Manufacturing Overhead

What is Manufacturing Overhead?

Manufacturing overhead refers to the indirect costs associated with the production process that are not directly tied to a specific product. It comprises the expenses required to operate a manufacturing facility which are not directly assignable to individual units of production.

This expense category typically includes the following:

• Indirect materials (e.g., cleaning supplies, lubricants)
• Indirect labor (e.g., maintenance crew, supervisors)
• Factory rent and utilities
• Depreciation of manufacturing equipment
• Insurance policies
• Repairs and maintenance
• General supplies

Companies normally allocate manufacturing overhead to products based on a predetermined overhead rate, which is calculated by dividing the total estimated overhead costs by an allocation base (such as direct labor hours, machine hours, or production volume).

Properly accounting for this kind of overhead is essential for accurate product costing, budgeting, and pricing strategies, as it ensures that all production costs — not just direct materials and direct labor — are considered.

Synonyms

• Factory overhead
• Production overhead
• Indirect production costs

Importance of Measuring Manufacturing Overhead

In the B2B manufacturing space, accurately tracking and allocating manufacturing overhead can make or break a company’s profitability.

Proper product costing

As mentioned earlier, including your production costs in the final product cost calculation gives you more accurate margins and helps you make informed pricing decisions. It also helps you optimize your product mix.

Cost control

Accurate tracking of manufacturing overhead allows companies to identify areas for cost reduction and make necessary adjustments to improve profitability.

You also have to consider these costs when conducting a profitability analysis. From there, you can take measures to reduce your overhead or, if they aren’t popular with your customer base, remove those products from your catalog.

Financial reporting

Manufacturing overhead is a significant expense, so it plays a big role in financial reporting. On your financial statements, stakeholders need a clear picture of the company’s operations. So, you need to properly account for all the costs involved in producing your goods to accurately reflect your company’s financial health.

Tax implications

Manufacturing overhead impacts your tax obligations and allowable deductions. Proper measurement and allocation are necessary to ensure compliance with tax laws and regulations (e.g., ensuring GAAP compliance).

Manufacturing Overhead Components and Examples

To give you a better sense of what manufacturing overhead is, let’s take a look at the different expenses going into it:

Indirect materials

Materials used in the production process that cannot be directly traced to specific products (e.g., lubricants, cleaning supplies, and small tools) are called indirect materials.

For example, you might use lubricants in the production process, but it’s impractical (and maybe impossible) to measure and assign a specific amount of lubricant to each individual product. Instead, you can allocate these expenses to the entire production run based on your overhead allocation rate.

These relatively small expenses, when combined, can add up to a significant amount over time. Tracking them is important because they’re one of the most common sources of margin leakage.

Indirect labor

Indirect labor is the wages and salaries of employees who support the production process but don’t work directly on the manufacturing line. Maintenance staff, quality control personnel, and supervisors are all examples of indirect labor costs.

Similar to indirect materials, you can’t directly attribute these costs to a specific product or point in the overall process. Instead, you have to do so based on the overhead rate (more on this in a second).

Factory rent and utilities

Rent and utility costs for your production facility are considered overhead expenses because they’re not directly related to specific products. Like indirect materials and labor, these are indirect expenses. They include rent/mortgage payments, electricity, gas, water, and other utilities.

You can allocate these expenses to products based on your chosen allocation base (e.g., square footage used for production).

Depreciation

Depreciation is an interesting one because it’s not technically a cash expense. It represents the gradual wear and tear of your equipment over time. As it happens, though, your need to account for it in your product costing process to reflect the asset’s diminishing value due to wear and tear, obsolescence, or usage.

In the context of financial reporting, depreciation decreases the book value of tangible assets, which in turn impacts both the balance sheet and the income statement.

• On the income statement, you record depreciation, reducing your company’s taxable income and thus lowering its tax liability.
• On the balance sheet, accumulated depreciation is reported as a contra-asset account that offsets the gross value of the asset.

In both cases, these figures serve to provide stakeholders with a realistic view of your company’s assets net of depreciation. To calculate it, you can use a number of methods, including the straight-line method, which assumes that an asset degrades in equal amounts each year.

