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What is the overhead rate and how can you calculate it?

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If you work in corporate accounting, you probably deal with overhead costs on a regular basis. Overhead costs are the indirect expenses that are not directly traceable to a specific product or service, such as rent, utilities, insurance, depreciation, and salaries. Knowing how to calculate the overhead rate is important for allocating these costs to different cost objects, such as departments, projects, or products. In this article, you will learn what the overhead rate is, how to calculate it, and how to use it for joint and by-product costing.

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Tomi Akinwale ACCA, ACA, ACTI, B.TECH, FMVA, AAT.

Tax | Deloitte | Financial Reporting | Unlocking Your Career Potential
CA HENCY SHAH ????

??FCA | ??M.Com (F&T) | ??16x LinkedIn Top Voice | ???Information System Auditor | ??Certified Forensic Accountant…
Nicole W.

Accounting senior leader driving corporate transformations, post-merger integration, and writing the unwritten rules of…

1 Overhead rate definition

The overhead rate is the ratio of overhead costs to a base measure of activity, such as direct labor hours, direct labor costs, machine hours, or sales. The overhead rate shows how much overhead cost is incurred per unit of activity. For example, if the overhead costs for a month are $50,000 and the direct labor hours are 10,000, the overhead rate is $50,000 / 10,000 = $5 per direct labor hour. This means that for every hour of direct labor, the company incurs $5 of overhead costs.

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CA HENCY SHAH ????

??FCA | ??M.Com (F&T) | ??16x LinkedIn Top Voice | ???Information System Auditor | ??Certified Forensic Accountant | ??Certified Concurrent Auditor | ??Virtual CFO | ??Researcher | ??16K+ Family | ??800K+ Impressions
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Understanding the overhead rate and its calculation is pivotal for assessing operational efficiency and cost management within a business. It encompasses various indirect costs incurred beyond direct production expenses, shedding light on the overall financial health of an organization. To calculate it, one typically divides total overhead costs by the associated activity base, providing insights into resource allocation and potential areas for optimization. Delving deeper into this metric can significantly enhance strategic decision-making and drive sustainable growth.

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Marcelo Vicente da Silva

CFO l Financial Controller I Treasurer I Tax Strategist I Internal Controls I FP&A I Sarbannes Oxley I Auditor I Risk Advisory I IBGC CCA l Philosophy Enthusiastic l Harvard Kennedy School I The University of Chicago I
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The overhead rate encompasses costs associated with running a business that cannot be readily allocated to specific products or services. These costs encompass a wide array of expenses, ranging from rent and utilities to administrative salaries, insurance, and equipment depreciation. While these costs may not be directly tied to revenue generation, they are essential for maintaining the infrastructure and day-to-day operations of a company.

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2 Overhead rate calculation

Calculating the overhead rate requires a few steps. Firstly, you need to identify the overhead costs for a specific period, which can be found on the income statement or cost sheet. Secondly, choose a base measure of activity that is relevant and consistent for the cost object. This base measure should reflect how the overhead costs vary with the level of activity, such as direct labor hours or direct labor costs for labor-driven costs and machine hours for machinery-driven costs. Finally, divide the total overhead costs by the total base measure of activity to get the overhead rate. For example, if the total overhead costs are $50,000 and the total direct labor hours are 10,000, then the overhead rate is $50,000 / 10,000 = $5 per direct labor hour.

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Tomi Akinwale ACCA, ACA, ACTI, B.TECH, FMVA, AAT.

Tax | Deloitte | Financial Reporting | Unlocking Your Career Potential
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To calculate overhead recovery rate, you must identify all the fixed cost not directly related to the project and fix the costs into the pricing.

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3 Overhead rate application

Once you have calculated the overhead rate, you can use it to allocate the overhead costs to different cost objects. To do this, you need to multiply the overhead rate by the actual base measure of activity for each cost object. For example, if you want to allocate the overhead costs to two products, A and B, that use 4,000 and 6,000 direct labor hours respectively, you can multiply the overhead rate of $5 per direct labor hour by the actual direct labor hours for each product. The allocated overhead costs for product A are $5 x 4,000 = $20,000, and the allocated overhead costs for product B are $5 x 6,000 = $30,000.

