How to Calculate Overhead Application Rate
In managerial accounting and cost accounting, understanding the true cost of a product or service is vital for pricing, profitability analysis, and budgeting. While direct costs like materials and labor are easy to trace, overhead costs (indirect costs) require a systematic method of allocation. This is where the Overhead Application Rate (OAR), also known as the Predetermined Overhead Rate, becomes essential.
The Overhead Application Rate is a ratio used to assign estimated overhead costs to cost objects (like products or jobs) based on a specific activity base, such as labor hours or machine hours.
function updateBaseLabel() { var type = document.getElementById("allocationBaseType").value; var label = document.getElementById("baseLabel"); if (type === "dlh") { label.innerText = "Total Estimated Direct Labor Hours"; } else if (type === "mh") { label.innerText = "Total Estimated Machine Hours"; } else if (type === "dlc") { label.innerText = "Total Estimated Direct Labor Cost ($)"; } else if (type === "dmc") { label.innerText = "Total Estimated Direct Material Cost ($)"; } else if (type === "units") { label.innerText = "Total Estimated Units Produced"; } } function calculateOAR() { // Get inputs var overheadCost = parseFloat(document.getElementById("totalOverhead").value); var baseAmount = parseFloat(document.getElementById("baseAmount").value); var baseType = document.getElementById("allocationBaseType").value; var errorDiv = document.getElementById("errorMsg"); var resultDiv = document.getElementById("result-container"); var percentRow = document.getElementById("percentRow"); // Validate inputs if (isNaN(overheadCost) || isNaN(baseAmount) || overheadCost < 0 || baseAmount <= 0) { errorDiv.style.display = "block"; resultDiv.style.display = "none"; return; } errorDiv.style.display = "none"; // Calculate Rate var rate = overheadCost / baseAmount; var formattedRate = ""; var basisText = ""; var formulaText = ""; var isCostBasis = (baseType === "dlc" || baseType === "dmc"); // Format Logic if (baseType === "dlh") { formattedRate = "$" + rate.toFixed(2) + " per Direct Labor Hour"; basisText = "Direct Labor Hours"; } else if (baseType === "mh") { formattedRate = "$" + rate.toFixed(2) + " per Machine Hour"; basisText = "Machine Hours"; } else if (baseType === "units") { formattedRate = "$" + rate.toFixed(2) + " per Unit"; basisText = "Units Produced"; } else if (isCostBasis) { // For cost bases, it is often expressed as $ per $ or as a percentage formattedRate = "$" + rate.toFixed(2) + " per $1 of Base Cost"; basisText = baseType === "dlc" ? "Direct Labor Cost" : "Direct Material Cost"; } // Display results document.getElementById("rateResult").innerText = formattedRate; document.getElementById("basisResult").innerText = basisText; // Formula breakdown text formulaText = "$" + overheadCost.toLocaleString() + " ÷ " + baseAmount.toLocaleString() + " " + basisText + " = " + rate.toFixed(4); document.getElementById("formulaBreakdown").innerText = formulaText; // Percentage Logic for dollar-based allocation if (isCostBasis) { percentRow.style.display = "flex"; var percentage = (rate * 100).toFixed(2) + "%"; document.getElementById("percentResult").innerText = percentage; } else { percentRow.style.display = "none"; } resultDiv.style.display = "block"; }Why Calculate an Overhead Application Rate?
Manufacturing and service companies incur costs that cannot be directly traced to a specific unit of production. These include factory rent, electricity, supervisor salaries, and equipment depreciation. To ensure that each product is priced correctly to cover these expenses, accountants use the Overhead Application Rate to distribute these costs fairly.
Key Terminology
- Allocation Base: The metric used to link overhead costs to products (e.g., hours worked, machine time).
- Predetermined Overhead Rate: A rate calculated before the period begins, based on estimates.
- Applied Overhead: The amount of overhead cost assigned to products using the rate.
The Formula
The standard formula for calculating the predetermined overhead rate is:
Overhead Rate = Total Estimated Overhead Costs / Total Estimated Allocation Base
Choosing the Right Allocation Base
The accuracy of your costing depends heavily on choosing a base that actually drives costs (a "cost driver").
- Labor Intensive: If your production relies heavily on manual work, use Direct Labor Hours or Direct Labor Cost.
- Automated: If your production is heavily automated, use Machine Hours.
- Material Heavy: If overhead fluctuates with the cost of materials purchased, use Direct Material Cost.
Example Calculation
Imagine a furniture factory, "Quality Woods Inc." They estimate the following for the upcoming year:
- Total Estimated Overhead Costs (Rent, Electricity, Glue, etc.): $200,000
- Total Estimated Direct Labor Hours: 10,000 hours
Using the calculator above:
- Input 200000 into Overhead Costs.
- Select Direct Labor Hours.
- Input 10000 into the Base Amount.
Result: $20.00 per Direct Labor Hour. This means for every hour a carpenter works on a chair, the company must add $20 to the cost of that chair to cover overhead expenses.
Common Mistakes to Avoid
When calculating overhead rates, ensure you distinguish between estimated figures and actual figures. The predetermined rate is calculated at the beginning of the year using estimates. At the end of the year, you will compare the Applied Overhead (Rate × Actual Activity) with the Actual Overhead Costs to determine if you have over-applied or under-applied overhead.