Calculate Factory Overhead Recovery Rate Using ERP Data

Why overhead recovery is still done wrong in most plants

Factories often load overheads at a single rate for the whole plant, or worse, ignore them until the annual audit. This leaves production orders under-costed and the finance team reconciling large variances at month end. The ERP already holds the numbers to do it properly: actual indirect costs from finance and accounts, and machine or labour hours from production and planning.

An accurate overhead recovery rate spreads indirect costs across production orders in proportion to the activity that drives them. The result is a cost per piece that reflects reality, not a guess.

Decide which overheads to recover

Start by separating factory overheads into two groups: those that can be traced to production orders and those that cannot. Recoverable overheads typically include:

• Electricity and fuel used by machines in the production lines
• Depreciation on plant and machinery
• Consumables such as lubricants, cutting tools and cleaning materials
• Supervision wages for shift leaders and line inspectors

Non-recoverable overheads, such as factory rent, general insurance and head-office salaries, are usually written off to the profit and loss account. The ERP’s double-entry ledger will already split these into cost centres, so the list is usually a matter of reviewing the chart of accounts.

Choose the right absorption base

The absorption base is the measure used to allocate overheads to production orders. Common bases are direct labour hours, machine hours, or units produced. The best base is the one that most closely correlates with the overhead cost.

For a weaving mill, machine hours are usually the best base because electricity and depreciation are driven by how long the looms run. In a stitching line, direct labour hours may be more appropriate. Facteno captures both in the production module, so the data is already available without extra timekeeping.

Extract the numbers from the ERP

Pull the total recoverable overhead for the period from the trial balance. In most ERPs, this is a single general ledger code or a group of codes. For illustration, assume the following recoverable overheads for a month:

Total recoverable overhead = £28,000.

Next, extract the total absorption base for the same period. If machine hours are the base, sum the hours recorded against all production orders. For illustration, assume the plant recorded 14,000 machine hours in the month.

Calculate the overhead recovery rate

The formula is:

Overhead recovery rate = Total recoverable overhead / Total absorption base

Using the illustration figures:

Overhead recovery rate = £28,000 / 14,000 hours = £2 per machine hour

This rate is then applied to each production order based on the machine hours it consumes. An order that uses 500 machine hours will absorb £1,000 of overhead (500 × £2).

Apply the rate to production orders

In the ERP, the recovery rate can be set up as a standing overhead rate in the product costing module. When a production order is created, the system multiplies the order’s machine hours by the rate and adds the result to the order’s cost. This happens automatically, so the batch card and the cost ledger always agree.

Some plants use multiple rates—one for weaving, another for dyeing, for example—if the overheads and the absorption bases differ significantly between departments. The ERP will handle this as long as the cost centres and the production routes are set up correctly.

Reconcile absorbed overhead with actual overhead

At month end, compare the total absorbed overhead (rate × total machine hours) with the actual overhead incurred. In the illustration, absorbed overhead would be £28,000 (£2 × 14,000 hours), which matches the actual overhead. In practice, there will usually be a small variance due to timing differences or estimation errors.

If the variance is material, adjust the rate for the next period. Large, persistent variances usually indicate that the absorption base is not well matched to the overheads. For example, if electricity costs rise sharply but machine hours stay the same, the rate will under-recover until it is updated.

What to do next week

Review the chart of accounts in the ERP and tag each overhead cost as recoverable or non-recoverable. Then pull a report of machine or labour hours by production order for the last month. With these two lists, calculate a trial recovery rate and apply it to one production order to check the result. If the numbers make sense, set the rate in the system and run a reconciliation at the end of the week.