How to Calculate Manufacturing Overhead Rate: A Complete Guide

Manufacturing overheads form part of the product cost. Accounting for manufacturing overheads aims to equitably assign overheads to units produced during a period. Over­heads for a period are aggregated and then assigned to units produced using a method that reasonably captures the demand of the units on resources represented by overheads.

Usually, an average rate per unit is calculated and the same is applied to assign overheads to units produced. Overheads are aggregated at the cost centre level and average rate is calculated for each cost centre because the incidence of cost is different at different cost centres and different products consume varying amount of resources at each cost centre.

Conventional method for assigning overheads to units produced during the period involves the following four steps:

Total overheads for a particular period are collected under production cost centres and separate overhead absorption rates are used for different production cost centres. This is a refinement over the earlier practice of using a single absorption rate for the factory/facility.

In past, most firms were used to produce a single product or similar products, and the demand used to be created by each unit of such products on resources represented by fixed factory overheads did not vary significantly.

Consequently, use of the blanket rate did not impair the product cost. Firms felt the need for refinement when they added dif­ferent types of products which either do not use the resources of all the cost centres or the time spent by them in a particular cost centre is not uniform.

The conventional method required further refinement because it fails to produce the result with desired accuracy for firms that produce variety of products using the same facility in situations where the amount of resources consumed by a unit in a particular cost centre does not depend on the time spent by it in the cost centre.

Activity-based cost­ing (ABC) method, which is a refinement over the conventional method, provides result with much higher accuracy than that obtained by using the conventional method.

Allocation:

Overheads that can be identified to a cost centre are assigned to the cost centre. For correct allocation of factory overheads, source document which is used for collection of overheads must clearly indicate the cost centre which has received the benefit from the expenses covered under the document.

Notification of account-headings (standing order number) and cost centres is essential for allocating factory overheads to vari­ous cost centres. Examples of overheads that can be identified with cost centres are the following- depreciation, insurance, and repair and maintenance of equipment located in different cost centres, remuneration to supervisors and indirect workers dedicated to different cost centres, and power (if separate meters are installed in different cost centres).

Apportionment:

Apportionment refers to proportionate allotment of overheads common to various cost centres to those cost centres on some equitable basis. Examples of common overheads are the following- rent, rates, depreciation, repairs and maintenance of the building in which cost centres are located, lighting of the premises, works-manager’s salary, medi­cal director’s salary in a hospital, and managing partner’s salary in an accounting firm.

Allocation of directly identifiable items and apportionment of common items of factory overheads result in collection of total factory overheads under various cost centres, including support-service cost centres.

The following are some of the common bases used for measurement of benefits:

Two secondary criteria, other than the proportionate benefit, which are sometimes used for apportionment of factory overheads, are as follows:

(a) Ability to Pay:

One of the accepted principles of taxation is ‘what the traffic will bear’. This principle is sometimes applied in cost accounting for cost apportionment. E.g., sales office expenses may be apportioned to various product groups on the basis of sale value.

The assumption is that a product with a higher sale value can bear a higher burden of sales expenses, although actual efforts involved in selling an easy selling line but having higher sales must be lower as compared to the effort involved in other product lines having a lower sales value.

(b) Efficiency or Incentives:

In some organizations, overheads are apportioned on the basis of a predetermined activity level (often budgeted production or sales level). If actual performance exceeds the predetermined level, average per unit overhead cost would be lower as compared to the predetermined rate while failure to achieve the prede­termined activity level would result in a higher average per unit overhead cost. This provides an incentive for better performance.

Re-Apportionment:

Overheads of service cost centres are reapportioned to other cost centres based on the ‘proportionate benefit’ derived by those cost centres.

The following are some of the most apparent bases for reapportionment:

Usually technical estimates are used to reapportion overheads assigned to support-service cost centres to production cost centres, because often it is difficult to identify appropriate criteria for reapportioning service cost centre overheads.

One of the following methods is used to reapportion overheads of service cost centres to production cost centres:

(a) Direct redistribution method

(b) Step distribution method

(c) Reciprocal services method.

(a) Direct Redistribution Method:

A service cost centre renders services to production cost centres as well as to other service cost centres. This method ignores the services rendered by one service cost centre to other service cost centres. Service cost centre overheads are apportioned to production cost centres in the ratio of benefits received by them. This is a simple, but an inaccurate method.

