What Is Overhead Rate and Why Should Your Business Be Tracking It?

What is the overhead rate?

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.

Overhead rate formula

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 the best 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.

Examples of overhead allocation measures

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)]

Overhead rate allocation measures comparison

Direct labor

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. 

Machine hours

The total hours 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 run or units they produce.

Sales

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.

Overhead rate vs. direct costs

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 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.

How to calculate overhead rate

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:

• Machine hours: Let’s say the company ran its machines for 4,000 hours over the course of the year. If the company uses machine hours as its allocation measure, then its overhead rate for the year would be $58.75 per machine hour.
• Direct labor costs: The company could also establish its overhead rate by dividing administrative costs by direct costs. In this case, the overhead rate would be 1.31 ($235,000 divided by $180,000). This informs the company that it’s paying more in indirect costs than direct labor costs associated with this particular product line, revealing administrative costs could be getting too top-heavy.
• Total sales: Let’s say the company had $1 million in gross sales for the year. In that case, the overhead rate for the business would be 23.5%. This would serve as an indicator for the company of how much of its sales are going to non-revenue-producing activities. This is especially useful when company leaders want to focus on growing profit margins.

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.