In accounting 101, we all learned that costs consist of three components – labor, material and overhead. The definition of labor and materials are not difficult, but what is the definition of overhead? Its definition is “everything else”.

We also learned that overhead should be distributed to products (and cost centers, etc.) based upon some basis or proxy, classically direct labor hours. Automation has changed where we spend overhead hours. In highly automated supply chains, the direct labor hours may be minimal and have little or no relationship to how the so called overhead costs impact true costs. Using a single overhead allocation basis usually misses the mark, leading to misleading cost information.

For example, a food company’s supply chain moved two types of products. One was energy intensive (cook and freeze product line) and the other was not (blend dry ingredients and package). They used overhead allocation that divided total overhead by total cases and applied an overhead cost per case to each case produced (often called the “buck a case” method). Since energy was a major cost for the cook and freeze product line, it was not receiving its fair share of energy cost while the blend and package product line was being penalized.

Pointed out to management, we heard, “We know that and take it into consideration when we are making decisions.” Sorry, if the official costing numbers do not reflect fairly on products, decisions will usually be based on the official numbers, not what “we know”. With a few simple changes to the costing system to reflect energy fairly, decisions started to change. The cook and freeze winner became the cook and freeze loser very quickly. The marginal blend and package line became a profitable line.

How do we attack overhead elements and improve our costing accuracy? First, review the elements of overhead to find the major line items (big costs, these can have a meaningful impact on the cost of individual products or departments. Next, think of these elements as direct cost, not overhead. Treating these elements as direct cost may lead you to directly reporting the cost, for example adding them to the bill of materials (be careful, an operational snafu may be lurking here). Alternatively, you may want to develop an additional allocation method (activity costing may apply here).