The first of a multi-part series on overhead cost allocations and rates
Manufacturing businesses often use cost allocations to value their cost of goods sold and inventory. In particular, allocations are commonly used to determine manufacturing overhead, which is critical to understanding the true cost (and profitability) of the products they manufacture and sell.
However, some manufacturers do not update their overhead allocations regularly. The outdated, inaccurate information then works its way into their financial statements resulting in misunderstanding the profitability of certain products and poor business decisions based on that misinformation. For instance, if a manager believes that a product is not profitable based on inaccurate data, they may increase the price. That price increase could render the company uncompetitive; they could lose business that was actually profitable before the price change.
As the end of the year approaches, it is an ideal time for managers to review the rates used in overhead allocations. Depending on the costing system, rates can be based on department, machine, or another cost driver. Consider the following questions when deciding when to review your overhead rates and allocations:
- When is the last time you reviewed your overhead allocations or rates? The best practice is for managers to evaluate these factors regularly. Depending on your industry and the nature of your business, “regularly” could be once every one to three years.
- Has your business added or eliminated any operations or processes? Manufacturers that have recently added a machine shop or an additional production line might want to revisit their overhead allocations to ensure they are accurate, given their expanded capabilities.
- Similarly, manufacturers working to improve operational efficiencies may experience changes in their cost structures that could affect their overhead rates. If specific product lines or processes are benefiting from artificial intelligence, automation, or robotics that improve output, overhead cost allocations may need to be adjusted to account for the new technology as well as the adjusted throughput rates.
- Have your costs changed in other ways? Are your rent, property taxes, or general liability insurance premiums rising? Has the tight labor market-led you to increase salaries and other employee benefit program costs? Have new customer requirements regarding quality assurance or continuous improvement caused you to make operational changes? Significant cost changes require you to revisit overhead rates and allocations.
- Finally, do the overhead costs attributed to production reflect your overall costs? If production is absorbing too much or too little overhead, analyze your allocations. While, at times, there are legitimate reasons for variances between reported costs and actual costs, frequent or significant differences may indicate you need to reallocate costs.
To discuss your overhead allocations or rates, contact a member of HBK Manufacturing Solutions, a group of dedicated professionals focused on the manufacturing industry. We can be reached at 330-758-8613 or email@example.com.