Companies use various costing techniques to reach the expenses they incur to produce a product. In most cases, deriving the direct costs within the process are straightforward. However, fixed costs and other overheads may create some issues.
Consequently, companies use absorption costing to absorb those costs into the product cost. This process involves allocating those costs based on the activity levels.
Usually, companies include direct costs when establishing their profits. While it provides them with a base to understand how their processes work, it may not paint a clear picture. Companies also incur indirect costs during those processes.
However, they do not consider them in costing methods. Nonetheless, it does not imply those costs are not essential. Companies must consider those during their decision as well.
Companies can tackle the above issues by allocating indirect costs to direct costs. Companies can achieve this through a burden rate. This rate is an essential part of the decision-making process in managerial accounting. Therefore, it is crucial to understand what it is.
What is Burden Rate?
The term burden rate refers to the allocation rate of indirect costs to direct costs. Usually, it covers two areas, labor, and inventory. Companies allocate indirect costs to the direct costs for products or services through the burden rate.
Consequently, they get a better picture of the expenses involved in operations. On top of that, it allows them to establish the cost of producing or delivering a product.
Companies incur indirect costs in many forms. However, these costs may not always be apparent. In some cases, companies also refer to them as hidden costs associated with running operations.
Usually, they include unknown variable costs that can create issues in determining product costs. Companies must apply those indirect costs to their direct costs to understand their processes better.
Direct costs, in contrast, are much easier to establish. Usually, companies calculate these costs as they incur them during production. Direct costs include any expenses directly occurring due to manufacturing products.
For service firms, they consist of costs directly attributable to the process of rendering services. However, these costs do not constitute all the expenses incurred in those processes. Companies still bear indirect costs.
Companies use the burden rate to allocate indirect costs to direct costs. Usually, it applies to labor where the former expenses are prevalent.
However, the burden rate also applies to inventory. Companies use this rate to allot their indirect costs to expenses directly attributable to the production process.
This process falls under factory or manufacturing overheads for companies. Usually, it is straightforward to calculate the burden rate.
What does the Burden Rate consist of?
The burden rate consists of various indirect costs. Usually, companies separate these costs into two components.
These involve labor burden and inventory burden. Each of these comes with some items that they include as a part of indirect costs.
However, not all of these items will apply to every company. Nonetheless, the burden rate consists of the following in each area.
Companies incur various costs related to labor during the production process. Usually, the salaries and wages paid to employees involved in that process constitute direct costs.
However, these direct costs also cause other expenses, which companies may not consider. These costs are a part of the labor burden. Usually, it includes the following items.
- Travel expenses.
- Payroll taxes.
- Workers’ compensation.
- Medical insurance.
- Vacation and other statutory pay.
- Pension contributions.
- Annual bonuses.
- Other benefits.
Companies add all these costs as a part of their indirect expenses. Later, they covert it into a burden rate.
Like labor, companies incur various direct costs related to the material. However, they may also bear other indirect costs associated with the process.
For example, companies incur utility expenses on running machinery. On top of that, they also pay for repair and maintenance expenses related to the production process. Companies add these expenses and convert them into an inventory burden rate.
The inventory burden does not constitute a portion of the direct inventory costs. Instead, companies calculate it based on machine hours. Some companies also use other appropriate activity measures based on their needs.
How to calculate the Burden Rate?
Calculating the burden rate is relatively straightforward. Essentially, it provides a per-unit rate that companies use to allocate their indirect costs to direct costs.
Companies can calculate the burden rate for labor and inventory. In most cases, the former is more prevalent. Companies can use the following formulas for the burden rate.
Labour burden rate
The labour burden rate helps companies allocate indirect labour costs to direct labour costs. Usually, the labour burden for companies includes the items listed above.
Companies add those items to their direct costs for decision-making. The labour burden rate calculates the ratio between indirect labour and direct payroll costs.
Overall, the labour burden rate formula is as follows.
Labor burden rate = Indirect costs / Direct payroll costs
For example, a company pays its employees an annual wage of $100,000. It also incurs payroll taxes and benefit-related expenses for $20,000.
For that company, the labor burden rate will be $0.20 ($20,000 / $100,000). It implies that the labour burden rate is $0.20 for every $1.00 of direct labour cost.
Inventory burden rate
The inventory burden rate allows companies to add indirect material costs to the direct material costs. It accumulates all those indirect costs from the production process.
Then, it allocates them to the direct costs based on an appropriate activity measure. In most cases, companies use machine hours. However, other measures may also apply based on needs.
Overall, the inventory burden rate formula is as follows.
Inventory burden rate = Indirect material costs / Machine hours or other activity measures
For example, a company runs its machines that produce 100,000 products. Each product requires 1 hour of machine hour.
Thus, the machines run 100,000 hours each year. Apart from the direct costs, the company also incurs $10,000 to maintain and run those machines.
Therefore, the inventory burden rate for the company will be $0.10. It implies the company must add $0.10 for every $1.00 in inventory costs.
What is the difference between Burden Rate and Overheads?
Companies may include overheads as a part of their calculation for the burden rate. However, these differ based on a crucial factor.
In accounting, overheads refer to expenses associated with operations. It may include costs such as marketing, selling, administration, etc. However, these costs do not relate to the production process.
On the other hand, the burden rate helps establish the cost of production. However, overhead expenses do not relate directly to the production process.
On top of that, companies may have fixed and variable overheads. Usually, the former does not change with fluctuations in activity levels. These may include costs such as rent, depreciation, etc.
Variable overheads may change with activity levels. However, that activity may not relate to production levels. For example, companies may incur varied advertising expenses.
However, it does not depend on how many goods they produce during a period. Some of these also relate to selling activity rather than production. Therefore, overheads do not relate to providing goods or services.
The burden rate is the rate companies allocate indirect costs to direct costs. However, it only covers the production process.
The burden rate consists of two components, including labour and inventory burden. Each of these defines the items to include when calculating indirect costs. On top of that, companies can calculate the burden rate for each component.