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How to Compute Overhead Rates and Utilize Variances

Cost Accounting 101 – Overhead Rate Computation

This post on how to compute overhead rates and utilize variances is the third installment in our Cost Accounting 101 primer.  The goal is to help you determine what should and should not be in your overhead rate/pool, what is required to set an overhead rate, and how that rate can be used to make better business decisions.  Given the amount of manufacturing that has moved off shore in the past 20+ years (some of which will hopefully return one day), the cost accounting skills needed to support a domestic manufacturing concern are more difficult than ever to find; consequently, we are striving to perform some basic education around how cost accounting works and how it can help businesses improve profitability, cash flow, and the like.

What costs belong in an Overhead Pool

Defining what costs should be part of an overhead pool, typically starts with a discussion about what items do not belong in an overhead pool.  Most all SG&A items do not belong in an overhead pool, including Sales, Marketing, Distribution, Administration, R&D, and similar functions that are not directly related to manufacturing.  The items that do belong in an overhead pool include Manufacturing Support, Quality, Manufacturing Engineering, Document Control and similar functions that support the production processes.  Direct Labor, as in the labor associated with producing the product, is not part of the Overhead Pool.  See our post How to Compute a Direct Labor Rate post for more details on establishing a Direct Labor pool, if you have not done so already.

The majority of our clients are smaller concerns and really only have one department (or class if you are using QuickBooks), that constitutes the entire overhead pool.  The first part of generating an overhead rate is developing a budget for the overhead pool.  Shown below is an example of a client’s manufacturing overhead pool with several months hidden for display purposes:

How to compute overhead rates and utilize variances requires a monthly overhead spend plan.

From the above, you can see we have a monthly spending forecast, consisting of four account groups–1) Indirect Labor (in contrast to direct labor); 2) Materials (low value non inventory items and Packaging materials; 3) Freight In which is the cost of shipping material and products (not outbound materials.  The total planned spend for 2020 is $1,661.4K at line f.

How to compute the overhead rate, absorption plan and planned absorption variance

Computing the overhead rate, which is amount of overhead dollars to be absorbed into product costs in one hour, is fairly straightforward once you have computed your earned hours, because the overhead dollars will be absorbed when work orders are confirmed or closed.  Most ERP systems will allow you to assign a cost account and department for the credit side of the absorption entry.  Here’s is the summary of our overhead absorption plan which is based on the same earned hours projection made in How to Compute Earned Hours and Direct Headcount:

Overhead rate and absorption plan example.

As you can see above, at row f, we have the total planned Overhead Spend plan by month, totaling $1,661.4K.  Next, we bring in the monthly Earned Hours forecast that was computed in an earlier blog post, totaling 56,696 hours.  Dividing the $1,661.4K in Overhead Spend by the planned earned hours gives us our hourly overhead absorption rate–$29.304/hour.  Using our hourly rate, we multiply the monthly earned hour plan to compute the monthly planned overhead to be absorbed at line i.  Finally, at row j you can see the planned absorption variance for 2020, with totals to $0.0k at year end.  As you can probably surmise, there is not a precise correlation between monthly earned hours and monthly overhead spending.  For example, in February we plan to spend $111.7K in overhead and generate 6,608 earned labor hours, producing $193.6K of absorption.  So in February, we would say that we are over absorbed on overhead.  But other months will offset with unfavorable variances, given that the entire year reconciles to $0.0K.

How to dissect a monthly overhead absorption variance

On a monthly basis you will want to analyze your overhead absorption variance vs. you plan to determine what portion is due to spending and what is due to absorption.  Here is an example showing you the calculations for our hypothetical February 2020 close results:

Details on overhead absorption variance for February 2020. Total variance is $90.1K unfavorable.

Looking at the above results, you can see that our fictitious company had $124.0K of spending, at row a, on the actual P&L in February 2020.  Of the $124.0K spent, $115.8K was absorbed into inventory due to the 3,950 hours of earned labor generated by manufacturing.  This produced $8.2K of unfavorable under absorbed factory overhead.  Relative to the plan, we were expecting to $81.9K of favorable or over absorbed overhead in February.  So what happened?  You can easily split the planned absorption variance into a spend and an absorption component.  To compute the spend component, we just subtract the actual spend, at row a, from the planned spend at row g (or from our plan that we referenced on the earlier post) to derive the spend variance, which was an unfavorable $12.2K. 

To compute the absorption component, we just subtract the Actual Overhead Absorbed in February, at row d, from the Planned Overhead Absorption, at row f.  The total absorption component of the spend variance was $77.9K.  Looks like we planned for significantly more earned hours that was actually generated.  Looks like the department manager for the overhead department is off the hook, but someone needs to speak with operations about why the earned hours were so much lower than planned.

