Don’t Let Overhead Accounts Get Ripe for the Picking

Target Audience: Manufacturers & Developers, Managers, M&D Industry, Tax Interest and Updates, Accountants and Consultants

Overhead costs are a part of every business, and accounting for them can be problematic. For manufacturers, overhead costing is particularly complex. Accounts tend to be large, and nonaccounting managers don’t always understand how they work. As a result, these overhead accounts can be open invitations to fraud.

Is the door open?

Overhead accounts frequently are catch-alls for everything that can’t be directly allocated to production. Manufacturing overhead costs include equipment maintenance and depreciation, building maintenance, administrative and executive salaries, taxes, insurance, and utilities. Most of these costs are incurred in relatively large amounts, and none will change appreciably whether production increases or diminishes.

It isn’t difficult to track overhead costs, many of which are fixed. The challenge comes in deciding how to allocate the costs to products.

Like most manufacturers, you probably develop an overhead rate to use in allocating costs to production. Typically, the rate is determined by dividing estimated overhead expenses by estimated totals in the allocation base (usually direct labor hours) for a coming period of time. Then you multiply the rate by the actual number of direct labor hours for each job to establish the amount of overhead that should be applied.

In some companies, the rate is applied plantwide, across all jobs. This is particularly appropriate for organizations that make single products, such as bricks, over long periods of time. If your product mix is more complex, you may use multiple overhead rates to allocate costs more accurately. If one department is machine-intensive and another is labor-intensive, for example, multiple rates may be appropriate.

Get accounts under control

In either case, however, it’s likely you’ll need to adjust the allocations after you know the actual costs. And there’s one problem with overhead cost accounting: Variances are almost certain. There are likely to be more variances if you use a plantwide overhead rate, but even the most carefully thought-out multiple rates won’t always be 100% accurate.

The result? Large accounts that most employees in the company don’t understand and that require constant adjustment. You couldn’t create a more inviting situation for fraud, particularly if you’re a small or midsize manufacturer with a solid history of trust in your employees and less stringent internal controls.

But you can protect yourself. Reduce the chance of overhead fraud by:

• Conducting independent reviews of all adjustments to manufacturing overhead and inventory accounts,

• Studying significant overhead adjustments over different periods of time to spot anomalies,

• Discussing complaints about high product costs with nonaccounting managers,

• Evaluating your existing overhead allocation and making adjustments as necessary, and

• Closely monitoring any accounts — such as overhead — that are obvious places to hide fraud.

Internal controls such as these won’t make it easier to allocate your overhead costs. You’ll still need to decide what rate you’ll use and how best to apply it. And allocating costs more accurately won’t guarantee that you make a profit. To do that, you have to actually sell what you produce.

Keep what you earn

Internal controls will help ensure that the money you need to pay the costs is where it belongs — in the overhead account, not in someone’s pocket. Because overhead costing can be complex, consult with your professional tax advisor.

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