(b) Step Distribution Method:

Under this method, service cost centres are ranked in order of the magnitude of overhead to be reapportioned. Sometimes, support-service cost centres are ranked on the basis of the number of service cost centres to whom services have been rendered by the particular service cost centre.

Overhead of the support-service cost centre, which is ranked first, is reapportioned to all other cost centres including service cost centres. The overhead of the service cost centre ranked second would then be reapportioned to all other cost centres except to the service cost centre ranked first.

In this manner, overhead of a service cost centre would be reapportioned to all cost centres including service cost centres ranked lower to that service cost centre. This method provides more accurate results as compared to the direct redistribution method. How­ever, it often fails to provide the desired result, because in reapportioning the overhead of a particular support-service cost centre, support-service cost centres ranked higher are ignored.

(c) Reciprocal Service Method:

This is the most accurate method because it recognizes and gives due weightage to inter service transfers.

The following methods deal with reciprocal services:

(i) Simultaneous equation method,

(ii) Repeated distribution method,

(iii) Trial and error method.

(i) Simultaneous Equation Method:

There are two steps in this method. First, overheads of ser­vice cost centres are ascertained using simultaneous equation method; and second, over­heads collected under service cost centres are reapportioned to production cost centres on the basis of certain predetermined percentages.

(ii) Repeated Distribution Method:

Simultaneous equation method can get quite complicated if there are several service cost centres. Repeated distribution method is the easiest one to follow. Under this method, overheads of service cost centres are reapportioned to other service and production cost centres on the basis of predetermined percentages. The process continues until the figures under service cost centres either get exhausted or become too small to be of any consequence.

(iii) Trial And Error Method:

Under this method, the first step is to ascertain overheads of service cost centres by repeated distribution method. The second step is to reapportion the total overheads of service cost centres to the production cost centres on the basis of predeter­mined percentages.

Absorption:

Commonly used methods for assigning overheads to units produced in a particular period assume that volume is the only cost driver. In other words, they assume that the amount of resources (represented by overheads) consumed by units produced vary in proportion to the quantity produced during the period. Therefore, the absorption rate per unit is calculated by dividing total overhead for the period by number of units produced.

How­ever, in most situations, units of different products produced are not uniform. E.g., a firm producing pumps of different types and different sizes cannot use a rate per unit for overhead absorption. It has to establish rate per equivalent unit, taking a particular type of pump as the measurement unit, provided it can convert one unit of each variety of pumps into equivalent units.

Usually, firms use machine hour rate for machine-intensive cost centres and direct-labour hour rate for labour-intensive cost centres. Use of an hourly rate provides accurate result in situations where the amount of resources, in a particular production cost centre, consumed by different units routed through that cost centre varies in direction proportion to the time spent by those units in that cost centre.

Moreover, use of an hourly rate avoids the complexity of converting one unit of each variety of products into equivalent units.

Pre-Determined Overhead Rates:

Firms use predetermined overhead absorption rate computed for a normal period (usually, one year) of business activity. Usually, budgeted figures are used to calculate the overhead absorption rate. Therefore, the method does not involve additional clerical work.

The fol­lowing are the advantages in using predetermined overhead absorption rate:

(i) Product costs can be worked out promptly.

(ii) Product costs can be estimated correctly even before production activity commences and this helps the management in deciding the prices to be quoted to prospective customers.

However, this may not be counted as a true advantage for two reasons. First, price of a product is determined by factors operating at the market place; and second, product cost determined for use in valuing stock cannot be used for decision making except in rare circumstances.

(iii) Product costs are not unnecessarily affected by seasonal fluctuations in costs and activity levels.

Some cost accountants suggest the use of moving average rate for overhead absorption. Under this method, moving average is calculated with reference to figures for the 12 months immediately preceding the month for which the rate has to be determined. E.g., if rate is to be determined for the month of August 2008, figures for 12 months ended July 2008 will be considered in calculating the absorption rate.

This method uses figures pertaining to some of the months falling in the previous accounting year and to that extent the rate gets distorted because past figures fail to incorporate changes planned in the budget for the current year.

