Shop overhead rate: calculate it from 2 estimates

• pull last year's overhead totals and sort out each cost you cannot tie to a single job, since those costs belong in the overhead estimate.
• estimate direct labor from payroll records for the same period as the overhead estimate, and write down what the labor figure includes.
• divide your overhead estimate by your labor estimate to get your own rate, and keep both inputs dated in the working file.
• multiply the labor on each job by that rate, and write the overhead amount on the job ticket as its own line.
• write a dated note with the reason whenever you revise the rate, so earlier job tickets stay traceable.

Overhead costs are the costs that you incur to run a business but can't directly attribute to any specific business activity, product, or service, according to Microsoft Learn. Your first task is to sort each cost on your books into costs you can tie to a single job and costs you cannot. The definition is one publisher's wording, so treat it as a working test rather than a rule every firm must follow.

Direct labor sits outside overhead in this method. The rate needs inputs from your records: the overhead estimate and the direct labor estimate. Keep rent, utilities, insurance, and office costs in one list, and keep wages paid for hands-on work in another list. Mixing the lists would make the rate measure something other than the costs you meant to spread across jobs.

A company may know it will have a contract to produce 100 custom units long before it knows the utility costs for the next year, according to OpenStax. Your shop can face the same gap between what you know and what you will spend, so write down the date of each estimate. Keep the date beside the figure in your working file, because it shows what you knew when you prepared the figure.

The example counts custom units, so its unit count does not transfer to service calls. Take the timing point from the example rather than the unit count. Your service calls will have their own labor and overhead figures, drawn from your records. Ask whether any of your costs depend on a contract that is not yet signed.

Before you build the estimate, list each overhead category in one column and mark whether it ties to a specific job. Costs that tie to a specific job belong on that job's ticket instead of the overhead pool. Keep the list in whatever form your shop already uses. Carry this list forward into the yearly estimate, since the estimate starts from the same categories.

Estimated yearly overhead of $250,000

Dinosaur Vinyl, according to OpenStax, uses the expenses from the prior two years to estimate the overhead for the upcoming year to be $250,000. That method starts from money already spent, so the first input is spending from the prior years. Pull the expense records for the most recent full year before you write any figure down. Gathering the records first keeps the estimate tied to actual spending rather than memory.

Gather the overhead side into one list, covering the categories you sorted earlier, and total that list for the most recent full year. Keep each amount in dollars so the total can be compared with the labor estimate later. Write the source of each amount beside it, such as a bank statement or an invoice, so the figure can be checked. Mark any amount you estimated rather than recorded, because that amount may move when actual figures arrive.

Adjust the list for changes you already know about, such as a lease that is ending or an insurance renewal. Note each adjustment beside its amount and the date it takes effect. Leave out any cost you sorted as tied to a specific job, because that cost belongs on the job's ticket. Keep the adjusted list on a separate page, so the original records stay unchanged.

Your own estimate replaces the example's $250,000, and it should come from your records rather than from the example. Check the finished estimate against your records for the same period once more before you use it. Write the final figure at the top of the working file so every later step draws from it.

Keep the estimate separate from the actual results, so the two can be compared later in the year. Label the estimate with its period and the date you prepared it. That label is the reference you will use when you review the year. Matching labels also help you find an earlier estimate quickly.

Estimated direct labor of $100,000

Dinosaur Vinyl, according to OpenStax, also used its payroll records to estimate that it will spend $100,000 on direct labor. Payroll records are the starting point for the labor side of the rate, so pull them for the same period as the overhead estimate. Matching the periods keeps both inputs comparable. Look at the wage lines first, then the hours behind them, and note which pay is tied to hands-on work.

Count wages for hands-on work on jobs as direct labor, and leave office pay out of that figure. Write the reason for each split in the working file, so a later reviewer can follow it. Check the split again whenever a new kind of wage appears in the payroll records.

Write down what the labor figure includes, such as overtime, helper hours, or paid time off, and decide how each item is treated. Keep that decision on file with the estimate, so the labor base stays the same from one review to the next. Changing the treatment midyear would change the base, so record any change as a new dated figure.

The labor estimate is the number you divide by, so a labor figure that is too low raises the rate and one that is too high lowers it. Check the labor figure against the payroll records again before dividing. Confirm that the payroll extract covers the same dates as the overhead list. Fix any date gap before you calculate the rate, not after.

Dividing the overhead estimate by the labor estimate produces the rate you will apply to jobs, so both inputs should be final first. Record the labor estimate with its period and the date of the payroll extract, so the record is traceable. Keep that record with the overhead list, so the rate can be rebuilt from its parts.