Hope fully you found this enlightening and can utilize it in your own organizations.  If you need help setting up your cost accounting processes, please give us call.  If you would like a copy of any of the workbooks used as examples, feel free to reach out.  We have the tools to help.


A picture of the author -- Chase Morrison
About the Author
Chase Morrison provides CFO services, utilizing Profitwyse’s 3D Growth Platform™, enabling his business owner clients to more readily achieve their goals for wealth creation and family legacy.  Contact him today to learn how your business can hit the accelerator using Profitwyse’s proven platform.


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How to Compute Earned Hours and Direct Headcount

Cost Accounting 101 – Earned Hours and Direct Headcount

To determine how much direct headcount a work center requires, you first need to determine how many hours of labor is going to be required given your build plan.  This is why we are frequently asked how to compute earned hours and direct headcount, which we have been doing for many years. 

Developing the build plan requires input from both Marketing/Sales to identify what is going be shipped, in what quantities and in what month.  Here is an example of a typical revenue plan that could be generated by Marketing/Sales. 

compute earned hours and direct headcount starts with your revenue plan as displayed

In this example, the important lines are the Units sold or shipped.  To simplify the example, we are going to produce the units sold in the month the units are to be sold without giving consideration to inventory levels, safety stock, service levels, etc.  But in a more realistic situation, all those factors would be combined with the units shipped below to compute a demand plan that more closely aligns with organizational goals for total inventory.

How to develop a build plan

Using the revenue plan as the starting point for our build plan, the next step is to factor in a yield rate.  Looking at our example below, you can see that Product XYZ has a planned yield rate of 95%, which means that we plan to scrap 5%.  There are some nuances to consider relative to how you factor in scrap, but for now we are just increasing the units needed by the yield (Units Finished / Yield %), to compute the units started.  Again, looking at the month of January for Product XYZ, we need to finish 16,621 to ship that same quantity.  To have 16,621 complete, we need to start 17,496 units when the expectation is to scrap 5% of the units started.  

Manufacturing Engineering provided the per unit labor standard for Product XYZ, which was set at .0130 hours per unit, which when multiplied by the number of starts–17,496–indicating a need for 227 hours of direct labor build time to complete this requirement.  We go through the same process for all 5 products for the entire year.  Though many rows and columns are hidden on the image below, you can see the totals for all the products at the bottom of the worksheet.  You can review the results below and see that the total number of hours of direct labor required to finish 2,883,287 units is 56,696 hours.  The 56,696 hours flows into our headcount plan model. 

compute earned hours and direct headcount summary plan

As we mentioned there are some consideration you need to make regarding how to plan for scrap.  One of the first considerations is how does your ERP system handle scrapped units.  Do you scrap units off the work order before any direct labor is earned?  Or do you scrap units after the work order is confirmed, which includes the earned hours in the scrapped unit.  This has implications for both how you plan scrap and overhead absorption.  So be sure you understand where the confirmation process for each good and bad unit occurs to more accurately estimate production variances.  Our hypothetical ERP system is assumed to scrap units after confirmation, which increases the cost of scrap and decreases potential labor efficiency variances.

Final Step — Converting earned hours into direct labor headcount.

Our final step in how to build an earned hours and direct labor plan uses many of the same assumptions that were used to compute our direct labor rate in our post on How to Compute a Direct Labor Rate.  If you did not read that post, you may want to take a minute to review it so you will better understand some of the assumptions being used here. 

The final result is below, with several of the months hidden to accommodate our screen width.  Below we describe each row in more detail, but essentially the point of this exercise is to see where you may potentially have too much headcount or too little headcount.  If you reviewed our post on How to Compute a Direct Labor rate, you may recall that our rate calculation assume 25 full time employees, which has carrier over to this example, along with all the same assumptions regarding holidays, vacation time, sick pay, etc.  Please review the summary below and continue on for a deeper explanation on all the calculations.

compute earned hours and direct headcount work center example

Here is an explanation of the various rows, using the letters in the right margin:

