In the last few years, many overhead costs—like utilities, insurance, interest expense, and executive salaries—have skyrocketed, causing some companies to pass along some of the burden to customers by charging higher prices for their goods and services.
If you’re feeling the squeeze from these increases, you might be asking yourself if upping your prices is the right move for your business.
Before raising your rates, it’s essential to understand how to allocate indirect costs to your goods or services. Correct cost allocation is critical to evaluating product and service line profitability, which helps you make informed pricing choices for your business.
Define your overhead costs
All businesses face overhead costs. These accounts typically act as catch-alls for any expense that cannot be directly allocated to production.
Some examples of overhead costs are:
- Interest expense
- Taxes
- Insurance
- Utilities
- Equipment maintenance and depreciation
- Rent and building maintenance
- Administrative and executive salaries
Generally speaking, your indirect production costs are fixed over the short term, so they won’t change appreciably whether your production increases or decreases.
Calculate your overhead rates
Determining how to allocate these costs to products using an overhead rate is where the challenge comes in. Your overhead rate is generally determined by dividing estimated overhead costs by the estimated totals in the allocation base for a future time period.
Once this is done, multiply your rate by the actual number of direct labor hours for each product to determine the amount of overhead that should be applied.
For some organizations, this rate is applied across all products produced by the company. While this strategy may be appropriate for a company that makes one standard product for an extended period, it may not be suitable for other types of companies.
If your range of products is more complex and customized, you might want to use multiple overhead rates to allocate your expenses more accurately.
For example, If one of your departments is labor-intensive and another is machine-intensive, setting multiple rates may be the best choice for your business.
Dealing with variances
One issue with accounting for overhead costs is that variances from actual costs are almost always inevitable. If you’re using a simple organization-wide overhead rate, you’re likely to have more variance. With that said, even the most meticulously devised multiple-rate strategies won’t always come in with 100% accuracy.
This can result in large accounts needing constant adjustment, causing some managers to have to deal with complex issues they may not fully understand.
A situation like this leaves organizations open to dealing with human error or fraud. Luckily, you can drastically limit the chance of overhead mistakes with these four internal control procedures:
- Address complaints about high product costs with non-accounting managers
- Evaluate your current overhead allocation and make adjustments as needed
- Conduct independent reviews of all adjustments to your overhead and inventory accounts
- Study impactful overhead adjustments over different periods of time to discover anomalies and issues
Have questions? Smolin can help
While cost accounting can be a challenging process for any manager, you don’t have to deal with it alone. Call the knowledgeable professionals at Smolin, and we’ll help you apply a comprehensive approach to estimating overhead rates and adjusting them when needed.