Why multiple overhead rates should be used in this company rather than a single rate?
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What is an Overhead Rate?The overhead rate is the total of indirect costs (known as overhead) for a specific reporting period, divided by an allocation measure. The cost of overhead can be comprised of either actual costs or budgeted costs. There are a wide range of possible allocation measures, such as direct labor hours, machine time, and square footage used. A company uses the overhead rate to allocate its indirect costs of production to products or projects for one of two reasons. First, it can price them appropriately to cover all of its costs and thereby generate a long-term profit. If the overhead rate is not included in the cost of a product, then there is a risk that the company will significantly underprice its products or services, and eventually go bankrupt. Second, it must allocate costs to its inventory on hand at the end of the reporting period, as required under both Generally Accepted Accounting Principles and International Financial Reporting Standards. The result is fully-loaded inventory costs that it reports on its balance sheet. A company with low indirect costs will have a lower overhead rate, which makes it more competitive with other firms that must apply a larger amount of overhead cost to their products and services. How to Calculate an Overhead RateThe overhead rate can be expressed as a proportion, if both the numerator and denominator are in dollars. For example, ABC Company has total indirect costs of $100,000 and it decides to use the cost of its direct labor as the allocation measure. ABC incurs $50,000 of direct labor costs, so the overhead rate is calculated as: $100,000 Indirect costs ÷ $50,000 Direct labor = 2:1 Overhead rate The result is an overhead rate of 2:1, or $2 of overhead for every $1 of direct labor cost incurred. Alternatively, if the denominator is not in dollars, then the overhead rate is expressed as a cost per allocation unit. For example, ABC Company decides to change its allocation measure to hours of machine time used. ABC has 10,000 hours of machine time usage, so the overhead rate is now calculated as: $100,000 Indirect costs ÷ 10,000 Machine hours = $10.00 per machine hour Using Multiple Overhead RatesIt is possible to have several overhead rates, where overhead costs are split into different cost pools and then allocated using different allocation measures. For example, fixed benefit costs could be allocated based on the cost of direct labor incurred, while equipment maintenance costs could be allocated based on machine hours used. This approach results in more fine-tuned allocations, but is more time-consuming to compile. Terms Similar to Overhead RateOverhead rate is also known as the predetermined overhead rate when budgeted information is used to calculate it. Recommended textbook solutions
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Technical Writing for Success3rd EditionDarlene Smith-Worthington, Sue Jefferson 468 solutions Technical Writing for Success3rd EditionDarlene Smith-Worthington, Sue Jefferson 468 solutions What Is Overhead?Overhead refers to the ongoing business expenses not directly attributed to creating a product or service. It is important for budgeting purposes but also for determining how much a company must charge for its products or services to make a profit. In short, overhead is any expense incurred to support the business while not being directly related to a specific product or service. Key Takeaways
OverheadUnderstanding OverheadA company must pay overhead on an ongoing basis, regardless of how much or how little the company sells. For example, a service-based business with an office has overhead expenses, such as rent, utilities, and insurance that are in addition to direct costs (such as labor and supplies) of providing its service. Expenses related to overhead appear on a company's income statement, and they directly affect the overall profitability of the business. The company must account for overhead expenses to determine its net income, also referred to as the bottom line. Net income is calculated by subtracting all production-related and overhead expenses from the company's net revenue, also referred to as the top line. Types of OverheadOverhead expenses can be fixed, meaning they are the same amount every time, or variable, meaning they increase or decrease depending on the business's activity level. Overhead expenses can also be semi-variable, meaning the company incurs some portion of the expense no matter what, and the other portion depends on the level of business activity. Fixed OverheadFixed overhead is overhead costs that remain static for a long period of time and do not change as business activity ebbs and flows. Regardless of if business is growing or slowing, fixed overhead remains the same. Examples include rent, depreciation, insurance premiums, office personnel salaries. and the cost of licenses. Variable OverheadVariable overhead consists of the overhead costs that fluctuate with business activity. These are overhead costs that are not static. As business activity increases, so does variable overhead. As business activity slows, variable overhead decreases. Examples include office equipment, shipping and mailing costs, marketing, legal expenses, and maintenance. Semi-Variable OverheadSemi-variable overhead is a combination of fixed and variable overhead where some costs are incurred regardless of business activity but may also increase if business activity grows. Examples of semi-variable overhead include commissions and utility costs. For utilities, a base amount is charged and the remainder of the charges are based on usage. Other TypesOther categories of overhead may be appropriate depending on the business. For example, overhead expenses may apply to a variety of operational categories. General and administrative overhead traditionally includes costs related to the general management and administration of a company, such as the need for accountants, human resources, and receptionists. Selling overhead relates to activities involved in marketing and selling the good or service. This can include printed materials and television commercials, as well as the commissions of sales personnel.
