This is a guest post by Alan Hart, MBA, Principal Consultant at Pacific Shine Group in Portland, Oregon.
I recently visited a small manufacturing company in the Southwest. They’ve been family-owned for three generations and only in the last few years have they fully upgraded to a manufacturing ERP software and automated work center labor time collection.
I asked their controller how often they updated their labor and overhead burden rates. His reply was: “I don’t think we’ve done this since the last controller left over a year ago. We are using the old rates which I know are outdated, but haven’t quite figured out how to calculate and maintain these rates on a regular basis.”
If this sounds familiar, please realize you’re not alone.
In this article, I will address common questions related to calculating direct labor and overhead burden rates and walk the reader through a method for obtaining the most accurate product costs (and inventory valuation) for all manufacturers as long as they use actual operation times during routing sequences.
It is important to note that using standard times (and standard hourly rates) does not generally work for job shop and limited quantity (and often changing designs and configurations) manufacturers, and I will further clarify these points as we go along.
What are direct labor and overhead burden rates?
US GAAP tells us that we must absorb (capitalize) all direct labor costs and all production (factory) overhead into the inventory we produce every accounting period (e.g., month).
What that means is that both direct labor (payroll expenses and payroll related expenses pertaining to direct manufacturing labor) and all overhead expenses that must be allocated to manufacturing activities should be fully allocated (or absorbed) into every item your company manufactures during the accounting period.
There are two primary reasons for that:
- To make sure your inventory is correctly stated on the balance sheet at period end, which also affects how your cost of goods sold (and hence your gross profit) is presented on your Income Statement. This is what GAAP is mainly concerned with.
- To get a better picture of how certain products, product lines, or even customers or customer jobs are performing in each period and compared with previous periods or similar jobs performed in the past, etc. Every business owner or manager wants and needs to know what his or her true costs are. Using the correct absorption rates can help you achieve that.
How do these principles apply to your business?
Whether you manufacture standard products, either mass-produced or in smaller batches, or you are a job shop that makes products to order or in very limited quantities and with frequent changes to the bill of material, these principals apply to you. We are going to learn a very simple method to periodically calculate and apply these rates.
How often should you calculate the rates and update your software with the new rates?
The answer to this question is how stable your rates have been over time. Initially, if you’ve never (or very infrequently) determined these rates, you should probably do this more often. Under normal circumstances we recommend doing this quarterly, although we’ve seen companies perform this process as often as monthly and as seldom as annually.
What to do:
- Decide on a time period in which to conduct the analysis. This can typically be the last closed fiscal quarter, the last closed month, etc. All reports obtained in this analysis must cover the chosen period only.
- Gather all relevant expenses during the analysis period.
- Perform the calculation.
Please note that all this information can be obtained from your manufacturing ERP software.
What expenses should be included in the analysis?
The following three cost groups explain the distinction between direct, indirect and applied overhead. Companies with a lesser degree of automation will have to rely more on their payroll processing reports and possibly on manually-entered employee time cards.
To calculate the direct labor burden rate you must know (in the period chosen for analysis):
1) Your total direct labor and all direct labor payroll related expenses. These include:
a. Wages – regular hours
b. Wages – overtime
c. Wages – personal time off, holidays, sick days, bonus pay, etc.
d. Employer payroll taxes
e. Employer paid benefits
To calculate the overhead burden rate you will need:
2) Your total indirect labor. These are employees that do not directly work in building or making your product, but indirectly support the manufacturing operations. Examples include:
a. Warehouse personnel
c. Material buyers
d. Material handlers
e. Production supervisors
f. Production administrators
g. Anyone else who supports the production or manufacturing process.
The expense categories are the same as in direct labor listed above.
3) GAAP requires that overhead associated with making, warehousing and shipping a product be absorbed into inventory cost. Many small manufacturers don’t do it or don’t do it correctly, but this needs to be done (or at least understood by management). These allocated expenses typically include:
b. Production equipment leases
g. Equipment and building maintenance
h. Other expenses that are related to the manufacturing activities
You must be able to define and document a reasonable allocation method. This may be based on square footage of the various production departments, including all indirect activities, or based on headcount. Use the method you chose to perform the general overhead expense allocation.
