Definition of overhead ratio
Overhead ratio is the comparison of operating expenses and the total income which is not related to the production of goods and service. The operating expenses of a company are the expenses incurred by the company on a daily basis. The operating expenses include maintenance of machinery, advertising expenses, depreciation of plant, furniture and various other expenses. These expenses when controlled can provide a company by maintaining the quality of the business. All companies want to minimise overhead expenses so that it helps them understand and manage the revenues of the company.
By definition, the ratio of operating expenses to the sum of taxable equivalent net interest income and other operating income. The overhead ratio shows the proportion of expenses to total income which cannot be used for production of goods and services.
Formula for overhead ratio
Overhead Ratio can be ascertained with the help of the following formula
Overhead ratio = Operating Expenses / (Taxable net interest income + Operating income)
Operating income is the company’s earning capacity from the manufacture of goods and services. Operating expenses are the day to day expenses of a business that can include rent, utilities and others.
A company would try as much as it can to lower these expenses without it affecting the production of goods and services so as to maintain the competition in the industry. Cutting down of these expenses has a positive effect on the ratio, but the quality of production of the goods and services have to be maintained so that the business can last.
It is important for every business to maintain a lower overhead ratio as it can help them with their production. Some overhead expenses can be curbed while most others can be avoided completely, and minimizing these overheads would benefit the business and its returns.
For example, if your overhead costs to the company are about $25,000 and the direct costs to the company are $50,000, then the overhead ratio would be calculated as overhead cost/direct costs which would be of .50. A set overhead rate for all companies similar to your company can help ascertain if your company has advantage over all other companies. Say if the standard overhead rate is 1.5 and if your rate is .50 then you have an advantage over all other companies as you have the overhead ratio of your company is lower than most others.