Manufacturing overhead items are those factory costs that are necessary for production but which are not conveniently traceable to specific production units. Basically, the accountant lumps all individual overhead items together and applies them to products through the use of averages. In its simplest form, this means that a N100,000 overhead total would be spread over 100, 000 units at a rate of N1 per unit.
Because individual costs cannot be traceable directly to physical units, some factors common to both physical units and to fluctuations in overhead cost as a whole should be used as a basis for overhead application. This common denominator differs between companies but the most widely used basis is selected after considering:
- The factor already associated with individual products or jobs (e.g. direct material and direct labour).
- Necessary clerical costs or effort in application.
- Differences in final results. Where results do not differ significantly, the easier method is used. The most important criterion for selecting of a base is relating overhead to its most causal factor.
Basis for Overhead application
The following basis is widely used for overhead application:
Physical Units Produced
Since information on the units produced is easily accessible for applying manufacturing overhead, this method is quite straightforward. In this method, the overhead rate can be estimated using the expression below:
Overhead Rate = Total Overhead/ Total Units Produced
This method applies factory overhead equally to each unit produced and is valid only when the units produced are homogenous and receive nearly identical attention and effort.
Direct Labour Hours
This method is often used because most overhead costs are more closely related to time expiration than to any other factors. For instance, fixed costs such as depreciation, rent, taxes, and insurance relate to a given time period. Indirect labour and supply usage are more closely related to the input of hours of effort etc. This is why time devoted to specific products is often the most reasonable factor for correlating overhead with products. Time is traced to specific products by using work tickets for direct labour. Overhead rates are developed by dividing the total estimated overhead by the total estimated direct labour hours.
Mathematically, Overhead Rate = Total Estimated Overhead/ Total Estimated Direct Labour Hours
Thus, the amount of overhead applied to any given product is dependent on the amount of time devoted to an operation or product.
Due to mechanization, machine time is often a better indicator of overhead cost incurrence than direct labour time. Depreciation, property taxes, supply usage, and indirect labour frequently are more closely related to machinery utilization than to direct labour usage. In theory, then, machine time may be the most valid base for overhead application. This method’s drawbacks include the extra expense and time required to summarize total machine hours per unit.
Direct Labour Cost
If labour rates are nearly uniform for every operation, the use of a labour base for overhead application yields the same results as using direct labour hours. Direct labour hours are the better base in most instances. For instance, a senior worker may earn N 420 per hour while a junior worker may earn N 300 per hour. If 200% of the direct labour cost rate is in effect, the overhead cost of a given job that requires one hour of direct labour would be N 840 if the senior worker were used and N 600 if the junior worker were used. Standard or average labour rates generally prevent such ridiculous results. Direct labour cost as an overhead base may conceptually be better than labour hours where many overhead items represent fringe labour costs that are primarily tied to direct labour cost or where high-cost direct labourers make the greatest use of high-cost facilities and complex machinery.
Unless the labour and equipment needed for material handling are a major part of overhead, the use of direct material cost or weights is not a valid theoretical base for overhead application. Again, material may be used as a base where the final results are the same regardless of the overhead base adapted. Sometimes, storeroom and material handling overhead is separated from other factory overhead and is applied to jobs on the basis of direct material weight or bulk. The remaining overhead items would be applied by using some other base.