How to Find Estimated Manufacturing Overhead Cost

Manufacturing overhead encompasses all indirect costs associated with the production process that cannot be directly linked to a specific product. These expenses are necessary for factory operations but do not become a part of the finished good. Understanding and accurately estimating these costs helps businesses make informed decisions regarding product pricing, budgeting, and financial planning. Accounting for manufacturing overhead provides a complete picture of production expenses, aiding profitability analysis and inventory valuation.

Identifying and Classifying Manufacturing Overhead

Manufacturing overhead includes various costs not directly traceable to individual units. One category is indirect materials, which are used in the manufacturing process but do not become a part of the final product. Examples include lubricants for machinery, cleaning supplies, and small tools or fasteners used across multiple products.

Another type is indirect labor, representing the wages of employees who support the production process but are not directly involved in creating the product. This includes salaries for factory supervisors, maintenance staff, quality control personnel, and janitorial staff. Their work is not easily tied to a specific unit of output.

Other indirect manufacturing costs cover various factory-related expenses. These include factory rent, utility bills (electricity, water, gas), depreciation of factory machinery and buildings, factory insurance, and property taxes on the factory.

Estimating overhead requires understanding how these costs behave in relation to production volume. Fixed overhead costs remain constant in total, regardless of the production level, such as factory rent or straight-line depreciation. Variable overhead costs change directly with production volume, like indirect materials or certain utilities tied to machine usage. Mixed overhead costs contain both fixed and variable components, such as a utility bill with a fixed service charge and a variable charge based on consumption.

Estimating Total Manufacturing Overhead

Forecasting total manufacturing overhead begins with analyzing historical data. Past overhead costs serve as a starting point, but they require adjustments for anticipated changes. Factors like expected inflation, changes in utility rates, planned production volume shifts, and new equipment purchases affecting depreciation must be considered.

For mixed costs, techniques like the high-low method can separate their components. This method uses the highest and lowest activity levels and their corresponding total costs to estimate the variable cost per unit and total fixed cost. While simple, this approach provides a basic understanding of cost behavior. More sophisticated statistical methods, such as regression analysis, can provide a more precise estimate by considering all available data points and identifying the relationship between costs and activity.

Estimating total manufacturing overhead involves quantitative analysis and management judgment. Input from various departments and management’s expectations for future operations, production levels, and resource needs are important. This comprehensive approach helps create a realistic and actionable overhead budget.

Allocating Overhead to Production

Once total estimated manufacturing overhead is determined, the next step involves assigning or “allocating” that total to individual products or services. This allocation is necessary because overhead costs, unlike direct materials or direct labor, cannot be directly traced to specific units, yet they are part of the product’s total cost.

To distribute overhead, businesses select an allocation base, a measure that drives the incurrence of overhead costs. Common bases include direct labor hours, direct labor cost, or machine hours. The selected base should ideally have a cause-and-effect relationship with the overhead costs being allocated, such as using machine hours if machine usage drives utility costs.

A predetermined overhead rate is calculated before the production period begins using the formula: Estimated Total Manufacturing Overhead divided by the Estimated Total Amount of the Allocation Base. This rate is then used to apply overhead to individual units or jobs as they are produced. For example, if the rate is $10 per machine hour and a product requires 2 machine hours, $20 of manufacturing overhead would be applied.