Overhead RatioDefined with Formula, Examples & More

Adiste Mae
Last Updated: September 22, 2022
Date Published: September 22, 2022

What is an Overhead Ratio?

The overhead Ratio is used to identify how much of the fixed costs are incurred by a company relevant to its operating income.

A lower overhead ratio means that a greater portion of costs incurred is from direct costs than operating expenses.

overhead ratio

Overhead Ratio Formula

The primary industry that benefits from this cost measurement are the banking industry.

In an overhead ratio computation, a company may determine which part of costs are from indirect expenses (costs that are not directly related to the production process or service).

The Formula for Overhead Ratio is:

Overhead Ratio = Operating Expenses / (Operating Income + Taxable Net Interest Income)

Some express overhead as the proportion between the operating expenses and revenue, but this method specifically describes the operating expense ratio.

Explanation

The overhead ratio’s two major components are operating expenses and operating income.

First is the Operating Expense.

These are expenses related to business operations as a whole, not only in the production department but to every department involved in the business’s current operations.

Examples of operating expenses include office rent, utilities, repairs and maintenance costs of machinery or equipment, insurance expenses, etc.

The second major part is the operating income, which can pose a challenge in its determination. It involves the following steps:

  • The denominator/divisor requires the operating income and the taxable net interest income to be added.
  • To get the operating income, the operating expenses shall be deducted from the gross profit.
  • For net interest computation, the interest income and interest expense are both recognized.
  • Banks are frequent users of net interest income calculation, but companies may also rely on this computation when applicable.

Examples

The following accounting information is presented by SVA Company.

  • Operating Income = $125,000
  • Operating Expense = $ 27,500
  • Taxable Net Interest Income = $37,000

The formula to get the overhead ratio is shown as follows:

Overhead Ratio = Operating Expenses / (Operating Income + Taxable Net Interest Income)

Overhead Ratio = $ 27,500 / ($125,000 + $37,000)

Overhead Ratio = 17%

For a more accurate analysis of the overhead ratio of the company, it is better to compare the result with other companies within the same industry.

Use of the Overhead Formula

The overhead formula can be a performance monitoring indicator of the company.

A low ratio indicates a positive performance while a high overhead ratio indicates a poor business performance.

Cost minimization is one of the best solutions to achieve high profitability.

There are two common areas that a company may consider in terms of operating expenditures:

  • Some expenses are inherent and inevitable, but there are some ways companies can reduce them at some point. The company must find a solution to minimize such inevitable costs.
  • The other component is expenses that can be completely eliminated. A company may put more focus on this component for more positive results.

A company should not just be focusing on cost minimization.

There are other factors they must also consider to achieve the company’s goal, which is to increase the company’s profitability rate.

Overhead Ratio Formula in Excel

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  1. Mizzou University of Missouri "Calculating overhead and price" Page 1 . September 22, 2022

  2. University of Washington "External Rates" Page 1 . September 22, 2022