Are you pricing your products high enough to make a profit? You probably know the direct labor and materials costs that go into your product or service, but what about all those other costs, such as rent, insurance, licenses, office wages and accounting fees? Are you recovering those expenses?
These are all indirect costs of running a business, and your selling prices must be enough to recoup these expenses and make a profit. But how do we calculate those costs and allocate them to a product to get the total cost? Let's go through the process of allocating overhead expenses.
What Are Indirect Overhead Costs?
Indirect overhead costs are those expenses that cannot be allocated directly to the cost of manufacturing a product or providing a service. They do not vary directly with production volume. A business can have two types of indirect overhead: manufacturing and fixed/admin overhead.
Examples of items that make up fixed and administrative overhead are:
- Office rent
- Administrative salaries
- Legal and accounting fees
- Advertising costs
- Licenses and permits
Indirect manufacturing overhead expenses are such items as:
- Quality control wages of personnel
- Materials handling, such as forklift operators
- Equipment maintenance and cleaning
- Factory clerical staff
- Rent and depreciation of production building and equipment
- General factory supplies
- Factory supervisors
What Are the Overhead Recovery Methods?
The structure of the manufacturing process determines the method used to allocate indirect costs. The most common allocation methods are the number of direct labor hours and the number of machine hours used to produce a product.
A process that uses mostly labor to make a product will use labor hours to allocate overhead costs. On the other hand, it makes more sense to use machine hours as the allocation basis for a process that is highly automated.
How Do You Calculate the Overhead Recovery Rate?
Let's take the example of the Hasty Hare Corporation, a manufacturer of sneakers for rabbits, and calculate its overhead burden rate. The process of making sneakers is highly automated, so Hasty Hare's accountants use machine hours to determine the overhead burden rate.
We have the following figures for costs and production of the company's best-selling sneaker, Blazing Feet:
- Direct labor costs - $28/pair
- Direct materials costs - $47/pair
- Machine-hours available/year - 15,000 hours
- Machine-hours required for Blazing Feet - 1/2 hour
- Indirect manufacturing overhead - $115,000
- Fixed and administrative overhead - $425,000
- Target profit margin - 15 percent
To find the overhead burden rate:
(Indirect manufacturing overhead + fixed overhead)/machine-hours = ($115,000 + $425,000)/15,000 hours = $36/machine-hour
Since it takes one-half hour of machine time to make a pair of Blazing Feet, the overhead burden rate is $18 per pair (1/2 X $36).
What Is the Final Selling Price?
The purpose of calculating the overhead burden rate is to make sure the selling price recovers all costs and leaves a reasonable profit. Let's calculate the selling price for Blazing Feet.
Total cost of production = direct labor + materials + overhead burden
Total cost of production = $28 + $47 + $18 = $93/pair
Since Hasty Hare wants to make a 15% profit margin, the final selling price is:
Final selling price = $93/(1 - 0.15) = $93/0.85 = $110/pair
To verify: Selling price less product costs = profit
$110 - $93 = $17
Profit margin = $17/$110 = 15%
How to Fine-Tune the Overhead Recovery Rate
The allocation of overhead burden rates is intended to assess more accurately the profitability of a product. In some cases, a combination of allocation methods may be required rather than an overall approach for all indirect costs, such as using machine hours in the example of Hasty Hare.
For example, it could make more sense to allocate employee benefits costs on the basis of a labor recovery rate calculation and spread maintenance costs on the basis of machine hours.
Whichever cost recovery strategies you choose, the object is to account for your total operating costs across all of the products and services that the company sells.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for National Funding, PocketSense, Bizfluent.com, FastCapital360, Kapitus, Smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.