The estimates above give this calculation:

If the total labor paid for the job is $66, the overhead applied to the job is $2.50 times that amount, or $165, according to OpenStax. The same multiplication applies to any job's labor total once you have your own rate. Use the example to check your arithmetic before you use your own figures.

Start with the labor actually paid on one completed job, taken from payroll or time records for that job. Using paid labor rather than a quoted labor figure keeps the job record matched to what the shop actually spent. Note the job's name or number beside the labor total, along with the dates the labor was worked. For the work order fields that hold this record, see the field service work order checklist.

Multiply that labor total by your rate and write the overhead amount on the job ticket as its own line, next to the labor line. Keeping overhead on its own line lets anyone reading the ticket see labor and overhead separately. Check the overhead line against the labor line and the rate before you close the ticket.

Use the same multiplication for every job, so the overhead line is worked out in the same way across the shop. A shared method makes later comparison of job tickets simpler for your records. Write the method on a card or in your working file where staff can read it. Review the method each time the yearly estimate changes, since that review is where any new rate should be entered.

Do not carry the $2.50 example rate onto your own jobs, because it is the example's rate and not a figure measured for your shop. Replace it with the rate you calculated from your own estimates before you apply the rate to any ticket.

Illustrative example with round numbers

This example uses invented round numbers to show the arithmetic, and it is not a figure from any shop. Take a yearly overhead estimate of $100 and a direct labor estimate of $50. Dividing the overhead estimate by the labor estimate gives a rate of 2, which means $2 of overhead for each $1 of labor. For an illustrative job with $50 of direct labor, multiplying $50 by 2 gives $100 of overhead.

Figure 4.18 shows the monthly costs, the annual actual cost, and the estimated overhead for Dinosaur Vinyl for the year, according to OpenStax. Use the same kinds of figures in your own review: monthly costs, the annual actual cost, and the estimated overhead.

Record your monthly overhead costs in the same layout as the estimate, so the actual and the estimate can be read side by side. Add each month's actual costs to the record as they become known. Keep the monthly record in the same file as the yearly estimate. Date each entry so the monthly timing stays visible.

Read each category's monthly amount against its estimated amount, and note any category that runs well above or below plan. Write a short reason beside each note, such as a repair or a price change you can name. A note with a reason is easier to explain when someone asks about the rate later. If your job cost lines need setting up first, see job costing setup for field service.

Write the date, the reason, and the new rate in the record each time you rerun, so the change can be explained later. Keep the earlier rate in the record too, so both rates can be compared. Mark which rate was applied to each job ticket before the change, so earlier tickets stay traceable. Tickets written before a change keep the rate that was in force then.

Keep the estimate worksheet, the payroll extract used for direct labor, and the overhead list together, each with its date. Store them in the same place as the job tickets they support, so a reviewer can trace a rate to its inputs. A complete file lets you retrace the rate without rebuilding it from memory. Name the files by year and period so they sort in order.

Keep each dated record of a rerun with its reason, so the estimate can be traced to the period it covers. Note which costs moved between the overhead list and the job tickets during the year, since moving a cost changes the overhead total. Record the date of each move beside the note. Review the moves at year's end so the records match, which makes the next estimate easier to prepare.

Keep a copy of the job ticket that shows labor and overhead as separate lines, so you can retrace the rate applied to that job. Keep the copy with the labor record for the same job. Keep copies for every job, not just the large ones. Choose the same filing method for every job so the copies are easy to retrieve.

Keep a short note of the sources you used for each figure, such as payroll records and the overhead list, so each input can be checked later. Name each source with its date and the person who supplied it, if that person is known. The note should say where each amount came from, not just what it is.

Today, open your most recent full year of overhead records and list each cost in one column, marking any cost you can tie to a single job. That list is the starting point for your yearly overhead estimate.

What counts as overhead?

Costs you cannot tie to a specific business activity, product, or service belong in the overhead estimate. Use the sorting test in the “What overhead means” section when reviewing your records.

How is the example rate found?

Divide $250,000 of overhead by $100,000 of direct labor to get $2.50 of overhead for each dollar of direct labor. Use estimates covering the same period when calculating your own rate.

What overhead lands on a $66 labor job?

At the example rate, $165 of overhead lands on that job. Your own figure depends on your own rate, not on the example rate.

Can the calculation be rerun?

Yes, you can run overhead calculation multiple times for the same fiscal period if you change cost accounting policies or detect specific errors, according to Microsoft Learn.

Is $2.50 a typical rate?

No typical rate is established here; $2.50 is the example rate. Build your own rate from your own estimates instead of relying on the example figure.

Can the estimate be made before utility costs are known?

Yes, an estimate can precede known utility costs. Date it so you can distinguish the estimate from actual costs recorded later.