Burden rate is the rate at which indirect costs are allocated to direct costs to give a truer picture of the cost of producing or delivering a product or service. It is typically used to determine labor and inventory overhead costs. Understanding your burden rate can help you make more informed decisions with regards to labor or production.
Everyone knows the old adage “you have to spend money to make money.” What business owners are constantly trying to figure out is how much they have to spend to turn a profit, and whether or not they are overspending. Burden rate is an important calculation that can help them better answer these questions
A burden refers to a load that is difficult to carry—and that’s important to keep in mind when thinking about burden rate. In a sense, your burden rate is the extra load you have to carry in terms of your business finances. It gives you more insight into your profit and loss statement—which highlights your direct costs and indirect costs.
Your direct costs are the costs that go directly into the production or delivery of your product or service. These costs are typically categorized as cost of goods sold (COGS) and appear right under your income to show you your gross profit. Indirect costs—or overhead costs—on the other hand, are the costs that go into running your business. They are subtracted from your gross profit in order to show you your net profit, or bottom line.
This all seems pretty straightforward. There is a hidden variable here, though, and it’s one that can be confusing to a lot of business owners. That variable is the impact your indirect costs have on your direct costs.
This variable is called burden rate.
Burden rate is the rate at which indirect costs are allocated to direct costs to give a truer picture of the cost of producing or delivering a product or service. Said another way, burden rate is a way to compare direct and indirect costs.
This concept is easier to explain with an example of how burden rate impacts your labor costs.
Let’s say you own an advertising agency. You have graphic designers and copywriters on staff, and these employees’ time is billable to your clients. As such, you report their billable wages as COGS. When you review your profit and loss statement, you will see their billable wages subtracted from total income to show your gross profit. This is important information, because you can tell at a glance if the services you deliver are profitable, at least from a high level.
However, there are other expenses that go into having employees. These expenses—which aren’t billable to your clients—at a minimum include payroll taxes and workers compensation insurance. Depending on your benefits plan structure, they may also include health insurance, retirement plan matching, travel allowances, and other fringe benefits like cell phone allowances, among other expenses.
These additional expenses are added together to arrive at your labor burden cost, or the cost of employing your staff above and beyond wages. Labor burden cost is divided by wage costs to arrive at your burden rate.
Burden rate doesn’t only apply to labor, though. In manufacturing, burden is applied to inventory to arrive at the actual cost of producing an item. This is often referred to as factory or manufacturing overhead, and it can include labor, machine hours, and other overhead costs that indirectly impact the cost of manufacturing products for sale.
Burden rate is easy to calculate once you determine what should be included in the burden cost number.
Going back to our example of an advertising agency, let’s say your graphic designers are paid $60,000/year and your copywriters are paid $64,000/year. Annual taxes, insurance, and benefits per employee are calculated at $15,000 per year for graphic designers and $17,000 per year for copywriters.
The labor burden rate for your graphic designers is:
Labor burden / Payroll cost = Labor burden rate
$15,000 / $60,000 = $0.25
And for your copywriters, the labor burden rate is:
$17,000 / $64,000 = $0.27
This means for every dollar you spend on wages, you incur $0.25 in overhead costs for your graphic designers and $0.27 in overhead costs for your copywriters.
Inventory burden rate is very similar to labor burden rate. Instead of focusing only on additional labor costs, though, inventory burden rate can also be calculated by activity measure.
For example, let’s say you own a factory that manufactures dongles. The machine you use to manufacture these dongles costs $1,000/month to keep in service. Each dongle takes 1 hour to manufacture. Finally, your machine is in service 160 hours per month.
Your manufacturing overhead cost in this simple example is $1,000. We divide this number by the activity measure of 160 hours to come up with our inventory burden:
Overhead cost / Activity = Inventory burden rate
$1,000 / 160 = $6.25
So, for every hour your dongle machine is in use, you will add $6.25 to the direct costs of producing your dongles to arrive at your fully burdened inventory cost. Since it takes 1 hour to make a dongle, you will add $6.25 to the cost of each dongle to arrive at the true cost of your completed inventory.
Note that inventory burden rate is a GAAP (generally accepted accounting principals) requirement so that the full cost of inventory is accurately reported on a business’s balance sheet. Inventory burden rate is also sometimes called factory overhead, manufacturing burden, and indirect production costs.
