What is the overhead rate?
Sunday, October 31, 2010 at 5:48AM The overhead rate is the total of indirect costs (known as overhead) for a specific reporting period, divided by an allocation measure. The cost of overhead can be comprised of either actual costs or budgeted costs. There are a wide range of possible allocation measures, such as direct labor hours, machine time, or square footage used.
A company uses the overhead rate to allocate its indirect costs to products or projects, so that it can price them appropriately to cover all of its costs and thereby generate a profit. If the overhead rate is not included in the cost of a product, then there is a risk that the company will significantly underprice its products or services, and eventually go bankrupt.
The overhead rate can be expressed as a proportion, if both the numerator and denominator are in dollars. For example, ABC Company has total indirect costs of $100,000 and it decides to use the cost of its direct labor as the allocation measure. ABC incurs $50,000 of direct labor costs, so the overhead rate is calculated as:
$100,000 Indirect costs
$50,000 Direct labor
The result is an overhead rate of 2.0.
Alternatively, if the denominator is not in dollars, then the overhead rate is expressed as a cost per allocation unit. For example, ABC Company decides to change its allocation measure to hours of machine time used. ABC has 10,000 hours of machine time usage, so the overhead rate is now calculated as:
$100,000 Indirect costs
10,000 Machine hours
The result is an overhead rate of $10.00 per machine hour.
A company with low indirect costs will have a lower overhead rate, which makes it more competitive with other firms that must apply a larger amount of overhead cost to their products and services.
Similar Terms
Overhead rate is also known as the predetermined overhead rate when budgeted information is used to calculate it.
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