In Part 1 of this series, I gave an overview of the different categories of overhead rates. In Part 2, I’ll show you not only how to calculate overhead rates, but some of the strange lingo that’s part of the process.
The two factors that determine overhead rates are the base, sometimes called the burdenable base or prime dollars, and the expense, or overhead. The overhead rate is merely the ratio between your expenses and your base.
The Base
The base, or prime dollars, is comprised of several categories, or “pools“:
- Direct Labor - employees’ wages/salaries that work directly on specific contracts. This can be further broken down into separate pools for Engineering, Manufacturing, Field Service, etc.
- Direct Material - raw material or parts purchased for specific contracts
- Subcontract Material - larger assemblies that exceed a certain dollar threshold
- Travel - travel and lodging directly related to specific contracts
- Other Direct Cost - items that don’t fit into any of the other categories
Overhead Expense
Sometimes referred to as “burdens“, overhead includes expenses not directly related to specific contracts, such as employee medical benefits, rent, electricity, etc. Expenses are categorized by pool. For instance, the maintenance expense for a drill press would be allocated to the Manufacturing pool, while the calibration expense for an oscilloscope would be classified as an Engineering expense.
The Calculation
The purpose of calculating the overhead rate is to see what the ratio is between your direct costs and your expenses. This makes it easier to spot trends, as both sides of the ratio vary year to year.
Here’s an example. Company A projects direct Engineering labor of $10 million, and Engineering-related expenses of $15 million for 2009. This works out to an Engineering overhead rate of 150%:
15,000,000 / 10,000,000 = 1.5 x 100 = 150%
Company B, on the other hand, has direct Engineering labor of $8 million, and Engineering overhead expense of $11 million:
11,000,000 / 8,000,000 = 1.375 x 100 = 137.5%
Company B has done a better job of controlling its overhead expense, and is better positioned to win future contracts from the government. Of course, this is a simplistic view, and the other overhead pools (material, travel, etc.) would have to be taken into account.
How can we apply this to personal finance? You could use your wages as the base, and calculate a year-to-year overhead rate using your expenses. You’d be able to spot trends over time. Expenses can be measured as a percentage of your income.
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