Overhead rate, defined as an expression of overhead costs which are displayed across periods, is an essential function for a business which must manage cash carefully because of overhead costs. It compares cost to productivity to yield a final rate which can be used to compare efficiency to cost. The objective is to have an rate of overhead which decreases each period, ideally. This rate can be expressed as overhead rate per hour, overhead rate per unit, per month, per period, and more.
Overhead rate means, very specifically, overhead cost divided by the main factor of productivity in work. This factor can be labor hours, labor cost, machine hours, or another measure. All-in-all, overhead rate analysis evaluates whether a company is making value of the overhead costs it incurs or whether productivity must be increased to sustain firm value.
This rate of overhead, to indicate increased efficiency in the production of a company, should decrease. This shows that either overhead cost is decreasing or productivity, keeping a standard overhead, is increasing. Though a firm would prefer to have both at optimal levels it can experience increased value with a positive change in either.
Exceptions to the above paragraph exist. If the rate of overhead is increasing because of a plant expansion it may not be a negative indication. Additionally, if labor hours or cost are increasing while a company experiences a decrease in productivity then the overhead rate variance might appear favorable though it is not. Critical thinking skills are required to make sense of the any of the financial ratios in a company.
The formula is quite simple. For a company to calculate overhead, the most difficult task is to keep pristine records of cost and production. From these, the overhead rate equation is a matter of simple division.
Overhead rate = Overhead cost / productivity (labor hours, labor cost, machine hours, etc.)
For example, John is the chief operating officer of a plant which produces chemicals for pharmaceutical companies. John runs a “tight ship” in his plant: he knows what factors are important and sets achievable goals to increase productivity. To balance this, he is a caring manager who motivates the best of those who he works with.
John spends 1 day each month looking over the important measurements and research which tell him the productivity of his plant. This gives John a solid understanding of his plant from a perspective which he may not have seen.
Overhead Rate Direct Labor Cost Calculation
John decides to calculate overhead rate direct labor cost to evaluate the plant. He performs this calculation:
Overhead Cost = $5,000
Labor Cost = 100
Rate of Overhead = $5,000 / 100 = 50
John compares this to the overhead rate of 52 from last month. He then digs deeper to find that labor productivity has decreased, showing a false decrease in overhead rate per direct labor cost.
John talks with the employees and finds that many are distressed by a recent injury at the plant. A young lady, new to the plant, has slipped on a spilled liquid and injured herself. This liquid was accidentally spilled by a coworker. John believes this may have caused a decrease in morale which has caused labor efficiency to decline.
Create a Plan
John creates a plan to revamp safety procedures at the plant. He sends the plan off to the CFO of the plant and finds that this will not be excessively expensive to implement. He then gets confirmation from the board of directors to try his plan.
John is not sure if this will increase employee morale. Despite this, John moves forward with the plan. In 2 months time, if labor efficiency has not returned to original levels, then he will attempt to fix the problem another way. With a foundation of research and proper management John, unsure of this plan, is sure that he can achieve his goal.
If you want to find out more about how you could utilize your unit economics to add more value to your organization, then click here to download the Know Your Economics Worksheet.
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