What is Factory Overhead?
Factory Overhead, also known as manufacturing overhead, comprises all indirect expenses incurred by the business in the regular running of a factory’s operations. It doesn’t include the direct cost incurred by way of labor and material costs.
Table of contents
- What is Factory Overhead?
- These are all indirect costsIndirect CostsIndirect cost is the cost that cannot be directly attributed to the production. These are the necessary expenditures and can be fixed or variable in nature like the office expenses, administration, sales promotion expense, etc., they can’t be attributed to a particular product or service directly and include expenses like depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. , factory rent expenses of factory, electricity, property expenses, supervision expenses, etc.
- These expenses are allocated using various methods, which can be based on the amount of time spent as a percentage to direct material costDirect Material CostDirect Material Cost is the total cost incurred by the company in purchasing the raw material along with the cost of other components including packaging, freight and storage costs, taxes, etc. that are related directly to the manufacturing and production of various products of the company. or direct labor costDirect Labor CostDirect labor costs refer to the total cost incurred by the company for paying the wages and other benefits to its employees against the task performed by them, which are straight away related to the manufacturing of the products or provision of the services. or prime costPrime CostPrime cost is the direct cost incurred in manufacturing a product and typically includes the direct production cost of goods, raw material and direct labour costs. It is an essential part of total manufacturing expenses. Costing and effective pricing of the goods are primarily determined on their basis., to name a few. Due to the Indirect nature of such expenses, absorbing these expenses requires judgment and allocation skills on the part of the organization to provide a clear picture of expenses incurred.
Classification of Factory Overhead
These overheads are incurred on account of meeting the regular functioning of the factory and keeping the administrative expensesAdministrative ExpensesAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts. incurred regularly associated with the working of the factory. Therefore, it can be classified in several ways. Some of the most popular classification techniques are enumerated below:
#1 – Percentage of Direct Material Cost
It is 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.
Overhead Rate = (Direct Material Cost / Factory Overheads) * 100
#2 – Percentage to Prime Cost
Another technique to classify Factory overhead is to compute it as a percentage of the prime cost (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 recognition of time devoted to work by skilled and unskilled workers, leading to biased 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 10000 sports shoes for the LIFA brand based out of Norway.
ABC International has furnished the following cost expected to incur in the manufacturing of 10000 shoes:
ABC International charges a 20% gross margin on direct costsDirect CostsDirect cost refers to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects. and a 10% margin on factory overheads. Therefore, based on the same, the price at which ABC International will quote for manufacturing 10000 shoes is as follows:
Calculate the total manufacturing overheadManufacturing OverheadManufacturing Overhead is the total of all the indirect costs involved in manufacturing a product like Property Tax on the production premise, Remunerations of maintenance personnel, Rent of the manufacturing building, etc. :
Calculate the selling price per unit:
Thus ABC International should quote $3.33 to LIFA Brand for manufacturing 10000 sports shoes.
How does the Business account for Factory Overhead?
- The allocation of factory overheads is quite challenging but, at the same time, crucial in a manufacturing setup. 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. Then these are bifurcated into those which can be allocated and those which cannot be assigned. After that, based on classification, as discussed above, overheads are accounted for in each division/department. Based on this, an overhead rate is determined. It is used for budgeting purposesBudgeting PurposesBudgeting is a method used by businesses to make precise projections of revenues and expenditure for a future specific period of time while taking into account various internal and external factors prevailing at that time. and comparisons over the period to determine under or over absorption.
- It enables the business to determine true profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. by considering indirect expenses incurred by the business.
- By determining this, a business can analyze and make peer comparisons to see how their competitors are faring in and whether such expenses are more than their competitors and accordingly take remedial actions to control them.
- These are indirect costs, and it is difficult to control them, unlike direct costs, as they don`t directly link with the output and, in some cases, are difficult to allocate.
- The allocation of factory overhead is a cumbersome process, and there is no single method that is entirely objective. Due to this limitation, such overhead sometimes leads to the wrong estimation of production cost or service rendering.
- Another big drawback is that allocation is generally based on machine or labor hours. However, it has been observed that not all factory overhead is linked to these factors; expenses like rent and insurance taxes are not much affected by these factors.
- Factory Overhead is a significant expense incurred by the business, especially in manufacturing setup. It involves all indirect expenses that cannot be directly attributable to any particular job or work is undertaken.
- However, their importance is equal to direct expenses and needs to be accounted for with utmost care. Another critical factor is the general nature of these expenses. Most of these are fixed or semi-variable, unlike direct costs, mostly variable. 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.
This article has been a guide on What is Factory Overhead & its Definition. Here we discuss its classification and examples along with its advantages and disadvantages. You can learn more about it from the following articles –