There are various manufacturing overhead expenditures that business owners and management personnel must monitor and control. Business operations incur various expenses, including payroll, rent, utilities, and taxes. If you have a firm grasp of this cost category, you'll be more equipped to make fiscally responsible judgments on the job.
Manufacturing overhead can be easily calculated, allowing you to save costs and increase your company's bottom line. Read further to know more about manufacturing overhead costs, relevant types of costs under this overhead, and how to calculate them.
What Is Manufacturing Overhead?
Overhead expenses incurred by a manufacturer to produce a product are known as manufacturing overhead (MOH) costs. Manufacturing overhead refers to the indirect costs related to goods production by manufacturing businesses. These costs are not directly tied to the cost of materials or direct labor, but rather include expenses such as rent, utilities, depreciation of equipment, maintenance, and supplies.
However, similar to the direct material and direct labor expenses, it is factored into the ultimate price of the product. Depreciation of machinery, pay for industrial workers, and power to run machinery are all examples of manufacturing overhead. Manufacturing overhead costs are critical but they cannot be traced back to a specific product or service. Instead, they are allocated to the cost of goods produced using various methods, such as predetermined rates, actual usage, or activity-based costing.
The calculation and management of manufacturing overhead are essential for determining the total cost of producing goods, which, in turn, affects pricing decisions and profitability analysis. Generally accepted accounting rules (GAAP) specify that a manufacturing overhead cost must be accounted for in the cost of completed products and work in progress on the balance sheet and in the cost of goods on the income statement.
What Are the Different Types of Indirect Costs Related to Manufacturing Overhead?
Indirect expenses in manufacturing are those that cannot be directly attributed to a specific product. Overhead expenses are included in the price of the finished good at a rate that has been established in advance. The rate at which indirect expenditures, such as rent, utilities, and insurance are absorbed into direct production costs is known as the overhead absorption rate.
Manufacturing overhead includes the following categories of expenses:
- Indirect labor
- Materials used indirectly
- Utilities
- Physical expenses
- Money spent
Indirect labor
Workers who aren't directly involved in making the product are considered 'indirect labor', or the expense to the business of paying them. Security guards, housekeepers, mechanics, plant managers, supervisors, and quality inspectors all fall under the category of indirect labor expenditures.
By activity-based costing, which entails first identifying and then allocating expenses to overhead activities, cost accountants are able to calculate the indirect labor cost.
Activity-based costing, for instance, involves keeping track of the hours worked by every worker in the factory who isn't directly engaged in making the product; this information is used to determine the total production cost, which is then distributed among the various goods.
Materials used indirectly
These expenses are incurred for raw materials that are utilized in production but do not directly contribute to a finished good. Indirect materials typically consist of consumables like machine lubricants, light bulbs, and cleaning supplies. As it is impossible to keep tabs on each individual indirect material utilized, cost accountants must allocate these expenses throughout the entire stock.
At a paper mill, for instance, wood pulp is not considered an indirect material because it is principally utilized in the production of paper. Yet, there is an unavoidable indirect cost associated with making paper: lubrication.
Utilities
Overhead expenses like utilities like natural gas, electricity, and water, vary as production volume does. The market's need for a certain product will determine whether or not its price goes up or down. They are considered a form of variable overhead due to their varying levels of use. Financial analysts total up this expenditure for the complete establishment and divide it up among all stock on hand.
Physical expenses
Materials and supplies required for production are included in these estimates. Typical manufacturing expenses consist of initial investment and depreciation in a manufacturing facility, as well as the cost of new machinery and the cost of maintaining existing machinery.
Both the decreasing balance and straight-line methods are used by accountants to determine this expense. An annual depreciation rate is applied to the asset's book value using the falling balance technique. The carrying amount of a fixed asset is written down at an equal rate during the item's useful life using the straight-line depreciation technique. It is employed when the depreciation of the asset follows no discernible pattern.
Money spent
The term 'financial overhead' is used to refer to fixed monetary expenses that a business incurs regularly but can't do anything about. Insurance, auditing, and legal expenses, as well as any property taxes the government may assess against your factory, all fall under this category. They are spread out throughout the full stock of products and don't fluctuate much.
Fixed, Variable, and Semi-Variable Overhead
Several types of manufacturing overhead are identified and categorized by their patterns of occurrence. There are fixed overhead costs and variable overhead costs that vary with production. This results in three forms of behavior-based overhead costs:
- Fixed overhead costs: Manufacturing production has little effect on fixed overhead expenses.
- Variable overhead costs: The output is used to calculate the variable overhead expenses.
- Semi-variable overhead costs: Overhead expenses that are only partly changeable are called semi-variable expenses.
Fixed Overhead Costs
These fixed overhead expenditures are constant regardless of the level of industrial activity or the number of manufactured goods. These overhead expenses are not subject to change depending on administrative decisions and are instead capped at a predetermined level derived from historical data. Depreciation of manufacturing equipment, rent for the warehouse, land for storage, and depreciation of the building itself are all factors.
Variable Overhead Costs
These fixed expenses shift depending on the output level. The amount of output generated or stored has an immediate impact on them. Included in these are the price of goods sold and delivered, as well as the price of advertising and promotion, and the price of power used in production.
