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How to Calculate the Overhead Rate

Standard costs need to account for overhead (the miscellaneous costs of running a business) in addition to direct materials and direct labor. Overhead is much more difficult to measure than direct materials or direct labor standards because overhead consists of indirect materials, indirect labor, and other costs not easily traced to units produced.

Therefore, measuring how much overhead should be applied to different units produced is very challenging. To assign overhead costs to individual units, you need to compute an overhead allocation rate.

Remember that overhead allocation entails three steps:

  1. Add up total overhead.

    Add up estimated indirect materials, indirect labor, and all other product costs not included in direct materials and direct labor. This amount includes both fixed and variable overhead.

    For example, assume that total overhead for Band Book Company is estimated to cost $100,000.

  2. Compute the overhead allocation rate.

    The allocation rate calculation requires an activity level. You choose an activity that closely relates to the cost incurred. The most common activity levels used are direct labor hours or machine hours. Divide total overhead (calculated in Step 1) by the number of direct labor hours.

    Assume that Band Book plans to utilize 4,000 direct labor hours:

    Overhead allocation rate = Total overhead / Total direct labor hours = $100,000 / 4,000 hours = $25.00

    Therefore, for every hour of direct labor needed to make books, Band Book applies $25 worth of overhead to the product.

  3. Apply overhead.

    Multiply the overhead allocation rate by the number of direct labor hours needed to make each product.

    Suppose a department at Band Book actually worked 20 hours on a product. Apply 20 hours x $25 = $500 worth of overhead to this product.

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