What Type of Account Is Manufacturing Overhead?

Cost accounting is a fundamental practice for businesses, especially those involved in manufacturing. It focuses on collecting, analyzing, and reporting various costs related to producing goods. Understanding different cost types, including direct materials, direct labor, and overhead, allows companies to make informed decisions about pricing, production levels, and financial management.

Understanding Manufacturing Overhead

Manufacturing overhead includes all indirect costs incurred during production that cannot be directly traced to specific products. Unlike direct materials or direct labor, manufacturing overhead supports the production process without becoming a visible part of the final item. These costs are necessary for the factory to operate but are not easily assigned to individual units. Manufacturing overhead is also known as factory overhead or production overhead.

These costs are distinct because their expenses are not directly tied to the volume of specific goods produced. For example, factory rent remains the same whether one unit or one thousand units are manufactured. This distinction is important for accurate cost allocation and financial reporting.

Classifying Manufacturing Overhead in Accounting

Manufacturing overhead is classified as a temporary or control account in accounting systems. It serves as a holding place to accumulate various indirect production costs before they are assigned to products. These accumulated costs are eventually expensed through the Cost of Goods Sold (COGS) when the products are sold.

Manufacturing overhead is considered a product cost, meaning it is initially capitalized into inventory accounts like Work-in-Process (WIP) and Finished Goods inventory. These costs are part of the asset’s value until the asset is sold. Unlike period costs, which are expensed immediately, manufacturing overhead flows through inventory accounts on the balance sheet. It becomes an expense on the income statement as part of COGS only when the inventory is sold, aligning with the matching principle of accounting.

Key Components of Manufacturing Overhead

Manufacturing overhead includes various indirect costs that support the production process. Indirect labor is a component, covering wages for employees who work in the factory but are not directly involved in making products. This includes salaries for factory supervisors, maintenance staff, quality control inspectors, and security guards.

Indirect materials are another part of manufacturing overhead. These consist of supplies used in production that do not become a direct part of the finished product. Common examples of manufacturing overhead include:

• Lubricants for machinery, cleaning supplies, disposable tools, and office supplies used within the factory.
• Factory utilities, such as electricity, water, and natural gas used to power the plant and equipment.
• Depreciation on factory equipment and buildings.
• Factory rent, property taxes on the manufacturing facility, and factory insurance.

Applying Manufacturing Overhead to Products

Applying manufacturing overhead to products involves a process called overhead allocation or application, which uses a predetermined overhead rate. This allocation is necessary because manufacturing overhead costs are indirect and cannot be directly traced to individual products. These costs are assigned to products using a systematic approach.

Companies calculate a predetermined overhead rate at the beginning of an accounting period by estimating the total manufacturing overhead costs for the period and dividing them by an estimated activity base. Common activity bases include direct labor hours, direct labor costs, or machine hours. This rate allows businesses to assign a portion of the indirect costs to each unit produced, making the product’s total cost more accurate without waiting for actual overhead costs to be known. This applied overhead then becomes part of the product’s total cost, alongside direct materials and direct labor.