Finance & Capital mentor Stephen King responds to the following question from an inc.com user:
A client of mine has requested that I calculate my overhead rate. I have not yet calculated it because I have only been in business for two years. I understand that the overhead rate is indirect costs divided by direct costs. How do I calculate the factor?
A book that I have been reading has indicated a sample overhead factor of 1.3. In a recent period, I had $30,000 in indirect costs and $60,000 in direct costs. What is the actual formula?
Stephen King's response:
Overhead rates are typically used by manufacturing companies to allocate overhead costs to products and by service companies to allocate overhead costs to client projects. A company can use performance ratios, such as an overhead rate, to effectively manage its operations and to measure its overall performance against that of similar companies in its industry. (Related: Watch Norm Brodsky talk about getting help following your business's critical numbers.)
An overall overhead rate can be calculated by dividing overhead (indirect) costs -- for example, rent and utilities -- by direct costs -- for example, labor. If your overhead costs are $30,000 and direct costs are $60,000, your overhead rate is .50. If the typical overhead rate for companies in your industry is 1.3, and your rate is .50, you have a competitive advantage with your lower overhead.
Performance ratios such as overhead rates should be tracked monthly, quarterly, and annually. Tracking overhead rates over time will highlight trends and normalize exceptions caused by extraordinary items or the timing of monthly expenses.
Related resource: The U.S. Small Business Administration offers a guide called "Pricing Your Products". The publication covers retail pricing and pricing for services and includes a discussion of overhead rates.
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