Factory Overhead

Updated on January 3, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

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.

Explanation

Factory Overhead

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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.read more 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.

You can download this Factory Overhead Excel Template here – Factory Overhead Excel Template

ABC International has furnished the following cost expected to incur in the manufacturing of 10000 shoes:

Factory Overhead Example 1

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.read more 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:

Factory Overhead Example 1-1

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. read more:

Example 1-2

Calculate the selling price per unit:

Example 1-3

Thus ABC International should quote $3.33 to LIFA Brand for manufacturing 10000 sports shoes.

How does the Business account for Factory Overhead?

Advantages

Disadvantages

  • 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.

Conclusion

  • 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.

Recommended Articles

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 –

Reader Interactions

Comments

  1. GYANCHAND KATARIYA says

    GOOD CALCUTION EXCELLENT …….ANY ONE CAN UNDERSTAND THE ABOVE CALCUTION

  2. Qadeer Raza says

    Its very helpful for me to understand of Unit manufacturing Cost and for FOH.

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