Allocating labor and overhead to inventory is more than compliance — it’s imperative to your operational efficiency and financial accuracy.
With audit season around the corner for calendar year-ends, planning and preparation is key to having a successful and efficient audit. Often this means collaborating with your auditor to work through complex transactions and revisiting accounting estimates to verify their accuracy and avoid unnecessary hiccups near deadlines.
For many manufacturing companies, a complex area commonly requiring audit adjustments is the capitalizing labor and overhead expenses to the balance sheet through inventory. Although this can be a tricky area for an audit or just your everyday accounting, being proactive can lead to a smoother audit process and more accurate financial reporting.
Understanding the audit focus
Auditors evaluating inventory-related allocations are primarily concerned with whether costs are properly capitalized and whether the methods used to allocate labor and overhead are consistent, reasonable, and compliant with accounting standards.
Under the accounting standard for inventory (ASC 330), in addition to direct materials, inventory should include direct labor and a portion of overhead costs attributable to the manufacturing process. Importantly and often overlooked, overhead must be allocated based on “normal capacity” and not inflated due to idle time or abnormal production levels.
Auditors will assess:
- The basis for overhead allocation (e.g., labor hours, machine hours)
- The consistency of allocation methods across reporting periods
- The accuracy of labor cost calculations
- The reasonableness of “normal capacity” based on average production levels under expected operating conditions
- The completeness of supporting documentation
Common labor and overhead expense allocation mistakes
Common mishaps when allocating labor and overhead expenses to inventory include:
- Improper capitalization — Including non-production costs or failing to exclude abnormal costs like spoilage or excessive freight.
- Inconsistent allocation methods — Switching between labor-hour and machine-hour bases without justification.
- Lack of documentation — Missing routing sheets, payroll breakdowns, or overhead allocation schedules.
- Overreliance on estimates — Using outdated or unsupported assumptions for labor and overhead rates.
What problems occur if you improperly allocate labor and overhead expenses?
Improperly allocating labor and overhead expenses can lead to significant issues even beyond an audit, including:
- Distorted financial statements
- Inaccurate budgeting and forecasting
- Profitability erosion through variances
- Highly volatile margins
- Cash flow and tax implications
- Operational inefficiencies
- Customer service and reputation damage
- Strategic misalignment
Labor and overhead expense capitalization example
Below is an example to illustrate the negative margin impact of improperly capitalizing excess capacity by not adjusting for a “normal capacity” rate:
Budgeted overhead expense = $500,000
Anticipated capacity = 100,000 units
Overhead rate = $500,000/100,000 units = $5 per unit
Actual production = 70,000 units
Overhead variance = 100,000 units – 70,000 units = 30,000 units x $5 per unit = $150,000 overhead variance
Annual sales = $5 million
Margin impact = $150,000 overhead variance/$5 million sales = 3% margin impact
By not adjusting for actual production, inventory is inflated by $150,000 and as this inventory is sold, margins will drop sharply resulting in inaccurately representing the true profitability and value of the product.
How to allocate labor and overhead expenses for audit purposes
To help improve your audit outcome when allocating labor and overhead expenses to inventory, consider these tactics:
Review allocation methodologies
Document your current allocation methods. Whether you use a predetermined overhead rate or activity-based costing (ABC), verify the rationale is clear and aligns with your operational realities. For example, if labor hours are your primary cost driver, validate this remains the most appropriate basis given current production processes.
Validate labor cost calculations
Calculate direct labor costs using accurate time tracking and wage rates. For indirect labor (e.g., supervisors, maintenance), confirm costs are allocated using a consistent and reasonable method. Review payroll records by department and reconcile them with production schedules and routing sheets.
Compile overhead data
Gather all overhead expenses — rent, utilities, depreciation, insurance — and categorize them into fixed and variable components. Allocate these costs using your chosen method and document the assumptions behind each allocation. Avoid including abnormal costs or those unrelated to production.
Reconcile inventory valuation
Verify your inventory valuation reflects the allocated labor and overhead. Perform a perpetual inventory subledger review and investigate discrepancies.
Prepare supporting documentation
Auditors will expect to see the following documentation when validating the allocation:
- Calculations detailing labor and machine time
- Payroll summaries by department
- Overhead allocation schedules
- Journal entries adjusting inventory and recording cost of goods sold
Collaborate with your audit team
Engage your auditors early. Share your allocation methodologies and ask for feedback. If there are any concerns with the allocation methodology, it’s recommended to visit these concerns ahead of final audit fieldwork.
How CLA can help with capitalizing labor and overhead expenses
Allocating labor and overhead to inventory is more than a compliance exercise — it’s imperative to your operational efficiency and financial accuracy. By proactively reviewing your methodologies, validating your data, and collaborating with your auditor, you can help your organization to have a smoother audit.
Monitoring monthly variances is key to measuring plant performance and avoiding write-offs, and a labor and overhead study can help uncover those variances. CLA has conducted labor and overhead studies for a wide variety of manufacturers.