How to Calculate an Overhead Rate

Calculate your business overhead allocation rate accurately. Determine how much indirect cost should be assigned to your products or services based on your chosen allocation base.

function updateLabel() { var type = document.getElementById('baseType').value; var label = document.getElementById('baseAmountLabel'); var input = document.getElementById('baseAmount'); if (type === 'labor_cost') { label.innerText = 'Total Direct Labor Cost ($)'; input.placeholder = 'e.g. 20000'; } else if (type === 'labor_hours') { label.innerText = 'Total Direct Labor Hours'; input.placeholder = 'e.g. 1500'; } else if (type === 'machine_hours') { label.innerText = 'Total Machine Hours'; input.placeholder = 'e.g. 500'; } } function calculateOverheadRate() { // Get inputs var indirect = parseFloat(document.getElementById('indirectCosts').value); var baseVal = parseFloat(document.getElementById('baseAmount').value); var type = document.getElementById('baseType').value; var resultArea = document.getElementById('result-area'); var finalRateDisplay = document.getElementById('finalRate'); var summaryDisplay = document.getElementById('calculationSummary'); // Validation if (isNaN(indirect) || isNaN(baseVal)) { alert("Please enter valid numbers for both Indirect Expenses and the Allocation Base."); return; } if (baseVal === 0) { alert("The Allocation Base amount cannot be zero."); return; } // Calculation Logic var rate = 0; var rateText = ""; var formulaText = ""; if (type === 'labor_cost') { // If base is currency (Direct Labor Cost), rate is usually a percentage rate = (indirect / baseVal) * 100; rateText = rate.toFixed(2) + "%"; formulaText = "For every $1.00 of Direct Labor Cost, you incur $" + (indirect / baseVal).toFixed(2) + " in overhead."; } else { // If base is hours (Labor or Machine), rate is Currency per Hour rate = indirect / baseVal; rateText = "$" + rate.toFixed(2) + " per hour"; var hourType = (type === 'labor_hours') ? "Direct Labor Hour" : "Machine Hour"; formulaText = "For every " + hourType + ", you allocate $" + rate.toFixed(2) + " in overhead costs."; } // Output Results resultArea.style.display = "block"; finalRateDisplay.innerText = rateText; summaryDisplay.innerText = formulaText; }

How to Calculate an Overhead Rate

Understanding how to calculate an overhead rate is essential for any business that wants to price its products correctly and understand its true profitability. While direct costs (like raw materials and factory labor) are easy to trace to a specific product, overhead costs are the "hidden" expenses that keep the business running but aren't directly tied to one specific unit of production.

What is an Overhead Rate?

The overhead rate is a cost allocation method used to associate indirect expenses with direct production. It helps you distribute the cost of things like rent, administrative salaries, electricity, and insurance across the goods or services you sell. By applying an overhead rate, you ensure that every product sold contributes its fair share toward paying off these general business expenses.

The Overhead Rate Formula

The standard formula for calculating the overhead rate is straightforward:

Overhead Rate = Total Indirect Expenses / Total Allocation Base

To use this formula, you need two key figures:

1. Total Indirect Expenses: These are costs that cannot be traced directly to a specific product. Examples include factory rent, equipment depreciation, utility bills, and supervisor salaries.
2. Allocation Base: This is the driver used to distribute the costs. Common bases include Direct Labor Cost, Direct Labor Hours, or Machine Hours.

Step-by-Step Calculation Example

Let's look at a practical example of how to calculate an overhead rate for a manufacturing company.

Step 1: Estimate Indirect Costs

The company estimates its total overhead expenses for the year will be $100,000. This includes rent, insurance, and indirect labor.

Step 2: Choose an Allocation Base

Since the company's production is labor-intensive, they decide to use Direct Labor Hours as the base. They estimate 5,000 hours of labor will be worked this year.

Step 3: Apply the Formula

Using the calculator above or manual math:

• $100,000 (Indirect Costs) / 5,000 (Direct Labor Hours) = $20.00 per hour.

This means for every hour an employee works on a product, the company must add $20.00 to the product's cost to cover overhead expenses.

Types of Allocation Bases

Choosing the right allocation base is critical for accuracy. Here is a breakdown of when to use which:

• Direct Labor Cost ($): Best when wage rates vary significantly across employees, but overhead relates closely to the cost of labor. The result is expressed as a percentage (e.g., 150% of labor cost).
• Direct Labor Hours: Best for labor-intensive manual processes where the time spent is the primary driver of resource usage. The result is expressed in dollars per hour.
• Machine Hours: Best for highly automated manufacturing where machinery usage drives costs (electricity, repairs) more than human labor. The result is expressed in dollars per machine hour.

Why Overhead Allocation Matters

Failing to calculate an accurate overhead rate can lead to under-costing or over-costing your products. Under-costing leads to pricing your products too low and losing money on every sale. Over-costing may lead to pricing your products too high and losing market share to competitors.