Burden rate refers to the indirect costs associated with producing a product or service or employing someone. Businesses use it to weigh direct and indirect costs and make managerial decisions.
Direct costs go directly into the production or delivery of a product or service. In accounting, these are typically cost of goods sold and you factor them into gross profit. Indirect costs, or overhead costs, go into running a business and keeping its doors open. You can subtract them from gross profit to show a business’s net profit, or bottom line.
You can calculate the burden rate for labor or inventory. There are separate formulas for each.
Get a FREE review of your books
NerdWallet Small Business helps you get your business in shape for taxes, loans, and growth. Stop worrying about accounting and speak with a real, human expert from our partner, Xendoo.
What is the burden rate formula for labor?
Labor burden / payroll cost = burden rate
You calculate the labor burden rate by dividing labor burden cost by wage costs. Labor burden cost is the cost of employing staff beyond wages. These expenses include payroll taxes and workers’ compensation insurance at a minimum. They may also include health insurance, retirement plan matching, travel allowances and other fringe benefits.
Calculating the burden rate for labor example
Let’s say you own an advertising agency. You pay your graphic designers $60,000 per year and you pay your copywriters $64,000 per year. You calculate annual taxes, insurance and benefits per employee at $15,000 per year for graphic designers and $17,000 per year for copywriters.
Labor burden rate (for graphic designers):
$15,000 / $60,000 = $0.25
Labor burden rate (for copywriters):
$17,000 / $64,000 = $0.27
For every dollar you spend on wages, you incur 25 cents and 27 cents in overhead costs for your graphic designers and copywriters, respectively.
What is the burden rate formula for inventory?
Overhead cost / activity = burden rate
Burden rate doesn’t only apply to labor. In manufacturing, you apply burden to inventory to find the actual cost of producing an item. Businesses often refer to this as factory or manufacturing overhead. It can include labor, as well as machine hours and other overhead costs.
Calculating the burden rate for inventory example
For example, let’s say you own a manufacturing plant. The machine you use to manufacture items costs $1,000 per month to keep in service. Each item takes one hour to manufacture. Your machine is in service 160 hours per month.
Your overhead cost in this example is $1,000. We divide this number by the activity measure of 160 hours to come up with our inventory burden:
$1,000 / 160 = $6.25
So, for every hour your machine is in use, you will add $6.25 to the direct costs of producing your items.
Note that inventory burden rate is part of generally accepted accounting principles. It ensures you accurately report the full cost of inventory on the balance sheet. People also refer to inventory burden rate as factory overhead, manufacturing burden, or indirect production costs.
Get a FREE review of your books
NerdWallet Small Business helps you get your business in shape for taxes, loans, and growth. Stop worrying about accounting and speak with a real, human expert from our partner, Xendoo.
Using burden rate to make business decisions
Fully burdened costs tell you how much you really pay to employ someone or produce an item.
Consider the advertising agency example from earlier. Let's say you outsource the copywriting position for the same amount you pay your in-house copywriters ($64,000 per year). In that case, you would save $17,000 per year in indirect costs per copywriter.
Or, maybe you don’t want to outsource this position. But you’d like to consider bringing on an additional part-time copywriter. You now know the full cost for employing the copywriter will be around 27 cents per hour in addition to their hourly rate.
Similarly, you might decide an additional $6.25 per item isn't worth producing it in-house. If you're paying $13 in direct costs plus $6.25 in indirect costs, the fully burdened item costs $19.25. Perhaps you find a factory that will produce the same items for $15.25 each. You may decide to sell your manufacturing machine and outsource production in that case.
This article originally appeared on Fundera, a subsidiary of NerdWallet.
