To accurately assess profitability and price their products appropriately, businesses look at the overhead rate — the cost added on to the direct costs of production. The overhead rate spreads indirect costs across direct costs based on the allocation measure, which can be a dollar amount for direct costs, total labour hours, or even machine hours.
Overhead rate example: Anna’s ice cream factory
Example 1: Overhead rate per employee
Anna has an ice cream factory that had overhead expenses totalling $900,000 in June. In that same month, she had 400 employees working on the production line.
Overhead rate = Indirect cost / Number of employees = $900,000 / 400 staff = $2,250
The factory’s overhead rate per employee is $2,250. This means that it cost the company $2,250 in overhead costs for every employee.
Example 2: Overhead rate per hour worked
In July, Anna’s factory had overhead expenses totalling $900,000 and her staff worked a total of 504,000 hours making ice cream.
Overhead rate = Indirect cost / Hours worked = $900,000 / 504,000 hours = $1.79
The factory’s overhead rate per hour is $1.79. This means that it cost the company $1.79 in overhead costs for every hour of labour.
Example 3: Overhead rate per direct cost
In August, Anna’s factory had overhead expenses totalling $1,000,000 and direct costs totalling $250,000
Overhead rate = Indirect cost / Direct costs = $1,000,000 / $250,000 = $4
The factory’s overhead rate per direct cost is $4. This means that it cost the company $4 in overhead costs for every dollar spent on direct expenses.
Anna now knows how to accurately price her ice cream in order to maintain a healthy profit margin that compensates for her indirect costs.
