How to Calculate Overhead Rate Depending On Direct Labor Costs

What Is an Overhead Rate?

The overhead rate tells you how much indirect cost you need to allocate to each unit of production, each hour of labor, or each square foot of floor space. It is expressed as a percentage or a dollar amount per base unit. A reliable overhead rate helps you price products accurately, plan budgets, and evaluate profitability.

Why Use Direct Labor Cost as the Allocation Base?

Direct labor cost is often the easiest and most stable driver of overhead for many small‑ and medium‑sized businesses because:

• It directly reflects the amount of work performed.
• It correlates well with utilities, supervision, and support staff expenses.
• Historical payroll data is readily available.

If your overhead truly moves with labor effort, using direct‑labor cost will give you a more realistic picture than a simple flat‑rate approach.

Step‑By‑Step Calculation

1. Gather Direct Labor Data

Collect the total direct‑labor cost for the period you want to analyze (month, quarter, or year). Include wages, overtime, payroll taxes, and employee benefits.

• Example: 5,000 hours @ $30/hour = $150,000

2. Determine Total Overhead Costs

Sum all indirect expenses that support production but cannot be traced directly to a product. Typical items include:

• Rent and utilities
• Equipment depreciation
• Supervisory salaries
• Quality‑control and administrative support

For a new plant, you can benchmark against similar facilities or use industry averages.

3. Compute the Overhead Rate

Use the formula:

Overhead Rate = (Total Overhead Costs ÷ Total Direct‑Labor Cost) × 100%

Or, for a dollar‑per‑dollar rate:

Overhead Rate ($ per $ Direct Labor) = Total Overhead Costs ÷ Total Direct‑Labor Cost

Example: $300,000 overhead ÷ $150,000 direct labor = 2.0 → 200% overhead rate.

4. Apply the Rate to Future Jobs

Multiply the projected direct‑labor cost of a job by the overhead rate to estimate total cost:

Total Job Cost = Direct‑Labor Cost + (Direct‑Labor Cost × Overhead Rate)

If a new order requires $20,000 in direct labor, the overhead added would be $20,000 × 2.0 = $40,000, for a total of $60,000.

Industry‑Specific Examples

Manufacturing

Factories often base overhead on labor hours because machine setups, maintenance, and floor supervision scale with hands‑on work.

• Direct‑Labor Cost: $250,000 per year
• Total Overhead: $500,000 per year
• Overhead Rate: 200% (or $2 of overhead for every $1 of labor)

Construction

Project‑based contractors allocate overhead to each crew’s payroll, reflecting site supervision, insurance, and equipment rentals.

• Direct‑Labor Cost for a project: $80,000
• Allocated Overhead: $48,000
• Overhead Rate: 60%

Professional Services

Law firms or consulting agencies use billable‑hour salaries as the base. Overhead includes office rent, software licences, and marketing.

• Annual Direct‑Labor (billable salaries): $600,000
• Annual Overhead: $180,000
• Overhead Rate: 30% (or $0.30 per $1 of labor)

Quick Reference Checklist

Step	What to Do	Key Input
1	Collect total direct‑labor cost	Hours × Wage + Benefits
2	Sum all overhead expenses	Rent, utilities, admin salaries…
3	Calculate the overhead rate	Overhead ÷ Direct‑Labor
4	Apply the rate to new jobs	Projected labor cost × Rate

Tools & Templates to Accelerate Your Calculation

• Activity‑Based Costing Excel Template – allocate overhead by multiple cost drivers.
• Financial Statements Templates – consolidate overhead into income statements and balance sheets.
• Excel Financial Dashboard – visualise labor cost trends vs. overhead.

Putting It All Together

Use the checklist above, plug your numbers into the simple formula, and verify the result with a quick dashboard view. Adjust for inflation or seasonal labor spikes by updating the direct‑labor cost input each period.

Ready to streamline your overhead allocation? Explore the Activity‑Based Costing Excel tool to automate the calculations and gain deeper insight into your cost drivers.