Overhead Application Rate
The overhead rate is a cost involved in producing a good or service. The cost of the corporate headquarters is an example of an overhead expense that isn't directly tied to output. An overhead rate is applied to the direct production-related costs in order to disperse or allocate the overhead costs based on specific indicators.
For instance, overhead charges may be assessed at a set rate based on the quantity of machine hours or labor hours required to create the goods.
While there are several approaches to determine an overhead rate, the following is the starting point for all calculations:
Overhead rate = Indirect costs/ Allocation Measure
- Indirect costs are expenses that do not directly relate to the creation of a good or service.
- Every measurement that is required to produce the good or service is an allocation measure. For a specific product or time period, it might be the number of machine or direct labor hours.
The overhead rate is calculated based on a specified time frame. Hence, if you wanted to determine the indirect costs for a week, you would sum up your weekly overhead or indirect charges. The measurement of what is put into production for the same period would then be taken.
So, the total weekly cost of direct labor for production that week would be the denominator if you were to calculate the overall direct labor cost for the week. In order to determine how much overhead expenses were incurred for each dollar spent on direct labor for the week, you would divide the indirect costs by the allocation measure.
Overhead (or indirect) expenses divided by direct costs, or whatever you're measuring, is the formula for the overhead rate. Direct costs, which are typically those that are expressed in cash, include direct labor costs, direct machine costs, or direct material costs. These are all also referred to as "activity drivers" or "allocation measures."
Example 1: Costs in Dollars
Let's say a business has $20 million in overhead costs for the time being. The business is curious about the relationship between direct labor costs and overhead. At the same time period, the company incurred direct labor costs in the amount of $5 million.
To calculate the overhead rate:
Divide $20 million (indirect costs) by $5 million (direct labor costs)
The overhead rate is equal to $4 ($20/$5), which means that for every dollar spent on direct labor costs, the business must pay $4 in overhead charges.
Example 2: Cost per Hour
The number of hours can also be used to describe the overhead rate. Let's imagine a business spent $500,000 in overhead costs in one month. The business records 30,000 machine hours in that same month to make its goods.
To calculate the overhead rate:
Divide $500,000 (indirect costs) by 30,000 (machine hours).
The corporation pays $16.66 in overhead expenses for every hour the machine is running, or its overhead rate.
The management may set the price of the product appropriately to ensure that there is adequate profit margin to offset the $16.66 per hour in indirect costs by calculating how much overhead is incurred for each hour the machine is producing the company's goods.
An overhead rate is a cost incurred during the production of a good or service.The cost of the corporate headquarters is an example of an overhead expense that isn't directly tied to output.
By figuring out how much it costs in overhead for each hour the machine is producing the company's goods, management may determine the price of the product suitably to ensure that there is enough profit margin to pay its indirect costs.
A company's bottom line or profitability might increase if it succeeds in tracking and reducing its overhead rate.