What is the Overhead Rate?
The Overhead Rate represents the proportion of a company’s revenue allocated to overhead costs, directly affecting its profit margins.
How to Calculate Overhead Rate (Step-by-Step)
Overhead costs represent the indirect expenses incurred by a company amidst its day-to-day operations.
Overhead costs are recurring cash outflows required for a company to remain open and “keep the lights on.” However, overhead costs are not directly tied to revenue generation, i.e. indirect costs.
In spite of not being attributable to a specific revenue-generating component of a company’s business model, overhead costs are still necessary to support core operations.
Companies with fewer overhead costs are more likely to be more profitable – all else being equal.
Calculating the overhead rate begins with determining which expenses of the company can be classified as overhead costs. Once the specific costs have been identified, the sum of all the costs is divided by revenue in the corresponding period.
Overhead Cost Examples
The list below includes common examples of overhead costs:
- Repair / Maintenance
- Property Taxes
- General and Administrative Costs (G&A)
- Office Supplies
- Telephone Bills and Travel
- 3rd Party Fees (e.g. Accounting, Legal)
Overhead Rate Formula
The formula for calculating the overhead rate is as follows.
The first input, overhead costs, can be determined using the following formula.
- Indirect Materials → The material costs that cannot be categorized as direct material costs, e.g. cleaning supplies, glue, shipping tape.
- Indirect Labor → The cost of labor for employees not directly involved with core production of revenue, e.g. janitor, security guards.
- Indirect Expenses → Any operating expense that does not qualify as a direct cost, e.g. utilities, rent, transportation.
Effectively, the metric allocates a company’s overhead costs across its revenue to arrive at a per-unit percentage.
However, please note that the overhead rate we’ve explained thus far uses revenue as the allocation measure, but there are other variations that compare overhead costs to metrics such as:
- Direct Costs
- Machine Hours
- Labor Hours