What Is Overhead Rate?
Overhead rate allocates indirect costs to products or services so you can price accurately and understand true profitability. Learn how to calculate and apply it.
Key Takeaways
- Overhead rate spreads indirect costs across your output so you can calculate true unit costs.
- Common allocation bases include labour hours, machine hours, and direct costs.
- Underestimating overhead leads to underpricing and eroding margins.
- Review your overhead rate at least annually as your cost base changes.
What overhead rate is
Overhead rate is a percentage or monetary amount that represents the indirect costs associated with producing a unit of output or delivering a unit of service. Overheads are costs that cannot be directly traced to a specific product or customer — rent, utilities, management salaries, insurance, software subscriptions, and administrative staff. Because these costs are real and must be recovered, they need to be allocated to your output. Overhead rate is the mechanism for doing that, ensuring every product or service you sell is priced to cover not just direct costs but a fair share of indirect costs.
How to calculate it
The standard formula is: Overhead Rate = Total Overhead Costs ÷ Allocation Base. The allocation base is whatever best links overhead consumption to output. Common choices are total direct labour hours (for labour-intensive businesses), machine hours (for manufacturing), or total direct costs. Example: if your annual overheads are £120,000 and your team works 10,000 billable hours per year, your overhead rate is £12 per billable hour. This means every hour billed needs to recover £12 of overhead on top of the direct labour and materials cost. Adding this to direct costs gives you the total cost to serve.
Applying it to pricing
Once you know your overhead rate, apply it whenever you price a job or product. If a project requires 20 hours of direct labour at £40/hour (£800 direct cost), plus £200 materials, and your overhead rate is £12/hour, the fully-loaded cost is: £800 + £200 + (20 × £12) = £1,240. Your price must exceed £1,240 to be profitable. Many SMEs price based on direct costs alone and then wonder why profits never materialise. Overhead recovery is the gap between what looks profitable on a job-by-job basis and what actually shows up as profit in the accounts.
Reviewing and adjusting overhead rate
Your overhead rate should be recalculated at least once a year, or whenever there is a significant change in your cost base or volume. If you move premises, hire additional admin staff, or take on a major new software system, your overheads rise — and your overhead rate needs to rise too, or you will underprice. Conversely, if volume increases while overheads stay roughly flat, your overhead rate per unit falls, giving you margin to be more competitive on price. Tracking overhead rate over time also helps you assess whether cost control initiatives are working.