What Is Manufacturing Overhead in Accounting?

Understanding manufacturing overhead is fundamental for any business that produces goods. Cost accounting provides the framework for determining the total cost of production. It represents an integral part of a product’s total cost, directly impacting inventory valuation, pricing decisions, and profitability.

Understanding Manufacturing Overhead

Manufacturing overhead includes all indirect costs incurred within a factory or production facility. These costs are necessary for the manufacturing process but cannot be directly attributed to a specific product unit. Unlike direct materials or direct labor, which are expenses directly traceable to a product, manufacturing overhead costs support the overall production environment. For instance, factory rent or electricity for the production line are examples. These expenses are essential for operations but do not physically become part of the product itself.

Specific Costs Included in Manufacturing Overhead

Manufacturing overhead includes various indirect costs, each playing a role in production. These costs are categorized because tracing them to individual products would be impractical or too expensive.

Indirect materials are factory materials not a significant part of the final product or difficult to trace. Examples include lubricants for machinery, cleaning supplies, or small fasteners like glue and nails. These items are necessary for smooth production, equipment maintenance, and cleanliness.

Indirect labor refers to wages and salaries of factory personnel who do not directly work on specific units. This includes factory supervisors, maintenance staff, quality control inspectors, and security guards. Their efforts are vital for efficient operation and safety, but their work cannot be easily tied to a single product.

Other indirect factory costs support the manufacturing operation. These encompass factory rent, utilities, and depreciation of factory equipment. Factory insurance premiums and property taxes on the manufacturing building also contribute. These costs maintain the physical infrastructure necessary for production.

How Manufacturing Overhead Behaves

Manufacturing overhead costs behave differently based on changes in production volume.

Fixed manufacturing overhead costs remain constant in total, regardless of the production level within a relevant range. Examples include factory rent, straight-line depreciation of factory equipment, and factory insurance premiums. These costs are incurred even if no units are produced, relating to production capacity rather than actual volume.

Variable manufacturing overhead costs change in total directly with production volume. As more units are produced, total variable overhead increases. Examples include indirect materials like lubricants consumed more heavily with increased machine usage, and electricity for production equipment. The cost per unit for variable overhead remains constant, but the total cost fluctuates with output.

Mixed manufacturing overhead costs have both fixed and variable components. A common example is a utility bill with a fixed service charge plus a variable charge based on consumption. These costs show complex behavior, as one portion remains constant while another changes with production.

Applying Manufacturing Overhead to Products

Manufacturing overhead costs must be applied to products for accurate inventory valuation and to determine the cost of goods sold. As these costs are indirect, they cannot be directly traced to individual units. Generally Accepted Accounting Principles (GAAP) require manufacturing overhead to be included in the cost of finished goods and work-in-progress inventory.

Businesses often use a predetermined overhead rate (POHR) to apply overhead costs. This rate is calculated before the accounting period by dividing estimated total manufacturing overhead costs by an estimated total of an allocation base. Common allocation bases include direct labor hours, machine hours, or direct labor costs, chosen for their correlation with overhead incurrence. For instance, if a company estimates $100,000 in total overhead and 10,000 direct labor hours, the POHR would be $10 per direct labor hour.

As products are manufactured, the POHR applies overhead to each unit or batch. For example, a product requiring 5 direct labor hours would have $50 of overhead applied. This application enables full product costing, essential for financial reporting.

Actual manufacturing overhead costs rarely perfectly match applied overhead. This difference results in either overapplied or underapplied overhead. Overapplied overhead occurs when applied overhead exceeds actual incurred overhead, while underapplied overhead means actual overhead was greater than applied. This difference is typically adjusted at the end of the accounting period, often by adjusting the Cost of Goods Sold.

Manufacturing Overhead Versus Other Business Expenses

Distinguishing manufacturing overhead from other business expenses is essential for proper financial reporting. Manufacturing overhead specifically relates to costs incurred within the production facility.

Direct costs, such as direct materials and direct labor, are easily traceable to specific products and are distinct from manufacturing overhead. Direct materials become an integral part of the finished product, and direct labor involves employees directly converting raw materials into finished goods. Unlike overhead, these costs are directly assigned to each unit produced.

Non-manufacturing costs, also known as period costs, are expenses not directly related to goods production and are expensed when incurred. These include selling, general, and administrative (SG&A) expenses like sales commissions, advertising, office rent, and administrative staff salaries. Manufacturing overhead is a product cost, included in inventory valuation until goods are sold. Period costs, however, are expensed immediately on the income statement. This distinction is important because product costs are inventoried, while period costs are not.