What are overhead costs and how to calculate them?

With the help of overhead costs, you allocate indirect costs that cannot be directly assigned to a specific cost unit to in­di­vidu­al cost units. By adding the overhead costs to the direct costs, you calculate the total costs for a product or service.

What are overhead costs?

The cost of a product or service is made up of direct and overhead costs, with both having a direct effect on the resulting price. Since direct costs can be assigned to in­di­vidu­al cost drivers (which stands in stark contrast to overhead costs), they are easily de­term­in­able. However, to cover overhead costs, it is advised to include them in the cost of in­di­vidu­al products or services and to take them into account when de­term­in­ing their final value.

In general, there are two types of overheads – either cost centre or those related to cost drivers. Examples of the latter type include costs for rental, de­pre­ci­ation, as well as training- vehicle-, building-, energy-, ad­vert­ising-, or telephone and internet-related costs. On the other hand, cost centre overheads relate to branches, business de­part­ments, and product groups. Overhead costs can be generally split into four separate cat­egor­ies:

• Material overheads (e.g. warehouse rental, salaries of workers from the purchase de­part­ment, from the incoming goods warehouse, as well as those in­spect­ing the goods)
• Pro­duc­tion overheads (e.g. factory rental, natural wear and tear of machinery)
• Sales overheads (e.g. sales and marketing de­part­ment salaries)
• Ad­min­is­trat­ive overheads (e.g. HR and ac­count­ing de­part­ment salaries, office supplies)

How to determine overhead costs

Overhead costs refer to the per­cent­age added to direct costs, enabling the al­loc­a­tion of overhead costs to cost units. The overhead cost rate can be de­term­ined for each type of cost centre using a cost ac­count­ing sheet or al­loc­a­tion table.

Before de­term­in­ing the overhead cost rate and al­loc­at­ing it to in­di­vidu­al cost units, dis­trib­ute the overhead costs to the various cost centres. Al­loc­a­tion is based on the cause-and-effect principle. Cost centres refer to specific business areas, often cor­res­pond­ing to the de­part­ments or func­tion­al units within a company. This allows you to track which costs were incurred in which business areas. These costs can then be broken down further and assigned to in­di­vidu­al products. To dis­trib­ute the overhead costs to cost centres in the first step, you first need to know the total sum of the overhead costs.

How to allocate overhead costs to cost centres

Using an Operating Cost Al­loc­a­tion Sheet (OCAS), you can dis­trib­ute overhead costs across various cost centres. The operating cost al­loc­a­tion sheet is a tool used in cost ac­count­ing. In a table, different types of overhead costs and their re­spect­ive amounts in pounds are assigned to the relevant cost centres. For an accurate al­loc­a­tion of overhead costs, it is important to use a cause-oriented dis­tri­bu­tion key. In the following example, the overhead cost types (salaries, rent, and insurance) are allocated using the following common dis­tri­bu­tion keys:

• Employee salaries according to their re­spect­ive cost centres
• Rental costs according to the surface used (sq. m.) of re­spect­ive cost centres
• Employee insurance costs according to their re­spect­ive cost centre

Cal­cu­lat­ing overhead costs

The following formula is used to calculate the overhead cost rate:

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The overhead cost rate formula can be un­der­stood as follows: divide the total overhead costs by the cal­cu­la­tion base. The cal­cu­la­tion base typically refers to the re­spect­ive direct costs (e.g., material costs) of the cor­res­pond­ing cost centre. Finally, multiply by 100 to obtain the per­cent­age rate.

Al­loc­at­ing overhead costs to cost units

Once the overhead cost rate has been de­term­ined, the overhead costs can be allocated to in­di­vidu­al cost units. To do this, simply add the overhead costs to the direct costs.

Cost-plus pricing

Cost-plus pricing is necessary when a company man­u­fac­tures various goods at different costs. The cost dif­fer­ence can then be traced back to materials and various man­u­fac­tur­ing processes. With this form of cal­cu­la­tion, you can decide between plantwide overhead and de­part­ment­al overhead rates.

Plantwide overhead rate: In this case, the total amount of overhead costs is settled with one overhead rate, which is de­term­ined by dividing the former by the total direct costs amount from a given financial period. However, the main dis­ad­vant­age of this method lies in the fact that there is an un­chan­ging ratio between overhead costs and different direct cost types.

De­part­ment­al overhead rate: Using the multiple overhead rate means that each pro­duc­tion de­part­ment may have its own pre­de­ter­mined overhead rate. With overhead and direct costs in mind, such de­part­ments can be materials-, pro­duc­tion-, ad­min­is­tra­tion- and sales-based. It is by means of this method that the overhead rate was cal­cu­lated in the example above. Labor hours and machine hours are commonly used in many factories.

How to calculate overhead costs with an example

To better un­der­stand entries in a cost al­loc­a­tion sheet, let’s il­lus­trate this with an example for the material cost centre: There are 8 employees working in the pur­chas­ing de­part­ment, incoming goods warehouse, and incoming goods in­spec­tion. These de­part­ments belong to the material cost centre. Each employee earns a monthly salary of £2,500, resulting in overhead costs of £20,000. The monthly insurance cost per employee in this cost centre is £500, adding up to overhead costs of £4,000 for insurance. Ad­di­tion­ally, warehouse rental costs amount to £6,000, rep­res­ent­ing the overhead costs for rent.

Cal­cu­lat­ing overhead costs example

Using our example, the overhead cost rate for material overheads can be cal­cu­lated by dividing the total overhead costs of £30,000 by the direct costs of £100,000 and then mul­tiply­ing by 100. This results in an overhead cost rate of 30%.

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Al­loc­at­ing to cost units

In the given example, the direct costs for material overheads are derived from the total value of purchased and processed materials. For instance, if the material costs for a product or service are £1, they are subject to an overhead surcharge of 30%. This results in total costs of £1.30.

Please note: This article includes a legal dis­claim­er.