There are two major methods of allocating manufacturing overhead: direct labor or departmental machine hours.
Allocating manufacturing overhead by direct labor requires less bookkeeping to track and is a relatively simple calculation. However, direct labor as an allocation method works best in a less automated environment, as the method hinges on increases in direct labor correlating to increases in manufacturing overhead costs.
departmental machine hours
Departmental machine hours allow for a better relationship between hours run and overhead. However, this method requires significantly more detailed record-keeping, as errors in hours can significantly impact the bottom line.
Regardless of your application method, manufacturing overhead is always at risk of being under-applied. Some of the more common mistakes we see include:
- incorrect budgeting of overhead costs
- incorrect calculation of the hours used for base
Most companies base manufacturing overhead calculation on an estimate as opposed to actual numbers for ease of calculation. Some rely on their ERP system to calculate this for them.
The most important consideration for companies in the manufacturing industry is to test the calculations on an annual basis. This should include examining both the allocation base and overhead costs.
If you need more help with your analysis, an Embark manufacturing industry expert is here to help!