Hourly overhead rate: 3 capacity cases to compare

An hourly overhead rate is budgeted overhead divided by expected labor hours, showing how much overhead you allocate to each hour.

• Use the same activity measure across all three capacity cases.
• Estimate overhead from how your costs behave at each level.
• Record the capacity assumption beside each rate.
• Check rounded rates before using them in a comparison.

You get it by dividing the overhead you expect to spend by the activity you expect to use. Shop overhead is the cost of running the operation that is not the direct labor on a job itself, such as space, equipment upkeep, supervision, and utilities. Those costs still have to be recovered, and spreading them across billable hours is one way to do that.

The OpenStax textbook Principles of Accounting, Volume 2: Managerial Accounting calls this the standard overhead rate. In its example, " the standard overhead rate is the total budgeted overhead of $10,000 divided by the level of activity (direct labor hours) of 2,000 hours ."

The important word in that definition is budgeted . The rate depends on what you plan to spend and how many hours you plan to bill, rather than on what you spent in the past. When your output changes, both planning numbers can change, and the rate changes with them. That is why the capacity level you plan for matters so much.

This post walks through three capacity cases from the same OpenStax example: 100%, 90%, and 110%. Each case gives a different expected overhead and a different rate, so you can set them side by side. The goal is not to find one correct answer. It is to see the range your rate can take and to decide which level you plan for.

For help choosing the inputs, see overhead inputs before a job price .

At 100% capacity, the overhead rate is the overhead you budget at that level, divided by the activity you expect at that level. Start with this case, because the other two are read against it.

The example sets up its base case this way: Connie's Candy budgets capacity of production at 100% and determines expected overhead at this capacity . It also puts a number on output at that level: units of output at 100% is 1,000 candy boxes . The standard rate uses 2,000 direct labor hours as its activity base, so the base case is built from both a dollar figure and an hour figure.

The same example also separates variable overhead from the total. The standard variable hourly overhead rate is $2.00 ($4,000/2,000 hours), taken from the flexible budget at 100% capacity . Splitting variable overhead out of the total matters when you want to know which part of the rate follows activity. A rate built partly from variable amounts will respond to a change in output differently than one built only from amounts that stay put. That is a general point about cost behavior, and the example shows it with its own figures.

Before you look at the other cases, write the base case down in full. Record the total budgeted overhead, the activity level, the units or hours behind it, and the resulting rate. If you track variable overhead, record that part on its own line. These items become your reference point for every comparison that follows, and they are the first figures to check when a later number looks wrong.

At 90% capacity, the example states: "if Connie's Candy only produced at 90% capacity, for example, they should expect total overhead to be $9,600 and a standard overhead rate of $5.33 (rounded)" ( OpenStax ). This is the lower of the two alternative levels the example examines.

Set that next to the base case. Expected overhead falls from the base-case figure to the 90% figure, while activity drops by the difference between 90% and 100% capacity. Overhead falls by less than activity does, so the standard rate in this case ends up higher than the rate in the base case, not lower. It is easy to assume that lower output means a lower rate. This case shows why that assumption can fail.

Why would overhead fall so little? In general terms, some overhead may not shrink when work slows. Rent or a salaried supervisor is an example of a cost that may stay the same size for a period. For your shop, a 90% case works as a planning check. It shows what a slower period would do to the rate you charge against each billable hour. That answer matters when you set prices, review staffing, or decide how much overhead you can absorb if work comes in below plan.

Keep one caution in mind. The 90% case is a planning figure, not a forecast of your results. The example asks what would happen at this level. It does not predict what will happen in any particular shop, including yours.

The example asks what overhead outcomes will be at 110% capacity, and it answers with figures for a higher output. It states that if "Connie's Candy produced 2,200 units, they should expect total overhead to be $10,400 and a standard overhead rate of $4.73 (rounded)" ( OpenStax ).

Two details here deserve attention. First, the higher-output quantity is labeled inconsistently as units rather than hours. That wording alone does not establish a different denominator for the $4.73 rate; confirm the activity base before comparing it with the base-case rate. Second, more output brings more total overhead than the base case. Even so, the rate is a ratio of the two figures, so the dollar amounts alone do not tell you the answer.

Run this case before you commit to a plan, especially if you expect work to come in above the level you budgeted. The higher-output figure shows what the rate looks like when the shop is busier than planned, and whether the budgeted overhead still fits that level of activity.

The rate moves from case to case because expected overhead and the activity level both change, and the rate is the result of dividing one by the other. Neither number moves alone in these examples.

The overhead amounts rise from the 90% case to the base case and again at the higher output. Those amounts move in a steady direction, but the rates do not follow them in a simple line. Each rate is divided by its own activity figure, and the activity figures change too. So a rate can move the opposite way from overhead in the same comparison.

A useful habit is to check the direction of each change before you look at the result. Ask whether overhead went up or down, and whether activity went up or down. Then ask which change was larger. That order keeps you from reading a rate as a verdict on spending when it is really a result of the activity base.

This is also why a single planning number can hide a lot. A rate that looks stable from one period to the next may still rest on overhead and activity that both moved. When you present a rate, show the overhead and activity behind it, not only the result.

Under the Federal Acquisition Regulation (FAR), costs of idle capacity are costs of doing business and are a factor in the normal fluctuations of usage or overhead rates from period to period .

The same section defines the term. Idle capacity means the unused capacity of partially used facilities . It also describes idle capacity in a longer sentence, which is worth reading in full:

> It is the difference between that which a facility could achieve under 100 percent operating time on a one-shift basis, less operating interruptions resulting from time lost for repairs, setups, unsatisfactory materials, and other normal delays, and the extent to which the facility was actually used to meet demands during the accounting period.

