Overhead Rate

The overhead rate allocates a company’s indirect (overhead) costs to products, services, departments, or projects. Overhead costs are not directly traceable to a single unit of production (for example, rent, utilities, administrative salaries, insurance, and general maintenance). Applying an overhead rate helps determine the full cost of producing goods or services and supports pricing and profitability analysis.

Key takeaways

• The overhead rate expresses how much indirect cost is allocated per unit of an allocation measure (dollars of direct cost, labor hours, machine hours, etc.).
• It helps ensure product or service prices cover both direct and indirect costs.
• Monitoring and managing the overhead rate can improve profitability; however, comparisons should be made within the same industry and company size.

Formula and calculation

Basic formula:
Overhead rate = Indirect costs / Allocation measure
– Indirect costs: total overhead for the chosen period.
– Allocation measure: the activity driver used to allocate overhead (e.g., total direct labor dollars, labor hours, machine hours).

Compute both numerator and denominator for the same period (monthly, quarterly, annually). The result can be expressed as cost per dollar (e.g., $4 of overhead per $1 of direct labor) or cost per unit of activity (e.g., $16.66 per machine hour).

Using the overhead rate

• Add the allocated overhead to direct production costs to estimate the full cost of a product or service.
• Common allocation measures: direct labor hours, machine hours, direct labor dollars, or other activity drivers.
• Overhead often consists of fixed and semi-variable costs that persist regardless of production volume (rent, some utilities, management salaries). If not allocated correctly, pricing may be too low and the business can be unprofitable.
• For more accurate costing, companies may use multiple cost drivers or activity-based costing to reflect different overhead behaviors.

Direct costs vs. overhead

• Direct costs: expenses directly traceable to production (direct labor, direct materials, production-specific wages and supplies).
• Overhead (indirect) costs: expenses not directly attributable to a single product or service.
• The overhead rate spreads indirect costs across products or services based on the chosen allocation measure, enabling fairer cost assignment.

Limitations

• Overhead rates can be misleading if a company has few overheads or most costs are direct.
• Rates vary widely by industry and company size; large firms with corporate functions typically show higher overhead.
• A single allocation measure can oversimplify cost causation. Activity-based methods may be needed for complex operations.
• Seasonal or one-time overheads can distort period-specific rates.

Examples

Example 1 — Cost in dollars
– Indirect costs for the period: $20,000,000
– Direct labor expenses for the same period: $5,000,000
– Overhead rate = $20,000,000 / $5,000,000 = $4
Interpretation: $4 of overhead is allocated for every $1 of direct labor.

Example 2 — Cost per hour
– Indirect costs for the month: $500,000
– Machine hours logged in the month: 30,000
– Overhead rate = $500,000 / 30,000 = $16.66 per machine hour
Interpretation: Each machine hour carries $16.66 of overhead to be covered in pricing.

Conclusion

The overhead rate is a practical tool to allocate indirect costs and support pricing, budgeting, and profitability analysis. Select an allocation measure that reflects how overhead costs are driven; when operations are complex, consider multiple drivers or activity-based costing to improve accuracy. Regularly review overhead components and rates to maintain effective cost control.