How to Calculate Factory Overhead Costs

Factory overhead represents indirect costs incurred within a manufacturing environment. Understanding these costs helps businesses accurately determine product costs, aiding decisions on pricing, inventory, and financial management.

Understanding Factory Overhead

Factory overhead includes all manufacturing costs not directly traceable to a product unit. Unlike direct costs like raw materials or direct labor, overhead costs indirectly support the production process within the factory. These costs are incurred within the factory and are necessary for operations.

Accurate accounting for these indirect costs is essential for precise product costing. Failing to include overhead underestimates production expenses, leading to incorrect pricing and reduced profitability. Accurate costing also ensures proper inventory valuation for financial reporting.

Factory overhead differs from direct costs like materials and labor. Direct materials are primary product components, and direct labor involves wages for those physically creating goods. Overhead facilitates production but isn’t physically integrated into the product.

Factory overhead is distinct from non-manufacturing costs, including selling, general, and administrative (SG&A) expenses. SG&A costs cover marketing, distribution, and company management. These are expensed when incurred and not added to product cost for inventory. Factory overhead is essential for continuous factory operation.

Identifying Factory Overhead Costs

Identifying factory overhead costs is the first step in its calculation. These indirect costs are shared across products or the entire production process, making unit assignment impractical. Categorizing them ensures all relevant indirect manufacturing costs are included.

Indirect materials are a common factory overhead component. These materials are used in production but are not a significant part of the final product or are difficult to trace to specific units. Examples include lubricants, cleaning supplies, and small tools consumed during manufacturing.

Indirect labor refers to wages and salaries of factory personnel not directly working on the product. This includes supervisors, maintenance staff, and quality control personnel. Their compensation is a necessary production cost but cannot be directly attributed to individual units.

Factory utilities are another overhead cost. These include electricity for machinery and lighting, water for processes, and natural gas for heating or equipment. These costs support the entire factory’s operations, not just a single product.

Factory building costs contribute to overhead via rent or depreciation. If owned, a portion of the building’s cost is allocated as depreciation. Machinery depreciation and maintenance costs are also included, as equipment wears down and needs upkeep.

Factory insurance and property taxes are typical factory overhead costs. Insurance protects the facility and assets, while property taxes are on factory real estate. Both are necessary for plant operation but don’t directly contribute to product creation. These examples show costs for production not easily traced to individual units.

Determining the Overhead Rate

A predetermined overhead rate allocates indirect manufacturing costs to products. Established at the start of an accounting period, it estimates overhead cost per unit of activity. The formula is: Predetermined Overhead Rate = Estimated Total Factory Overhead Costs / Estimated Activity Base.

“Estimated Total Factory Overhead Costs” sum all expected indirect manufacturing costs for the period, including indirect materials, labor, utilities, rent, depreciation, insurance, and property taxes. Accurate estimation is important for reliable product costing.

The “Estimated Activity Base,” or allocation base, measures activity driving overhead costs. Common bases include direct labor hours, machine hours, direct labor costs, or units produced. Selecting an appropriate base is important; it should have a cause-and-effect relationship with overhead costs. For example, if machine operation drives utility costs and depreciation, machine hours are suitable.

Choosing the right allocation base ensures fair distribution of overhead costs based on consumed resources. If overhead increases with employee work hours, direct labor hours are suitable. If automated processes dominate, machine hours might better reflect resource consumption. The objective is to select a base that best represents how overhead is generated.

For example, if a company estimates $500,000 in factory overhead and 25,000 direct labor hours, the rate is $500,000 / 25,000 = $20 per direct labor hour. This rate is then used to apply overhead to products.

Applying Factory Overhead

Once established, the predetermined overhead rate assigns indirect manufacturing costs to products or jobs. This process determines the full production cost per unit. The formula is: Applied Overhead = Predetermined Overhead Rate x Actual Activity Base used by the product or job.

For every unit of the activity base consumed, a corresponding overhead cost is assigned. For example, if the rate is $20 per direct labor hour and a job uses 10 hours, $200 ($20 x 10) of overhead is applied to that job. This amount becomes part of the job’s total cost.

Applying overhead is essential for accurate inventory valuation. Accounting standards require manufactured inventory costs to include direct materials, direct labor, and allocated factory overhead. This ensures inventory on the balance sheet reflects a complete production cost, impacting Cost of Goods Sold and reported profitability.

Using the $20 per direct labor hour rate, if Job A uses 30 direct labor hours, the applied overhead is $600 ($20 x 30). This $600 is added to Job A’s direct material and direct labor costs to determine its total manufacturing cost.

Applying overhead determines accurate product cost, aiding competitive pricing. It also provides a basis for inventory valuation for financial reporting. Understanding the full production cost, including applied overhead, helps management with product mix decisions and evaluating production efficiency.