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, and square footage used. A company uses the overhead rate to allocate its indirect costs of production to products or projects for one of two reasons, which are:
It can price them appropriately to cover all of its costs and thereby generate a long-term 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.
It must allocate costs to its inventory on hand at the end of the reporting period, as required under both Generally Accepted Accounting Principles and International Financial Reporting Standards. The result is fully-loaded inventory costs that it reports on its balance sheet.
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 = 2:1 Overhead rate
The result is an overhead rate of 2:1, or $2 of overhead for every $1 of direct labor cost incurred.
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 = $10.00 per machine hour
It is possible to have several overhead rates, where overhead costs are split into different cost pools and then allocated using different allocation measures. For example, fixed benefit costs could be allocated based on the cost of direct labor incurred, while equipment maintenance costs could be allocated based on machine hours used. This approach results in more fine-tuned allocations, but is more time-consuming to compile.
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.
Overhead rate is also known as the predetermined overhead rate when budgeted information is used to calculate it.