Ask the Accounting Community

Hello-

I know this seems a basic topic. We are working to calculate an overhead rate and are using indirect expenses and direct labor hours in a manufacturing environment.  This approach seems appropriate, however the rate seems abnormally high.  I believe there is excess spending in OH and this rate may be showing that.  Is there a different way to calculate the rate, maybe based on sales?  Looking for suggestions on the calculation if any.  Or maybe it is what it is

Hello-

I know this seems a basic topic. We are working to calculate an overhead rate and are using indirect expenses and direct labor hours in a manufacturing environment.  This approach seems appropriate, however the rate seems abnormally high.  I believe there is excess spending in OH and this rate may be showing that.  Is there a different way to calculate the rate, maybe based on sales?  Looking for suggestions on the calculation if any.  Or maybe it is what it is

Tania,

I see a few ways where this might lead to high, but inaccurate results.  

First, is the driver of your direct costs really direct labor?  The level of capital-intensity or degree of supplier-driven costs in your product may affect this decision.  If labor costs aren't the big driver, you may want to use a different allocation vector.  (Example, if your direct cost is 95% driven by inventory purchased by suppliers, other costs would not make a good application vector)

Second, is direct labor a driver of your indirect costs, such that direct labor is the right application vector?  This could be determined by the nature of your indirect costs (and how you classify direct and indirect).  If a big element of indirect cost is real-estate management, for example, perhaps sq ft of manufacturing space is a better application vector.  If you can, making pools of indirect spending that are headcount-driven (HR), or space driven (Real estate management) or purchased inventory driven (procurement function) will be more useful for proper allocation.

Once you have examined these two, if you are still seeing high application rates, it may be an indicator that indirect spending is too high.  This can be because 1) the company is spending too much on overhead functions for their usefulness, 2) there's a challenge in the breakeven point of volume, or 3) there's a misclassification of direct vs. indirect spending.  

Willing to chat if you'd like.

Hello-

I know this seems a basic topic. We are working to calculate an overhead rate and are using indirect expenses and direct labor hours in a manufacturing environment.  This approach seems appropriate, however the rate seems abnormally high.  I believe there is excess spending in OH and this rate may be showing that.  Is there a different way to calculate the rate, maybe based on sales?  Looking for suggestions on the calculation if any.  Or maybe it is what it is

Hello-

I know this seems a basic topic. We are working to calculate an overhead rate and are using indirect expenses and direct labor hours in a manufacturing environment.  This approach seems appropriate, however the rate seems abnormally high.  I believe there is excess spending in OH and this rate may be showing that.  Is there a different way to calculate the rate, maybe based on sales?  Looking for suggestions on the calculation if any.  Or maybe it is what it is