How to Calculate Overhead Costs in 5 Steps
To calculate the overhead costs of a business, add all the ongoing business expenses that keep your business running but do not contribute to the revenue generation process. These are indirect costs such as administrative expenses, selling and marketing costs and production expenses.
Calculating and recording the overhead costs regularly will help you save money, get a better price for your products and services and allow you to streamline the business operations.
What this article covers:
- How to Calculate Overhead Costs
- How to Calculate Overhead Absorption Rate
- How to Calculate Overhead Rate per Employee
NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.
How to Calculate Overhead Costs
To calculate overhead costs, follow the steps below:
List the Expenses
Make a comprehensive list of indirect business expenses including items like rent, taxes, utilities, office equipment, factory maintenance etc. These are your overhead costs. Direct expenses related to the production of goods and services, such as labor and raw materials, are not included in overhead costs.
While categorizing the direct and overhead costs, remember that some items cannot be attributed to a specific category. Some business expenses might be overhead costs for others but a direct expense for your business.
Add the Overhead Costs
Total the monthly overhead costs to calculate the aggregate overhead cost. This is the amount of money that you need for running your business
Calculate the Overhead Rate
The overhead rate or the overhead percentage is the amount your business spends on making a product or providing services to its customers. To calculate the overhead rate, divide the indirect costs by the direct costs and multiply by 100.
If your overhead rate is 20%, it means the business spends 20% of its revenue on producing a good or providing services. A lower overhead rate indicates efficiency and more profits.
Compare to Sales
When setting prices and making budgets, you would need to know the percentage of a dollar that is allocated to overheads. To calculate the proportion of overhead costs compared to sales, divide the monthly overhead cost by monthly sales, and multiply by 100.
For example, a business with monthly sales of $100,000 and overhead costs totaling $40,000 has ($40,000/ ($100,000) x 100 = 40% overheads.
Compare to Labor Cost
To measure the efficiency with which business resources are being utilized, calculate overhead cost as a percentage of labor cost. The lower the percentage, the more effectively your business is utilizing its resources.
Divide the total overhead cost by the total labor cost for the month and multiply by 100 to express it as a percentage.
How to Calculate Overhead Absorption Rate
The amount of indirect costs that are assigned to goods and services is known as overhead absorption. The indirect costs are not directly traceable. Overhead absorption is required by both GAAP and IFRS for external financial reporting.
The overhead is attributed to a product or service on the basis of direct labor hours, machine hours, direct labor cost etc. The overhead absorption rate is calculated to include the overhead in the cost of production of goods and services. It’s used to define the amount to be debited for indirect labor, material and other indirect expenses for production to the work in progress.
There are several methods for calculating the absorption rate.
Percentage on Direct Material Method
The direct material cost is one of the primary components for product cost. Under this method, the absorption rate is based on the direct material cost. To calculate this, divide the overheads by the estimated or actual direct material costs.
Percentage on Direct Material Cost = Overhead / Direct Material Costs x 100
Direct Labour Cost Method
The estimated or actual cost of labor is calculated by dividing overhead by direct wages and expressed as a percentage.
Direct Labor Percentage = Overhead / Direct Wages x 100
Prime Cost Percentage Method
The prime cost is the sum of direct labor and direct material costs of a business. To calculate the prime cost percentage, divide factory overhead by prime cost.
Prime Cost Percentage = Overheads / Prime Cost x 100
Labour Hours Method
The labor hour rate is calculated by dividing the factory overhead by direct labor hours.
The formula is:
Labor Hour Rate = Overheads/ Labor Hours
Machine Hour Rate
Machine hour rate is calculated by dividing the factory overhead by machine hours.
Machine Hour Rate = Overheads/ Machine Hours
Sale Price Method
Under this method, budgeted overheads are divided by the sale price of units of production.
Sale Price = Overheads/Sale Price of Production Units
How to Calculate Overhead Rate per Employee
To calculate the overhead rate per employee, follow the steps below:
- Calculate the labor cost which includes not just the weekly or hourly pay but also health benefits, vacation pay, pension and retirement benefits paid by the employer.
- Compute the total overheads of the business.
- Divide the overhead costs by the number of billable hours. For example, if your business has six technicians, the overhead costs are divided between them.
- Adding the overhead costs and the labor cost to billable hours gives you the net cost of that employee to the business per hour.
By lowering the proportion of overhead, a business can gain a competitive advantage, either by increasing the profit margin or pricing its products more competitively.