To calculate overhead cost for each unit, divide estimated overhead by estimated activity, multiply by a product's activity, then divide by its units. Overhead is any cost that keeps the business running but cannot be traced straight to one product, such as rent, utilities, insurance, equipment upkeep and the wages of staff who work across the whole shop. Once you know the overhead cost for each unit, you can price with more confidence, see which products cost more to make than they appear to, and tell whether a weak margin is a pricing problem or a volume problem.
Small shops often skip this calculation because it feels like something for large manufacturers. That is a costly oversight. A cafe roasting its own beans, a print shop running jobs on a press, or a workshop building furniture all carry rent, power and admin costs that have to be recovered somewhere. If those costs are left out of the unit price, someone still pays them, usually the owner through lower pay or a shrinking bank balance. The five steps below give you a repeatable way to put a number on that hidden share.
This method follows the traditional allocation approach shown in the OpenStax textbook example. You estimate overhead for a period before it happens, choose a measure that drives it, and spread it across the units you expect to make. You do not need special software for this. You need last year's costs, a rough forecast, and a calculator. The worked example uses the figures from a textbook example published by OpenStax, so you can check each step against the source.
You will need a few things before you start: a list of the costs you pay each year, a rough count of the hours your people spend making or handling products, and an honest forecast of how many units you expect to sell. None of these needs to be perfect. The calculation is more useful when the inputs are reasonable and written down than when they are exact and lost in someone's head.
1. Add up the overhead for the period
Begin by listing every cost that supports the whole shop rather than one item. Overhead usually includes rent, utilities, insurance, software subscriptions, equipment repair, cleaning, and the pay of anyone whose time is spread across all products. Direct materials and the labor that goes straight into a product are not overhead. Take those out first, because they are charged to units directly.
Pull at least a year of bank and card statements and go through them line by line. For each line, ask whether the cost would still exist if you made nothing for a month. If it would, it is probably overhead. If it rises and falls with output, such as packaging or the materials built into each item, it belongs with direct costs. Loan principal repayments and money you take out as owner's pay are usually not treated as running costs, so check with an accountant how your business records them.
Forgotten items are the usual problem. Owners often leave out bank fees, card processing charges, vehicle costs for deliveries, part-time bookkeeping help, and depreciation, which is the gradual loss in value of machines and tools as they age.
Sort the list into logical groups, such as premises, equipment, and administration, rather than one long column. Groups make it easier to see which costs move together and to check your totals later. The US federal rules for government contracts in FAR 31.203 describe indirect costs in similar terms. Once direct costs have been charged to the work, indirect costs are those left over to allocate, and they should be accumulated by logical cost groupings with due consideration of the reasons for incurring them. Those rules apply to government contracts, so treat them as a model for sorting, not as rules for your shop.
Some bills serve more than one purpose. A power bill may cover both the production floor and a small office. Split these costs using a measure that fits, such as floor space or hours of use, and write down the reason. You do not need perfect precision here. You need a split you can explain to a bank manager, a business partner or yourself next year.
Then total the list for the period you are planning. In the textbook example, the company estimates total overhead costs at the beginning of the year to be $2,500,000. Use an estimate, not last month's bills, because you need the rate before the year's actual costs are known. Adjust the estimate if you know a cost is changing, such as a lease that is going up or a machine you have just bought.
When the list is complete, add it up and compare the total with a year of bank and card activity. Large gaps can mean a cost has been missed or counted twice, and it is much cheaper to find that now than after you have set prices for the year.
2. Pick the activity measure and estimate its total
Overhead needs a yardstick. The rate in this method is overhead divided by something that drives the work, called the base or activity measure. For a hand-finishing shop, that is often labor hours. For a shop that runs machines, it may be machine hours. The best measure is the one that goes up when overhead is used more. Pick one measure for the whole shop and use it consistently.
If you sell goods bought in and resold, labor may barely appear in your costs. In that case the activity measure could be the number of orders or the number of items handled, which still tracks how much time the shop spends on each sale. The choice is yours, provided you explain it and stick with it.
To estimate the base, start with last year's timesheets or the hours recorded on jobs. Adjust for what you know is coming, such as a planned hire, a change in opening hours, or a product you are dropping. If you have no hour records, start logging them now, even if the first months are rough. A measure you cannot count each month is hard to check later, so choose one your current systems can track.
When you record hours, keep the categories simple. Two or three groups, such as production, finishing and packing, are easier to keep up than a dozen, and they still show where the time goes. Simple records that are kept every week beat detailed records that are kept only in the busy months.
Be careful about what you count. Breaks, cleaning, and time spent waiting for materials are real, but you must decide whether they belong in the hours you count. Whatever you decide, use the same definition every time so the rate compares like with like.
In the textbook example, the textbook uses direct labor hours and estimates the total for the year at 1,250,000 hours. Make sure this total covers the same period as your overhead estimate. Mixing a yearly overhead figure with a monthly hours figure produces a rate that is badly off, and it is an easy error to make in a spreadsheet.
The federal contract rules in FAR 31.203 make the same point about timing. For contracts other than those subject to paragraph (g)(1) of FAR 31.203, the base period for allocating indirect costs is the contractor's fiscal year used for financial reporting. That fiscal year will normally be 12 months, although a different period may be appropriate in some circumstances. For your shop, the practical lesson is to use one 12-month year for both overhead and hours, unless you have a good reason to do otherwise.
