April 26, 2021 By SmartBiz Team

The better a business manages overhead costs, the more competitive and successful they are in the marketplace.

Overhead costs are necessary expenses paid to keep your business running, like utilities and taxes. These are indirect costs, not related to specific business activities that generate money.

Having a solid accounting of your overhead helps you set a better price for your products or services, shows where you can save, and can even reveal ways to streamline your operations. Below, we’ll introduce you to overhead rates before walking you through how to calculate overhead.

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What Are Overhead Rates?

Overhead rates reflect all the indirect expenses you must pay to create and offer your products or services. As such, overhead rates reflect the rent you pay for your office space, the utilities you pay to keep your office space comfortably running, and your company’s insurance plans.

Note that overhead rates are not the same as overhead costs, which are the dollar amounts you spend on indirect expenses (i.e., all expenses that aren’t direct labor, raw material, or manufacturing costs). Instead, overhead rates are your total overhead costs divided by the total number of machines, sales, or labor hours required to produce the product. Whichever factor you divide by is called your allocation measure.

Given the above, you can express overhead rates via the following formula:

Overhead rate = total overhead costs/allocation measure

You should also note that overhead costs are either fixed or variable. Fixed costs are independent of production – office rent is a great example, as your rent does not change if you produce more or less. Variable costs depend on production – for example, if your production process is energy-intensive, then your electric bill may increase as you produce more goods.

Examples of Overhead Rates

Below are mathematical examples of how to calculate overhead rates:

1. Direct labor overhead rates

If your overhead costs total $500,000 during a certain time period and your direct labor costs total $375,000 during this period, your direct labor overhead rate is:

$500,000/$375,000 = 1.33

This ratio signifies that every dollar of direct labor costs generates $1.33 in total overhead costs.

2. Machine-hours overhead rates

For the same $500,000 in overhead costs, if your machine hours cost $400,000, then in dividing your total overhead by your machine hour costs, you calculate a machine-hours overhead rate of:

$500,000/$400,000 = 1.25

This ratio signifies that every dollar of machine-hour costs generates $1.25 in total overhead costs.

3. Sales overhead rates

Again using $500,000 in overhead costs, if you generate $750,000 in sales during this month, your sales overhead rate is:

$500,000/$750,000 = 0.66

This ratio signifies that for every dollar your company earns, you spend $0.66 on overhead.

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Steps to Calculate Overhead

Now that you understand the basics of overhead rates, below is an in-depth guide on how to calculate your overhead rates.

1. List All Business Expenses

Include overhead costs like rent, utilities, taxes, and building maintenance. Other expenses that are considered overhead include inventory, raw materials, and labor costs.

2. Classify Each Overhead Expense

Categorize each item on your list of expenses as direct or indirect costs. There are three types of overhead costs: fixed, variable, and semi-variable.

For example, if you manufacture coffee mugs, the shop floor labor and cost of raw materials are direct costs since they incur when the cups are being created.

Indirect costs are often referred to as the “real cost of doing business.” Indirect costs go beyond the direct costs. Examples include utilities, office equipment rental, computers, and mobile phones. Other common indirect costs include advertising and marketing, accounting, and payroll services.

Another example of an indirect labor cost would be an assistant who helps run the office but isn’t assigned to creating a specific product.

Indirect costs can be both fixed and variable. The majority of direct costs are variable as they change when additional units of a product or service are created.

Costs can also be categorized as semi-variable, also known as a semi-fixed cost or a mixed cost. It’s a cost composed of a mixture of both fixed and variable components.

Keep in mind that some items don’t fall easily into one category or the other, so you need to make your best guess.

3. Total the Overhead Costs

Most business owners find monthly is the most useful time period to calculate. Add all of the overhead costs for the month to calculate the total overhead cost.

4. Compare Overhead to Sales

Divide your monthly overhead cost by monthly sales, and multiply by 100 to find the percentage of overhead cost.

For example, a business with monthly sales of $900,000 and overhead costs totaling $225,000 has ($225,000/$900,000) * 100 = 25 percent overhead.

It’s important to know the percentage of each dollar that goes to overhead. In the example above, twenty-five cents of every dollar goes to overhead. This helps you allocate costs when you create a budget and set prices. The lower your overhead percentage (rate), the larger your profit.

5. Compare Overhead to Labor Cost

Calculate overhead cost as a percentage of labor cost. This measure is useful as an estimate of how efficiently resources are utilized. Divide the monthly labor cost into the total overhead cost for the month and multiply by 100 to express it as a percentage.

The lower the percentage, the more effectively your business is utilizing its resources.

Advantages of Overhead Rates

Among the advantages of regularly calculating overhead costs and rates are:

  • Tax deductions . Your company can deduct all its manufacturing overhead costs from its taxes. Although you can deduct most overhead costs during the year that you incur them, you must depreciate equipment costs over several years.
  • Absorption costing . If you factor the number of direct labor hours, production costs and other overhead allocation rates into how you price your goods and services, you may be able to entirely cover your costs with your sales revenue. Don’t make the common mistake of setting your prices based solely on labor and machinery – rent, utilities, insurance, and all your other indirect costs influence your sale prices too.

Limitations of the Overhead Rate

According to Investopedia , the overhead rate (percentage) has limitations when applied to businesses with few overhead costs or when costs are mostly tied to production. Also, it's important to compare the overhead rate to companies within the same industry and roughly the same size. A larger business will have a higher overhead rate than one that's smaller and with less indirect costs.

Additional limitations of using overhead rates to understand and control your company’s finances are:

  • The effect of rising prices . With inflation, running a business means ever-increasing indirect costs. As such, to remain profitable, you may need to increase your sale prices. However, there may come a point past which raising your prices decreases your number of potential customers. In turn, you may find yourself with less money for handling the overhead expenses that first posed this problem.
  • Overhead costs existing outside manufacturing times. Even when you’re not producing your products, overhead costs don’t go away. You pay rent for your office space even on weekends, and you pay for heat 24/7 to keep your pipes from freezing during the winter. As such, you often need to spend money when you’re not producing the items that earn you this money in the first place. This arrangement leads to less cash flow and lower profit margins. That said, if you adequately account for this limitation, business success remains possible.
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