What other information do you need?
In most cases you will need to obtain the total number of productive direct labor hours. Direct productive labor (assigned to work orders) in a given period is completely absorbed into WIP inventory and is used to pre-determine the future rate of this direct labor. Machine hours are also an option which is mentioned below This is often obtained by running a labor analysis report in your ERP or manufacturing software. In less automated systems, it is the sum of all the hours reported on job time cards or production employee time cards (where hours are assigned to jobs). This number of hours will determine the standard direct labor hourly rate and overhead hourly rate, both of which will be used to charge costs to your WIP (work in process) inventory account during work order production, or work on specific jobs.
There are other methods that can be used, such as by using machine hours to establish the rates when machine hours are the dominant production input. Additionally, direct labor and overhead rates can be weighted by work center or machine, or labor type (in case of highly varying hourly labor rates). In this example we are assuming you will be using direct labor hours to arrive at the standard hourly rates and that no weighting is applied.
Direct labor hourly rate:
Divide your total direct labor expense (everything you collected in section 1 above) by the total number of direct labor hours during the analysis period. This is your standard direct labor burden rate. This is to pre-determine the rate for future periods, until this analysis is repeated (e.g., quarterly). This is acceptable for GAAP as long as you are not materially misstating your inventory and COGS.
Overhead hourly burn rate:
Divide the total indirect labor expenses plus allocated overhead (sum of sections 2 and 3 above), by the total number of direct labor hours. This is your standard overhead hourly burden rate.
When you update your ERP or manufacturing software with these two rates, every job you run with the updated rates will start accumulating more accurate costs. Your WIP account will absorb costs at the new rates multiplied by operation times (clock-ins / clock-outs at work centers or machines). When a work order or job is closed, the final value in WIP (consisting of all direct material, direct labor and applied overhead) will be moved to finished goods inventory and upon sale to your customers, your cost of goods account will be charged with this value. The difference between the selling price and the sold inventory value is, of course, your gross profit.
Note that most ERP or manufacturing software applications allow you great freedom in setting up the machines, work centers, burden rates weighting, and other options to closely suit the way your manufacturing operation works.
When you set up your general ledger cost of sales section of the chart of accounts in a similar fashion to what is described in my CTS Guides manufacturing blog article “Manufacturing Software Tips for Small Business Cost Accounting” from February 21, 2013, you will be able to determine whether your overhead is over or under absorbed in a given period. This will assist you in making adjustments to your burden rates, and in conjunction with your periodic analysis as described above, you will soon be able to tune these numbers in fairly accurately.
It is important to note that no mater how close you try to get these numbers, there will always be a variance. You will either be over or under absorbed. This is normal and actually expected as long as the variance is not very large. A large variance may introduce material errors to your inventory valuation and cost of goods sold and affect visibility of true product costs.
Once you start analyzing your direct labor and overhead burden rates and updating them in your ERP or manufacturing software, you will begin to better understand what your true product costs are, while obtaining more accurate financial statements due to more accurately stated inventory value and cost of goods sold. You will start realizing what your best performing products and jobs are and who are your most and least profitable customers. Your ERP or manufacturing software will help you achieve more consistency and accuracy in achieving these goals.
About the Author
Alan Hart is Principal Consultant at Pacific Shine Group in Portland, Oregon, with responsibility for client business development and hands-on client project implementations. Prior to starting Pacific Shine Group, he worked in various executive accounting and finance positions with technology and growth companies. Notable is his 18 years in the hi-tech manufacturing industry where he served as Controller, Vice President of Finance and CFO of several privately as well as publically held companies.
Combining his skills and experience in engineering with deep understanding of technical accounting, he is able to assist small and medium-size manufacturing companies establish GAAP compliant accounting and reporting systems.
Alan holds an MBA degree from the University of Birmingham and a degree in Marine Engineering and Naval Architecture.
He can be reached at (310) 384-1453 or firstname.lastname@example.org.