Calculate overhead

CALCULATING OVERHEAD
AND PRICE
lan Hauff, pricing expert and small business specialist for University Outreach and Extension at the

A University of Missouri-St. Louis, has devised a seven-step process for calculating the all-important
overhead percentage, which is shown in Fig. I-I on the following page. After the overhead
percentage is determined, important pricing decisions can be made.
To calculate overhead percentage, several terms must be defined. These are found in Table I-I.
For instance, an overhead percentage of 220% means that for every $1.00 of direct labor billed to the
customer, the business must collect an additional $2.20 ($1.00 x 220%) from that customer just to cover
its cost of doing business. Thus, if a job required a direct labor wage of $8.50 per man-hour, overhead of
$18.70 ($8.50 x 220%) must be added, thus totaling a direct labor cost of $27.20 per man-hour. It is at
this point that many business owners are shocked to discover the large difference between the total direct
labor wage and the direct labor cost.

TABLE I-I. PRICING-RELATED TERMS.

TERM DEFINITION

Business Expenses All expenses found on the company’s income statement (also known as the
profit and loss statement).

Overhead Expenses All costs found on the income statement except for direct labor, direct
materials, and costs attributable to outside subcontractors that can be billed
directly to a customer’s account.
Overhead expenses are absorbed by the business and factored into the
selling price as a percentage of the direct labor cost. They include indirect
costs such as accounting, advertising, depreciation, indirect labor,
insurance, interest, legal fees, rent, repairs, supplies, taxes, telephone,
travel, and utilities.

Direct Labor Labor used to produce products and services purchased by customers.
These man-hours are directly attributable to customer activity.

Indirect Labor Labor used to provide supporting services to the business such as
accounting, clerical, custodial, customer services, management, purchasing,
sales, and warehousing. These man-hours support business functions that
are not directly chargeable to the customer.

Direct Materials Materials used in the final product or service purchased by customers.
These materials are charged directly to the customer’s account.

Overhead Ratio between direct labor and overhead expenses. This percentage is used
Percentage to allocate overhead expenses proportionately to direct labor dollars billed to
customers.

Source: Mildred S Pozner and Catherine M. Frank, Industry at a Glance Report: Manufacturing Job Shops,University of Missouri-Rolla, SBRI
Center, 1999, 80-82.

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FIG. I-I. PROCESS FOR CALCULATING OVERHEAD PERCENTAGE,

Step 1 1. Classify each employee’s contribution, or portion
Determine the “average” thereof, as either direct or indirect labor. Determine the
hourly wage paid to hourly wage rate paid to each direct labor employee and
direct labor employees. include the business owner, if applicable. Total the
hourly wage rates and divide by the number of people
counted.

2. Calculate the number of direct labor workdays in a
calendar year by subtracting the average number of
Step 2
days that direct labor employees will not be present for
Estimate direct labor
work because of weekends, holidays, vacations, and
workdays available in the
miscellaneous (injury, personal illness, etc.). Count only
calendar year.
direct labor employees. Do not include any indirect labor
employees in the estimate.

3. Multiply available direct labor workdays by the
Step 3 scheduled 8-hour workday minus the average number of
Estimate billable direct daily non-billable direct labor hours. Non-billable direct
labor hours for work year. labor hours include lunches, breaks, company meetings,
training, cleanup, etc., that a customer will not be
charged for directly.

Step 4
Estimate billable direct 4. Multiply billable direct labor hours by average direct
labor dollars for work year. labor wage.

5. Subtract billable hours from the total man-hours
available in a work year, which is 2088 hours. The
remainder equals the non-billable direct labor hours.
Step 5 Multiply this number by the average direct labor rate to
Estimate non-billable direct arrive at the non-billable direct labor dollars. Non-billable
labor dollars for work year. direct labor dollars are absorbed by the company and
must be passed on to the customer through the
overhead percentage.

6. Refer to the actual or pro forma income statement and
Step 6 total all the business expenses shown for the year.
Estimate all overhead Deduct the cost of billable direct labor, direct materials,
expenses for work year to and costs attributable to outside subcontractors that will
include non-billable direct be billed directly to a customer’s account. Do not deduct
labor. the cost of non-billable direct labor. Adjust the overhead
expenses for yearly inflation and projected price
changes by multiplying the total by the anticipated
percentage increase.

Step 7 7. Divide the yearly overhead expenses (step 6) by the
Calculate the annual yearly billable direct labor dollars (step 4), and convert
overhead percentage. this ratio to a percentage.

2

Job shop owners are often shocked to learn the magnitude of their overhead, but including overhead in
the prices a firm charges for its products and services is essential for the firm’s survival and profitability.
After the overhead percentage has been calculated, a business owner can examine the possibilities for
making changes in the business that will yield desired results, such as lowering overhead in targeted
areas, raising prices, decreasing production times, etc.

Pricing Services
To calculate the price for a job shop service, the firm must set the desired percentage gross margin on
selling price. (Gross margin on selling price is the preferred method for adding profit to a product or
service because it matches the reporting done in income statements where sales revenue is recorded.)
Thus, the price a shop should sell its services for is calculated by:

Avg. Direct Labor Rate (in $/man-hour; from Step 1)
+ Overhead Rate (Avg. Direct Labor Rate x Overhead % [Step 7]; in $/man-hour)
Direct Labor Cost (in $/man-hour)

For a desired gross margin on selling price of x%, convert x% to a decimal and calculate the price:

Direct Labor Cost ÷ (100 – x) = Charging Rate per man-hour

Example:
Smith’s Welding Shop has determined its average direct labor rate to be $15.00/man-hour. It has
calculated that its overhead percentage is 200%. It now wants to make a 15% gross margin on selling
price. The price Smith’s Welding Shop must charge for its services is found by:

$15.00/man-hour Avg. Direct Labor Rate
+ $30.00/man-hour Avg. Direct Labor Rate x Overhead Percentage
$45.00/man-hour Direct Labor Cost

For a 15% gross margin on selling price,

$45.00 ÷ (.85) = $52.95/man-hour

Smith’s Welding Shop must ask $52.95 per man-hour for its services to make the desired profit margin.

Pricing Products
A similar method to pricing services is used to establish product prices. Calculate the cost of producing
one item or unit and use the gross margin on selling price method shown in the service example above to
find selling price.

Example:
If Smith’s Welding Shop makes and sells a specific type of widget in addition to providing services, it
would need to find the cost of producing one widget before it could set a price for the product. Both direct
material costs and direct labor costs must be included in the price calculations. If production time for one
widget is 10 minutes and each widget uses $0.84 in materials:

$45.00/man-hour ÷ 60 minutes = $0.75/minute

$0.75/minute x 10 minutes/widget = $7.50 direct labor cost per widget
+ $0.84 direct material costs per widget
$8.34 cost to produce one widget

For a 15% gross margin on selling price,
$8.34 ÷ (.85) = $9.82 selling price for each widget

3

Calculate overhead

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