Sum of rent, utilities, insurance, admin salaries, etc.
Direct Labor Cost ($)
Direct Labor Hours
Machine Hours
$
Overhead Rate:–
Interpretation:–
How to Calculate the Overhead Rate
Understanding how to calculate the overhead rate is essential for accurate product pricing and budgeting. The overhead rate (or burden rate) allows businesses to allocate indirect costs to direct production activities, ensuring that every product sold covers not just the materials and labor used to make it, but also the rent, electricity, and administrative support required to run the business.
The Overhead Rate Formula
The standard formula for calculating the predetermined overhead rate is dividing your estimated total indirect costs by a specific allocation base.
Overhead Rate = Total Indirect Expenses / Allocation Base
Where:
Total Indirect Expenses: Costs that cannot be traced directly to a specific product (e.g., factory rent, utilities, equipment depreciation).
Allocation Base: A measure of activity used to assign costs, such as Direct Labor Cost, Direct Labor Hours, or Machine Hours.
Step-by-Step Calculation Guide
Follow these steps to determine your overhead rate:
Identify Indirect Costs: Sum up all expenses for the period that are not direct labor or direct materials. This includes indirect labor, supplies, repairs, taxes, and insurance.
Select an Allocation Base: Choose the metric that drives your overhead costs.
If your process is labor-intensive, use Direct Labor Hours or Direct Labor Cost.
If your process is automated, use Machine Hours.
Determine the Total Base Amount: Calculate the total amount of the allocation base for the same period (e.g., total machine hours projected for the year).
Divide: Divide the total indirect costs by the total base amount.
Example Calculation
Imagine a manufacturing company, "Precision Parts Inc.", with the following annual projections:
Total Indirect Overhead Costs: $150,000
Total Direct Labor Costs: $100,000
Using Direct Labor Cost as the base:
$150,000 / $100,000 = 1.50 or 150%
This means for every $1.00 spent on direct labor, the company must add $1.50 to the product cost to cover overhead expenses.
Why is the Overhead Rate Important?
Calculating the overhead rate accurately helps in:
Pricing Strategy: Ensures prices are high enough to generate profit after covering all indirect expenses.
Budgeting: Helps managers forecast cash flow needs based on production volume.
Efficiency Analysis: Monitoring the rate over time can indicate if overhead costs are growing faster than production output.
Choosing the Right Allocation Base
The accuracy of your overhead rate depends heavily on the allocation base selected:
Direct Labor Cost ($): Best when wage rates are uniform, and overhead is driven by workforce costs. Result is usually a percentage.
Direct Labor Hours: Ideal when skill levels and wage rates vary significantly. Result is a dollar amount per hour.
Machine Hours: The standard for highly automated environments where machinery depreciation and power usage drive costs. Result is a dollar amount per hour.
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