Semi-Variable Overhead Costs
Overhead expenses that are only semi-variable are a mix of the two types of expenditures. As a result of having both a fixed and variable part, they are not proportional to production levels. The cost of factors like phone calls, equipment upkeep, and other expenses.
What Is Included in Manufacturing Overhead?
When accounting for manufacturing overhead, it's important to include a variety of indirect expenses. Electrical power and materials are essential for manufacturing and assembly facilities. A few examples of manufacturing overhead expenses are as follows.
- Manufacturing facility or production unit lease fees.
- Utilities including water, electricity, and internet connectivity.
- Hardware and software for the building's electronic systems.
- Insurance and property taxes.
- Machine and equipment depreciation.
- Supplies for the factory overhead that are not directly traceable to production.
- Compensation for workers unrelated to output such as maintenance crews, supervising teams, and janitors.
- The cost of inspecting and testing products to ensure they meet quality standards.
Apart from this, the inclusion of certain costs depends on the nature of the business. General administrative and marketing costs are generally not included in manufacturing overhead. Legal expenses, audits, and executive salaries may or may not be factored into the overhead manufacturing model. As these costs have nothing to do with production, they are usually listed elsewhere.
Allocate more money than you think you need for overhead
Estimate the facility's overhead expenses on a monthly basis. You may calculate the amount of money you need to set aside for overhead by looking at your previous bills, statements, and records. You might want to put away more money than you anticipate in case of unexpected expenses or repairs.
Repurposing discarded machinery and tools
To save money on costly replacements, see if there is anything usable in your inventory you can utilize to do some quick fixes. Verify the integrity and compatibility of these parts. Taking a component from a decommissioned machine and installing it in another machine is one example of this.
How to Calculate Manufacturing Overhead Cost?
Establishing the overhead production expenses and exercising manufacturing overhead control is the first step. These are examples of indirect costs that contribute to keeping the factory open. When these ancillary expenses are totaled together, it becomes clear how much they really cost. You may calculate the manufacturing overhead rate by plugging the estimated manufacturing overhead expenses into the aforementioned calculation.
Your production costs are on the right track if your overhead manufacturing rate is low; if the proportion is large you're probably dealing with a slow production process.
You may use this information to better manage your company and create a realistic financial plan. A more precise budget may be made with the knowledge of how much money must be set aside for production overhead.
Examples of Manufacturing Overhead Cost
Manufacturing overhead costs are expenses incurred in the production of goods that cannot be directly attributed to a specific product. Examples of such costs include rent, insurance, utilities, depreciation of equipment, maintenance and repairs, property taxes, and indirect labor.
Manufacturing Overhead Formula
Manufacturing overhead costs are typically allocated to products based on a predetermined overhead rate, which is calculated by dividing the estimated total overhead costs by an allocation base such as direct labor hours, number of units or machine hours. The formula to calculate manufacturing overhead formula is -
Manufacturing Overhead = Fixed Overhead + Variable Overhead / No. of Units Produced
How to Calculate Manufacturing Overhead
To calculate manufacturing overhead, first, determine the total cost of indirect materials, indirect labor, and other indirect costs incurred during the production process. This can be done by reviewing the company's financial records and expense reports.
Next, determine the allocation base, such as direct labor hours or machine hours, that will be used to allocate overhead costs to products. Then, divide the total manufacturing overhead costs by the allocation base to determine the overhead rate. Finally, multiply the overhead rate by the actual amount of the allocation base used by each product to determine the amount of manufacturing overhead that should be allocated to each product.
Manufacturing Overhead Calculation Example
You may have a look at the shoe manufacturing industry. If they have a successful month, they can make 100 pairs of shoes at the cost of 1000 for each pair, including indirect expenditures. The manufacturing overhead for this would be 10,000, or 1000 times 10 workers.
The first step is to calculate the monthly sales. Imagine they have a monthly sale of 50 pairs of shoes. If their monthly sales average is 50, then a percentage of that is 5,000. In percentage terms, that works out to 2%, which is excellent.
Streamline Supervision of Manufacturing Overheads for Business Growth
Manufacturing overhead is an expense that is often estimated by a company's accounting department based on the planned volume of output or the number of items manufactured during the time period. Each business will have its own unique procedure for arriving at this number, but it will typically include looking back on former projects, comparing them to the current one, analyzing how much of each item was used, and calculating manufacturing overhead.
Automating expense entry and streamlining production activities helps to monitor manufacturing overhead costs without manual dependencies. TranZact enables this by integrating sales, purchases, production, and inventory and ensures that no details are missed in the process.
FAQs on Manufacturing Overhead
1. Why is manufacturing overhead so important?
Production and manufacturing costs provide insight into the performance of business operations. High manufacturing overhead costs can be an alarming sign hinting towards ineffective processes and that's why it's important to monitor these overhead costs closely.
2. What is not included in the manufacturing overheads?
Not all managerial and promotional efforts are included in the manufacturing overheads. Thus, it may not include things like bad debts, legal fees, or audit costs.
3. When determining manufacturing overhead, what factors should be considered?
The following factors should be considered when determining manufacturing overhead -
- Keeping track of real expenditures.
- Assigning the expense to a general ledger account for use in production.
- Spending time in the process account for allocating the overhead.
