HOW TO DETERMINE OVERHEAD RATES
Overhead expenses are those production and nonproduction costs not readily traceable to specific jobs or processes. Overhead expenses encompass three general areas: indirect materials, indirect labor, and all other miscellaneous production expenses, such as taxes, insurance, depreciation, supplies, utilities, and repairs. Therefore, overhead expense is part of the total costs of maintaining and staffing a business.
Production overhead includes such items as factory supplies and materials that are used in the production process, supervisors’ salaries, maintenance and repairs of machinery, and utilities. Nonproduction overhead include salaries of building maintenance, medical, and security personnel, rent or depreciation on plant and equipment, insurance on plant and equipment, the costs of meeting government regulations, and administrative salaries and expenses.
Determining Overhead Rates
The accurate accounting and allocation of overhead expenses are very important factors in calculating the true costs of goods and/or services sold and in setting a profitable selling price for those products and services. But since the exact amount of overhead expense that will need to be applied to products is not known at the time the products are manufactured or the service is provided, overhead expense must be estimated as part of the budget process. Accounting professionals (either in-house or outside) can, with the help of production supervisors and decision-point managers, develop projections of the volume of production, and the cost of production for the coming year.
If the company produces only one product, the account merely divides the total estimated overhead by the expected volume of output to derive the standard overhead rate, burden rate, or indirect cost rate (an overhead rate per unit). During the fiscal year, the accountant keeps track of the number of finished goods going into inventory and allocates overhead for these units by multiplying by the standard overhead rate. These finished goods are then said to have absorbed a portion of the total overhead costs.
In a company that produces more than one product, however, the procedure is much more complex. The accountant’s allocation of overhead is complicated by the variations in the production process for different products. One item may require a labor-intensive finishing process, for example, while another relies more on machinery. As a result, the same standard overhead rate cannot be applied accurately to all products. Instead, the accountant must choose an activity base upon which to calculate the allocation of overhead to finished products.
Commonly used activity bases include direct labor hours, direct labor costs, and machinery hours. Other allocation formulas are based on sales dollars, gross-margin dollars, and employee count.
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