Although under this method, delay is less as compared to delay in calculating the actual rate; it fails to provide data well in advance for the purpose of cost estimation. Therefore, it is preferable to use predetermined overhead absorption rate.

Length of the Period:

The general principle governing the selection of the period is that the period should be long enough to normalize the rate. In industries which are subject to cyclical fluctuations in business, perhaps the best alternative is to select a period which covers all the phases of a cycle. The period in such a case may be longer than one year. Selection of period is also influenced by seasonality of costs.

Many overhead items such as repairs and maintenance, rates and taxes, and heating and insurance are not incurred evenly throughout the year. If there is a predominance of such items, the period selected should be longer as compared to that in industries in which costs accrue evenly.

Similarly, in industries in which production is sea­sonal, the period selected should be longer as compared to that in which production volume does not fluctuate from period to period. The objective is to determine the normal rate.

Usually, predetermined overhead absorption rates are calculated at the beginning of each accounting year.

What Activity Level should be Used?

Overhead rate per unit or per hour is influenced by the activity level used as denominator in calculating the rate.

The estimated activity level can be based on the following:

(1) Average output of past years;

(2) Estimated output of the current year;

(3) Normal production capacity.

The average output of past few years does not represent the normal capacity. Therefore, the rate calculated by using the average output as denominator is not the normal rate. This method is suitable for small firms because of its simplicity. In large firms, conditions are rarely static and, therefore, average output of past years should not be used for computation of predetermined overhead rates.

Estimated output of the current year (the period in which the rate will be used) may or may not represent the normal capacity. In the year of depression, estimated production level is likely to be lower as compared to the normal production level. Similarly, in boom period, estimated production level is likely to be higher as compared to the normal production level.

Overhead absorption rate determined based on estimated output would be compara­tively higher during recession and lower during boom. In other words, during the period of reduced activity and falling prices, the cost of production would be higher as compared to the cost during the period of normal business. Similarly, during the period of increased activity and rising prices the cost of production would be lower. This is highly illogical.

Moreover, it is against the basic cost-accounting principle that products should neither be loaded with abnormal costs nor benefit from abnormal gains. According to this prin­ciple, abnormal costs should be directly charged to the Costing Profit and Loss Account and abnormal gains should be directly credited to the Costing Profit and Loss Account.

In accordance with this principle, the predetermined overhead absorption rate should be a normal rate and should be such that the total overhead is absorbed if normal produc­tion is achieved. If the actual production is below the normal production, the unabsorbed overheads arising due to idle capacity should be transferred to the Costing Profit and Loss Account. Similarly, if the actual production exceeds the normal production, over-absorbed overheads should be credited to the Costing Profit and Loss Account.

Normal capacity refers to the expected average production over a sufficiently long period covering a business cycle. Expected average production is determined taking into account the practical capacity and the average market demand. Normal capacity should be used as denominator for calculating predetermined overhead absorption rates and temporary fluctuation in output level should be disregarded.

The following are the advantages in using normal production capacity in calculating the predetermined over­head absorption rates:

(a) It helps calculate and recover the true cost of production. If a factory or a cost centre is operating below normal capacity, it cannot be said that the whole of the fixed cost has been incurred in achieving the actual output.

(b) It helps calculate and highlight losses due to idle time.

The twin objectives of cost accounting, namely, determination of normal product cost and cost control are best achieved by using normal recovery rate. Therefore, normal capacity should be used for calculating the predetermined overhead absorption rate.

Under or Over-Absorption of Overheads:

When a firm uses predetermined rate to absorb overhead, factory overhead incurred during a period may exceed the factory overhead applied to units produced during that period. The excess is under-absorbed overhead. E.g., if overhead incurred was CU 100,000 and overhead applied to production units was CU 90,000, there was under-absorption of CU 10,000.

If applied overheads exceed overheads incurred, the difference is over-absorbed overhead. E.g., if actual overhead was CU 100,000 and overhead applied to production was CU 120,000, there was over-absorption of CU 20,000. In either case, the difference must be analysed to determine the causes of the variance. Under- or over-absorption may arise either due to the difference between actual expenditure and budgeted expenditure or due to difference in normal production volume and actual production.

