What is Factory Overhead?
Factory Overhead, also known as manufacturing overhead, comprise of all indirect expenses incurred by the business in the regular running of operations of a factory. It doesn’t include the direct cost incurred by way of labor cost as well as material cost.
Explanation
- These are all indirect costs, they can’t be attributed to a particular product or service directly and includes expenses like depreciation, rent expenses of factory, electricity, property expenses, supervision expenses, etc.
- These expenses are allocated using a variety of methods which can be based on the amount of time spent as a percentage to direct material cost or direct labor cost or prime cost to name a few. Due to the Indirect nature of such expenses absorbing these expenses requires judgment and allocation skills on part of the organization to provide a clear picture of expenses incurred.
Classification of Factory Overhead
These are incurred on account of meeting the regular functioning of the factory as well as keeping the administrative expenses incurred in the regular activity associated with the working of a factory. This can be classified in several ways. Some of the most popular classification techniques are enumerated below:
#1 – Percentage of Direct Material Cost
The simplest and the most popular method; in those cases where the factory overhead cost is substantial to the total cost. Under this, the overhead rate is determined and expenses are absorbed as per the rate.
#2 – Percentage to Prime Cost
Another technique to classify Factory overhead is to compute it as a percentage of prime cost (which includes direct material cost, direct labor cost, and direct expenses cost).
#3 – Percentage to Direct Labor Cost
Under this, it is classified as a percentage of the direct labor cost incurred by the business. However, the method lacks in giving due recognition to time devoted to work by skilled and unskilled workers and leads to bias results.
Examples of Factory Overhead
ABC International is into manufacturing oh sports shoes. The company manufactures customized sports shoes based on customer requirements. Recently ABC International has decided to quote for a tender comprising deliver of 10000 sports shoes for LIFA brand based out of Norway.
ABC International has furnished the following cost expected to incur in manufacturing of 10000 shoes:
ABC International charges 20% gross margin on direct costs and 10% margin on factory overheads. Based on the same the price at which ABC International will quote for manufacturing 10000 shoes is as follows:
Calculate the total manufacturing overhead:
Calculate the selling price per unit:
Thus ABC International should quote $3.33 to LIFA Brand for manufacturing 10000 sports shoes.
How Factory Overheads are Accounted for by the Business?
- The allocation of factory overheads is quite challenging but at the same time very important in a manufacturing set up. The cost involved is substantial and proper apportionment necessitates correct allocation to derive the real profitability of the respective departments.
- These are firstly collected from all departments/divisions and then bifurcated into those which can be allocated and those which cannot be allocated. Thereafter based on classification as discussed above overheads are accounted for to each division/department. Based on this an overhead rate is determined which is used for budgeting purposes and for comparison over the period to determine under or over absorption.
Advantages
- This is that it enables the business to determine true profitability by taking into consideration indirect expenses incurred by the business.
- By determining this, a business can analyze and do peer comparison to see how their competitors are faring in and whether such expenses are more than their competitors and accordingly can take remedial actions to control them.
Disadvantages
- These are indirect costs and it is difficult to control them unlike direct costs as they don’t have a direct link with the output and in some cases are difficult to allocate as well.
- Allocation of factory overhead is a cumbersome process and there is no single method that is completely objective and due to the limitation in this method, at times such overhead leads to the wrong estimation of cost of producing a product or rendering a service.
- Another big drawback is that allocation is normally based on machine hours or labor hours, however, it has been observed that not all factory overhead is linked to these factors, expenses like rent, insurance taxes are not affected by these factors much.
Conclusion
- Factory Overhead is an important expense incurred by the business especially in Manufacturing set up and it involves all indirect expenses which cannot be directly attributable to any particular job or work is undertaken.
- However, their importance is equal just like direct expenses, and needs to be accounted for with utmost care. Another important factor is the general nature of these expenses and most of these are fixed or semi-variable in nature, unlike direct costs which are mostly variable and as such business needs to understand these factory overheads holistically and keep a tab on them as these are most difficult to control and also at the same time pivotal to the success of a business.
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