Overhead Rate
The ratio used to allocate indirect manufacturing costs to products based on a chosen activity driver such as labor hours or machine hours.
What is Overhead Rate?
The overhead rate (also called the predetermined overhead rate) is a cost allocation tool used to assign indirect manufacturing costs—overhead—to individual products or jobs in proportion to some measure of activity. The most common allocation bases are direct labor hours, machine hours, or direct labor cost. The rate is calculated by dividing budgeted total overhead costs by the budgeted activity level: Overhead Rate = Estimated Overhead ÷ Estimated Activity Base. For example, if a factory budgets $500,000 in overhead and 25,000 direct labor hours, the overhead rate is $20 per direct labor hour. As each product is made, overhead is applied by multiplying the hours consumed by this rate. The goal is to ensure that each unit of output bears a fair share of the facility's indirect costs. Any difference between applied overhead and actual overhead is settled as a variance adjustment at period end.
Example
A custom furniture shop budgets $300,000 in annual overhead and 15,000 machine hours. The overhead rate is $20/machine hour. A dining table requiring 8 machine hours is assigned $160 in overhead. If actual overhead is $315,000 and actual machine hours are 15,500, the company is over-applied by $5,000 (15,500 × $20 = $310,000 applied vs. $315,000 actual).