Overhead and Methods of Overheads Tutorial - Ways to calculate overhead costs - ask Question from an Accounting Expert!

Overhead and Methods of Overheads

Indirect resource, indirect labor, and other maintenance costs are referred to as "overhead costs" because they are involved in the regular day-to-day operations of the firm but cannot be neatly attributed to any one particular good or service. They must be distributed among the associated costs as accurately and feasible because they are secondary expenses or to rephrase it in another way, it's the cost of labor, materials, or activities that are not rationally linked to the sale of products of the organization.

Types of Overhead

There are three types of overhead.

Fixed Overhead: It includes all the fixed expenses that do not change on monthly basis. For example mortgage values, bank payments, property taxes etc.

Variable Overhead:This includes some variable expenses that fluctuate on monthly basis as per your requirements ex. electricity bills, gas bills etc.

Semi-variable Overhead: As the name indicates, it means the cost fluctuation between fixed and variable overhead expenses ex. fluctuating phone bills on monthly basis as per the requirements. It is further of various types:

  • Employee incentives and bonuses: It encompasses all the awards and bonuses presented to the staff of the firm at different intervals.
  • Janitorial services: It includes all the charges you have to pay for extra cleaning messes.

Ways to calculate overhead costs:

Your firm will benefit from keeping an organized and thorough documentation of your operational costs, which will aid in determining the optimal pricing for your good. This also aids in proper saving and   identifying various methods to optimize your marketing strategy by maintaining accurate records. Various steps enrolled in this process are:

  • Calculate all of your expenses and categorize them accordingly: Make a thorough accounting listof your company's expenses which should becomprehensive, sorted extensively and include items like office rents ofyour company, basic necessities, taxes, and building maintenance. These are illustrations of overhead expenses. Overhead costs do not include other expenditures like inventory, equipment, or labor. Being organized makes a person easy to categorize each thing and calculate it.It's critical to keep in mind that some objects are difficult to categorise, necessitating some judgment. For instance, the majority of companies label legal expenses as overhead. Cost of lawyer's comes under direct expense as it is a legal regulation.
  • Calculate on annual basis: After adding up individual month overhead costs it sums up to know about the annual costs of the company.
  • Calculate overhead rate: This is calculated by dividing indirect costs with direct costs and multiply it with 100.
  • How to calculate overhead costs in comparison with the sales:In order to compute this divide monthly overhead costs by monthly sales and multiply it by 100.
  • How to calculate overhead costs in comparison with the labor costs: In the same way divide monthly overhead costs with monthly labor costs and multiply it with 100.

Methods of overhead

1. Direct material cost method:

Direct Material Percentage Rate = (Factory Overhead / Direct Material Cost) * 100

Advantages of this method are:

This approach is appropriate for departments that only produce a single product, uniform products, or items that are evaluated using a common standard.

  • It is appropriate to organizations with straightforward manufacturing processes.
  • This technique is the simplest to comprehend and use.

2. Direct labor cost method:

Applicable when the wages do not vary much

Direct Labor Percentage Rate = (Factory Overhead /Direct Wages) * 100

Advantages of this method are:

  1. When labour costs make up a significant amount of the overall cost, this strategy is employed.
  2. This approach is ethical if various labourers of different skill levels are hired to create a product.
  3. It is easy to comprehend and put into practise.
  4. Because labour costs are less variable than material costs, this method is preferable to the proportion of direct cost of materials method.
  5. The time required is directly correlated with the amount of wage being paid. A product must be finished in a longer amount of time if higher salaries are to be paid.
  6. Direct wage comparisons between periods are more reliable.

3. Prime cost percentage methods

Prime Cost Percentage Rate = (Factory Overhead / Prime Cost) * 100

Advantages of this method are:

  1. This approach is incredibly straightforward to comprehend and use.
  2. It accords equal weighage to labor and material used and takes time into its account.

4. Direct labor hour method:

Applicable for non-uniform or manual production

Labor Hour Rate = Factory Overhead / Labor Hours

Advantages of this method are:

  • The time that the labor spends is taken into account in the computation of the overhead rate.

5. Machine Hour Rate Method:

Applicable for manual production

Machine Hour Rate = Factory Overhead / Machine Hours

Advantages of this method are:

  1. The machine hour rate assures an appropriate charge if machine work predominates in any production.
  2. It isthe optimal method of recovery whether one operator operates several machines or multiple operators run a single machine.
  3. When determining machine hour rate, the time which is utilized for production purposes is taken into account only. Therefore, it is a logical approach.
  4. Calculating machine hour rates in advance is fairly simple.
  5. It facilitates the distribution of indirect costs among several jobs.
  6. Using the task sheets, it is possible to calculate the expense portion of a job with a high level of accuracy.
  7. The price for this work is fixed.

Types of machine hour rate:

Ordinary Machine hour rate: Rate of all the indirect expenses related to use of machine for production.

Composite machine hour rate: Encompasses both variable and fixed expenses for running a machine.

Group machine hour rate: Only used if same type of machines are used in industry.

6. Rate per unit production method:

Applicable for uniform production and production of one element

Overhead Absorption Rate per Unit = Factory Overhead / Units of Production

7. Sales price method:

Sales Price Recovery Rate = (Factory Overhead / Sales Value Unit of Production) * 100

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