Overhead rate is a ratio of a business’s administrative costs relative to some other input or sales volume. This rate is calculated by totaling a company’s indirect costs (also called burden) – costs that can’t be allocated to a single activity or line of business – and dividing them by some other metric – typically direct costs, machine hours or gross sales.
Overhead rate is important to track so you know how much your business is spending on back-office costs relative to expenses for profit-producing activities. Only by tracking your overhead rate can you gauge whether your indirect costs are excessive relative to the size and scope of your business. [Read related article: Direct Costs vs. Indirect Costs]
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A company’s overhead rate is its cost not of producing a product or service, but of simply staying in business, divided by some other metric (or allocation measure). The business’s overhead includes all of its expenses on its income statement, except those that are directly connected to manufacturing a product or service.
Overhead rate represents the ratio of company overhead – rent and other administrative costs – to direct cost, sales, or other inputs, such as machine hours. It provides company owners and managers with an indication of indirect costs compared to, for example, its direct costs of manufacturing or gross sales.
To calculate your company’s overhead rate, you start by adding up all of its indirect costs. These are costs not directly tied to a certain activity or product line and include things like rent, utilities, office supplies, and salaries for administrative staff. You can do all of this pretty easily with good small business accounting software, but you should know what the system is doing before you try it on your own.
Once indirect costs are totaled, the sum is divided by some allocation measure. This can be a measure of those costs that are directly allocable to particular activities or product lines, the company’s total sales, or some other measure.
Indirect costs / Allocation measure = Overhead rate
A company can measure its indirect costs relative to several different metrics in order to achieve its overhead rate. Two of the most common are sales and direct costs. Which metric to use is based on what is most insightful for a specific business. The goal is to compare indirect costs to some other measure so that it can be calculated and tracked objectively. [Read related article: How to Calculate Cost of Goods Sold (COGS)]
|Direct labor||Agricultural and other operations that have labor dedicated to various product lines|
|Machine hours||Large manufacturers and industrial companies|
|Sales||Companies with a narrow scope or just a few product lines|
One way to measure overhead rate is to divide overhead costs by total direct labor costs. These are the costs directly associated with production of a certain good or service. For many companies, this won’t be a very telling metric, but it can be important for companies like packing plants, agricultural operations and manufacturers with multiple dedicated product lines.
Total hours that a company runs its machines over a period can also be an allocation measure for establishing overhead rate. Using this accounting method, a company can measure and track its dollars of overhead per hour of machine runtime. This is an ideal method for big manufacturers – especially those that depreciate their equipment based on the number of hours they’re run or units they produce.
Of the three, sales is perhaps the most applicable allocation measure for the largest number of companies. Using this metric, companies can compare their administrative expenses to gross sales of products or services. By tracking overhead as a percentage of total sales, companies can judge whether their non-revenue-producing activities are too large compared to their gross revenues. And they can more easily gauge how sales volume will impact their profitability.
Measuring overhead rate involves separating indirect costs from direct costs, and several measures of overhead rate are actually ratios of one against the other. To understand overhead rate, you first need to understand what direct costs are and how they work. Direct costs are expenses incurred by a company that are related to individual productive activities of the company, such as the costs for running a particular manufacturing line or offering a particular service.
When you calculate your company’s overhead rate, you first have to separate all of these costs tied to particular product lines, so you’re left with your total costs that aren’t tied to individual activities. These are your total indirect costs (the costs of simply staying in business), including things like office supplies, rent, utilities and salaries for administrative staff.
To see how overhead rate is calculated, let’s consider an example.
Let’s say there’s a manufacturing company that makes one line of products. The business pays $25,000 in annual rent; $10,000 in utilities; $100,000 for materials to manufacture its products; $15,000 for machine maintenance; $18,000 for packaging and transportation for its products; $200,000 in salaries and benefits to administrative staff; and $180,000 in hourly pay to workers in its plant.
In this example, the company’s total indirect (overhead) costs for the year would be $235,000 ($200,000 + $10,000 + $25,000), since the rest of the costs listed above are allocable specifically to the company’s product line. In other words, if the company stopped producing its product tomorrow, it would stop incurring those costs immediately, but it’d still have $235,000 in business expenses if it wanted to stay operational.
Once we’ve totaled the administrative costs, we can determine overhead rate by comparing overhead costs to a number of metrics. Here are some potential ways we could calculate overhead rate for the company:
While each of these overhead rates is different, a business can use any of them, depending on which one will provide the most useful insight and allow management to make the best business decisions.
Accounting software makes it easy to calculate your overhead rate and track it over various time frames.
Overhead rate is important for businesses to measure and track so they can gauge how their administrative costs are evolving over time and whether their business is overburdened with administrative costs rather than profit-producing activities. This also helps them know how much to charge for their products and establish a breakeven point in terms of output.
It’s good for business owners and managers to calculate and track overhead rate annually or semiannually, or even quarterly. If your business is growing very quickly or regularly changing activities or product lines, you may want to calculate even more frequently. Assuming your business isn’t changing too quickly, though, quarterly or semiannually is probably sufficient.
There are two big ways to lower your business’s overhead rate. One is to cut administrative costs. This can be effective, but it can also backfire. There’s the potential for managers to be penny-wise and pound-foolish, cutting corners unnecessarily and leading to even bigger problems.
The other big way to cut overhead rate is to grow. More activity spreads fixed costs. So, while costs don’t go down, the overhead rate is effectively diluted downward.