What Is Manufacturing Overhead? Costs and Calculation

Manufacturing overhead represents all indirect costs incurred during the production process that are not direct materials or direct labor. It encompasses a broad range of expenses for factory operations, yet these costs cannot be directly traced to specific units of production. Understanding manufacturing overhead helps businesses accurately determine the true cost of their products and make informed financial decisions.

Defining Manufacturing Overhead

Manufacturing overhead includes indirect costs necessary for production that cannot be easily or economically assigned to a particular product or job. For example, the rent paid for the factory building is an indirect cost because it supports the entire production facility, not just one specific item.

Numerous expenses fall under this category, including factory rent or building depreciation, utility bills for the production facility (such as electricity, gas, and water), and property taxes on the manufacturing plant. Other examples include the depreciation of factory equipment, the cost of maintenance and repairs for machinery, and the salaries of factory supervisors, quality control personnel, and security staff. Even indirect materials, like lubricants for machines or cleaning supplies used in the factory, are considered manufacturing overhead.

Selling expenses, such as sales commissions and advertising costs, and administrative expenses, like office rent and executive salaries, are also not part of manufacturing overhead.

Classifications of Overhead Costs

Manufacturing overhead costs can be categorized based on how they behave in relation to changes in production volume. This classification helps businesses predict and manage expenses, aiding in forecasting and budgeting.

Fixed Overhead Costs

Fixed overhead costs remain constant in total, regardless of the number of units produced. Examples include monthly factory rent, annual factory insurance premiums, and straight-line depreciation on factory machinery. The salaries of permanent factory management and property taxes on the factory building also fall into this category.

Variable Overhead Costs

Variable overhead costs change in direct proportion to the volume of production. Common examples include the cost of indirect materials, such as glue used in assembly or cleaning solvents consumed based on machine usage. Utilities that fluctuate directly with machine hours, like electricity for operating production lines, and hourly wages for indirect labor, such as material handlers who assist production, are also variable overhead.

Semi-Variable Overhead Costs

Semi-variable overhead costs possess both a fixed and a variable component. Factory utility bills often fit this description, featuring a fixed service charge each month plus a variable charge based on actual consumption. Maintenance costs can also be semi-variable, with a fixed retainer for routine checks and additional charges for repairs based on machine operating hours.

The Importance of Overhead Costs

Understanding and managing manufacturing overhead impacts a company’s financial reporting, pricing strategies, and overall profitability.

Product Costing and Financial Reporting

Manufacturing overhead contributes to the total cost of producing an item. This cost is important for financial reporting, especially for valuing inventory on the balance sheet. An accurate product cost, including overhead, ensures that financial statements present a true picture of a company’s assets and profitability.

Pricing Strategies

Knowing the full cost of production, including all allocated overhead, helps companies set competitive and profitable selling prices for their goods. If overhead is underestimated, a company might price its products too low, leading to insufficient revenue to cover all expenses and eroding profit margins. Conversely, an overestimation could result in prices that are too high, making products uncompetitive in the market.

Budgeting and Planning

Manufacturing overhead costs are also a large part of operational budgets and planning. By forecasting these expenses, management can allocate resources effectively, make informed decisions about production levels, and identify areas for potential cost control. Understanding how different types of overhead behave allows for more precise budgeting and better financial forecasting. This detailed insight into overhead also enables businesses to analyze the true profitability of individual products, product lines, or even entire production processes.

Calculating and Applying Overhead

Handling manufacturing overhead involves first accumulating all individual indirect costs and then systematically allocating them to the products manufactured. This allocation ensures that each unit produced bears a reasonable share of these necessary but indirect expenses.

Accumulating Overhead Costs

To begin, all individual manufacturing overhead costs incurred over a specific accounting period are summed up to arrive at a total manufacturing overhead figure. This includes all the fixed, variable, and semi-variable costs associated with running the factory for that period.

Applying Overhead with an Overhead Rate

Companies use an overhead rate, often called a predetermined overhead rate, to apply these indirect costs to products or jobs. This rate is calculated by dividing the total estimated manufacturing overhead costs for a period by an estimated total for an allocation base. An allocation base is a measure of activity that drives overhead costs, serving as a common denominator for distributing overhead. Common allocation bases include direct labor hours, direct labor cost, machine hours, or the number of units produced. The choice of allocation base depends on which activity best correlates with the incurrence of overhead costs in a particular manufacturing environment.

For example, if a company estimates its total manufacturing overhead for the year to be $100,000 and anticipates using 10,000 direct labor hours, the predetermined overhead rate would be $10 per direct labor hour ($100,000 / 10,000 hours). If a specific product requires 2 direct labor hours to complete, then $20 of manufacturing overhead ($10 per hour x 2 hours) would be applied to that product. This applied overhead is then added to the direct materials and direct labor costs to determine the product’s total manufacturing cost.