Sometimes, a business will include other indirect costs in calculating their burden rates. These costs can include rent, breakroom supplies, IT costs, and other overhead costs. If you choose to include other indirect costs in your burden rate calculations, you must be careful to only include those costs that actually apply to your business situation.
For example, if your rent expenses are directly impacted by the number of workers you have—as might be the case if your office is in a coworking space that rents by the desk—then including rent expense in your burden calculation would make sense. If, on the other hand, your rent wouldn’t change by adding or reducing your number of employees, then you might not want to include rent in your burden calculation.
It’s fairly common for business owners to conflate burden rate with overhead. However, there is an important distinction between the two. Overhead refers to an ongoing expense associated with operating a business. This can include anything from administrative to marketing costs. The key difference is that burden rate is used to determine the cost of production, whereas overhead expenses are not directly tied to your cost of production.
Within overhead there is fixed overhead and variable overhead. Fixed overhead are costs that don’t change when production costs change (i.e. the burden rate increases or decreases). These costs are fairly predictable and include things like rent, salaries, and depreciation.
Variable overhead expenses are affected by business activity, but not necessarily by sales. Some examples of variable overhead expenses include advertising expenses, legal expenses, office supplies, and repairs and maintenance expenses. Something like office supplies expenses will likely increase as a result of increased sales, but they are not directly tied to the production of a product or delivery of a service.
There is also something called burdened overhead. Burdened overhead costs are costs that can be partially attributed to direct costs and partially to pure overhead expense.
Both burden rate and overhead costs are essential for budgeting, but overhead will give you a better idea of how to budget because it factors in costs beyond production, such as liability, subscriptions, advertising, and taxes.
Many business owners use their fully burdened costs to make decisions about how to operate their business. This is why it’s so important to only include indirect costs in your burden calculation that apply to your particular business situation. Otherwise, you might make an unwise decision about your labor force or production strategy.
Going back to our advertising agency one more time, if we were to outsource the copywriting position in our advertising agency for the same amount we pay our in-house copywriters—$64,000/year—we would save $17,000 per year in indirect costs. Or maybe we don’t want to outsource this position, but instead we want to consider bringing on an additional part-time copywriter. We now know the full cost for employing the copywriter will be around $0.27/hour in addition to their hourly rate.
Similarly, we might decide an additional $6.25 per dongle is more than we want to pay to produce dongles in our own factory. If a fully burdened dongle costs $19.25—$13 in direct costs plus $6.25 in indirect costs—but we find a factory that will produce dongles for us for $15.25 per dongle, we might decide to sell our dongle-making machine, outsource the production of dongles, and instead focus on producing something else in our factory that will cost us less per hour to manufacture.
Burden rate and fully burdened costs typically won’t be reflected on a small business’s financial statements. Knowing your burden rate and fully burdened costs can help you make sound managerial decisions about your business, though. Especially if your business has highly variable indirect costs, analyzing your fully burdened labor or inventory costs will help you see how even minor changes in your business’s operations can help you realize more profitability.
The most difficult part of calculating burden rate is deciding what to include in the burden cost calculation. Simplicity is key here. Although you could argue that all indirect costs somehow tie back to the production or delivery of a product or service, overcomplicating the calculation will only make it more difficult to wisely use the burden rate information for your business.
Finally, there is more to running a profitable business than keeping costs low. Burden rate is one of many tools you can use to analyze the cost of doing business and steer your business toward deliberate profitability, but it shouldn’t be your main determining factor when making business decisions. Whether you are considering bringing on more labor or outsourcing production, it’s important to keep in mind the intangible benefits and risks of these business decisions. Sometimes, keeping expenses low has an unintended negative impact on your business as a whole.
Now that you know more about the hidden variable that is burden rate, you are better equipped to make more informed business decisions. As always, if you have questions about how burden rate impacts your business’s particular situation, consult with your accountant.
Billie Anne Grigg is a contributing writer for Fundera.
Billie Anne has been a bookkeeper since before the turn of the century. She is a QuickBooks Online ProAdvisor, LivePlan Expert Advisor, FreshBooks Certified Beancounter, and a Mastery Level Certified Profit First Professional. She is also a guide for the Profit First Professionals organization.
Billie Anne started Pocket Protector Bookkeeping in 2012 to provide an excellent virtual bookkeeping and managerial accounting solution for small businesses that cannot yet justify employing a full-time, in-house bookkeeping staff.