A manufacturing company incurs both direct and indirect costs of production and must set the selling price of its products high enough to cover both types of cost if it wants to make a profit. Under the standard costing model, indirect costs are allocated to each unit of production using a predetermined rate. Costs allocated in this way are compared to actual expenditures when they can be confirmed at the end of the accounting period, and any necessary adjustments are made then.

Direct Costs

Direct costs are so called because they can be directly attributed to manufacturing a single unit of the final product. For example, the wood used to manufacture a table is a direct cost, because the amount of wood required to make a single table is known, as are the number of hours taken to assemble it. With this information, the price paid for the wood and the labor rate per hour, calculating the direct costs of manufacturing the table is relatively straightforward. Raw materials, direct labor and direct expenses are the standard categories of direct costs incurred.

Indirect Costs

To remain operational, a manufacturing unit also incurs indirect or overhead costs. Rent, utilities, maintenance, warehousing and supervision are examples of indirect costs that cannot be allocated to a single unit of production but must be included in total production costs.

Overhead Rate

To arrive at a standard price for each unit produced, an overhead rate is determined at the start of the accounting period, based on estimated costs for the period. The rate is based on one of the direct costs such as labor or machine hours, depending on the manufacturing process used. Overheads are apportioned over the total quantity of products manufactured by applying the predetermined rate to each unit produced.


To calculate the overhead rate, the cost accountant first adds together all the indirect costs estimated or budgeted for the period for the required production quantity, and calculates the total direct labor hours required to produce that quantity. For example, if the annual budget is based on a production quantity of 10,000 units and the direct labor required for each unit is three hours, the total direct labor is 10,000 x 3 or 30,000 hours. The total overhead expenditure is then divided by the total labor hours to arrive at the overhead rate. If, in the example, total overhead amounts to $120,000 a year, the overhead rate will be $120,000 divided by 30,000 hours, or $4 per hour. As each unit requires three hours of labor, the indirect cost of each unit is $4 x 3, or $12.