How to Find & Calculate Indirect Manufacturing Costs

Manufacturing businesses incur costs to produce goods, categorized as direct or indirect. Direct costs, like raw materials and direct labor, are easily traceable to specific products. Indirect manufacturing costs, often called manufacturing overhead, are important but cannot be directly linked to individual units. Understanding, identifying, and managing these costs is important for accurate product costing, pricing decisions, and financial health.

Understanding Indirect Manufacturing Costs

Indirect manufacturing costs are factory-related expenses that are not direct materials or direct labor. They cannot be directly traced to a specific product, but are necessary for production. These are often termed manufacturing overhead, factory overhead, or factory burden.

Unlike direct costs, which are consumed by a product, indirect costs support the entire manufacturing operation. For example, wood for a chair is a direct material, and a carpenter’s wages are direct labor. Factory rent, however, supports all production within the facility, making it an indirect cost.

Examples of indirect manufacturing costs include expenses that keep the production environment functional. They include factory rent, mortgage payments, utilities (electricity, water, gas) used in the production facility, and depreciation of factory equipment and buildings. Indirect labor, such as salaries for factory supervisors, maintenance staff, quality control inspectors, and janitors, also falls into this category. Indirect materials, like lubricants, cleaning supplies, or small tools not part of the final product, are also considered indirect costs.

Indirect costs can exhibit different behaviors in relation to production volume. Fixed manufacturing overhead costs remain constant regardless of units produced within a relevant range, such as factory rent or straight-line depreciation of factory equipment. Variable manufacturing overhead costs fluctuate directly with production volume, like electricity for increased output or indirect materials consumed based on production levels. Mixed costs contain both fixed and variable components; a base amount is incurred regardless of activity, but an additional cost is added as activity increases. For example, a utility bill might have a fixed service charge plus a variable charge based on consumption.

Identifying Indirect Manufacturing Costs

Identifying indirect manufacturing costs requires a systematic approach to pinpoint and classify these expenses within a company’s financial records. Businesses typically review general ledger accounts, expense reports, and invoices to locate all expenditures related to the manufacturing facility. Each account is examined to determine if the cost contributes indirectly to the production process.

A well-structured chart of accounts helps in this identification, allowing clear segregation of manufacturing-related expenses from other operational costs. For example, a chart of accounts distinguishes manufacturing overhead from selling, general, and administrative (SG&A) expenses, which include costs like corporate salaries, advertising, or legal fees not directly tied to production. A factory manager’s salary is manufacturing overhead, while a sales manager’s salary is an SG&A expense. Source documents provide the basis for these costs: utility bills show factory energy consumption, depreciation schedules detail asset cost allocation, and payroll records confirm indirect labor expenses.

Once identified, costs need categorization. This can involve grouping costs by department (e.g., machining or assembly) to understand overhead incurred by each production area. Alternatively, costs can be classified by behavior (fixed, variable, or mixed), which aids in cost control and forecasting. This ensures all manufacturing costs, not directly traceable to a product, are accurately captured and distinguished from non-manufacturing expenses. Incorrect classification can lead to misstated product costs and flawed financial reporting.

Assigning Indirect Manufacturing Costs to Products

Once identified, indirect manufacturing costs must be assigned to products, a process known as cost allocation. This is necessary because indirect costs are part of the total cost of producing goods, and GAAP requires these costs be included in inventory value and cost of goods sold. Without allocation, the true cost of each product would be understated, leading to inaccurate pricing and profitability analysis.

Traditional allocation methods often rely on a single cost driver to distribute overhead across all products. Common cost drivers include direct labor hours, direct labor costs, or machine hours. To use this method, a predetermined overhead rate is calculated by dividing estimated total manufacturing overhead costs for a period by the estimated total amount of the chosen allocation base. For example, if estimated annual overhead is $500,000 and estimated direct labor hours are 100,000, the overhead rate would be $5 per direct labor hour. Each product receives an overhead allocation based on the actual amount of the cost driver consumed.

Activity-based costing (ABC) offers a refined approach to allocating indirect costs, especially for companies with diverse products or complex production processes. ABC identifies specific activities that consume resources and cause overhead costs, such as machine setup, product inspection, or order processing. Costs are first assigned to these activities, creating “cost pools.” Then, specific “cost drivers” are identified for each activity; for instance, the number of setups for machine setup. Overhead is allocated to products based on their actual consumption of these activities, providing a more accurate cost representation than a single, plant-wide rate.

Recording Indirect Manufacturing Costs

Recording indirect manufacturing costs involves accounting steps that track these expenses from incurrence to inclusion in the cost of products sold. Initially, when indirect costs are incurred, they are recorded by debiting a temporary “Manufacturing Overhead” account and crediting the corresponding asset or liability account (e.g., Cash, Accounts Payable, or Accumulated Depreciation). For example, when the factory utility bill is received, the Manufacturing Overhead account is debited. This account acts as a holding place for all indirect production costs.

As products move through production, manufacturing overhead is “applied” to Work-in-Process (WIP) Inventory. This application uses a predetermined overhead rate, established at the beginning of the accounting period. The Manufacturing Overhead account is credited, and the Work-in-Process Inventory account is debited, moving a portion of indirect costs into inventory where direct materials and direct labor are already accumulated. This ensures all manufacturing costs, both direct and indirect, are attached to products as they are made.

Once products are completed, their total accumulated costs, including applied manufacturing overhead, transfer from Work-in-Process Inventory to Finished Goods Inventory. This transfer is recorded by crediting WIP Inventory and debiting Finished Goods Inventory. When finished goods are sold, their costs move from Finished Goods Inventory to Cost of Goods Sold (COGS) on the income statement. This ensures the expense of producing the goods is recognized in the same period as the revenue from their sale.

At the end of an accounting period, actual manufacturing overhead incurred (debited to the Manufacturing Overhead account) is compared to overhead applied to production (credited from the same account). A difference results in either over-applied overhead (when applied overhead exceeds actual) or under-applied overhead (when actual overhead exceeds applied). This variance is typically adjusted by closing the balance in the Manufacturing Overhead account to Cost of Goods Sold, correcting the expense for the period. If significant, the variance may be prorated among Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold to more accurately reflect the cost in all affected accounts.