Insurance

Every manufacturer needs multiple kinds of insurance — property, liability, and product recall, to name a few. These costs are relatively easy to account for because they’re recurring expenses.

As such, you can allocate them directly to your products as they’re being produced and sold.

Repairs and maintenance

Any time you repair equipment, you add to your manufacturing overhead. Sometimes, this category will be higher. And sometimes, it will be lower. It all depends on the age of your equipment and any major repairs you’ve had to make.

Financial costs

Financial costs include anything related to your company’s financing. Interest on loans and bank fees are the two most common components in this category. Whenever you take out a loan or process a transaction, these costs are allocated to your products.

Taxes

Taxes are considered overhead because they apply to your entire company. Some are incurred at the national level, such as income or value-added tax (VAT), while others may be levied at the local level, such as property taxes.

How much you pay in taxes directly affects your profitability. When looking into your profit margins, you have to consider the fact that a certain percentage of your overall revenue goes straight there.

Fixed, variable, and semi-variable manufacturing overhead

The difference between fixed, variable, and semi-variable overhead lies in how these costs behave relative to production levels.

• Fixed manufacturing overhead costs are unaffected by production levels (e.g., rent, depreciation, property tax).
• Variable manufacturing overhead costs fluctuate in direct proportion to production levels (e.g., indirect materials, utilities).
• Semi-variable, or mixed overhead costs, remain constant up to a certain level of production, after which they begin to fluctuate with production levels (e.g., maintenance expenses, overtime wages).

Some variable manufacturing costs can go down with economies of scale. For example, you might pay less per part for indirect materials as you produce more of them.

Other ones are costs you can reduce by streamlining your business processes. For instance, by becoming more energy efficient or using less direct labor to produce the same amount of output, you can reduce your labor and energy costs.

What’s Included in Manufacturing Overhead?

As you can see, manufacturing overhead includes a wide range of expenses. It accounts for all the costs that indirectly go into producing your goods — from rent and utilities to taxes and insurance.

Understanding how to allocate these costs to your products is crucial for accurately determining the cost of goods sold and maintaining healthy margins.

To recap, to fully understand what’s included in your manufacturing overhead, you need to consider:

• Direct labor
• Indirect materials
• Indirect labor
• Factory rent and utilities
• Depreciation
• Insurance
• Repairs and maintenance
• Financial costs
• Taxes

And, within those categories, you have to consider the differences between fixed, variable, and semi-variable overhead costs. By separating them, you know what you need to do to optimize them for your business.

Manufacturing Overhead Formula

The formula you’ll use to calculate manufacturing overhead is actually quite simple:

Total Manufacturing Overhead = Indirect Fixed + Variable + Semi-Variable Costs

Let’s say a factory incurs the following overhead costs in a month:

• Indirect materials: $2,000
• Indirect labor: $10,000
• Factory rent: $5,000
• Utilities: $1,500
• Equipment depreciation: $1,200

The total manufacturing overhead is calculated as:

Total Manufacturing Overhead = $2,000 + $10,000 + ($5,000 + $1,500) + $1,200

The total manufacturing overhead for that month is $19,700.

Predetermined overhead rate formula

In addition to the total overhead calculation, businesses often calculate a predetermined overhead rate. This is how you allocate overhead on a per-unit basis. It’s especially helpful if you have a large product catalog with multiple product lines and individual items that vary in resource intensivity.

The formula is as follows:

Predetermined Overhead Rate = Estimated Overhead Costs / Units in Allocation Base

Let’s say the estimated overhead costs for the year at your manufacturing plant are at $1,000,000. You want to know how much that is worth in terms of the total hours of labor you need. According to your budget, you have enough for 10,000 hours of labor. Your predetermined overhead rate is calculated as:

Predetermined Overhead Rate = $1,000,000 / 10,000 hours

Your predetermined overhead rate would be $100 per hour. This means that for every hour of labor you record, it actually costs you $100 per hour of labor to keep your manufacturing plant up and running.

You can also run this formula with machine hours, production volume, as a percentage of prime costs (the sum of direct materials and direct labor), or with the activity-based costing (ABC) method.

