Your overhead rate tells you how much indirect cost you’re carrying for every dollar of direct cost, and it’s the number that lets you fold overhead into pricing accurately instead of guessing.
The formula
Overhead rate = Total overhead costs ÷ Total direct costs (or another allocation base, like direct labor hours), typically expressed as a percentage. An overhead rate of 40% means for every dollar of direct cost, you’re carrying 40 cents of overhead.
Choosing an allocation base
- Direct labor hours, common for service businesses where labor is the main direct cost
- Direct material cost, common for product businesses
- Machine hours, in production-heavy operations
Why this matters for pricing
A price that only covers direct cost plus a margin target, without folding in overhead, looks profitable per sale while the business as a whole struggles to cover its indirect costs. The overhead rate is what closes that gap in your pricing math.