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Fola A.

Finance and People Leader | Strategic financial planning | FCCA, CPA | Revenue Growth | Operational Efficiency → Cost Optimization → Team Leadership
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In calculating the overhead rate, activity measure is very important as that determines how the cost will be allocated. There are different activity methods but there must be a direct relationship between the cost and the measure of activity for the cost object. Once this allocation rate is determined then it is typically used to allocate costs to products, units, departments, SBUs, etc. This allocated overhead cost calculated by the overhead rate determines how much each of these products for example contributes to the overhead cost.

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4 Joint and by-product costing

Joint and by-product costing is a method of accounting for the costs of producing multiple products from a common input or process. For example, a refinery may produce gasoline, diesel, and kerosene from crude oil. Joint products are the main products that have significant sales value, such as gasoline and diesel. By-products are the incidental products that have low sales value, such as kerosene. To determine the cost of each joint product, you need to allocate the joint costs, which are the costs incurred before the split-off point, where the products become separately identifiable. To allocate the joint costs, you can use the overhead rate based on a physical measure, such as weight, volume, or units, or a market-based measure, such as sales value, net realizable value, or gross margin. For example, if the joint costs are $100,000 and the sales value of gasoline, diesel, and kerosene are $80,000, $60,000, and $10,000 respectively, you can allocate the joint costs based on the sales value ratio. The overhead rate for gasoline is $100,000 / $150,000 = 0.67, the overhead rate for diesel is $100,000 / $150,000 = 0.44, and the overhead rate for kerosene is $100,000 / $150,000 = 0.07. The allocated joint costs for gasoline are $80,000 x 0.67 = $53,333, the allocated joint costs for diesel are $60,000 x 0.44 = $26,667, and the allocated joint costs for kerosene are $10,000 x 0.07 = $667. To account for the by-product, you can either deduct its sales value from the joint costs before allocation, or recognize its sales value as other income after allocation.

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Nicole W.

Accounting senior leader driving corporate transformations, post-merger integration, and writing the unwritten rules of career development | CPA Exam instructor | Board member | LinkedIn Top Voice
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This reminds me of my CPA exam coaching sessions! We must also consider the scrap that comes from producing joint and by-products. Scrap can either reduce overhead costs or, if it’s a material amount, create additional revenue by reselling. The revenue from reselling would go straight to the bottom line since the production costs have already been accounted for.

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Ryan Reid

Tax Accountant || QuickBooks ProAdvisor || Servant Leader || Insurance Doer
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We have a clerical error here: The overhead rate for gasoline should be: **$80,000**/$150,00 or (.5333) The overhead rate for diesel should be: **$60,000**/$150,00 or (.4) The overhead rate for kerosene should be: **$10,000**/$150,00 or (.07) Amazingly, the final individual product costs are correct as written above even with the clerical error.

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5 Overhead rate limitations

The overhead rate is a useful tool for simplifying the overhead cost allocation process, but it also has some limitations. For example, it assumes a linear relationship between the overhead costs and the base measure of activity, which may not be true in reality. Additionally, the overhead rate may not capture the diversity and complexity of the cost objects or be affected by the choice of the base measure of activity. Furthermore, it may be distorted by the time period or level of aggregation used for calculation. These limitations should be taken into consideration when using an overhead rate to allocate costs.

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Ryan Reid

Tax Accountant || QuickBooks ProAdvisor || Servant Leader || Insurance Doer
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The overhead rate will be as accurate as the data you use. You could get different rates if you use different base measures of activity (i.e., sales revenue, weight, labor hours). Ensure you use the base measure that aligns the most with your business practices.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Corporate Accounting

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What is the overhead rate and how can you calculate it?

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1 Overhead rate definition

2 Overhead rate calculation

3 Overhead rate application

4 Joint and by-product costing

5 Overhead rate limitations

6 Here’s what else to consider

Corporate Accounting

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