It is not easy to manufacture something, and definitely not cheap. There are so many costs that go behind the manufacturing of a product that it becomes very hard to keep track. All of these costs are known as manufacturing overheads.
Let’s look in detail at what manufacturing overhead is, its formula, and how to calculate it.
As defined above, manufacturing overhead is basically part of a company’s manufacturing operations. They specifically comprise the costs incurred outside related to the cost of labor and direct materials. This is the mere reason why manufacturing’s overhead is also known as an indirect cost.
All the costs incurred outside the manufacturing facilities are not related to inventories and are not product costs. These are the costs like general or administrative expenses, including audit fees, corporate salaries, or any other kind of legal fees, which are recorded as expenses and are later added to the income statement of the accounting period.
Now the question arises, how to calculate manufacturing overhead?
Manufacturing overhead is the sum of all the indirect costs that incur while manufacturing a specific product. The overhead cost is an add-on to the cost of the final product, along with the direct labor and direct material costs.
It is notable that the manufacturing overhead costs also included depreciation of the equipment as well as the wages and salary paid to the factory employees. According to the Generally Accepted Accounting Principles (GAAP), the manufacturing’s overhead should be included in the cost of finished goods in the inventory as well as in the inventory representing work in progress on the balance sheet and income statement.
To calculate the manufacturing’s overhead, you need to identify the manufacturing overhead costs that incur to help the production run smoothly. You need to add all the indirect costs in order to calculate the manufacturing overhead.
The manufacturing overhead formula is:
Manufacturing Overhead Rate = Overhead Costs/ Sales X 100
An important point to note here is that if the manufacturing overhead rate is low, that means that the business is efficiently using its resources. On the contrary, if the manufacturing’s overhead rate is on the higher side; this indicates that the production process is lagging.
A lot of different types of overhead costs are included in the manufacturing’s overheads. Manufacturing overhead costs are known as indirect costs, as it is very hard to trace them with respect to each and every product. These costs are an addition to the final product based on the predetermined overhead absorption rate.
An overhead absorption rate is the manufacturing overhead cost per unit of the activity, like the labor costs, machine hours or labor hours.
Some of the indirect costs are:
– Indirect labor
– Indirect materials
– Financial costs
– Physical costs
All above-mentioned overhead costs are one way or another related to the manufacturing department of a business.
This is the cost to the company for all the employees who are not involved directly in the manufacturing of a product. This includes the salaries of janitors, security guards, plant managers, machine repairers, and quality inspectors.
The accountants derive indirect labor costs through activity-based costing, which majorly involves identifying the costs used explicitly for overhead activities and later assigning a cost to the product.
Indirect materials cost is the one that incurs while manufacturing the product, but these costs are variable and not subject to a single product. These costs are usually related to consumable items such as light
bulbs, lubricants for machines and equipment, and janitorial supplies. These costs are later on spread over the entire inventory to calculate the overhead cost of a product.
Utilities like electricity, natural gas, and water overhead costs can fluctuate depending on the production’s quantity. This may increase or decrease according to the demand for the product in the market. As the usage of these utilities is not constant, it is included in the variable overhead costs.
These overhead costs purely include financial costs that cannot be canceled or avoided by any means. This consists of the property taxes charged by the government on the manufacturing building, audit fees, legal fees, or any other kind of insurance policy. Usually, these
costs remain constant. Therefore, they are allocated to the entire produced inventory to get an estimate of the cost of manufacturing.
These costs are essential for manufacturing. The physical costs include the price tag of the property where the manufacturing is taking place, its depreciation, purchase of new equipment, repair cost of any machinery, and relevant costs.
Manufacturing overhead is one of the most integral parts of running a manufacturing unit. It is very important to track these overhead costs and stick to a predetermined budget so that you know how efficiently your business is running and performing, as it will help you reduce the overhead manufacturing costs in the future.
See Also: A Simple Guide To Double Declining Balance Depreciation Method
Wajiha is a Brampton-based CPA, CGA, and Controller with 17+ years of experience in the financial services industry. She holds a Bachelor of Science Degree in Applied Accounting from Oxford Brookes University and is a Chartered Certified Accountant. Wajiha spearheads Monily as its Director and is a leader who excels in helping teams achieve excellence. She talks about business financial health, innovative accounting, and all things finances.