Manufacturing overhead is comprised of indirect costs related to manufacturing products. It is an essential part of manufacturing accounting and as such, it should be one of the key factors in determining the prices of your products.
What is Manufacturing Overhead?
Manufacturing overhead costs are indirect costs that cannot be traced directly to the manufacturing of products, unlike direct material and labor costs. Rather, the overhead costs are incurred for auxiliary goods and services that support the manufacturing process, e.g. facility rent, utilities, salaries of non-production staff, etc.
As such, manufacturing overhead is allocated to the units produced during an accounting period, and should therefore also be included in the work-in-process inventory (WIP), finished goods inventory, and cost of goods sold (COGS) to accurately reflect on the balance sheet and keep the company in good financial health.
Manufacturing overhead should also be a key factor in determining the selling price of your products.
Types of Manufacturing Overhead Costs
Manufacturing overhead costs include all expenses that are indirectly related to the manufacturing process. These costs can further be divided into five subcategories: indirect labor, indirect materials, rent and utility costs, depreciation, and financial costs.
Indirect labor costs consist of the salaries of employees that work in the manufacturing department but are not directly involved in product-making. These include but are not limited to:
- Quality control specialists
- Production supervisors
- Plant managers
- Production planners
- Maintenance workers
- Plant security staff
To calculate indirect labor costs, all the expenses related to the salaries of these employees are added together.
Indirect materials, supplies, and repair parts
Indirect materials are consumables that are used on the production floor but are not part of any product’s bill of materials either because they are not directly used in the manufacture of products or they are used sporadically and in insignificant quantities per product. These may include but are not limited to:
- Fittings and fasteners
- Disposable protective equipment
- Cleaning supplies
- Light bulbs
- Supplies, tools, and repair parts for equipment
These items can be essential to production but do not qualify as parts of specific products, therefore they should be accounted for as indirect materials.
Rent and utilities
Facility rent and utility costs for heating, power, and water also fall into the manufacturing overhead category. While rent mostly stays the same throughout the year, utilities can vary depending on their market price or consumption. That is why rent is a fixed and utilities are a variable overhead expense.
Everything that is used can gradually lose its value – and manufacturing facilities and machinery are no exception. Depreciation cost is therefore used to account for the natural deterioration of the fixed assets in a company, including the depreciation of:
- Factory buildings
- Furniture and fixtures
- Computer equipment
Depreciation can be calculated by using the straight line method: take the initial cost of the asset and subtract its end-of-life value (salvage value). The result is the total amount that can depreciate. Now divide this depreciable amount with the asset’s expected lifespan to get the asset’s yearly depreciation.
Financial costs that fall into the manufacturing overhead category are comprised of property taxes, audit and legal fees, and insurance expenses that apply to your manufacturing unit.
Fixed Overhead vs. Variable Manufacturing Overhead
The aforementioned types of overhead can be divided into two categories: fixed and variable overhead.
The main difference between fixed and variable overhead is that variable overhead depends on the volume of production while fixed overhead is always the same. For example, when a new work shift is added, variable overhead increases while fixed overhead remains unchanged.
Fixed overhead expenses include:
- Property taxes and insurance
- Property rent
- Salaries of indirect labor
Variable overhead expenses include:
- Indirect labor overtime
- Indirect materials
- Utilities like electricity, heating, and water
Estimated vs. Applied vs. Actual Overhead
There are three ways to allocate manufacturing overhead, each with a specific process and purpose. These are estimated overhead, applied overhead, and actual overhead.
Estimated overhead is decided before the accounting year begins in order to budget and plan for the coming year. This is done as an educated guess based on the actual overhead costs of previous years.
Applied manufacturing overhead refers to overhead expenses being applied to single units of a product during an accounting period. This predetermined overhead rate is most often calculated by using direct labor hours as a basis. In highly automated environments, machine hours are used.
Using a predetermined overhead rate allows companies to accurately and quickly estimate their job costs by assigning overhead costs immediately along with direct materials and labor.
There will almost always, however, exist a difference between the applied overhead and the actual overhead calculated at the end of the accounting period. Then, actual overhead costs are reconciled with the applied overhead costs to make sure the correct numbers end up on the balance sheet.
Read more about Applied Overhead vs. Actual Overhead.
1. Direct labor hours per unit
Let’s say you have a workforce that uses a total of 8000 hours to manufacture 2000 custom bicycles per year. That means the labor hours per unit is 8000/2000 = 4 hours/unit.
2. Manufacturing Overhead per unit
Suppose that last year’s records show that your factory overhead was a total of $120,000. That means overhead per labor hour was 120,000/8000 = $15/h.
As it takes 4 hours to produce one bicycle, the overhead per unit should be 15 x 4 = $60/unit.
This applied overhead rate can now be used for job costing as well as for calculating the estimated manufacturing overhead for the year.
3. Estimated Manufacturing Overhead
As part of the budgeting and planning process, managers can use demand forecasts and the applied overhead rate to roughly estimate overhead costs for the coming year. Let’s suppose next year, you plan to sell 2500 bicycles. The estimated manufacturing overhead will then be 2500 x 60 = $150,000.
Alternatively, to make things more complex (and realistic), we might consider $40,000 to be variable overhead, i.e. 40,000/2000 = $20/unit, with a 1-to-1 relation to the number of bikes produced. The remaining $80,000 is fixed overhead.
In this case, the total expected overhead for the next year will be 2500 x 20 + 80,000 = $130,000.
This makes 130,000/2500 = $52 per unit, that is 13% less compared to $60 the prior year.
- Manufacturing overhead costs are indirect costs that cannot be traced directly to the manufacturing of products.
- Overhead costs are incurred for auxiliary goods and services that support the manufacturing process, e.g. facility rent, utilities, salaries of non-production staff, etc.
- Manufacturing overhead is divided into five distinct groups: indirect labor; indirect materials, supplies, and repair parts; rent and utilities; depreciation; financial costs.
- These types of overhead can be further divided into two categories: fixed and variable overhead. While variable overhead costs increase with the increase of manufacturing output, fixed overhead stays the same.
- There are three ways to allocate manufacturing overhead: estimated overhead, applied overhead, and actual overhead.
- Estimated overhead is an educated guess based on historical data, done in order to budget and plan for the coming period.
- Applied overhead refers to overhead expenses that are applied to single products. This is also calculated by using historical data and is used, for example, to estimate job costs.
- Actual overhead is the real cost of overhead calculated at the end of the accounting period. It is then compared with the applied overhead amount in order to reconcile the numbers on the balance sheet.
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