What exactly are overhead costs? A company incurs various costs, which can be divided into direct and overhead costs. Contrary to the former, the latter cannot be assigned directly to any cost drivers (which generally comprise of company products or services). If renting a factory producing bikes amounts to $20,000 per month, it is not possible to directly assign the cost of rent to each cost driver. It is for this very reason that it is advised to apply overhead rates to be able to assign overhead costs to individual cost drivers. Accordingly, if you add overhead costs to direct costs, what will result is the total cost of a product or service.
Overhead rates refer to that percentage of direct costs that enable assigning overhead costs to the respective cost object. It is determined on the basis of the causation principle. Overhead rates can be calculated by using the cost allocation method for each cost center category.
The cost of a product or service is made up of direct and overhead costs, with both having a direct effect on the resulting price. Since direct costs can be assigned to individual cost drivers (which stands in stark contrast to overhead costs), they are easily determinable. However, to cover overhead costs, it is advised to include them in the cost of individual products or services and to take them into account when determining their final value.
In general, there are two types of overheads – either cost center or those related to cost drivers. Examples of the latter type include costs for rental, depreciation, as well as training- vehicle-, building-, energy-, advertising-, or telephone and internet-related costs. On the other hand, cost center overheads relate to branches, business departments, and product groups. Overhead costs can be generally split into four separate categories:
Before you determine the overhead rate and, consequently, account for individual cost objects, spread the overhead costs across each cost center. The latter term refers to company units, often referred to as departments or operating sectors. In such a way, it is possible to observe in which sectors a company incurs most of its costs, which in turn helps to calculate the cost of individual products. To spread overhead costs across respective cost centers, you must firstly find out the sum of all overheads.
By means of the cost allocation method in table form – one of many cost accounting instruments – it is possible to spread overhead costs across all cost centers. This practice also requires a highly cost-reflective breakdown of overhead types. In the following example, overheads such as salary, rent, and insurance were broken down in the following manner:
Example: calculating the overhead rate by means of the cost allocation method
For a good understanding of the entries from the cost allocation method of calculation, let’s stick to one cost center only: the material overheads costs. There are a total of 8 employees – those from the purchase department, the incoming goods warehouse, and those who inspect the incoming goods. Employees receive a monthly salary of $2,500, which amounts to the total overhead cost of $20,000. The monthly insurance cost of each employee amounts to $500, resulting in the total insurance cost of $4,000. Warehouse rental is $6,000.
| Overhead cost type | Total | Material overheads costs | Production overheads costs | Administration overheads costs | Sales overheads costs |
|---|---|---|---|---|---|
| Wages | 90,000 | 20,000 | 30,000 | 20,000 | 20,000 |
| Rental | 36,000 | 6,000 | 20,000 | 6,000 | 4,000 |
| Insurance | 14,000 | 4,000 | 2,000 | 4,000 | 4,000 |
| Total overhead cost | 140,000 | 30,000 | 52,000 | 30,000 | 28,000 |
| Calculation base | 100,000 | 200,000 | 150,000 | 200,000 | |
| Overhead rate | 30% | 26% | 20% | 14% |
To calculate overhead costs, simply divide the total by the calculation base, with the latter referring to the direct costs (e.g. material costs) of respective cost centers. In the following example, calculating the overhead rate for the material overheads is done by dividing the total overhead cost of $30,000 by the calculation base of $100,000, giving a rate of 0.3 (30%).
In the example above, the calculation base for material overheads stems from the total amount of purchased and processed materials. It is only upon determining the overhead rate that the overhead costs can be allocated to individual cost drivers. For example, if materials for a single product cost $1, they are treated with an overhead rate of 30%, which results in the total cost of $1.30.
Cost-plus pricing is necessary when a company manufactures various goods at different costs. The cost difference can then be traced back to materials and various manufacturing processes. With this form of calculation, you can decide between single and multiple overhead rates.
Single overhead rate: In this case, the total amount of overhead costs is settled with one overhead rate, which is determined by dividing the former by the total direct costs amount from a given financial period. However, the main disadvantage of this method lies in the fact that there is an unchanging ratio between overhead costs and different direct cost types.
Multiple overhead rate: Using the multiple overhead rate means that each production department may have its own predetermined overhead rate. With overhead and direct costs in mind, such departments can be materials-, production-, administration- and sales-based. It is by means of this method that the overhead rate was calculated in the example above. Labor hours and machine hours are commonly used in many factories.
If you managed to calculate the overhead costs by means of respective overhead rates, you can now determine the final price of a product or service (from the sum of direct and overhead costs). The contribution margin, on the other hand, indicates the extent to which a product was involved in the success of any given company. Find out more about the contribution margin and how to calculate it in our article here.
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