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Is that "Overhead %" Really Helping You?

Stop using arbitrary overhead percentages! Learn why this common practice leads to inaccurate costing, poor decision-making, and missed opportunities for cost saving

Written by: Andrea Hill
Originally Published: 03 April 2017
Last Modified: 23 January 2025

A lot of manufacturing businesses tack on a standard overhead percentage to their manufacturing costs. It seems easy, right? Just slap on a 3% or 18% or 30% markup and cover those costs you know are there but maybe aren't doing a good job keeping track of. But accountants generally do not recommend adding arbitrary overhead percentages to product manufacturing costs. While it might seem like a quick and easy way to account for overhead, it actually creates more problems than it solves.

Imagine you're manufacturing metal components. You meticulously track the cost of raw materials like steel and aluminum. You know the precise labor hours involved in cutting, shaping, and finishing each part. But when it comes to accounting for the electricity that powers your machinery, you simply tack on an arbitrary "overhead" percentage.

This is where things get risky. Maybe you overestimate the electricity cost, making your components appear more expensive to produce than they actually are. This could lead to inflated prices that make you less competitive in the market. Or, you might underestimate the electricity cost, unknowingly selling your components at a loss. Even worse, what if your machinery starts to age and consume more energy? Because you're not tracking the actual electricity usage, this cost creep goes unnoticed, slowly eating away at your profits.

Why Arbitrary Overhead Percentages Are a Problem

  • Inaccuracy: Arbitrary percentages don't accurately reflect the true cost of overhead. This can lead to misinformed pricing decisions, inaccurate profitability analysis, and difficulty in identifying areas for cost optimization. You might be losing money on some items without even realizing it!
  • Distorted Decision-Making: If overhead costs are not accurately allocated, it can lead to poor decisions about product lines, pricing strategies, and investment in new equipment. You can't make informed decisions about pricing, production, or which products to focus on if you don't have a handle on your true costs.
  • Lack of Transparency: This method obscures the true drivers of costs, making it tough to find places to save money and hindering effective cost management. It's like flying blind when it comes to understanding your expenses.
  • Cost Creep: If your operating costs are changing over time (which they almost always are!), you risk not noticing these changes until a lot of money has slipped through the cracks. This can significantly impact your profitability and make it difficult to adapt to rising costs.

Just like a leaky pipe can drain resources over time, inaccurate overhead allocation can silently erode your margins. By relying on guesswork instead of real data, you're essentially operating with a blind spot in your cost analysis. This makes it impossible to optimize energy consumption, identify potential equipment upgrades, or make truly informed decisions about pricing and production..

What to Do Instead

Accounting pros recommend more accurate ways to handle overhead, and often, the best solution lies in utilizing a robust ERP (Enterprise Resource Planning) system. ERPs are designed to integrate all aspects of your business, including financials, inventory, and production processes. This gives you a centralized platform to track costs with precision. With an ERP, you can drill down into the details of your expenses, analyze real-time data, and generate detailed reports that help you understand your real overhead costs. This level of insight is simply not possible with arbitrary percentages or manual spreadsheets.

The good news is that ERP systems are more affordable than ever before, making them an accessible and invaluable investment for businesses of all sizes. In fact, for manufacturing companies serious about accurate costing and efficient operations, an ERP is arguably the single most useful investment you can make.

But even with a powerful ERP system, you'll still want to employ smart accounting methods to allocate your overhead costs effectively. 

One such method is "Departmental Overhead Rates." This approach offers a more refined way to allocate overhead compared to blanket percentages. By assigning overhead costs to specific departments based on their actual resource consumption, you gain a clearer understanding of where your money is going. For example, your production department might incur higher overhead due to machinery and electricity usage, while your design department might have lower overhead related primarily to software and office supplies. If you see a sudden spike in one department's electricity usage, it could signal a change in equipment efficiency, prompting you to investigate and address potential issues proactively. This level of granularity and control over cost allocation simply isn't possible with arbitrary overhead percentages.

Another method is "Direct Costing." This method simplifies cost analysis by focusing solely on variable costs directly tied to production. It treats fixed overhead costs, such as rent or administrative salaries, as period expenses rather than attaching them to individual products. This approach can be particularly useful for businesses with fluctuating production volumes, as it provides a clearer picture of the costs associated with each production run. However, it's important to remember that fixed overhead costs still need to be accounted for in your overall financial analysis.

Don't be afraid to reach out to an accounting expert for guidance. They can help you navigate the nuances of these costing methods, set up a system that accurately captures your overhead costs, and provide ongoing support to ensure your system remains effective as your business grows and evolves. Their expertise can be invaluable in ensuring you have a solid foundation for making sound financial decisions.

Embrace accuracy in your costing practices. Remember, knowing your true costs empowers you to make smart decisions about pricing, production, and your overall business strategy. By understanding the true profitability of your products and services, you can identify areas for improvement, optimize your operations, and ultimately achieve greater success. By understanding the drawbacks of arbitrary overhead percentages and embracing more accurate costing methods, you can gain a clearer picture of your business's financial health and set yourself up for greater success.

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