Over- or under-absorption of overheads should be calculated at the end of each accounting period. More frequent calculations may give rise to seasonal variations which offset each other over the full accounting period.

Under-absorbed overheads are written-off to the Profit and Loss Account and over-absorbed overheads are credited to the Profit and Loss Account if the following conditions are fulfilled:

(i) Over- or under-absorption has arisen due to the difference between the output achieved and the normal output level; or

(ii) The amount is not significant in relation to the total factory overhead incurred.

In both the above situations, production costs are normal and require no correction. Under-absorption arising due to idle capacity should always be charged to the Profit and Loss Account. Similarly, over-absorption arising due to higher (as compared to normal) capacity utilization should always be credited to the Profit and Loss Account.

If the variance is significant and has arisen from an error in the fixation of rates, produc­tion costs should be adjusted. The total variance is apportioned between inventories (fin­ished goods and work-in-progress) and cost of goods sold by using supplementary rates.

Some firms use ‘suspense account’ and transfer the amount of under- or over-recovery to the suspense account. The suspense account is carried over to subsequent accounting years for writing off as deferred charge or for crediting as deferred credit.

This method is justified only under the following circumstances:

(i) Variances have arisen due to seasonal fluctuations and business cycle which cover more than one period.

(ii) Variances have arisen in initial periods of a new project which is yet to achieve 100% utilization of the normal capacity.

This method is not in common use.

Capacity Levels:

Capacity generally implies the maximum that can be achieved by the best possible use of the available facilities and other resources (e.g. human resources, basic organization structures, and funds). Capacity depends upon the fixed amount of resources with which the manage­ment expects to run the business. The concept is applicable to plant and equipment and other resources such as human resources and material.

Usually, capacities of different operations in the production process are not balanced. Therefore, the ‘bottleneck operation’, which has the minimum capacity among all operations, determines the capacity of the complete production process. Let us take an example- assume that there are five operations A, B, C, D, and E in the production process. Capacities of A, B, C, and D are 1,000 units. The capacity of E is 900 units. The capacity of the production process is 900 units.

Usually, capacity is expressed in terms of number of units or standard hours per annum.

1. Theoretical Capacity (Ideal Capacity):

It refers to the output that can be achieved if production is carried out at a maximum speed without interruption. With reference to plant and equipment, it indicates the rated capacity, i.e., the capacity specified by the manufacturer or erector of the plant. Thus, theoretical capacity assumes no loss of time.

2. Practical Capacity:

This represents the production volume that can be achieved by efficient operation. Practi­cal capacity provides for unavoidable operating interruptions such as weekly off, time lost for repair, unavoidable inefficiencies, normal down-time, normal breakdown, and set­ups. Practical capacity should be determined taking into account the maximum number of hours for which the facility can be used during the year.

Practical capacity is determined by deducting unavoidable operating interruptions from theoretical capacity, and is usually expressed as a percentage of theoretical capac­ity. The percentage varies from industry to industry. On an average, practical capacity is expected to be between 75% and 85% of the theoretical capacity.

3. Normal Capacity:

The level of capacity utilization which satisfies the average customer demand is termed as normal capacity. Average is calculated by taking expected sales over a reasonably long period (3-5 years). Selection of a sufficiently long period levels out the peaks and troughs which come with seasonal and cyclical variations. Normal capacity is also termed as aver­age capacity and is often less than 100% of practical capacity.

4. Budgeted Capacity:

Budgeted capacity represents the expected (planned) level of activity for the budget period. Usually, budget period covers one year.

Capacity Based on Sales Expectancy:

Products are manufactured to be sold and, therefore, if a firm is unable to sell what it can produce, it would restrict its output for a particular period to the quantity expected to be sold during that period. Expected sales volume is determined after a careful analysis of the competitive conditions, general demand of the product and the influence of price changes on the sales volume.

While capacity based on sales expectancy is a short-term concept, normal capacity is a long-term concept. Usually, budgeted capacity represents capacity based on sales expectancy.

1. Actual Capacity:

Output achieved during the year is often termed as actual capacity. Usually, actual capac­ity fluctuates from year to year and may be more or less than the normal capacity. It cannot be more than the practical capacity.

