Overhead budget
Learning outcome statements
The learning outcome statements relevant for this section are:
- demonstrate an understanding of the relationship between the overhead budget and the production budget
- separate costs into their fixed and variable components
- prepare an overhead budget
The overhead budget outlines all indirect production costs (i.e., overhead costs), that are not directly tied to specific units produced but are necessary to support production activities. Overhead costs can include a wide range of expenses, such as utilities, rent, insurance, and indirect materials. These costs are separated into fixed and variable components to provide an accurate estimate of the indirect expenses associated with production goals. The overhead budget is essential for calculating both the cost of goods sold and the contribution margin, ensuring that production can proceed smoothly without financial strain.
Relationship between production and overhead budgets
The overhead budget is closely linked to the production budget, as overhead costs often fluctuate based on production levels. Variable overhead costs, such as utilities and indirect materials, increase with higher production volumes. In contrast, fixed overhead costs, like rent and insurance, remain constant regardless of production levels within a relevant range. Accurate overhead budgeting ensures that all indirect costs are accounted for, supporting the achievement of production targets without unexpected cost overruns.
Components of the overhead budget
Overhead costs in the budget are classified as either variable or fixed:
- Variable overhead costs: These change with production levels and may include indirect materials, utilities, or maintenance costs.
- Fixed overhead costs: These remain constant regardless of production volume within the relevant range and may include expenses like rent, insurance, or factory supervisor salaries.
By separating these costs, the budget provides a clearer picture of total overhead expenses, allowing GreenLine to allocate resources accurately.
Sometimes an overhead account isn’t already split into fixed and variable pieces - a mixed cost like maintenance or utilities can blend both together. The high-low method estimates the split by comparing the highest and lowest activity levels observed:
Once you know the variable cost per unit, you can back into the fixed cost by subtracting the variable portion from the total cost at either activity level.
Example: Using the high-low method
A company’s maintenance cost was $8,000 at 1,000 machine hours (its highest activity level) and $6,000 at 600 machine hours (its lowest activity level).
- Variable cost per hour: per hour
- Fixed cost:
Answer: Variable cost = $5 per machine hour; fixed cost = $3,000 per month
Preparing the overhead budget
Example: GreenLine overhead items
For GreenLine Furniture, the following are the overhead items:
Variable overhead costs per unit amounts to a total $1.50, composed of:
- Indirect materials: $1 per unit produced
- Utilities: $0.50 per unit produced
Fixed overhead is composed of:
- Factory rent of $6,000 per month
- Insurance of $1,500 per month
Fixed overhead costs remain constant, as they are not tied to production levels within the relevant range.
In this example, we’re using units produced as the cost driver for variable overhead allocation. This is because GreenLine’s production process is relatively straightforward, and overhead costs like indirect materials and utilities increase directly with the number of units produced, making per-unit allocation a practical approach. In more labor-intensive processes, however, direct labor hours might be a more suitable cost driver, as it would better align overhead with the labor effort required. For GreenLine’s purposes, per-unit allocation effectively captures variable overhead costs with fewer adjustments.
Using GreenLine’s production levels for Q4, the overhead budget calculates the costs associated with each overhead category. Monthly variable overhead is rounded to the nearest dollar - for example, November’s $1.50 per unit × 2,033 units = $3,049.50, which rounds to $3,050 in the table below.
| Month | Production units |
Variable overhead per unit |
Total variable overhead |
Rent | Insurance | Total fixed overhead |
Total overhead |
| October | 1,700 | $1.50 | $2,550 | $6,000 | $1,500 | $7,500 | $10,050 |
| November | 2,033 | $1.50 | $3,050 | $6,000 | $1,500 | $7,500 | $10,550 |
| December | 1,767 | $1.50 | $2,650 | $6,000 | $1,500 | $7,500 | $10,150 |
| Total | 5,500 | $8,250 | $22,500 | $30,750 |
This overhead budget provides GreenLine Furniture with a comprehensive view of indirect costs required to meet production goals for Q4. With detailed projections, GreenLine can allocate resources efficiently, ensuring they maintain a balance between supporting production and controlling overhead expenses.