  1. Calendar Days is just the days in each month.  Note that 2020 is a leap year, bringing the total number of days to 366.
  2. Work Days is just that, the number of work days in a given month.  You would guess that the number should be 260 days (5 days a week * 52 weeks), but it is actually 262.  There is one extra day and the extra day for leap year brings the total to 262.
  3. Holidays are spread out to the months when they will occur.  There are 8 holidays provided by our hypothetical company.
  4. Available work days is the total work days at b) less the holidays (262 work days – 8 holidays = 254 available work days.
  5. Gross available hours is computed by multiplying 8 hours (our hypothetical company has a nominal 8 hour work day) by the available work days at d).
  6. Now we subtract the potential vacation hours we expect the average employee to take, which is just straight lined for the year.  The assumption is 2.5 weeks or 100 hours for the year.  We suggest using historical vacation utilization reports to make this a bit more accurate, but this is just an example.
  7. We also want to subtract from gross available hours our expectation for Sick hours, which was 4 days or 32 hours for the year.  Again this is just straight lined across the year, but could be refined if desired using historical payroll information.
  8. Net Available hours is our Gross available hours less vacation (f) and sick time (g).  This is essentially the straight-time hours we expect the average employee to be on site and available for work, before accounting for any overtime, which is 1,900 hours per year.
  9. We are just bringing over our overtime assumption from the direct labor rate calculation, which is an additional 8% of hours.
  10. Total Available Hours is the total number of hours we expect employees to be producing value for the company.  In 2020, this was 2,052 hours per employee.
  11. Available Headcount, as we mentioned earlier, is expected to be 25 full-time employees for this work center in 2020.
  12. Available Hours is multiplying the monthly headcount by the monthly Total Available Hours at j.
  13. The Requirement Hours are just coming from the yielded build plan that was based on the sales volume.
  14. The Overage/(Shortfall) line is just the difference between the Available Hours at l minus the Requirement Hours at m.  A positive variance indicates that we have more manpower than is demanded in form of Requirement Hours.  Assuming that we were going to back fill the months with a Shortfall using contract labor, then the Overage hours would be unfavorable labor variance and should be part of the Variance Forecast.  If the plan is to modify the production timing to accommodate the total Requirement Hours, then no variance will be generated.  A Shortfall–more Requirement Hours than Available Hours–is assumed to be solved using contract labor, in which case there would be no efficiency variance.  Note: In our labor rate forecast we did not include an assumption for Contract Labor.  If you have this issue, you may want to revisit your Direct Labor Rate computation to adjust for adding in some amount of contract labor. 
  15. Again, a Shortfall is assumed to be filled by Temporary Labor.  This row has the hours required to be back filled by Temporary Labor.  As you can see, the total hours of Temp Labor back fill is 7,667 hours, which translates into almost 4 man years of labor. 
  16. Total Temp Headcount Required is just converting the monthly Shortfall hours at o, into headcount.
  17. Both lines q and r are about computing the unfavorable labor variance, in hours and heads respectively, due to the surplus hours.
  18. Labor Variance Dollars would be integrated in your P&L plan.

In an earlier post, we describe the process for computing the monthly labor variance, which is comprised of a rate component and an efficiency component.  We suggest you review the the How to Compute a Direct Labor Rate post for more details

Hope fully you found this enlightening and can utilize it in your own organizations.  If you need help setting up your revenue  and build plans, please give us call.  If you would like a copy of any of the workbooks used as examples, reach out.  We have the tools to help.


A picture of the author -- Chase Morrison
About the Author
Chase Morrison provides CFO services, utilizing Profitwyse’s 3D Growth Platform™, enabling his business owner clients to more readily achieve their goals for wealth creation and family legacy.  Contact him today to learn how your business can hit the accelerator using Profitwyse’s proven platform.


Learn How to Compute Direct Labor Rates

Cost Accounting 101 – Direct Labor Rates

It is always surprising when we are introduced to a new prospective client when we discover that they do not attribute any direct labor cost in their costing process.  Many of our clients are midsize, privately-held, manufacturing companies that frequently do not have the cost accounting talent on hand needed to develop the rates as well as do not understand how they would be used.  In this blog post, you will learn how to compute direct labor rates, or at least one way of setting direct labor rates for a manufacturing business.

What Purpose is Served Using Direct Labor Rates?

Direct Labor Rates enable a manufacturing organization to answer two questions: 1) do we understand what it costs to deploy our direct labor work force, including both straight time, overtime, along with all associated benefits (health insurance, vacation, holidays, 401K plan, employer payroll taxes, etc.); and 2) are using utilizing our direct labor force as efficiently as planned.  

Direct labor is generally one of the larger, if not the largest, components of manufacturing or conversion costs.  Just as a reminder, conversion costs typically consist of direct labor, direct material, overhead, and sometimes a material overhead burden.  These three or four items generally constitute the total cost of a product.  A robust cost/continuous improvement process will utilize both labor rates and efficiencies to maintain a lean focus.

Step 1 – Collect the hourly payroll costs for each work centers

A direct work center is just a department that consists of predominantly factory workers that are actually touching the product.  There is frequently a debate when setting standards about should supervisors be assigned to the work center or not.  Typically our recommendation is to look at the amount of their time to be associated with direct production.  If they are going to spend more time supervising–training, personnel oversight, etc.–then they should be assigned to an overhead department, such as Manufacturing Administration; otherwise, leave supervisors in the work center.

