How to Determine Total Overhead Costs Based on Direct Labor Hours
Manufacturing incurs a large number of costs, and attributing those costs to the end product is a necessary part of setting a profitable price. Allocating overhead cost requires making reasonable estimations of total cost and direct labor hours. But even the best predictions can miss the mark, and you’ll have to track actual costs and hours to adjust at the end of the period.
Overhead costs are largely fixed but may vary with changes in direct labor hours. If the year-to-year change in overhead costs is minimal compared with the change in direct labor hours, you can assume the impact of direct labor hours on overhead costs is inconsequential. If you want a more precise estimate, or if the variance is substantial, then perform a regression analysis using spreadsheet or statistical software on historical data. The result is a formula that shows the variable and fixed components of overhead cost.
Before beginning the period, forecast how many direct labor hours your employees will work. Direct labor costs are variable and readily predicted from production forecasts. For example, if an average basketball takes one direct labor hour and you anticipate making 400,000 basketballs, you can anticipate using 400,000 direct labor hours.
Entering your forecasted direct labor hours into your regression analysis allows you to predict the total cost of overhead. For example, if your regression analysis provided a formula that overhead equaled $100,000 plus $0.13 per direct labor hour, you would predict that overhead would cost $152,000 for the period in which you produce 400,000 basketballs. Managers apply estimated overhead to each product by dividing the estimated overhead by the estimated direct labor hours and multiplying that rate by the budgeted direct labor hours per product. For example, the estimate of $152,000 of overhead cost for 400,000 direct labor hours gives a rate of $0.38 per direct labor hour, or $0.38 of overhead applied to each basketball.
At the end of the period, overhead costs will be less, the same or more than your forecast. As long as your prediction was reasonably close, it should not derail your budgeting, and you can continue using the same model for future periods. The difference between your estimated overhead costs and your actual overhead costs must pass along to the products that passed through the facility. If you were under budget for overhead, overhead costs were overapplied; if you were over budget, overhead costs were underapplied. Failing to reconcile estimated and actual costs would make your inventory cost inaccurate, causing you to report a net income higher or lower than it actually is. For example, say you applied $0.38 in estimated overhead to each basketball, but actual expenses were $0.40 per basketball. If you had sold all 400,000 basketballs you made that year, you would report the cost of each basketball $0.02 lower than it should be and overstate net income by $8,000.