Source: FAR 31.205-17, Idle facilities and idle capacity costs .

The rule's wording lines up with the three cases in this post. The base case is built at 100%, and the 90% case asks what happens when the operation runs below that point. The rule gives a reason to expect rates to move from period to period, and the three cases show rates moving across capacity levels.

This is a federal acquisition rule. Treat it as the federal rule it is, and check your own cost rules before you apply its wording to your shop's rates. The example and the rule are useful for thinking through capacity, but they do not replace your own cost policies.

Plan for the case that matches the work you expect, and use the other two as checks. The base case at 100% is the natural starting point, because the example budgets capacity there. The lower and higher cases tell you how sensitive the rate is to changes in output.

Ask a few questions before you pick. How much of your billable work is already booked, and how much is still uncertain? If work is slow in certain months, does your overhead drop along with it, or does it stay where it was? Which part of your overhead is fixed for a period, and which part follows activity? Your answers point toward a level. A shop with steady bookings may plan near the base case and check the lower case for slow periods. A shop with uncertain demand may give the lower case more attention than the higher one.

Write down the level you chose and why. A rate with no stated capacity assumption can be reused later at the wrong level of output, and it can be mistaken for a rate that fits a different level of activity.

Explain each case in one plain sentence that names its capacity level and what the rate assumes. A sentence like "this rate assumes the shop runs at its budgeted level" lets the people who use the number see what it depends on.

Use the same wording for each case. Describe the 90% case as a check on slower work, and the 110% case as a check on higher output, so that nobody reads a lower rate as a discount or a higher rate as a surcharge. The point of each case is to show how the rate responds, not to set a price by itself.

If a rate changes between periods, show the cause as well as the new number. Say whether overhead moved, activity moved, or both. That keeps a rate change from looking like a pricing decision when it was really a change in the activity base.

Share the assumptions in writing. A short note with the capacity level, the activity measure, and the source of each overhead figure gives the next person a starting point, and it lets them test a case you did not run.

Set up the comparison by running the same calculation at each of the three capacity levels, with one activity measure throughout. Follow these steps in order.

1. Choose the activity measure. If you spread overhead across billable labor hours, use billable labor hours as the measure in all three cases.
2. Total the base-case overhead. Add up the overhead you budget at 100% capacity. Include every line you plan to spend at that level, and keep variable overhead on its own line if you track it that way.
3. Build the 90% and 110% cases the same way. Estimate expected overhead and activity for each level. Estimate overhead from your own cost behavior; keep the base-case total when expected costs remain unchanged.
4. Divide each case. Divide each overhead figure by its activity figure. Round the same way in every case, and say how you rounded.
5. Compare and explain the gap. Look at the three rates, then write down what drives any gap between them. A gap driven mostly by overhead raises different questions than one driven mostly by activity.

After the calculation, keep a short note beside each rate. Record the capacity level it assumes, the activity measure it uses, and the date the budget was set. Those three notes let someone else follow the comparison later.

For the next stage, see overhead allocation for a job rate .

In an illustrative budget, overhead is $10,000 and expected activity is 2,000 labor hours. Dividing $10,000 by 2,000 gives an hourly overhead rate of $5. Before calculating another capacity case, check whether expected costs change and estimate the hours using the same activity measure.

Three mistakes can distort a capacity comparison: mixing activity measures, assuming overhead stays flat without checking costs, and treating a rounded rate as exact.

The higher-output wording calls for a check of the activity base. The base case uses direct labor hours, while the higher-output quotation labels its quantity as units without establishing the rate's denominator. A rate built on one base should not be read directly against a rate built on another. If your own cases use different measures, convert them or label them clearly before you compare.

The second mistake is assuming overhead stays fixed without checking how costs behave. The example's expected overhead differs across the 90%, base, and higher-output cases. Change your overhead figures only when expected costs change at the new activity level; fixed overhead can remain unchanged.

The third is precision. The example labels its 90% rate and its higher-output rate as rounded, so the last decimal places are an approximation. If you divide to many decimal places and compare the results as if they were exact, small differences may look meaningful when they are not.

Run the 100%, 90%, and 110% cases before you set the overhead rate for your next period. The base case gives you a reference, the 90% case shows what a slower period does, and the 110% case shows what a busier period does.

Then pick the rate you plan to use and write down the capacity level behind it. If the rate is sensitive to a level you do not expect to reach, make that visible to the people who read the number.

The OpenStax example is a textbook illustration with its own figures. Your shop's numbers will differ, so take the method from these cases and apply it to your own budget rather than copying the dollar amounts. The method is the part that carries over: budget overhead at each capacity level, pick one activity measure, divide, and compare.

Today, gather your budgeted overhead and expected billable hours, then calculate your base-case rate before estimating the alternative capacity levels.

How do you calculate an hourly overhead rate?

Divide budgeted overhead by expected labor hours. Keep the budget and hours tied to the same capacity assumption.

Can overhead stay the same across capacity cases?

Yes, overhead can stay the same when expected costs remain unchanged. Check cost behavior before deciding whether to adjust the total.

Does a lower overhead rate set the job price?

No, the overhead rate alone does not set a job price. Use it to understand overhead allocation alongside the capacity assumption.

Related guides: Hiring a tech: 3 costs to load into your labor rate · Meal and rest time rules: 4 checks before a labor rate .