Discover the importance of allocating overhead when it comes to manufacturing and manufacturing products.
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.
What is Overhead Allocation?
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
Non-manufacturing overhead costs are expenses that your client’s company must pay but aren’t directly related to making the product. Selling, general, and administrative expenses are all classified as non-manufacturing. For instance, if your client owns Bubbles Bubblegum Company, the cost of ingredients, labour to make the gum, and the machinery that makes the gum are manufacturing overhead costs.
Your client’s marketing team works hard to sell the gum, but their salary is a non-manufacturing overhead cost. When your client prices their gum, they need to factor in both the expense of non-manufacturing overhead costs and the manufacturing overhead costs to make a profit and keep a healthy cash flow.
Common non-manufacturing overhead costs include:
- Property taxes
- Interest on business loans
- Office supplies
- Marketing expenses
Clients need this information to make educated business decisions when determining which products are the most profitable. With this in mind, you need to accurately match administrative costs with the products that use them.
A product that requires a lot of support and administrative overhead may seem like a big money-maker when it isn’t, and a product that doesn’t seem very profitable may actually be extremely efficient. You can add value to the services you provide your client by preparing reports that allocate non-manufacturing overhead for their own internal use.
Why is Overhead Allocation Important?
Overhead allocation is important because 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.
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.
Here are some examples of cost drivers:
- Direct Labour
- Taxes related to production
- Quality control and inspection fees
- Machine hours
- Square Footage
The traditional accounting method develops an average overhead cost rate and applies it to a cost driver, such as units produced, hours worked, or machine hours. The problem with this method is that it uses an average overhead rate, so some costs see over-representation in the product price, making the product seem less profitable.
Conversely, this method causes your client to under-report the costs of other products, making those products seem more profitable.
Activity Based Method
Activity-based costing is a method of allocating overhead costs with the activities that lead to these costs. You start by identifying every activity associated with producing an item and allocate a cost to that activity. The cost assigned to the activity is then assigned to products that require the activity for production. The steps for this method are:
- Identify activities related to non-manufacturing costs
- Determine the cost of these activities
- Identify the products associated with these activities
- Assign the cost of the activities to these products and customers
Activity-based costing is more accurate for allocating non-manufacturing costs because it matches costs with the activities that drive them.
This keeps your client from assigning overhead costs to products that don’t use them, giving management a better idea of a product’s profitability and helping them decide whether to continue certain products in light of their non-manufacturing costs.
Overhead Allocation Rate Formula
To calculate your overhead you need to do a couple of things: accumulate all manufacturing costs into one or more cost pools – a grouping of costs associated with your small business, and then to use a cost driver to figure out the overhead costs.
Cost Pool ÷ Cost Drivers = Overhead allocation per unit
Impact on Overhead Allocation 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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