It’s easy to track the costs of raw materials, but what about all of those overhead expenses that don’t really belong to a particular product? It’s tough to say just how much electricity you use to run your manufacturing equipment or how much rent should go toward a particular product. By using a consistent method of allocating those overhead costs, you can make sure you account for them and create smart pricing strategies.
Importance of Allocating Overhead
Why is cost allocation important? Allocating manufacturing overhead directly impacts your small business’s balance sheet and income statement. You have those expenses no matter what, and your accounting system requires you to keep track of them. Many accounting systems require you to allocate the costs to the goods you produce. By understanding how to assign those costs in a responsible and reasonable manner, you ensure your records are accurate and not distorted.
Beyond accounting requirements, allocating overhead helps you make decisions for your company, especially pricing. If you base your product pricing only on the direct costs, you cut into your profits. You still need to pay for all of those normal overhead costs. That means you have less left over from each product sale. By incorporating indirect costs into pricing, you can increase the pricing to cover them effectively without slashing your profits. Allocating overhead can also help you look for ways to cut your costs. It can be a motivator for different departments to improve the efficiency of their products to reduce overhead costs.
What Is Manufacturing Overhead?
Manufacturing overhead is a collection of costs that aren’t directly assignable to a product. They’re often shared across different departments or products, which makes them difficult to assign to one specific thing. During the production process, these costs are essential to the development and creation of goods, and you must allocate these expenses to products so that they properly reflect the full cost of producing the good.
During the manufacturing process, incidental goods are overhead. This includes things such as:
Although glue may be necessary to produce a good, it isn’t feasible for you to count exactly how much glue is used for each good and to determine the cost of that glue. The same concept relates to labour. It’s not feasible for you to track each minute of work for a good from a production supervisor, manager, or quality inspector. Other examples of manufacturing overhead include:
- Machine maintenance and repair
- Quality checking costs
- Selling costs
There are a few steps in allocating manufacturing overhead that you need to know. First, you need to gather and compile all relevant costs. The second step is to select a cost driver to allocate the costs.
- Rent for the period is $1,000.
- If the rent expense is allocated based on the number of finished goods and the number of finished goods is 100, divide the expense by the cost driver quantity to find the allocation per unit.
- In this situation, $10 (or $1,000/100) is allocated to the cost of each good.
You need to complete a journal entry to move the costs from manufacturing overhead, which is a general asset pool, to finished goods, which is a more specific asset account.
You can expand the example above to show the true importance of allocating the overhead. Instead of selling only one product. Imagine a company sells two different items. You produce all items in the warehouse that costs $1,000 to rent. How should you allocate these costs among the different products? The allocation occurs based on the selection of cost drivers.
Selecting Cost Drivers
You can allocate overhead in any way you choose based on the underlying calculation driver. In the example above, you need to allocate $1,000 across two goods. If one product takes up 70% of the warehouse, the square footage can allocate the costs at $700 for one good and $300 for the other. If one product produces 90% of the finished goods quantity, the costs are allocated $900 to $100. If you choose to allocate evenly to each item, the allocation is $500 for each one. With the method chosen above, the dollar amount assigned to each item changes based on the cost driver.
Impact on Balance Sheet
Why does it matter if you assign a product $900 or $500 of the costs in the example above? One important aspect relates to your balance sheet. All manufacturing overhead items are classified on the balance sheet in a general asset account. As you assign these costs, they’re transferred to a specific asset account for each item. This inventory balance is important to your report, as this is the valuation of the goods available for sale. Anything not sold remains on your balance sheet. If you assign $900 to a product that doesn’t sell, $900 stays on the balance sheet. If you only assign $700 to a product that doesn’t sell, this means the balance sheet reports $200 less inventory simply because of the costs assigned to the good.
Impact of Overhead Allocation on an Income Statement
Your income statement reflects the ultimate impact of assigning overhead costs, as manufacturing overhead has a direct impact on net income. This occurs through the cost of goods sold account because this figure comes from the information reported on your balance sheet. Based on the balance of the finished goods on the balance sheet, the costs that flow through to your income statement change.
In the situation above, imagine the company allocates $900 to one product and $100 to another. All of the first product sells, while none of the second product sells. In this example, the $900 that is now in finished goods inventory is reassigned to cost of goods sold. The expense recognized is the total cost of goods sold, including the $900.
In another example for comparison, you split the manufacturing overhead above to $500 for the goods that sell and $500 for the goods that don’t sell. Therefore, the cost of goods sold is the total expenses of the goods in addition to the $500. Your expenses are $400 less, your net income is $400 higher, and your income taxes are higher because of higher income.
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