The two main assumptions of the departmental overhead rate method include:

The departmental overhead rate is an expense rate calculated for each department in a factory production process. The departmental overhead rate is different at every stage of the production process when various departments perform selected steps to complete the final process.

By breaking up overhead costs for individual business sections rather than having a company-wide rate, management can assess corporate inefficiencies more accurately and take more specific action.

What Does the Departmental Overhead Rate Tell You?

An overhead rate, in managerial accounting, is an additional cost added on to the direct costs of production in order to more accurately assess the profitability of each product. To allocate these costs, an overhead rate is applied that spreads the overhead costs around depending on how much resources a product or activity used.

For example, overhead costs may be applied at a set rate based on the number of machine hours required for the product. In more complicated cases, a combination of several cost drivers may be used to approximate overhead costs.

The departmental overhead rate is specific to every segregated step in the entire process. For example, if a company makes bread, different departmental rates could be used for the actual production/manufacturing line and the bagging process.

Cost-cutting, efficiency and productivity are standard elements of a strong corporate performance methodology. Analysis and benchmarking of departmental overhead rates is an effective way to measure success. Comparisons between competitors, as well as among various internal departments help isolate efforts that are adding value, and those that are destroying enterprise value.

No two cost-cutting approaches are the same. Like all things in business, there are pros and cons to the myriad of strategies businesses can utilize. However, by following trends in departmental rates, patterns do emerge highlighting the delicate balance of short-term goals with long-term business requirements.

Determining Departmental Overhead Rates

Determining appropriate departmental rates is an area addressed by managerial accounting methods. Managerial accounting is the process of identifying, measuring, analyzing, interpreting and communicating information for the pursuit of an organization's goals.

This branch of accounting is also known as cost accounting. The key difference between managerial and financial accounting is managerial accounting information is aimed at helping managers within the organization make decisions, while financial accounting is aimed at providing information to parties outside the organization.

In managerial accounting, rather than using one overhead rate to allocate all of the overhead costs, overhead costs can be broken down by departments. Departmental overhead rates offer the flexibility to use a different activity or cost driver for each department. Often, some departments will rely heavily on manual labor while others require more machinery. Direct labor hours can be important to certain departments but machine hours might work better for others.

The overhead rate is a cost allocated to the production of a product or service. Overhead costs are expenses that are not directly tied to production such as the cost of the corporate office. To allocate overhead costs, an overhead rate is applied to the direct costs tied to production by spreading or allocating the overhead costs based on specific measures.

For example, overhead costs may be applied at a set rate based on the number of machine hours or labor hours required for the product.

Key Takeaways

• Overhead rate is a cost allocated to the production of a product or service. Overhead costs are expenses that are not directly tied to production such as the cost of the corporate office.
• By analyzing how much it costs in overhead for every hour the machine is producing the company's goods, management can properly price the product to make sure there's enough profit margin to compensate for its indirect costs.
• A company that excels at monitoring and improving its overhead rate can improve its bottom line or profitability.

Overhead Rate Formula and Calculation

Although there are multiple ways to calculate an overhead rate, below is the basis for any calculation:

Overhead rate=Indirect costsAllocation measure\text{Overhead rate} = \frac{\text{Indirect costs}}{\text{Allocation measure}}Overhead rate=Allocation measureIndirect costs​

Note that:

• Indirect costs are the overhead costs or costs that are not directly tied to the production of a product or service.
• Allocation measure is any type of measurement that's necessary to make the product or service. It could be the number of direct labor hours or machine hours for a particular product or a period.

The calculation of the overhead rate has a basis on a specific period. So, if you wanted to determine the indirect costs for a week, you would total up your weekly indirect or overhead costs. You would then take the measurement of what goes into production for the same period. So, if you were to measure the total direct labor cost for the week, the denominator would be the total weekly cost of direct labor for production that week. Finally, you would divide the indirect costs by the allocation measure to achieve how much in overhead costs for every dollar spent on direct labor for the week.

Using the Overhead Rate

The overhead rate is a cost added on to the direct costs of production in order to more accurately assess the profitability of each product. In more complicated cases, a combination of several cost drivers may be used to approximate overhead costs.

Overhead expenses are generally fixed costs, meaning they're incurred whether or not a factory produces a single item or a retail store sells a single product. Fixed costs would include building or office space rent, utilities, insurance, supplies, maintenance, and repair. Overhead costs also include administrative salaries and some professional and miscellaneous fees that are tucked under selling, general, and administrative (SG&A) within a firm's operating expenses on the income statement. Unless a cost can be directly attributable to a specific revenue-generating product or service, it will be classified as overhead, or as an indirect expense.

It is often difficult to assess precisely the amount of overhead costs that should be attributed to each production process. Costs must thus be estimated based on an overhead rate for each cost driver or activity. It is important to include indirect costs that are based on this overhead rate in order to price a product or service appropriately. If a company prices its products so low that revenues do not cover its overhead costs, the business will be unprofitable.

Direct Costs vs. the Overhead Rate

Direct costs are costs directly tied to a product or service that a company produces. Direct costs can be easily traced to their cost objects. Cost objects can include goods, services, departments, or projects. Direct costs include direct labor, direct materials, manufacturing supplies, and wages tied to production.

The overhead rate allocates indirect costs to the direct costs tied to production by spreading or allocating the overhead costs based on the dollar amount for direct costs, total labor hours, or even machine hours.

Limitations of the Overhead Rate

The overhead rate has limitations when applying it to companies that have few overhead costs or when their costs are mostly tied to production. Also, it's important to compare the overhead rate to companies within the same industry. A large company with a corporate office, a benefits department, and a human resources division will have a higher overhead rate than a company that's far smaller and with less indirect costs.

Examples of Overhead Rates

The equation for the overhead rate is overhead (or indirect) costs divided by direct costs or whatever you're measuring. Direct costs typically are direct labor, direct machine costs, or direct material costs—all expressed in dollar amounts. Each one of these is also known as an "activity driver" or "allocation measure."

Example 1: Costs in Dollars

Let's assume a company has overhead expenses that total $20 million for the period. The company wants to know how much overhead relates to direct labor costs. The company has direct labor expenses totaling $5 million for the same period.

To calculate the overhead rate:

• Divide $20 million (indirect costs) by $5 million (direct labor costs).
• Overhead rate = $4 or ($20/$5), meaning that it costs the company $4 in overhead costs for every dollar in direct labor expenses.

Example 2: Cost per Hour

The overhead rate can also be expressed in terms of the number of hours. Let's say a company has overhead expenses totaling $500,000 for one month. During that same month, the company logs 30,000 machine hours to produce their goods.

To calculate the overhead rate:

• Divide $500,000 (indirect costs) by 30,000 (machine hours).
• Overhead rate = $16.66, meaning that it costs the company $16.66 in overhead costs for every hour the machine is in production.

By analyzing how much it costs in overhead for every hour the machine is producing the company's goods, management can properly price the product to make sure there's enough profit margin to compensate for the $16.66 per hour in indirect costs.

Of course, management also has to price the product to cover the direct costs involved in the production, including direct labor, electricity, and raw materials. A company that excels at monitoring and improving its overhead rate can improve its bottom line or profitability.

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