Overhead consists of all indirect costs for a specific time period. Indirect costs are those not specifically or exclusively associated with a particular project or event: they would exist whether or not a project is in place. They include costs such as salaries for production managers, equipment maintenance, depreciation on equipment, rent, office supplies, and utilities. The purpose of calculating overhead rate is essentially to spread these costs proportionately over each project or contract.

Let’s discuss this in more detail. We’ve already defined overhead, so let’s define allocation base. An allocation base is the measure you use to quantify each project. It is always a direct cost, meaning it should pertain specifically to each project and vary accordingly. Examples of allocation base include direct labor hours, machine hours, kilowatt hours, or square footage. The most commonly used allocation base is direct labor hours. This includes the total hours for all employees involved in the creation of a product or delivery of a service.

For example, if your company’s overhead is \$100,000 and the total direct labor hours to create a product was 5,000, then your overhead rate for that project would be \$20 per direct labor hour.

• \$100,000/5,000 direct labor hours =\$20/direct labor hour

This can also be calculated in terms of direct labor cost as the allocation base. If we assume that each employee is paid \$10/hour and we maintain the 5,000 direct labor hours from above, then the total direct labor cost is \$50,000 (\$10*5,000 hours). Now, remember that your company’s overhead is \$100,000. This means that your overhead rate is 2 (\$100,000/\$50,000=2), meaning that for every \$2 you spend on indirect costs (overhead), you spend \$1 on direct costs. You have a 2-to-1 ratio of indirect costs to direct costs.

There are several reasons why calculating your business’s overhead rate is extremely important, both for managing your business internally and for providing information externally. First of all, according the U.S. Generally Accepted Accounting Principles (GAAP) it is required for a business to apply all manufacturing costs, including indirect costs, to its inventory on hand by the end of the reporting period.

Additionally, overhead is important in determining the costs of products. If only direct costs are used to determine the price of a product, you are not truly getting an accurate representation of how much it cost your business to produce the product. The price should be determined by including indirect costs to ensure you don’t underprice the product.

Overhead can also be used to determine your company’s break-even point in production. The break-even point is when your company’s revenue equals all of its expenses. Break-even can be calculated as overhead rate + 1. So, if your overhead rate is 2, then your break-even point is 3, and you must earn \$3 in revenue for every \$1 in costs in order to break even.