The overhead rate is a cost accounting term that refers to an amount that a business uses to allocate or apply indirect costs (overhead costs) to products or services. The overhead rate is typically calculated as a ratio of estimated overhead expenses to an estimated allocation base over a specific period of time.
Overhead costs include expenses like rent, utilities, administrative salaries, and insurance – essentially, the costs of running a business that cannot be directly attributed to the production of goods or services.
The allocation base can vary depending on the business and its operations. Common allocation bases include direct labor hours, machine hours, or direct labor costs – essentially, something that is expected to have a direct relationship with the overhead costs incurred.
The formula to calculate the overhead rate is:
Overhead Rate = Total Overhead Costs / Total Allocation Base
For example, if a company estimates $500,000 in overhead costs for the year and 50,000 direct labor hours, the overhead rate would be $10 per direct labor hour ($500,000 / 50,000 hours). This means that for every hour of direct labor used in production, the company will allocate $10 in overhead costs to the product or service being produced.
The overhead rate is used to apply overhead costs to products or services, which helps businesses determine the total cost of production and set prices accordingly. It’s important to note that this process involves estimation, and the actual overhead costs and allocation base may differ from the estimates. This can result in overapplied or underapplied overhead, which needs to be adjusted at the end of the accounting period.
Example of the Overhead Rate
ABC Widget Co. is a manufacturer that has various overhead costs, including rent, utilities, administrative salaries, insurance, and more. To accurately cost their widgets, they need to allocate these overhead costs to each widget produced.
At the beginning of the year, ABC Widget Co. estimates their annual overhead costs to be $200,000. They also estimate that they will have 20,000 machine hours for the year, as their production process is largely automated and machine hours are a significant driver of their overhead costs.
Therefore, they calculate their overhead rate as follows:
Overhead Rate = Total Overhead Costs / Total Machine Hours
Overhead Rate = $200,000 / 20,000 hours
Overhead Rate = $10 per machine hour
So, ABC Widget Co. will apply $10 of overhead costs to the production of widgets for each machine hour used.
Now, let’s say it takes 2 machine hours to produce one widget. Therefore, using their overhead rate, ABC Widget Co. would apply $20 in overhead costs to each widget ($10 per machine hour * 2 hours). This overhead cost would then be added to the direct materials and direct labor costs to determine the total cost of producing each widget.
It’s important to note that the overhead rate is based on estimates, and the actual overhead costs and machine hours may differ from these estimates. At the end of the year, ABC Widget Co. would need to adjust for any overapplied or underapplied overhead based on the actual costs and hours incurred.