Other categories such as research overhead, maintenance overhead, manufacturing overhead, or transportation overhead also apply. Examples of OverheadSome common examples of overhead costs companies must assume are rent, utilities, administrative costs, insurance, and employee perks. Rent and Utilities The costs associated with
maintaining the office or manufacturing space companies must have in order to perform their business is an example of overhead. This includes rent as well as utilities such as water, gas, electricity, internet, and phone service. Additional costs such as a subscription to virtual meeting platforms like Zoom (ZM) also
must be factored into a company's overhead. Administrative Costs Administrative costs are often one of the most expensive facets of a company's overhead. This can include the cost of stocking the office with the necessary supplies, the salaries of office associates, and external legal and audit fees. Administrative costs can range from the supply of toilet paper in the office restroom to hiring an external
audit firm to ensure the company complies with industry-specific regulations. Insurance Depending on the company, businesses are required to hold many different types of insurance in order to operate properly. These can include basic property insurance to protect the company's physical assets from fire, flood, or theft as well as professional liability insurance, health insurance for its employees, and car
insurance for any company-owned vehicles. While none of these costs are directly related to generating revenue for the company by providing a good or service, the business is often legally mandated to purchase these various types of insurance if it wishes to operate within most jurisdictions. Employee Perks Many larger companies offer a range of benefits to their employees such as keeping their offices stocked
with coffee and snacks, providing gym discounts, hosting company retreats, and company cars. All of these expenses are considered overhead as they have no direct impact on the business's goods or services. Special ConsiderationsOverhead is typically a general expense, meaning it applies to the company's operations as a whole. It is commonly accumulated as a lump sum, at which point it may then be allocated to a specific project or department based on certain cost drivers. For example, using activity-based costing, a service-based business may allocate overhead expenses based on the activities completed within each department, such as printing or office supplies. Why Is Overhead Cost Important?Overhead cost is important because it is the cost to run your business. Understanding and managing your overhead well, particularly how it relates to your business output, will help ensure your business is profitable and to obtain the best margins you can on your sales.
What Are Different Types of Overhead?Broadly speaking, overhead can be organized into three main types. Fixed overhead includes expenses that are the same amount consistently over time. These can include rent and depreciation on fixed assets. Variable overhead expenses include costs that may fluctuate over time such as shipping costs. Semi-variable costs are a blend of the two. Utilities are an example of a semi-variable cost. How Is Overhead Calculated?Since overhead is often considered a general expense, it is accumulated as a lump sum. This is then allocated to a specific product or service. There are a number of different ways of calculating overhead, however, the general rule is the following: Overhead rate = Indirect costs/ Allocation measure. The indirect costs are the overhead costs, while the allocation measure would include labor hours, or direct machine costs, which is how the company measures its production. The Bottom LineOverhead refers to the costs of running a business that are not directly related to producing a good or service. These costs can be fixed, such as rent, or variable, such as transport costs. They can also be semi-variable, such as utilities. Effectively managing your overhead allows you to keep costs low, set competitive prices, and maximize the most of your revenues. Why are multiple overhead rates used rather than a plantwide overhead rate in some companies?Some companies used multiple overhead rates because plantwide overhead rate is not always accurate which can lead to overapplication on one product and under application on the other. Multiple overhead rates are used by big companies that have a wide variety of cost pools and cost drivers.
Why do companies use a predetermined overhead rate rather than an actual overhead rate multiple choice question?The use of predetermined overhead rates can help smooth fluctuations in actual overhead costs due to periodic variations (such as seasonal changes). This will ensure that product costs remain constant over the year.
Why are multiple department overhead rates more accurate for product costing than a single plantwide rate?Traditional Costing uses a single plant wide overhead rate while activity based costing uses a multiple departmental overhead rates. Multiple departmental overhead rates provide a more accurate product cost because it allocates its cost fist to the different activities that are undertaken in producing the product.
Why departmental overhead rates might be used instead of a single plantwide overhead rate?Using departmental overhead rates will better reflect the costs of manufacturing Product A and Product B compared to using a single, plant-wide overhead rate.
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