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Overhead and Methods of Overheads

Overhead is a term used for the way of measuring indirect expenses, or those expenditures that are essential for and contribute for the continuation of well-being of any business, but don't add directly for the profits of the company. Various examples of indirect expenses includes rent of office, utilities and maintenance costs for work facility, insurance fees for staff, fines and other licensing fees.

Frequently, a business owner will compute the ratio of indirect expenses with direct expenses. Direct expenses are those that go directly toward producing a profit-making product or service like the cost of labor and materials. Then the resulting ratio of indirect with direct expenses is known as an overhead rate, and may be also figured as an overhead percentage.

The various methods of absorption of overheads :

1.       Rate per unit of production

This is the simplest method. In this method, the units of production are taken as the source for overhead' absorption rate.

2.      Percentage on Direct Material Cost

In this method, the direct material cost is taken as the source of overhead absorption rate.

3.      Percentage on Direct Labour Cost

In this method, the direct labour cost forms the foundation of overhead absorption rate.

4.      Direct Labour Hour Rate

In this method, overhead absorption rate is determined on the basis of direct labour hours

How to Calculate Overhead Rating or Percentage

1.       Divide indirect expenses with direct expenses. There should be the same measure of time for both calculations.

2.       Evaluate the resulting figure which is also known as the overhead rate against typical overhead rates for other companies in a particular industry sector. If your overhead rate is lower than the typical overhead rate, then you have a competitive advantage.

3.       Then convert the overhead rate to an overhead percentage.