How to Determine Total Overhead Costs Based on Direct Labor Hours
Manufacturing overhead is a term used to describe the indirect costs associated with making a product. Overhead costs are expenses required for the manufacturing process other than the direct costs of labor and materials. Businesses engaged in manufacturing usually allocate manufacturing overhead costs as a proportion of some amount linked to the production process for accounting, cost control and pricing purposes. For some firms, calculating overhead costs based on direct labor hours works well.
Overhead Costs Overview
The cost of manufacturing a product breaks down into three categories: direct materials, direct labor and manufacturing overhead. Direct materials are those used in the actual production process. Likewise, direct labor is the work required to make a product. There are a number other costs associated with a manufacturing operation. These are indirect costs, which are referred to as overhead. For example, the electricity used by a factory is essential, but consumption of electricity isn't directly tied to making specific products.
Generally accepted accounting principles require that a portion of the overhead costs be allocated to each unit produced. This portion can be difficult, however. For example, it's not obvious how much of the property tax on a factory should be allocated to each item manufactured. Businesses typically assign a portion of overhead that is proportional to some value that is directly linked to the production process.
In highly automated factories, overhead is often assigned based on the machine hours required per unit produced. When factory operations are labor-intensive, direct labor makes a more useful basis for allocating overhead.
Estimating Overhead Expenditures
As a preliminary to allocating manufacturing overhead, you must make an estimate of future overhead costs. This estimate should be based on historical and current information. Power bills for the previous year is an example of useful historical information. The bill for next year's property taxes would be current information. An estimate of overall overhead expenditures is simply the sum of all projected overhead costs for the next accounting period.
Overhead includes electricity, insurance, factory supplies other than direct materials and depreciation. It also includes the cost of shop floor managers, inspectors and maintenance workers. Overhead does not include non-factory business expenses like selling, general and administrative expenses. Suppose you find the sum of these and other overhead costs for the ABC Company are likely to be $1.4 million. This is the projected manufacturing overhead for the next year.
Allocating Overhead Costs
Before you can determine the actual total overhead cost, factory overhead must be allocated on a per unit basis. Suppose ABC Company expects to produce 30,000 regular widgets in the coming year that require two hours of direct labor each. That comes to 60,000 hours. In addition, the firm plans to make 10,000 deluxe widgets, each of which requires four hours of direct labor. That's another 40,000 labor hours, bringing the total to 100,000 hours direct labor.
Management projects $1.4 million in factory overhead. Divide the $1.4 million by 100,000 hours and you get $14 overhead per direct labor hour. Since regular widgets use two hours labor, you allocate two times $14 per widget, or $28. For deluxe widgets the calculation is four times $14, or $56.
Calculating Total Overhead Cost
Once you have determined how much overhead to allocate to each unit produced based on direct labor, calculating total overhead costs for any given number of units is easy. Suppose ABC Company makes 7,500 widgets in a calendar quarter, plus 2,500 deluxe widgets. Multiply $28 times 7,500 and multiply $56 times 2,500. Add the results together and you find the total overhead cost for the quarter is $350,000.
Issues with Overhead Allocation
Accuracy when it comes to allocating overhead costs per unit of production is important for pricing purposes. When you add direct labor and direct materials costs to the overhead allocation, the result provides a reliable estimate of the cost of manufacturing. When a factory operation is labor-intensive, basing overhead allocation on direct labor hours provides an accurate estimate because the overhead cost will correlate closely with the labor used. However, it is important to use up-to-date figures when determining manufacturing overhead since these expenses will change over time.
References
Tips
- The total overhead costs appear in both the ending inventory on the balance sheet and the cost of goods sold expense on the income statement.
- Total budgeted overhead costs rarely equal the total actual overhead costs; the difference is a variance. At the end of the year, the company records this variance as a cost of goods sold expense.
- Direct labor hours are one measure for calculating overhead costs. Other methods exist, such as machine hours. The direct labor hours method works well for companies whose overhead expenses relate to the work of direct labor employees. For example, a company whose employee benefits and payroll taxes represent a large portion of its costs should use the direct labor hours method.
Warnings
- If your budgeted overhead costs or budgeted direct labor hours are inaccurate, your overhead rate also will be inaccurate. Use the most current budget to calculate these numbers.
Writer Bio
Based in Atlanta, Georgia, William Adkins has been writing professionally since 2008. He writes about small business, finance and economics issues for publishers like Chron Small Business and Bizfluent.com. Adkins holds master's degrees in history of business and labor and in sociology from Georgia State University. He became a member of the Society of Professional Journalists in 2009.