Challenges in Allocating Manufacturing Overhead

1. Indirect costs are tough to identify.

Misclassifying costs can lead to inaccuracies in overhead allocation, either overburdening or underburdening certain products with costs, which ends up distorting your profitability analysis.

The thing is, it’s quite difficult to account for all of these, especially your non-recurring expenses. Utilities and rent are fairly easy because you can look at the invoices on the same day of every month.

But what about indirect materials? You might not even notice them when you’re going through an expense summary.

2. You have to choose the right allocation base.

Selecting the appropriate allocation base for your manufacturing plant is crucial for fair overhead distribution. We’ve mentioned the common bases above, but, if the one your choose doesn’t reflect actual resource consumption, your allocation will come out skewed.

Let’s say you rely heavily on automated machinery but you allocate overhead based on labor hours. Well, then, the allocation would disproportionately burden labor-intensive products and underallocate to machine-heavy ones.

3. Production volumes significantly impact certain cost drivers.

While your fixed overhead costs remain constant regardless of production volumes, variable overhead changes as you ramp up or roll back production activity. Accurately allocating these mixed costs requires careful analysis and proper segmentation of overhead categories, especially if you’re a seasonal business.

4. Multi-product and multi-department operations are inherently complicated.

If you’re producing multiple products or operating in multiple departments, the complexity of overhead allocation increases significantly. Different products and departments consume resources at different rates. They all require detailed tracking of resource usage across the entire manufacturing process.

Failing to properly account for the diverse consumption of overhead resources leads to inaccurate product costing. For instnace, one of your products that consumes more machine hours but fewer labor hours might be unfairly allocated overhead if the allocation base focuses solely on labor.

5. Predetermined overhead rates rely on estimates.

They’re calculated based on estimates of future overhead costs and activity levels. To get that first number in the equation, you have to run a projection. So, it all comes down to the effectiveness of your cost management process and the accuracy of your estimated numbers.

You also have to remember unforeseen changes in production levels, cost drivers, and external factors like inflation or supply chain disruptions will affect these throughout the year.

When actual overhead costs deviate significantly from estimates, the predetermined rates cause significant under- or over-allocation of overhead, distorting your reported product costs and profit margins.

Impact of Manufacturing Overhead on Profitability

Like we’ve just said, accurate allocation of manufacturing overhead is essential for determining the true cost of each product, ensuring proper pricing strategies, and making informed business decisions.

If you’re using any form of cost-based pricing…

• Overallocating overhead costs to certain products, it inflates their total cost, which creates higher prices and potentially lower sales.
• Underallocated overhead result in unrealistically low product costs and profitability, leading to unsustainable pricing strategies that can ultimately hurt your business.

It also affects how you allocate resources to different parts of your business. If you underestimate the costliness of manufacturing a particular item, you’ll end up spending less efficiently in that area. If you overestimate it, you might roll back when instead you could be scaling.

The Role of Technology in Managing Manufacturing Overhead

There are several ways how software can help you better control and allocate manufacturing overhead.

Automation

Digitalizing your data entry and analysis processes eliminates manual errors and makes daily accounting easier. Your software can automatically classify and allocate expenses, and make projections based on its own data. It also helps you keep more accurate and detailed records of resource consumption — both direct and indirect.

Data analytics

By using tailored dashboards, you can track overhead costs in real-time, generate automated financial reports with efficiency metrics, drill down on your allocations to identify errors, and adjust your processes accordingly.

Simplification and standardization

Tools make your process repeatable. The more you can standardize your cost allocation in a consistent and scalable manner, the less likely you are to make mistakes, especially as you deal with turnover and training new employees.

ERP integration

With every part of your manufacturing process interconnected, data flows seamlessly between production and accounting systems. ERP (enterprise resource planning) is the backbone of your data and processes, and your ability to integrate everything with your CPQ and cost accounting systems will save you a lot of time and analysis struggles.

Technological innovation

New technologies like IoT and AI are changing the way we approach production and overhead cost management. For instance, IoT sensors placed on machinery help you get accurate data on actual machine hours, downtime, maintenance needs, and energy consumption to inform your overhead cost allocation process.

People Also Ask