Overhead Rate: How to Calculate and Apply It

The overhead rate is the amount of overhead you charge to a product, job or customer for each unit of an allocation base, such as direct labor hours or machine hours, and it is how most manufacturers and service firms turn a large pool of indirect cost into a number they can put in a quote. The formula is a simple division, but setting the base, using budgeted rather than actual figures, and handling the difference at the end of the year all need care, and a rate that rises when volume falls can lead a company to price itself out of business. This guide gives the formula, works three examples with checked arithmetic, explains under- and over-applied overhead, and covers the volume trap. It belongs to unit economics and budgeting and forecasting, builds on cost allocation methods and activity-based costing, and leads to the break-even calculator and break-even analysis.

The formula

Predetermined overhead rate = Budgeted overhead / Budgeted quantity of the allocation base
Applied overhead = Overhead rate × Actual quantity of the base used

A predetermined (budgeted) rate is set at the start of the year, so that jobs can be priced and costed during the year without waiting for actual overhead costs. Choose an allocation base that has a cause-and-effect link to overhead: direct labor hours in labor-intensive operations, machine hours in automated ones, direct labor cost or material cost where hours are not tracked, and units or orders for simple operations.

Example 1: a plantwide rate

Budgeted overhead is $900,000 and budgeted direct labor hours are 30,000.

• Overhead rate = 900,000 / 30,000 = $30 per direct labor hour
• A job that uses 120 direct labor hours receives 120 × 30 = $3,600 of overhead
• If the job has $2,400 of materials and $4,200 of direct labor (120 hours at $35), the full cost is 2,400 + 4,200 + 3,600 = $10,200
• A price with a 25 percent gross margin on price is 10,200 / 0.75 = $13,600

Example 2: departmental rates

Two departments cause overhead in different ways, so use separate rates.

Check: 600,000 / 10,000 = 60; 300,000 / 20,000 = 15; total overhead is $900,000, the same as the plantwide pool.

A job that uses 20 machine hours in Machining and 50 labor hours in Assembly receives 20 × 60 + 50 × 15 = 1,200 + 750 = $1,950 of overhead. With a plantwide rate of $30 per labor hour and, say, 70 total labor hours on the job, the job would have received 70 × 30 = $2,100. The departmental rate recognizes that the job uses little of the expensive machining resource. For a job using 80 machine hours and 10 labor hours, the departmental overhead is 80 × 60 + 10 × 15 = 4,800 + 150 = $4,950, against a plantwide charge of 90 × 30 = $2,700. Using plantwide rates, the second job would be underpriced by $2,250 of overhead, while the first would be overpriced. Departmental or activity-based rates reduce these distortions. See activity-based costing.

Example 3: under- and over-applied overhead

Because the rate is set in advance, applied overhead rarely equals actual overhead. Suppose the plantwide company has actual overhead of $930,000 and uses 29,000 direct labor hours.

• Applied overhead = 29,000 × 30 = $870,000
• Actual overhead = $930,000
• Under-applied overhead = 930,000 - 870,000 = $60,000

Overhead was under-applied: jobs were charged less than the overhead actually incurred. The difference is usually handled in one of two ways: written off to cost of goods sold at year-end if it is small, or allocated between work in progress, finished goods and cost of goods sold in proportion to the overhead applied in each if it is material. If actual hours were 31,000, applied overhead would be 930,000 and the result would be zero; with 32,000 hours, the result would be 30 × 32,000 = 960,000 applied against 930,000 actual, or $30,000 over-applied.

The size of the variance is a message. Large under-applied overhead means rates were too low and jobs were underpriced, or that actual overhead overran the budget. Investigate whether the cause is spending (actual overhead above budget) or volume (hours below budget), using the budget variance approach in budget variance analysis.

The volume trap

Overhead is largely fixed, but the rate is a per-hour figure that depends on volume. When volume falls, the rate rises.

If budgeted hours of 30,000 fall to 24,000 and overhead stays at $900,000, the rate becomes 900,000 / 24,000 = $37.50, an increase of 25 percent. A company that re-quotes using the higher rate raises its prices, loses more business, volume falls further and the rate rises again. This is sometimes called the overhead death spiral. The remedy is to recognize that, in the short run, the fixed overhead will not fall with volume, and to price on contribution for incremental business, ensuring that total contribution covers overhead over time. See contribution margin.

A related issue is treating unused capacity as a cost of jobs. Use the rate based on normal or practical capacity, and report the cost of unused capacity separately as a management issue, not as a charge on the work that was done.

Choosing the base: quick guide

Excel formulas

Overhead rate:         =BudgetedOverhead/BudgetedBase
Applied overhead:      =Rate*ActualBase
Under/(over)-applied:  =ActualOverhead-AppliedOverhead
Rate at lower volume:  =FixedOverhead/NewBase

Keep a separate sheet for each year's rates, and keep the rate fixed during the year unless there is a major change in the plan.

Using the rate in pricing

The rate is a tool for full-cost quotes, such as custom work and tenders. Use it to check that the quote covers overhead, then compare with market prices. In competitive situations, the contribution of the job, not the fully loaded cost, tells you the lowest price that still adds to profit. See pricing strategy.

Overhead in product businesses

For product companies, overhead includes warehousing, quality control, planning and supervision. Rates based on units or orders can be used to estimate the overhead per SKU or customer. Reducing complexity, improving forecast accuracy and cutting excess inventory lower this overhead. See demand planning and inventory optimization.

Common mistakes

• Using actual overhead and actual hours and getting a rate that moves every month.
• Choosing a base with no link to the cost.
• Using one plantwide rate for very different departments.
• Raising the rate as volume falls and pricing yourself out of the market.
• Ignoring under-applied or over-applied balances until the year-end.
• Treating idle capacity as part of job cost.
• Using fully loaded rates for incremental decisions.

FAQs

What is the overhead rate?

The amount of overhead charged to products or jobs per unit of an allocation base, found by dividing budgeted overhead by the budgeted quantity of the base.

How do you calculate the overhead rate?

Divide budgeted overhead by the budgeted amount of the base, such as direct labor hours or machine hours.

What is under-applied overhead?

The amount by which actual overhead exceeds overhead applied to jobs using the predetermined rate.

Should I use one overhead rate or several?

Several, if departments differ in what drives their overhead. Separate rates give more accurate job costs.

Why does the overhead rate rise when volume falls?

Overhead is mostly fixed, so the same cost is spread over fewer units of the base. Do not respond by raising prices without checking contribution.