Here is our example Work Center #1.  If you have multiple work centers, then you are going to want to segregate them into separate departments in your payroll and accounting systems:

Example of work center #1 payroll register

As you can see, we have 25 employees and are listing their current hourly rates, expected total annual hours (52 weeks * 40 hours a week = 2080), and the annual wages based on the rate and expected hours.  We are including the Annual hours so if there are part time employees, their wages will have the correct weighted impact to the overall average.  Basically, all of calculations are going to be based on the Work Center average employee.

Step 2 – Compute the new total year total wages and the number of hours you expect employees to be at work

Now that we have come up with our current employee base, which will be the basis used for the new rates, we need to make a couple of adjustments.  The first is adding in an expected impact for merit increases.  If your company has an annual merit increase process, then this is the place to add in the impact to the merit.  Here we are adding in 5%.  If you think there is going to be a 5% increase, but it will not take effect until July 1st, for example, then you would want to prorate the rate by 50% and only use 2.5%.  You will have an impact to your monthly variance, but your year-to-date variance will get more accurate as the year progresses. 

The next step is to compute the straight time number of hours we expect each employee to be at work.  Starting with the full time 2,080 hours, we reduce it by 100 hours for 2.5 weeks of vacation; 2) 64 hours for 8 days of paid holidays (New Years, Memorial Day, etc.); and 3) 32 hours for estimated sick time.  You will want to adjust this for your company specifics, but the goal is to reduce the 2,080 buy the number of hours we believe each employee will be unavailable for productive work.  These adjustment do not affect what we will pay each employee in total, for what will now be 1,884 hours of productive work, which is the $39,989.75 on average.

If your company experiences some level of overtime requirements, this is where to add it into the model.  In our assumptions, we are guessing that the average employee will incur 8% overtime beyond their straight time hours, adding 151 hours to their productive time available.  Also we need to add in the overtime compensation at 150% of their straight time rate.  This means that the average employee will see $44,336.33 ($39,989.75 + $4,346.58) in the W2 at year end and they will be available for productive work 2,036 hours (1,884 @ straight time + 151 @ double time).

Step 3 – Add in other related benefits and payroll taxes to compute total costs and final labor rate

The last step consists of adding all the related payroll and benefits cost.  In the example below we adding 7.65% for the employer’s matching Social Security and Medicare benefits and $10,200.00 for the estimated average healthcare benefit cost.  This brings the total comp, plus benefits and payroll deductions for the average employee to $57,928.06 per year.  In the last step, we divide this by the number of hours we expect each employee to be available for productive work–2,035 hours–to produce the new direct labor rate of $28.47/hour. 

Adding in related payroll cost to final direct labor calculation

Step 4 – Computing labor variances using a direct labor rate

Now that you know how to compute direct labor rates, the next step is learning how to analyze monthly results.  There are three components to computing a labor variance: 1) actual direct labor costs; 2) earned labor; and 3) earned hours.  Earned labor is a function of earned hours and is just a product of multiplying earned hours by a direct labor rate.   The example below is a hypothetical example of a company’s Work Center #1 results for February 2020.  As you can see below, the hourly wages (straight time plus overtime), Payroll Taxes (FICA) and Benefits totaled $118,997 (a).  The Actual Direct Hours, which would have been derived from looking timecards or a time clock, were 4,150.  The production system reported 3,950 earned hours for this work center during February, which multiplied by the hour plan rate of $28.47, produces $112,456 (d) of Earned Labor.  Immediately, comparing the actual direct labor cost of $118,997 vs. $112,456 you can see that we have an unfavorable labor variance of $6,542.  So what produced the labor variance, rate/cost or efficiency?

Display of Work Center #1 labor rate and absorption variance calculations

The calculations for separating a labor variance into rate and efficiency is a fairly straight foward process, as you can see above.  Note that adding the Rate and Efficiency variances equals the original variance at e).  In this instance, we can see that the majority of the variance pertains to efficiency.  Management can now take a deeper dive into the sources of the efficiency variance to determine where it pertains to incorrect labor standards, or not enough available production work or some delays due to part avaiability or whatever.  This with the intent to improve efficiency in the near future.

Hope fully you found this enlightening and can utilize it in your own organizations.  If you need help setting up standard costs, or inventory reduction processes, please give us call.  We have the tools to help.


A picture of the author -- Chase Morrison
About the Author
Chase Morrison provides CFO services, utilizing Profitwyse’s 3D Growth Platform™, enabling his business owner clients to more readily achieve their goals for wealth creation and family legacy.  Contact him today to learn how your business can hit the accelerator using Profitwyse’s proven platform.