Calculating overhead rates can seem complicated and intimidating on the surface. However, knowing your company’s overhead rate is an important part of understanding your business, and it’s really not as complicated as it seems. Overhead covers operating expenses not directly related to a specific project or client. Having a favorable overhead rate can make your business more competitive with others in the same field and help you appear more desirable when bidding for contracts. Tweet This It can also help you determine accurate pricing for the products and services your business provides, as well as reveal your break-even point in production.
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.
The formula for overhead rate is overhead divided by allocation base. It looks like this: Overhead Rate = Overhead/Allocation Base
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.
Lowering your overhead rate
What if you are told by a government agency or other potential business partner that your overhead rate is too high? How can you lower it? The best way to lower your overhead rate is to decrease your overhead costs, and there are many ways to accomplish this. One is by making sure to review yearly contracts before automatically renewing them, including your insurance policy and your contracts with your suppliers. There may be an opportunity to negotiate cheaper prices on goods or get a better rate on your insurance. If your current suppliers aren’t willing to negotiate, other companies might be more flexible in order to get your business.
Perhaps the rent on your factory or office building is too high and it might be worth relocating to a lower rent area or trying to renegotiate your lease. Talk to your department heads about how goals can be achieved more efficiently within their department. They may have some good ideas around where to cut costs.
Lower overhead costs make you more competitive with other businesses when you bid for contracts or try to enter supplier programs. Lower costs also mean you are more likely to have a higher profit. Higher profit can help make other companies more comfortable doing business with you. For example, if you were able to lower your overhead cost to $80,000 (from the $100,000 above), then your new overhead rate would be 1.6 ($80,000/$50,000=1.6). Overhead rates can vary greatly by business size and industry. Small businesses are likely to have higher overhead rates because they are producing on a smaller scale and they typically have less “area” over which to spread their overhead costs.
Overhead rates allow you to track the expenses of your business that don’t directly relate to a specific project and spread those costs evenly over projects. They can help you manage your business more efficiently by determining your business’s break-even point and making sure its products are priced appropriately. They are also useful to show potential business partners how you relate to competitors. Although the calculation can be intimidating at first, just remember the formula: Overhead Rate = Overhead/Allocation Base or Overhead Rate = Indirect Costs/Direct Costs.
Photo Credit: PuzzleMonkey!, Flickr.