Definition
The term overhead to cost of sales ratio is used by analysts to estimate the impact overheads have on the company's cost of goods sold. The overhead to cost of sales ratio provides company management with insights into the growth of overheads as sales increase over time.
Calculation
Overhead to Cost of Sales Ratio = Total Overheads / Cost of Goods Sold
An increasingly popular variation of this calculation eliminates overheads from the denominator too, by including only the direct labor and materials portion of the cost of goods sold as shown below:
Overhead to Cost of Sales Ratio = Total Overheads / (Direct Labor + Direct Materials)
Explanation
At one time, companies were concerned about their direct labor costs and how this affected the company's cost of goods sold. As assembly line processes became more efficient and automation more prevalent, the focus shifted to overheads.
Overhead expense include costs such as depreciation or depletion, tools and equipment (non-capital), repair expenses, rent, property taxes, utilities, maintenance expenses as well as indirect labor costs and indirect materials such as rework. Also known as the cost of goods sold, a company's cost of sales is made up of those expenses incurred when making a product, or supplying a service; this includes raw materials and direct labor.
Overheads now account for a large proportion of the company's cost of goods sold. For this reason, company's carefully track the ratio of overheads to cost of sales. While direct labor and raw materials costs will track sales volumes in the near term, overheads such as property taxes and depreciation on plant, property and equipment are relatively fixed in the short-term. The company's management team will examine the overhead to cost of sales ratio to identify opportunities to reduce those overheads in the long-term.
Example
Sales have been slowly declining at Company A, and the management team is concerned the fixed portion of overheads is affecting margins. The team engaged several analysts to examine the company's overhead to cost of sales ratio over the last several years. The analysts assembled the table below and presented it to Company A's management team.
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Total Overhead Expenses | $6,135,000 | $6,442,000 | $6,764,000 | $7,102,000 | $7,457,000 |
| Direct Labor | $1,678,000 | $1,670,000 | $1,547,000 | $1,497,000 | $1,442,000 |
| Raw Materials | $3,115,000 | $3,102,000 | $2,874,000 | $2,781,000 | $2,678,000 |
| Total Direct Labor and Materials | $4,793,000 | $4,772,000 | $4,421,000 | $4,278,000 | $4,120,000 |
| Overhead to Cost of Sales Ratio | 128% | 135% | 153% | 166% | 181% |
The analysts discovered that overhead expenses were increasing by roughly 5% per year, however, the decline in sales lowered the company's direct labor and raw materials cost. Unfortunately, the overheads that are relatively fixed in the near term were nearly 200% of the company's cost of sales.
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