What Is MOH Accounting and What Does It Include?

Manufacturing businesses incur various costs to produce goods. Beyond direct materials and direct labor, other expenses are necessary for the manufacturing process. These additional costs, which cannot be directly traced to individual units, are known as Manufacturing Overhead (MOH). Accounting for MOH is crucial for determining the complete cost of production, influencing pricing, and assessing profitability. Including these indirect costs ensures the true economic effort behind each product is captured, providing a more accurate financial picture.

Defining Manufacturing Overhead

Manufacturing Overhead encompasses all indirect costs associated with the production process that are not direct materials or direct labor. These costs are essential for factory operations but cannot be practically or economically traced to a specific product unit. For instance, the rent paid for a factory building or the electricity used to power machinery are costs that support overall production, rather than being linked to a single item. This distinction from direct costs is important because direct materials, like the steel for a bicycle frame, and direct labor, such as the wages of the assembly line worker, are directly incorporated into the finished product.

MOH is considered an indirect cost because it is difficult to precisely determine how much of a particular overhead expense applies to each unit manufactured. For example, the cost of lubricants for machinery benefits all products run on that machine, not just one. Including these indirect costs in product costing, as required by generally accepted accounting principles (GAAP), provides a comprehensive view of the total cost of production. This comprehensive cost is then used to value inventory on the balance sheet and calculate the cost of goods sold on the income statement.

Components of Manufacturing Overhead

Manufacturing overhead comprises various types of indirect costs, each playing a supporting role in the production environment. These categories include indirect materials, indirect labor, and other indirect manufacturing costs, all of which are necessary for operations but are not directly integrated into the final product.

Indirect materials are those used in the manufacturing process that do not become a significant part of the finished product or are impractical to trace to specific units. Examples include lubricants for machinery, cleaning supplies for the factory floor, and small tools or fasteners like screws and bolts. While these items are consumed during production, their individual cost per unit is often too small or their usage too widespread to justify direct tracing.

Indirect labor refers to the wages and salaries of factory personnel who do not directly work on transforming raw materials into finished goods. This category includes factory supervisors, maintenance staff who repair equipment, quality control inspectors, and security guards for the manufacturing facility. These employees provide essential support services that enable direct laborers to perform their tasks and ensure the smooth operation of the production process.

Other indirect manufacturing costs encompass a broad range of factory-related expenses that are not materials or labor. This includes fixed costs like factory rent or lease payments, and property taxes on the manufacturing plant, which are incurred regardless of production volume. Variable costs within this category include factory utilities, such as electricity and water used for production, and the depreciation of factory buildings and manufacturing equipment. Additionally, maintenance and repair costs for machinery, factory insurance, and office supplies used within the plant also fall under this grouping.

Allocating Manufacturing Overhead

Since manufacturing overhead costs cannot be directly traced to specific products, they must be systematically assigned or “allocated” to units produced to determine a full product cost. This allocation is necessary to provide an accurate picture of production expenses for pricing decisions and financial reporting.

The primary method for distributing these indirect costs involves using a predetermined overhead rate (POHR). The predetermined overhead rate is calculated at the beginning of an accounting period by dividing the estimated total manufacturing overhead costs for that period by an estimated total amount of an allocation base. This rate allows companies to apply overhead costs to products as they are manufactured, rather than waiting for actual overhead costs to be known at the end of the period.

The formula is: Predetermined Overhead Rate = Estimated Total Manufacturing Overhead Costs / Estimated Total Amount of the Allocation Base.

Common allocation bases, also known as cost drivers, are chosen because they are believed to have a cause-and-effect relationship with the overhead incurred. Examples of these bases include direct labor hours, machine hours, direct labor cost, or even the number of units produced. For instance, if machine operation drives a significant portion of overhead, machine hours would be a suitable allocation base. Once the POHR is established, it is multiplied by the actual amount of the allocation base consumed by a product or job to apply overhead costs. This applied overhead is then added to the direct materials and direct labor costs to arrive at the total manufacturing cost of the product.

Adjusting Manufacturing Overhead Accounts

The overhead applied to products using a predetermined rate is an estimate, and it rarely precisely matches the actual manufacturing overhead costs incurred during a period. This difference necessitates an adjustment to the manufacturing overhead accounts at the end of the accounting period.

When the overhead applied to products is greater than the actual overhead incurred, it results in “over-applied overhead.” This implies more overhead costs were assigned than spent, potentially overstating product costs. Conversely, if the overhead applied is less than the actual, it leads to “under-applied overhead,” meaning not enough overhead was allocated, which could understate product costs.

The most common and straightforward method for handling over- or under-applied overhead, especially when the amount is not significant, is to close the variance directly to the Cost of Goods Sold (COGS) account. If over-applied, COGS is decreased, increasing net income. If under-applied, COGS is increased, decreasing net income.

For more substantial variances, or in larger companies, proration may be used. Proration involves distributing the over- or under-applied overhead across Work-in-Process (WIP) inventory, Finished Goods (FG) inventory, and Cost of Goods Sold (COGS) accounts. This method allocates the variance proportionally to where the applied overhead currently resides within the inventory and expense accounts.