The burden rate is the allocation rate at which indirect costs are applied to the direct costs of either labor or inventory. You should add burden to the direct cost of either labor or inventory when you want to present the total absorbed cost of these items.
The two situations in which the burden rate is used are:
- Labor. Payroll taxes and benefits are added to an employee's wages to arrive at the total cost of labor for that individual. The burden rate is the dollar amount of burden (i.e., overhead) that is applied to one dollar of wages. For example, if the annual benefits and payroll taxes associated with an individual is $20,000 and his wages are $80,000, then the burden rate is $0.25 per $1.00 of wages.
- Inventory. Manufacturing overhead costs are added to the direct material and direct labor costs of an inventory item to arrive at the total cost (the fully burdened cost) of that item. This type of burden is sometimes applied based on the amount of direct labor cost charged to a product, but may use some other measure, such as the amount of machine time used. For example, if the amount in the manufacturing overhead cost pool is $10,000 and there are a total of 1,000 hours of machine time used by all products, then the burden rate is $10.00 per machine hour used.
The formula for calculating labor burden is:
Labor burden cost ÷ Payroll cost
The formula for calculating inventory burden is:
Manufacturing overhead cost ÷ Activity measure
It is particularly important to include the burden rate when reporting on the full cost of labor, because some benefit packages can increase the total cost of labor to a point even 50% greater than the cost that is initially indicated by an examination of payroll records. This information is useful when deciding whether to outsource operations to low-cost labor regions, as well as to decide whether to lay off employees. The burden rate concept is especially worthwhile in situations where the bulk of a company's business comes from directly billable hours, where you need to be as precise as possible in tracking profits by person.
The association of burden with inventory is required by the accounting standards (including Generally Accepted Accounting Principles and International Financial Reporting Standards), so that the full cost of inventory is reported in a company's balance sheet. This information is of less use for internal decision-making purposes, where managers typically use direct costs instead.
The burden rate is also known as factory overhead, manufacturing burden, and indirect production costs when used in regard to inventory. The burden rate is also known as labor burden when used in regard to labor.