What Is Inventory Overhead and How Do You Calculate It?

Determining the cost of inventory extends beyond adding up the price of raw materials and direct labor. A large portion of a product’s cost is its overhead, which represents the indirect expenses necessary to bring an item to a saleable condition. Correctly applying these overhead costs is a requirement for proper financial reporting and provides a clearer picture of a company’s profitability.

Components of Inventory Overhead

Inventory overhead consists of all indirect costs incurred during the production process. Unlike direct costs, such as the wood used to build a chair, these expenses are not traceable to a single unit of production. U.S. Generally Accepted Accounting Principles (GAAP), under Accounting Standards Codification 330, mandate that these indirect production costs be included in the final value of inventory to reflect its full cost.

Indirect Materials and Labor

Indirect materials are supplies used in the production process that are not part of the final product. This category includes items like lubricants for machinery, cleaning supplies for the factory floor, and low-cost fasteners. Indirect labor refers to the wages of employees who do not physically construct the product but are necessary for the manufacturing operation. Examples include the salaries of factory supervisors, quality control inspectors, and equipment maintenance staff.

Facility and Equipment Costs

Costs associated with the manufacturing facility are a component of overhead. This includes rent on the factory building, property taxes, and utilities consumed during operations. The depreciation of manufacturing equipment, which allocates the machinery’s expense over its useful life, is also an overhead cost. Costs for repairs and maintenance on this equipment fall into this category as well.

Excluded Costs

Certain costs must be excluded from inventory overhead. Per GAAP, selling, general, and administrative (SG&A) expenses are not capitalized into inventory because they are unrelated to production and must be expensed when incurred. Examples include:

• Marketing and advertising budgets
• Sales commissions
• The salaries of corporate executives
• Rent for the corporate headquarters

Abnormal costs, such as those from excessive material waste or redundant freight charges, are also treated as period expenses.

Calculating and Allocating Inventory Overhead

Assigning overhead to inventory requires a method known as absorption costing, which is mandated by GAAP. The process begins by creating a pool of all indirect manufacturing costs for a specific accounting period. This involves summing up every includable overhead expense, such as factory rent, indirect labor wages, and equipment depreciation.

After the total overhead cost pool is determined, an allocation base must be selected. An allocation base is a measure of activity that drives overhead costs, such as direct labor hours, machine hours, or the number of units produced. The chosen base should have a strong cause-and-effect relationship with the overhead costs to reflect the resources consumed by production.

With the total overhead and allocation base finalized, a predetermined overhead rate is calculated by dividing the Total Estimated Overhead Costs by the Total Estimated Allocation Base. For instance, if a company anticipates $100,000 in overhead and 20,000 machine hours, the rate is $5 per machine hour. This rate is established before the period begins for consistent product costing throughout the year.

The final step is to apply the overhead rate to the products. As each unit or batch is produced, the company multiplies the actual amount of the allocation base used for that product by the predetermined overhead rate. If a specific product requires 3 machine hours to complete, it would be assigned $15 of manufacturing overhead ($5 rate x 3 hours). This applied overhead is added to the product’s direct material and direct labor costs to arrive at its total inventory cost.

Impact on Financial Statements

The allocation of inventory overhead affects a company’s financial statements. On the balance sheet, applying overhead increases the carrying value of the inventory asset. Inventory must be recorded at its full cost, including direct materials, direct labor, and a share of manufacturing overhead. As products are made, the allocated overhead costs are capitalized, becoming part of the inventory asset rather than being immediately expensed.

This treatment of overhead costs directly influences the income statement when the inventory is sold. As long as a product remains in inventory, its associated overhead costs stay on the balance sheet. Upon sale, the total cost of that product, including the applied overhead, is transferred from the inventory asset account to the income statement. This transfer is recorded as the Cost of Goods Sold (COGS).

The movement of these costs from the balance sheet to the income statement follows the matching principle in accounting. This principle dictates that expenses should be recognized in the same period as the revenues they helped generate. By including overhead in COGS, the full cost of an item is matched against the revenue from its sale. This affects the calculation of gross profit and the company’s net income.