Accurate overhead allocations are essential to understanding financial performance and making informed pricing decisions. Here’s guidance on how to estimate overhead rates to allocate these indirect costs to your products and how to adjust for variances that may occur.
What’s included in overhead?
Overhead costs are a part of every business. These accounts frequently serve as catch-alls for any expense that can’t be directly allocated to production, including:
- Equipment maintenance and depreciation,
- Factory and warehouse rent,
- Building maintenance,
- Administrative and executive salaries,
- Taxes,
- Insurance, and
- Utilities.
Generally, such indirect costs of production are fixed, meaning they won’t change appreciably whether production increases or diminishes.
How are overhead rates calculated?
The challenge comes in deciding how to allocate these costs to products using an overhead rate. The rate is typically determined by dividing estimated overhead expenses by estimated totals in the allocation base (for example, direct labor hours) for a future period of time. Then you multiply the rate by the actual number of direct labor hours for each product (or batch of products) to establish the amount of overhead that should be applied.
In some organizations, the rate is applied companywide, across all products. This is particularly appropriate for organizations that make single, standard products — such as bricks — over long periods of time. If your product mix is more complex and customized, you may use multiple overhead rates to allocate costs more accurately. If one department is machine-intensive and another is labor-intensive, for example, multiple rates may be appropriate.
How do you handle variances from actual costs?
There’s one problem with accounting for overhead costs: Variances are almost certain. There are likely to be more variances if you use a simple companywide overhead rate, but even the most carefully thought-out multiple rates won’t always be 100% accurate.
The result? Large accounts that many managers don’t understand and that require constant adjustment. This situation creates opportunities for errors — and for dishonest people to commit fraud. Fortunately, you can reduce the chance of overhead anomalies with strong internal control procedures, such as:
- Conducting independent reviews of all adjustments to overhead and inventory accounts,
- Studying significant overhead adjustments over different periods of time to spot anomalies,
- Discussing complaints about high product costs with nonaccounting managers, and
- Evaluating your existing overhead allocation and making adjustments as necessary.
Allocating costs more accurately won’t guarantee that you make a profit. To do that, you have to make prudent pricing decisions — based on the production costs and market conditions — and then sell what you produce.
Need help?
Cost accounting can be complex, and indirect overhead costs can be difficult to trace. We can help you understand how to minimize the guesswork in accounting for overhead and identify when it’s time to adjust your allocation rates. Our accounting pros can also suggest ways to monitor cost allocations to prevent errors and mismanagement.