What is a predetermined overhead rate?
A predetermined overhead rate is an estimated amount of overhead costs that will be incurred during a set period of time. This rate is used to allocate or apply overhead costs to products or services.
Predetermined overhead rates are essential to understand for eCommerce businesses as they can be used to price products or services more accurately. They can also be used to track the financial performance of a business over time.
In this post, you’ll learn all about:
- What overhead is and why it’s important to predict.
- Examples of predetermined overhead rates in real-world contexts.
- How this metric can directly impact your business.
But before we dive deeper into calculating predetermined overhead, we need to understand the concept of overhead itself.
What is overhead?
Overhead refers to all the indirect costs incurred in running a business. These costs cannot be easily traced back to specific products or services and are typically fixed in nature.
Examples of overhead costs include:
- Office supplies
Anytime you can make the future less uncertain, you’ll be more successful in your business.
That’s the entire idea of predetermined overhead rates—by estimating the amount of overhead that will be incurred, you can better plan for and control these costs.
How do I know if a cost is overhead or not?
Despite what business gurus say online, “overhead” and “all business costs” are not synonymous.
So how do you know if a cost is overhead? Short answer: If it’s indirect and fixed, it’s most likely overhead.
Indirect costs are those that cannot be easily traced back to a specific product or service. For example, the office rent mentioned earlier can’t be directly linked to any one good or service produced by the business.
Fixed costs are those that remain the same even when production or sales volume changes. So if your business is selling more products, you’ll still be paying the same amount in rent.
A good rule of thumb is to ask yourself if the cost will be incurred regardless of how much product you’re making.
For example, let’s say you own a small t-shirt company. The cost of your office rent would be considered overhead because it’s something you have to pay regardless of how many t-shirts you sell.
Conversely, the cost of the t-shirts themselves would not be considered overhead because it’s directly linked to your product (and obviously changes based on the volume of products you create and sell).
Why are predetermined overhead rates important?
Predetermined overhead rates are important because they provide a way to allocate overhead costs to products or services.
This allocation helps businesses to better understand the costs associated with rendering a service or producing a product. In other words, it gives you a clearer picture of your business’s profitability.
It also allows businesses to make more informed decisions when pricing their products or services. If you know how much overhead is associated with each product, you can add that cost to the price and ensure that you’re making a profit.
How to calculate a predetermined overhead rate
There are various ways to calculate a predetermined overhead rate. The most common method is to use the formula:
(Total Estimated Overhead Costs / Total Estimated Activity) x 100 = Predetermined Overhead Rate
For example, if a business has estimated that its overhead costs for the upcoming year will be $120,000 and its total estimated activity for the year is 12,000 hours, its predetermined overhead rate would be:
($120,000 / 12,000) x 100 = $10 per hour
That means this business will incur $10 of overhead costs for every hour of activity.
Another example: if a business has estimated that its overhead costs for the upcoming year will be $200,000 and its total estimated activity for the year is 25,000 hours, its predetermined overhead rate would be:
($200,000 / 25,000) x 100 = $8 per hour
Again, that means this business will incur $8 of overhead costs for every hour of activity.
Another way to calculate your predetermined overhead rate is by using a percentage of direct labor costs. To do this, you would use the following formula:
(Total Estimated Overhead Costs / Total Estimated Direct Labor Costs) x 100 = Predetermined Overhead Rate
For example, if a business has estimated that its overhead costs for the upcoming year will be $120,000 and its total estimated direct labor costs for the year are $600,000, its predetermined overhead rate would be:
($120,000 / $600,000) x 100 = 20%
This means that for every dollar of direct labor costs, the business will incur $0.20 in overhead costs.
A predetermined overhead rate is a useful tool for businesses of all sizes. By understanding how to calculate this rate, business owners can better control their overhead costs and make more informed pricing decisions.
Of course, that leaves us with a glaring question: how can you predict your overhead costs to plug them into this equation?
How to predict overhead costs
The most important step in calculating your predetermined overhead rate is to accurately estimate your overhead costs.
This will require you to take a close look at all the indirect costs associated with running your business. You’ll need to consider both fixed and variable costs, as well as one-time and recurring expenses.
Once you have a good handle on all the costs involved, you can begin to estimate how much these costs will total in the upcoming year.
The best way to predict your overhead costs is to track these costs on a monthly basis. This will give you a good idea of what to expect in the upcoming year.
Once you have a handle on your estimated overhead costs, you can plug these numbers into the formula to calculate your predetermined overhead rate.
What are some examples of overhead costs?
- Salaries and benefits for office staff
- Legal and accounting fees
- Advertising and marketing expenses
- Website hosting and maintenance fees
- Equipment rentals
- Shipping and transportation costs
What expenses are not considered overhead costs?
- The cost of goods sold (COGS)
- Direct labor costs
- Direct materials costs
Now, let’s look at some hypothetical business models to see actual use-cases for predetermined overhead rates.
Example 1: Marketing Agency
Here’s how a service-based business, namely a marketing agency, might go about calculating its predetermined overhead rate.
Some examples of overhead in a service-based business include:
- Employee benefits
- Office supplies
- Software subscriptions
Not a whole lot compared to other business models (which is probably why a lot of people choose to start these sorts of businesses!).
To calculate the predetermined overhead rate, the marketing agency will need to add up all of its estimated overhead costs for the upcoming year. Let’s say their total estimated overhead costs are $50,000.
