directly tied to production but are necessary for the business to operate. These typically include:

• Rent or mortgage payments for the facility
• Utilities (electricity, water, heating)
• Administrative and supervisor salaries
• Depreciation on machinery
• Factory insurance and property taxes

2. Select the Allocation Base (Denominator)

The allocation base is the driver used to distribute the overhead costs. It should be a measure that correlates with how overhead is incurred. Common bases include:

• Direct Labor Cost: Best for labor-intensive industries.
• Direct Labor Hours: Used when hourly wages vary significantly.
• Machine Hours: Best for automated or heavy manufacturing environments.
• Direct Material Cost: Used when materials are the primary cost driver.

3. Divide and Convert

Divide the total indirect costs by the total allocation base. The result is a ratio. To express this as a percentage, multiply by 100.

Calculation Example

Imagine a furniture manufacturing company with the following monthly data:

• Total Indirect Costs: $50,000 (Rent, Utilities, Admin)
• Total Direct Labor Cost: $200,000

Using the formula:

$50,000 / $200,000 = 0.25

This means the overhead rate is 25%. For every $1.00 spent on direct labor, the company incurs an additional $0.25 in overhead costs.

Applying the Rate to a Specific Job

Once you have the rate, you can estimate the total cost of a specific project. If a custom table requires $1,000 in direct labor, you would calculate the allocated overhead as follows:

$1,000 (Direct Labor) × 0.25 (Overhead Rate) = $250 (Allocated Overhead)

The total cost for the table would be $1,000 + $250 = $1,250.

Why Is This Important?

Accurate overhead calculation ensures that:

• Pricing is profitable: If you ignore overhead, you might underprice your products and lose money.
• Budgeting is accurate: It helps in forecasting future expenses based on projected production levels.
• Efficiency is monitored: A rising overhead rate might indicate that indirect costs are growing faster than production volume.