Overhead rate is the percentage of total sales that a business devotes to overhead expenses. Overhead rate is calculated by dividing the total overhead costs by the total sales, then multiplying that number by 100 to express as a percentage. This rate is used to measure the financial health of a business, and to determine if the business is devoting an appropriate amount of resources to cover overhead expenses.
Overhead rate is an important metric for businesses to consider, as it provides insight into the efficiency of a business. A high overhead rate may signal that a business is inefficiently using resources, resulting in higher costs and lower profits. Conversely, a low overhead rate indicates that a business is efficiently managing its resources and may be more profitable.
Example of Overhead rate
Let's take the example of a company that has total overhead costs of $1,000,000 and total sales of $10,000,000. The overhead rate for the company would be calculated as follows:
This overhead rate of 10% indicates that the company is spending 10% of its total sales on overhead expenses. This rate can be used by the company to compare its overhead rate to the industry standard, to determine if it is efficiently managing its resources.
In conclusion, overhead rate is a key metric for businesses to consider, as it measures the efficiency of a business and provides insight into the financial health of the business. Overhead rate is calculated by dividing total overhead costs by total sales, and multiplying that by 100 to express as a percentage.
Formula of Overhead rate
The formula for calculating overhead rate is:
This formula calculates the percentage of total sales that is devoted to overhead expenses. Overhead expenses include all costs incurred by the business that are not directly related to producing a product or providing a service, such as rent, utilities, insurance, and administrative costs.
To calculate the overhead rate, the total overhead costs are divided by the total sales, then multiplied by 100 to express as a percentage. This metric provides insight into the financial health of a business, as well as the efficiency of the business in managing its resources. A higher overhead rate may indicate that a business is devoting too many resources to overhead expenses, and a lower overhead rate may indicate that the business is efficiently managing its resources.
When to use Overhead rate
- Overhead rate can be used to measure the financial health of a business. Businesses should compare their overhead rate to industry averages to see how their performance compares to the competition. If their overhead rate is higher than the industry average, it may be a sign that the business is inefficiently using its resources.
- Overhead rate can be used to compare the cost of overhead expenses to the total sales of a business. This is beneficial because it helps businesses identify areas in which they can reduce overhead costs and become more profitable.
- Overhead rate can be used to calculate the cost of producing a product or service. This is beneficial because it helps businesses estimate the cost of production, and determine the price of their product or service that will generate the highest profits.
Types of Overhead rate
- Fixed Overhead Rate: A fixed overhead rate is a rate that is calculated using only fixed costs. This rate is used to measure how efficiently a business is using its fixed costs to generate sales.
- Variable Overhead Rate: A variable overhead rate is a rate that is calculated using only variable costs. This rate is used to measure how efficiently a business is using its variable costs to generate sales.
- Combined Overhead Rate: A combined overhead rate is a rate that is calculated using both fixed and variable costs. This rate is used to measure how efficiently a business is using both its fixed and variable costs to generate sales.
Advantages of Overhead rate
- It is a useful tool for budgeting and financial planning. Knowing the overhead rate of a business can help to predict future overhead costs, and plan for budgeting and financial decisions accordingly.
- It helps to identify areas of cost savings. By tracking the overhead rate of a business, managers can identify areas where overhead costs can be reduced.
- It can be used to assess the efficiency of a business. Comparing the overhead rate of a business to similar businesses allows managers to assess how efficient a business is in handling overhead costs.
Limitations of Overhead rate
- The overhead rate does not account for the different levels of complexity in the services or goods produced. For example, a business that produces highly complex products may have a higher overhead rate than a business that produces basic products.
- Overhead rate does not directly measure the profitability of a business. It is important to look at other metrics such as net income and gross profit margin to get an accurate picture of the profitability of a business.
- Overhead rate does not account for the fixed and variable nature of overhead expenses. Variable overhead expenses are those that change with production, while fixed overhead expenses remain constant regardless of production levels.
- Cost Volume Profit Analysis: Cost-volume-profit (CVP) analysis is a tool used to understand the effect of sales and costs on the profitability of a business. This analysis is based on the assumption that the overhead rate of a business remains constant.
- Activity Based Costing: Activity-based costing (ABC) is an accounting method that assigns overhead costs to specific activities in a business. This approach assigns costs to activities based on the level of activity associated with each cost, rather than simply assigning a single overhead rate to all activities.
Overall, Overhead rate is an important metric for businesses to consider, as it provides insight into the efficiency of a business. Additionally, there are several related approaches, such as Cost Volume Profit Analysis and Activity-Based Costing, that can be used to more accurately assign overhead costs to specific activities.
|Overhead rate — recommended articles
|Sales price variance — Variable Cost Ratio — Combined Ratio — Gross margin in retail industry — Sales mix — Cost-income ratio — Manufacturing cost — Cross elasticity of demand — GDP deflator
- Kar, K., Sarkar, S., & Tassiulas, L. (2002). A scalable low-overhead rate control algorithm for multirate multicast sessions. IEEE Journal on Selected Areas in Communications, 20(8), 1541-1557.