What is the 'Overhead Rate'

Overhead rate, in managerial accounting, is a cost added on to the direct costs of production in order to more accurately assess the profitability of each product. To allocate these costs, an overhead rate is applied that spreads the overhead costs around depending on how much resources a product or activity used.For example, overhead costs may be applied at a set rate based on the number of machine hours required for the product. In more complicated cases, a combination of several cost drivers may be used to approximate overhead costs.

BREAKING DOWN 'Overhead Rate'

Overhead expenses are generally fixed - they exist whether or not a factory produces a single item, a retail store sells a single product or a services firm lands a single client. Such expenses would include building or office space rent, utilities, insurance, supplies, maintenance and repair. They also comprise administrative salaries and some professional and miscellaneous fees that are tucked under selling, general and administrative (SG&A) within a firm's operating expenses on the income statement. Unless a cost can be directly attributable to a specific revenue-generating product or service, it will be classified as an overhead, or indirect, expense.

It is often difficult to assess precisely the amount of overhead costs that should be attributed to each production process. Therefore, costs must be estimated based on an overhead rate for each cost driver or activity. It is important to include indirect costs that are based on this overhead rate in order to price a product or service appropriately. If a company prices its products that do not cover its overhead costs, the business will be unprofitable.

Overhead Rate Formula

The basic equation is overhead (or indirect) costs divided by direct costs. Direct costs typically are direct labor, direct machine costs, or direct material costs - all expressed in dollar amounts. Each one of these is also known as an "activity driver" or "allocation measure." If overhead expenses for a company are $25 million and direct labor expenses are $5 million, then the overhead rate is 2:1, or $2 of indirect cost for every $1 of labor cost. The overhead rate can also be expressed in terms of the number of hours. For instance, if overhead expenses for a company are $75 million and machine hours used were $25 million, then the overhead rate would be $3 per machine hour. A company that can improve its overhead rate - i.e., reduce it - will improve its bottom line.

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