How to Calculate the Overhead Rate Based on Direct Labor Cost

The term "overhead" refers to the costs associated with producing a good or service that are essential but are not directly involved in the production process. For instance, you have to maintain machinery in a factory, even though maintenance is not part of the production process. Overhead costs must be accurately assigned to each unit of production, based on a consistent rate if you are to make well-informed choices concerning production planning and product pricing. It's vital to understand how to determine the overhead rate.

What is an Overhead Cost?

It is relatively simple to determine the direct costs involved in producing a good or service. For example, you can measure the amount of raw materials required to manufacture a good. You can determine the direct labor involved by measuring how long it takes workers to provide a service or to make a product.

Overhead costs are components of the production process that are not easily assigned on a per-unit basis. Examples of this include indirect energy expenses, equipment repairs, depreciation, property taxes and the salaries of maintenance workers. These costs are aggregated together as overhead.

Overhead costs are allocated to each unit of production in order to comply with generally accepted accounting principles. The key to effective allocation is to choose a method of determining the amount to allocate to each production unit that correlates logically with the production process used in your business.

Selecting a Model

The choice of a method for calculating an overhead rate depends on the nature of the specific production process.

For example, stylists in a hair salon provide services such as cutting, washing, styling and coloring their customers' hair. This is a very labor-intensive activity, and the production rate depends largely on the labor time that each service requires. By contrast, in an automated factory, output depends on the machine hours needed for each unit of production.

In general, it is appropriate to choose direct labor hours as a basis for computing an overhead rate when the production process is labor-intensive. In an automated factory, you would be likely to base overhead allocation on machine hours instead.

Calculating Overhead Based on Direct Labor

The first step to in calculate the overhead to be allocated to each of two jobs based on direct labor hours is to analyze the work process so that you can determine the average labor time required for each unit of production.

Suppose your business manufactures two models of widget. You find that making a small widget requires one labor hour, while large widgets require two hours.

During the next year or the next accounting period, you expect to produce 25,000 small widgets and 10,000 large widgets. The total number of direct labor hours required will be 45,000 hours.

Factor in the Indirect Costs of Production

The second step in the process is to add up all of the indirect coats of production. Suppose that the total equals $135,000. Divide this amount by 45,000 labor hours, to calculate the overhead rate. In this example, the rate works out to $3 per labor hour.

Finally, allocate the overhead by multiplying the overhead rate by the number of labor hours required. For small widgets, the allocation equals $3 (i.e., one hour of labor at $3 per hour). For large widgets, the allocated overhead is $6 (i.e., two hours of labor at $6 per hour).