## Definition

The term overhead rate refers to a ratio used by analysts to estimate the overhead costs allocated to each unit of production.  An increasingly less popular measure, analysts and company management can use the overhead rate to understand the magnitude of costs that are directly related to the manufacture of the company's products.

### Calculation

There are two approaches to calculating this metric. Traditionally, this first method was used:

As automation increases, small changes in direct labor result in large changes to the ratio.  To eliminate this problem, this second metric was developed:

### Explanation

When reporting expenses on the income statement, companies separate Selling, General and Administrative Expenses (SG&A) from those associated with the manufacturing of a product. Once separated, analysts can use the overhead rate to understand the magnitude of overhead expenses allocated to either each dollar (or hour) of direct labor or machine hour.

The following types of costs are typically assigned to overhead expense:

• Production Assets:  depreciation or depletion costs, tools and equipment (non-capital), repair expenses, rent, property taxes, utilities, and maintenance expenses.
• Labor:  indirect labor such as production supervisors, officer's salaries (allocated to production), factory administrators and employee benefits.
• Materials:  indirect supplies, scrap, rework, and spoilage.

The above expenses should only include those related to the company's production processes.  The same rule applies to those hours or dollars appearing in the denominator of this ratio.  Historically, direct labor dollars were used in the calculation of this rate; however, the growing use of automation increases the expenses appearing in the numerator, while lowering labor dollars in the denominator.  This trend makes the ratio extremely sensitive to small increases or decreases in labor dollars.  For this reason, it's more common for companies to use machine hours in the denominator.  The overhead rate is also criticized by analysts since companies may be able to increase production, and profits, by incurring more overhead costs.

### Example

Analysts at Company A were asked by the accounting department to determine the company's overhead rate.  The analysts used a combination of accounting data and manufacturing information to produce the tables below:

 Production-Related Overheads Dollars Depreciation \$1,310,715 Maintenance and Repairs \$936,225 Rents \$374,490 Utilities \$112,347 Indirect Labor \$636,633 Rework \$187,245 Property Taxes \$187,245 Total Overhead Expenses \$3,744,900

 Machine Hours By Plant Plant A 16,644 Plant B 24,966 Plant C 8,322 Total Machine Hours 49,932

Based on the above information, the analysts were able to calculate Company A's overhead rate as:

= \$3,744,900 / 49,932, or \$75.00 per machine hour