Overhead is the term used to describe all of the indirect costs that a business incurs. These costs are not directly related to the production of goods or services, but they are necessary to keep the business operational. Overhead can include rent, utilities, insurance, office supplies, and salaries for administrative staff.
In order to price goods or services accurately, businesses must calculate their overhead costs and add them to the direct costs of production. This will give them a more accurate picture of their overall costs, and help them to set prices that cover all of their expenses.
Here we break down the process of calculating the overhead percentage for a business.
Example Overhead Formula
Assuming all costs are already properly recorded in the company’s financial statements, you can figure out the overhead rate as a percentage of sales. This is done by adding the total overhead costs, and breaking them down by month. This number is then divided by monthly sales.
A simple example of this looks like: Overhead percentage formula: (Overhead ÷ monthly sales) x 100 = overhead percentage A tree trimming business calculates they have $3,000 in monthly overhead costs and make $15,000 in total monthly sales. As a result, the overhead percentage would be $15,000 divided by $3,000, which gives you 0.2. Multiply that by 100, and your overhead percentage is 20% of your sales
Steps to Calculate Overhead
Sometimes the financial data isn’t easily found in financial statements, so let’s break down the steps to calculate overhead.
Step 1 – Estimate the amount of time that each employee spends as either direct or indirect labor. Calculate the average hourly wage rate paid to each direct labor employee and any management to owner’s wages as well that go directly towards making the product. Then figure the total average direct labor hourly wage rate.
Step 2 – Next calculate the number of direct labor workdays the shop will be open for production. Be sure to subtract the days where direct labor employees won’t work, such as weekends, holidays, vacations, scheduled downtime, etc.
Step 3: Multiply available direct labor workdays by the scheduled average workday minus the average number of daily non-billable direct labor hours. Non-billable direct labor hours include lunches, breaks, company meetings, training, cleanup, etc., that a customer will not be charged for directly.
Step 4: Multiply billable direct labor hours by average direct labor wage.
Step 5: Subtract billable hours from the total hours available in a work year, which is 2088 hours (based on a 40 hour workweek). The remainder is the non-billable direct labor hours. Multiply this number by the average direct labor rate to arrive at the non-billable direct labor dollars. Non-billable direct labor dollars are absorbed by the company and must be passed on to the customer through the overhead percentage.
Step 6: Refer to the income statement and total the business expenses for the evaluation period. Take out the cost of billable direct labor, direct raw materials, and costs attributable to outside subcontractors that are attributed to a customer. Be sure to factor in annual inflation and any raw material price changes.
Step 7: Divide the average monthly overhead expenses (step 6) by the billable direct labor dollars (step 4), and convert this ratio to a percentage.
After the overhead percentage has been calculated, a business owner can examine the possibilities for making changes in the business that will yield desired results, such as lowering overhead in targeted areas, raising prices, decreasing production times, etc.
Job shop owners are often shocked to learn the true cost of their overhead and that they aren’t charging enough. Without knowing this number, it’s difficult for a business to survive and be profitable.
Definitions of Pricing Terms
Before discussing the steps to calculate overhead, here are some definitions to be aware of:
- Business expenses – All expenses found on the company’s income statement (also known as the profit and loss statement).
- Overhead expenses – All costs found on the income statement except for direct labor, direct materials, and variable costs attributable to outside subcontractors that can be billed directly to a customer.
Overhead expenses are absorbed by the business and factored into the selling price as a percentage of the direct labor cost. They include indirect expenses such as bank fees, property taxes, indirect labor, legal expenses, inventory storage, mortgage interest, rent, repairs, supplies, utilities, etc.
- Direct labor – Labor used to produce products and services purchased by customers. The cost of direct labor is directly attributable to customer activity.
- Indirect labor – Wages from business activity that supports the business and are not directly chargeable to the customer such as accounting, janitorial, customer service, owner salaries, etc.
- Direct materials – Materials used in the final product or service purchased by customers. These materials are charged directly to the customer’s account. Also referred to as the cost of goods sold (COGS)
- Overhead percentage – Ratio between direct labor and overhead expenses. This percentage is used to allocate overhead expenses proportionately to direct labor dollars billed to customers.
How to Price Services
To calculate the price for manufacturing costs, the company must set the desired percentage gross margin on the selling price. (Gross margin on selling price is the preferred method for adding profit to a product or service because it matches the reporting done in income statements where sales revenue is recorded.) The price a shop should sell its services for is calculated by:
Avg. direct labor rate (in $/machine hour; from Step 1)
+ Overhead rate (Avg. direct labor rate x overhead percent [Step 7];
in $/machine hour) direct labor cost (in $/machine hour)
For a desired gross margin on the selling price of X percent, convert that percentage to a decimal and calculate the price:
Direct labor cost ÷ (100 – x) = Charging rate per machine hour
Smith’s Machine Shop has determined that its average direct labor rate is $25.00/machine hour. The overhead percentage is calculated at 200 percent. It now wants to make a 15 percent gross margin on selling price. The price Smith’s Machine Shop must charge for their service is found by:
$25.00/machine hour Avg. direct labor rate
+ $50.00/machine hour Avg. direct labor rate ($25) x overhead percentage (200%)
$75.00/machione hour Direct labor cost
For a 15 percent gross margin on selling price,
$75.00 ÷ (.85) = $63.75/machine hour
Smith’s Machine Shop must ask $63.75 per machine hour for its services to make the desired profit margin.
How to Price Products
A similar method to price services is used to establish product prices. Calculate the cost of producing one item or unit and use the gross margin on the selling price method shown in the service example above to find the selling price.
If Smith’s Machine Shop makes and sells a specific type of widget in addition to providing services, it would need to find the cost of producing one widget before it could set a price for the product. Both direct material costs and direct labor costs must be included in the price calculations. If production time for one widget is 10 minutes and each widget uses $3.12 in raw materials:
$50.00/man-hour ÷ 60 minutes = $0.83/minute
$0.83/minute x 10 minutes/widget = $8.30 Direct labor cost per widget
+$3.12 Direct material costs per widget
$11.44 Cost to produce one widget
For a 15 percent gross margin on selling price,
$11.44 ÷ (.85) = $13.46 selling price for each widget
According to GAAP (Generally Accepted Accounting Principles), the manufacturing overhead will be classified as a cost of finished goods in inventory and work-in-progress inventory on the company’s income statement and balance sheet.