3. Divide overhead by the base to get the rate
Divide the overhead estimate by the activity estimate. In the textbook example, $2,500,000 of overhead divided by 1,250,000 direct labor hours gives $2.00 of overhead for each direct labor hour. The textbook builds the rate from those beginning-of-year estimates. The method is called predetermined because you fix the rate before the work happens.
Read the result in plain words. The rate says that each hour of work carries a certain amount of overhead. If your hours go up while overhead stays the same, the rate falls, and if your overhead rises faster than your hours, the rate rises. That relationship is what makes the rate useful for pricing.
Keep the rate steady for the period, even if actual overhead comes in higher or lower. That gap is useful information. Comparing actual overhead with the amount applied to products shows whether your estimate was close, and it tells you when the rate needs revising next period.
If a large cost changes for good, such as a new lease, update the estimate and recalculate from that point, and note the date so the change is easy to trace later.
Rounding deserves care. Keep extra decimal places in your spreadsheet and round only at the end, because rounding the rate early can push the final cost for each unit away from the true figure, especially on products that use many hours.
In a spreadsheet, the rate is a single formula: overhead divided by the base. Put the overhead estimate in one cell and the hours estimate in another, then let every product's figure refer back to that rate cell. When you update the estimate, every product updates with it, and you do not have to chase down numbers in several places.
4. Apply the rate to each product and divide by its units
Next, work out how much overhead each product should carry. Multiply the rate by the hours that product is expected to use. The textbook's Solo product is estimated to use 350,000 direct labor hours. With $2.00 of overhead for each direct hour, the Solo product is estimated to have $700,000 of overhead applied, as the textbook example shows.
Then divide that overhead by the units you expect to make of the product. The Solo product is estimated at 140,000 units. Dividing $700,000 by 140,000 units gives $5.00 of overhead for each unit. The textbook repeats the same calculation for every product, and sets out the overhead cost for each unit for all of them in its Figure 6.4.
This is where product mix matters. A product that uses more hours for each unit carries more overhead for each unit, even if its materials are cheap. If your products differ a lot in how long they take, estimate hours for each one rather than assuming every unit uses the same share of the shop.
Make sure the hours and units match what you expect to sell. If a product's volume is forecast but its hours are guessed, the unit cost figure will not reflect reality. Build the hours estimate product by product, then check that the products' hours add up to the total base from step two. If they do not, some overhead is being spread over hours that do not exist, or the reverse.
If the number of units for a product rises while its hours stay the same, the overhead for each unit falls, because the same overhead applied to that product is spread across more items. Check that your forecast of units is realistic, since an optimistic forecast makes overhead for each unit look smaller than it will turn out to be.
If your shop takes custom jobs, you can keep a standard hours figure for each job type and use it for quotes. Record actual hours on a few jobs to check the standard is close. A standard that drifts away from what jobs really take will slowly underprice your work.
If you make to order, the expected mix of jobs is your forecast. Revisit it when your customers change. If two products draw on the same bench or machine, their hours both count toward that base, and the overhead for the equipment is shared between them. Write down which product uses which equipment, so that a change to one product's hours does not quietly shift overhead onto the other.
5. Add the direct costs to get the total cost for each unit
Overhead is only part of what each unit costs. Add it to the direct material and direct labor cost for each unit to get the total cost for each unit. The textbook example does this by combining its overhead cost for each unit from Figure 6.4 with the direct material and direct labor costs from its Figure 6.3, which gives the total cost for each unit in its Figure 6.5.
Put your own direct material and direct labor cost for each unit next to the overhead figure, and the sum is the cost you should be covering when you price the product. Keep in mind that the $5.00 is an estimate built on forecast overhead, hours and units, so it moves whenever any of those change.
For direct costs, work from batches where you can. Take the cost of materials for a batch and divide it by the units the batch produced. For labor, multiply the hours the batch took by the pay rate, then divide by the same units. Average a few batches rather than relying on one, since a single unusual order can skew the figure.
Compare the total with your selling price, but do not stop there. If the total is above what customers pay, the shop loses money on each unit, even if the overhead figure looks reasonable. If the total is well below what customers pay, there is room in the margin for the profit you want. Either way, the cost for each unit tells you what the price has to cover, not what the market will bear.
Be honest about the margin. Add the profit you need on top of total cost for each unit, and the result is a sensible floor for your price. Price on cost alone and you will often find the margin you wanted never arrives.
Keep the figures in one place. A simple sheet with one row for each product, the hours, the units, the overhead for each unit, and the direct costs is enough. Use it when you quote jobs, when a supplier raises a price, and when you decide whether to keep a product on the menu or in the catalogue.
Work through the five steps once a year, and again whenever your costs or product mix change a lot. A rough estimate that you update is more useful than a precise-looking number you never revisit. Start with the overhead list in step one, because every later figure depends on it.
When you compare your results with actual figures at the end of a period, look for the gaps. If actual overhead ran well above the estimate, find out which group of costs caused it before you raise prices. If the hours were off, the problem may be in how staff record time rather than in the cost side at all.
Keep a dated copy of each year's figures. After a few cycles you will see patterns, such as overhead that creeps up at the same time every year, and you can plan price changes around them rather than reacting after the fact.
Finally, remember that the figures are a tool for decisions, not a verdict. Use the result to ask better questions about price, product mix and cost control, and to check that each unit is paying its share of the shop's running costs. Share the result with whoever sets prices or takes orders. A sales assistant who knows the overhead cost for each unit will quote more consistently, and a manager who understands where the numbers come from is less likely to override them on a whim.
Related guides: Overhead for each unit: 4 figures for stock costs · Cost of goods sold: 5 steps from count to books · State minimum wage per hour: 5 rates for shop employees.