Then, they’ll need to estimate the amount of activity or work that will be performed in that same time period. For this example, we’ll say the marketing agency estimates that it will work 2,500 hours in the upcoming year.
With these numbers, they can plug into the formula like so:
($50,000 / 2,500) x 100 = $20 per hour
This means that for every hour of work the marketing agency performs, it will incur $20 in overhead costs.
This predetermined overhead rate can be used to help the marketing agency price its services.
For example, if the agency knows it will need to complete a project that will take 10 hours of work, it can use its predetermined overhead rate to estimate the total cost of the project:
10 hours x $20 per hour = $200
This predetermined overhead rate can also be used to help the marketing agency estimate its margin on a project.
For example, let’s say the marketing agency quotes a client $1,000 for a project that will take 10 hours of work. The agency knows from its predetermined overhead rate that it will incur $200 in overhead costs for the project.
This means that the agency’s margin on the project will be:
$1,000 – $200 = $800
The agency can then compensate for this loss by charging their clients this higher rate.
Example 2: eCommerce Business
Let’s say we want to calculate the overhead cost of a homemade candle eCommerce business.
The predetermined overhead costs for this business may include:
- The cost of the website hosting and domain name
- The cost of the shopping cart software
- SSL certificate fees
- Payment processing fees (e.g., PayPal, Stripe)
- The cost of advertising
- The cost of shipping supplies
- The cost of packaging
- Indirect labor costs, such as the cost of the business owner’s time spent on administrative tasks, customer service, etc.
- The cost of utilities used to run the business, and so on.
In order to compensate for these costs, the business owner can use their predetermined overhead rate to price their products appropriately.
For example, if the predetermined overhead rate for the eCommerce business is $5 per hour, and it takes the business owner 2 hours to make a batch of candles, the predetermined overhead cost of those candles would be:
$5 per hour x 2 hours = $10 predetermined overhead costs for the batch of candles.
The business owner can then add the predetermined overhead costs to the cost of goods sold to arrive at a final price for the candles.
For example, if it costs the business $20 to make a batch of candles, the final price of the candles would be:
$20 (cost of goods sold) + $10 (predetermined overhead costs) = $30 final price for the batch of candles.
Again, this predetermined overhead rate can also be used to help the business owner estimate their margin on a product.
For example, if the business owner sells a batch of candles for $30, and the predetermined overhead costs were $10 for that batch, the business owner’s margin would be:
$30 (sale price) – $10 (predetermined overhead costs) = $20 margin on the batch of candles.
As you can see, calculating your predetermined overhead rate is a crucial first step in pricing your products correctly. By taking the time to estimate your overhead costs and calculate your predetermined overhead rate, you can ensure that your prices are fair and accurate and that your profits aren’t getting eaten away by hidden costs.
How often should you calculate your predetermined overhead rate?
You should calculate your predetermined overhead rate at least once per year. This will ensure that your rates are accurate and up-to-date.
Additionally, you should recalculate your predetermined overhead rate any time there is a significant change in your business, such as the addition of new equipment or a change in your product line.
By accurately calculating and tracking your predetermined overhead rate, you can gain valuable insights into the costs associated with running your business. This information can help you price your products or services more accurately and make better financial decisions for your business.
Should you have predetermined overhead rates for each department of your business?
Yes, it’s a good idea to have predetermined overhead rates for each area of your business.
This will help you track the costs associated with each department and make more informed decisions about where to allocate your resources.
For example, if you have a predetermined overhead rate for your marketing department of $5 per hour and you have a predetermined overhead rate for your shipping department of $3 per hour, you can quickly see that your marketing costs are higher than your shipping costs.
This information can help you make decisions about where to cut costs or how to allocate your resources more efficiently.
What if you don’t have all the information you need to calculate your predetermined overhead rate?
There are many folks reading this post that don’t have the historical data needed to calculate an accurate predetermined overhead rate. If that’s you, there are a few options you can consider:
1. Use an industry average predetermined overhead rate. This option is best if you’re just starting out and don’t have any historical data to work with.
Industry averages can be found in trade publications or online. Once you have an industry average, you can adjust it to fit your specific business needs.
For example, if you know that the industry average for predetermined overhead rates is $5 per hour, but you only have 2 hours of work to do each day, you can adjust the industry average to fit your needs by dividing it by the number of hours you work.
This would give you a predetermined overhead rate of:
$5 per hour / 2 hours = $2.50 per hour
2. Estimate your costs as accurately as possible. This option is best if you have some idea of your costs but don’t have exact numbers.
3. Hire a professional to help you calculate your predetermined overhead rate. This option is best if you’re unsure of how to calculate your predetermined overhead rate or if you don’t have the time to do it yourself.
You can hire professionals to help in the following ways:
- Look for a consultant or accounting firm that specializes in small businesses.
- Ask for referrals from other small business owners.
- Post a job on an online freelancing platform such as Upwork or Fiverr.
A predetermined overhead rate is a critical tool for any eCommerce business. By taking the time to accurately calculate your predetermined overhead rate, you can ensure that your prices are fair and accurate and that your profits aren’t being eaten up by hidden costs.
If you want to learn more about running and scaling a successful eCommerce business, subscribe to our blog.
Or, check out these other related posts:
- Use the Reorder Point Formula For Your Inventory
- Economic Order Quantity Formula: What It Is and How to Use It
- How to Use the Retail Price Formula to Calculate Pricing
- How to Calculate Ending Inventory with the Ending Inventory Formula