How to Calculate Manufacturing Overhead Cost
Accurately determine true product costs and optimize profitability by mastering essential manufacturing overhead calculation methods.
Manufacturing overhead represents indirect costs incurred during production that cannot be directly linked to a specific product. Accurately determining these costs is fundamental for product costing, helping businesses understand the full expense of creating their goods. Calculating manufacturing overhead is important for setting competitive prices, evaluating product profitability, and making informed financial decisions. This process ensures all production-related costs are accounted for, even indirect ones.
Understanding Manufacturing Overhead
Manufacturing overhead encompasses all indirect costs that arise within the factory or production facility. These costs are essential for production but do not physically become part of the finished good or represent direct hands-on labor, distinguishing them from direct materials and direct labor. Identifying these indirect expenses is the initial step in accurately costing manufactured items.
Examples include indirect materials like lubricants for machinery, cleaning supplies for the factory floor, and small tools not traceable to individual products. Indirect labor costs, such as salaries for factory supervisors, maintenance staff, or quality control personnel, also fall into this category. These individuals support the production process but do not directly assemble or shape the product.
Other significant overhead expenses involve factory utilities, including electricity, water, and heating/cooling for the plant environment. Factory rent or depreciation on the factory building represents the cost of the space where production occurs. Depreciation on factory equipment, property taxes, and factory insurance premiums also contribute to the overall indirect costs of manufacturing. These costs are incurred for the benefit of the overall production process rather than for a single unit of output.
Gathering Manufacturing Overhead Data
Accurately calculating manufacturing overhead begins with collecting all relevant financial data. This requires establishing a clear accounting period, commonly monthly, quarterly, or annually, to ensure consistency and align with business reporting cycles.
Various financial records serve as crucial sources for gathering manufacturing overhead data. General ledger accounts are primary repositories for expenses such as utilities, factory rent, and depreciation charges related to factory assets. These accounts systematically track financial transactions, providing a comprehensive overview of incurred costs.
Invoices from suppliers provide detailed records for indirect materials purchased, such as cleaning supplies or machine lubricants. Payroll records detail wages and salaries paid to indirect labor, including factory supervisors, maintenance personnel, and security staff. Ensuring the accuracy and completeness of data collected from all sources is paramount, as omissions or errors directly impact the precision of final figures.
Selecting an Allocation Base
Distributing manufacturing overhead costs to individual products or jobs requires choosing an appropriate allocation base. An allocation base is a measure of activity believed to drive or correlate with overhead costs. A well-chosen allocation base reflects the underlying cause-and-effect relationship between the activity and the overhead incurred, directly influencing how much overhead each product or service absorbs.
Common examples of allocation bases include direct labor hours, machine hours, direct labor cost, or direct material cost. If overhead costs are primarily driven by machine operation time, machine hours are suitable. If overhead relates more to human effort, direct labor hours or cost may be appropriate. The goal is to select a base that accurately reflects the consumption of overhead resources.
Choosing an appropriate allocation base emphasizes a causal relationship. If an activity’s increase leads to a proportionate increase in overhead, it is a strong candidate. The chosen base should be measurable, easily traceable, and consistently applied to ensure fairness and accuracy in cost assignment. The effectiveness of the overhead calculation hinges on the relevance and appropriateness of the selected allocation base.
Calculating and Applying the Overhead Rate
The core of manufacturing overhead calculation involves determining a predetermined overhead rate, which facilitates the application of indirect costs to products throughout the accounting period. This rate is calculated by dividing the total estimated manufacturing overhead costs by the total estimated allocation base for a specific period. For example, if estimated overhead is $500,000 and estimated machine hours are 10,000, the predetermined overhead rate would be $50 per machine hour. This rate serves as a standard charge for overhead based on the activity level.
Once the predetermined overhead rate is established, it is used to apply overhead costs to individual products or jobs as they move through the production process. The amount of overhead applied to a specific product or job is determined by multiplying the predetermined overhead rate by the actual allocation base used by that product or job. For instance, if a product required 5 machine hours and the overhead rate is $50 per machine hour, then $250 in manufacturing overhead would be applied to that product. This application allows for the timely estimation of product costs even before actual overhead expenses are finalized.
Under- or overapplied overhead arises when the actual manufacturing overhead incurred differs from the overhead applied using the predetermined rate. This discrepancy occurs because the predetermined rate relies on estimated figures for both total overhead and the allocation base, which may not perfectly match actual results. If actual overhead exceeds applied overhead, it is underapplied; if applied overhead exceeds actual, it is overapplied. This difference highlights the inherent challenges of using estimates in cost accounting.
Businesses handle under- or overapplied overhead at the end of the accounting period. A common approach is to adjust the Cost of Goods Sold account for the entire amount. For example, if overhead was underapplied by $10,000, Cost of Goods Sold would be increased by $10,000. Alternatively, if the amount is significant, it may be allocated proportionally to Cost of Goods Sold, Work-in-Process Inventory, and Finished Goods Inventory. This adjustment ensures that financial statements accurately reflect the true cost of goods manufactured and sold.