Determining Factory Overhead Rates

The process of accurately calculating factory overhead rates is often complex and is not an exact science. It is important to start with fundamental assumptions and then review the resulting calculation against actual overhead costs periodically.

It is often impractical to apply the same overhead rates for all operations. For example, one operation may be labor intensive, requiring many hours of manual labor and little power or maintenance. Another operation may utilize expensive robotic equipment that requires very little manual labor but has high maintenance and operation costs. The Work Order module allows you to maintain overhead rates separately for each operation code to improve the accuracy of the overhead calculation.

To illustrate the process of determining factory overhead rates, assume that a company's whole plant is under one roof, and has only one work center. Assume also that there are five, full-time production employees in the plant.

The total fixed costs that will be incurred in the new year are calculated as illustrated below.

Shop Supervision	$45000.00
Rent	72000.00
Insurance	15000.00
Depreciation	51800.00
Total Fixed Costs	$183800.00

Because the variable costs vary depending on the amount of production, the costs for the year are calculated based on different percentages of full production capacity, as illustrated below.

Percentage of Capacity	80%	90%	100%
Indirect Labor	$12800.00	$14400.00	$16000.00
Variable Utilities	4800.00	5400.00	6000.00
Maintenance	2240.00	2520.00	2800.00
Total Variable Costs	$19840.00	$22320.00	$24800.00

Now that total costs have been determined, overhead rates can be calculated. For this example, direct labor hours are used as the basis for determining the rates. This method is historically the most common basis of calculating factory overhead. In this example, if the factory is utilized at 100 percent capacity, there will be 10,000 hours of direct labor.

Dividing the total fixed costs and total variable costs by the number of hours determines the rate per hour to be used. The number of labor hours and the resulting rate per hour will be different based on the production capacity of the factory as illustrated below.

Percentage of Capacity	80%	90%	100%
Total Fixed Costs	$183800.00	$183800.00	$183800.00
Divided by Labor Hours	8000	9000	10000
Fixed Overhead per Hour	$22.98/HR	$20.42/HR	$18.38/HR
Total Variable Costs	$19840.00	$22320.00	$24800.00
Divided by Labor Hours	8000	9000	10000
Variable Overhead per Hour	$2.48/HR	$2.48/HR	$2.48/HR

If the projection for the year is to use 100 percent capacity of the factory, the fixed overhead rate of $18.38 per hour and variable overhead rate of $2.48 per hour should be used.

As this example shows, the variable overhead rate is a fixed rate, regardless of the percentage of production capacity that is assumed; however, the fixed overhead rate varies with the percentage of production capacity. The application of any overhead rate only approximates the actual overhead costs. Over time, there will be either an under- or over-application of overhead to work in process.