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Making informed pricing decisions and understanding the financial health of a business includes proper overhead allocations. Estimation of overhead rates is essential to allocating the indirect costs of overhead to product cost, and to making adjustments for unexpected expenses.
What is overhead?
Overhead is a factor in every business. Overhead accounts often serve as a catch-all for any expense not directly allocated to production. Overhead costs are usually fixed, so they do not fluctuate with production levels. Overhead costs include:
- Administrative and executive sales
- Building maintenance
- Factory and warehouse rent
- Equipment maintenance and depreciation
How are overhead rates estimated?
Knowing what your overhead costs are is only one step in deciding how to allocate these costs to products using an overhead rate. The overhead rate is usually determined by dividing estimated overhead expenses by estimated totals in the allocation base (for example, direct labor hours) for a future period. Then, the rate is multiplied by the actual number of direct labor hours for each product to establish the amount of overhead that should be applied.
Some organizations apply the overhead rate companywide, across all products. Organizations making single, standard products (such as bricks) over long periods benefit most from this method. When businesses have many products that are complex and customized it may be beneficial to use multiple overhead rates, applied depending on the product. For example, if one department is labor-intensive and another is machine-intensive differing rates may be useful.
Accounting for overhead costs has one large problem: there is almost always variance. Variance is particularly impactful when using a single company-wide overhead rate, but even multiple rates will not be entirely accurate.
To manage variance, adjustments must constantly be made, and large accounts that are difficult for many managers to understand. This situation leads room for errors and susceptibility to fraud by dishonest people.
Some steps can be taken to reduce the change of overhead anomalies using strong internal control procedures such as:
- Evaluating your existing overhead allocation, and making necessary adjustments
- Discussing complaints of high product costs with non-accounting managers
- Studying significant overhead adjustments over different periods of time to identify anomalies
- Conducting independent reviews of all adjustments to inventory and overhead accounts
Proper allocation of costs does not guarantee a profit. Making a profit is done with prudent pricing decisions, based on production costs and market conditions, and selling of products.
Cost accounting is complex, and indirect overhead costs can be difficult to keep track of. We can help you to create procedures that minimize the guesswork involved in overhead accounting, including knowing when to make adjustments. We can also help to develop methods to monitor cost allocations and prevent errors and mismanagement. Contact us at 949-860-9902 or click here, and we will contact you.