2. Idle Capacity:

Idle capacity represents the temporary idleness of production or distribution facilities due to slow down in the inflow of orders. Idle capacity is the difference between the normal capacity and the actual capacity. Idle capacity may be divided into normal idle capacity and abnormal idle capacity.

The difference between the normal capacity and the budgeted capacity may be viewed as normal idle capacity. The difference between the budgeted capacity and the actual capacity may be viewed as abnormal idle capacity.

3. Excess Capacity:

Excess capacity represents the capacity which the firm does not expect to utilize in the near future (3-5 years). Firms create excess capacity because either the investment is indivisible or it expects increase in demand in the long term. Excess capacity is the dif­ference between the practical capacity and the normal capacity.

Excess capacity in a workstation might arise due to imbalance in practical capacities among different worksta­tions. This excess capacity can be reduced by attempting synchronization of capacities of different workstations.

Accounting for Some Specific Cost Items:

1. Estimating and Drawing Office Expenses:

Estimating and drawing office expenses should be treated as a service cost centre. The overheads are usually reapportioned to production cost centres for final recovery. However, a portion of overheads collected under this cost centre is often treated as selling overhead and the balance is reapportioned to production cost centre.

E.g., expenses associated with preparation of tender estimates are treated as selling overhead. In a heavy engineering factory manufacturing specific on-off jobs, drawing hours for each job are recorded, and drawing office expenses are directly apportioned to jobs by using an hourly rate.

2. Canteen Expenses:

If the canteen runs on no profit, no loss basis, cost to the firm is zero. If the canteen is subsidized, the amount of subsidy is treated as factory overhead. The canteen is treated as a separate service cost centre and the net subsidy is reapportioned to production cost centres.

If there is more than one canteen (e.g. worker’s canteen, supervisor’s canteen, and officer’s canteen), each canteen should be treated as a separate cost centre. Similarly, subsidy to canteens supporting sales or administration offices should be treated as sales/ administration overhead.

3. Costs Auxiliary to Salaries and Wages:

Costs auxiliary to salaries and wages include contribution to PF, ESI, gratuity funds, pen­sion funds, and costs for providing fringe benefits to employees. If possible, auxiliary costs related to direct workmen should be charged to units produced by inflating the wage rates to be applied for the recovery of direct wages.

Alternatively, those should be treated as overhead of the respective cost centres. Auxiliary costs related to indirect workers and other employees should be treated as overhead.

Maintenance and Repair of Plant and Buildings:

Maintenance and repair cost should be analysed separately under the following categories:

(a) Costs of preventive maintenance

(b) Costs of major overhaul

(c) Costs of repairing breakdowns

Maintenance and repair costs include costs of maintenance spares and other materials, employee costs, and expenses of the maintenance department. The method of issuing ‘service order’ authorizing each maintenance and repair work helps accumulate costs. Usually, repair hours are booked against each service order along with costs of spares and other materials.

Maintenance department expenses are apportioned to each ser­vice order on the basis of maintenance hours. Costs accumulated against service orders are allocated to respective production cost centres. Cost for maintenance hours, not accounted for by service order, is reapportioned to production cost centres on some equitable basis.

True costs of maintenance and repair can be worked out only if costs of other services received by the maintenance cost centre and administration costs are added to maintenance cost centre expenses. However, as the total expenditure on maintenance and repairs is in itself an overhead cost, such precision is usually considered wasteful.

5. Cost for Packing:

Packing may be of the following three types:

(i) Primary packing- Packing that is essential for protection and convenient handling of the product;

(ii) Secondary packing- Packing that is essential for safe transportation of the product;

(iii) Fancy packing- Packing which aims to attract customers’ attention.

Primary packing is treated as factory overhead; secondary packing is treated as distribution cost; and fancy packing is treated as advertisement cost.

Packing department is a separate cost centre and the total expenses are apportioned between primary packing, secondary packing, and fancy packing on the basis of some technical estimate. Costs apportioned to primary packing are then reapportioned to pro­duction cost centres on some equitable basis.

6. Royalties and Patent Fees:

Royalty based on units produced is treated as factory overhead. Royalty based on units sold is treated as selling expenses. If royalty is a fixed charge such as rent, it is treated as factory overhead. The expenditure incurred for registration and renewal of patent is treated as administration overhead.