What Is Manufacturing Overhead?
Manufacturing overhead refers to the indirect costs incurred in the manufacturing of products. It is assigned to every unit produced so that the price of each product can be derived. Such costs include rent of the manufacturing building or premises, depreciation, utilities cost in manufacturing, like electricity, water, gas, oil repairs, maintenance costs incurred in production, insurance, etc.
Businesses add the manufacturing overhead costs to the direct materials and direct labor costs incurred in the process of production to obtain an appropriate Cost of Goods Sale (COGS). These costs do not include general and administrative expenses. These general expenses become a part of period costs.
Table of contents
- Manufacturing overhead refers to the unintended costs incurred during the production of products. For the price of each product to be determined, it is assigned to every unit produced.
- There are two types of these overheads, fixed and variable. Variable overheads depend on the number of units produced, such as electricity bills. However, fixed costs do not depend on the number of units produced; they remain the same. Examples include rent and depreciation.
- They are tax-deductible, and it helps to concise costs during inflation. However, it also has a few disadvantages, such as it requires a strong workforce that needs to be assigned to various manufacturing units, and this means that even when production isn’t happening, the costs remain the same.
Manufacturing Overhead Explained
Manufacturing overheads are those costs that are not directly traceable. This includes all indirect costsIndirect CostIndirect 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. related to manufacturing activity. It does not indicate period expenses. Instead, it adds to the direct costs incurred in labor and equipment to determine the price of the produced items.
The types of such overheads are – fixed and variable.
- Variable – It depends on the number of units produced. The cost changes if the number of units changes. Such expenses include sales commissionSales CommissionSales commission is a monetary reward awarded by companies to the sales reps who have managed to achieve their sales target. It is an incentive geared towards producing more sales and rewarding the performers while simultaneously recognizing their efforts. A sales commission agreement is signed to agree on the terms and conditions set for eligibility to earn a commission., electricity, water, etc.
- Fixed – These costs do not change even when the number of units produced changes. For example, rent, 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. , insurance, property taxes, and other costs involved with the production units and tools used.
The manufacturing overhead formula is as follows:
Let us consider the following manufacturing overhead examples to understand how to calculate it:
Below is the manufacturing overhead statement of Alfa Inc. for 2018, where the company has an estimated overhead of 9000, 10000, and 11000 units. The company has some variables and some fixed overhead in the information below. The variable overhead depends on the number of units, whereas fixed overhead remains fixed irrespective of the number of units manufactured.
Below are the variable overhead expenses of the company
- Indirect Material cost = $1 per unit.
- Electricity Expenses = $0.50 per unit.
- Royalty Expenses = $0.25 per unit.
- Other Indirect Material Cost = $2 per unit.
Below are the fixed overhead expenses of the company
- Factory Rent = $10,000.
- Depreciation on Plant, Machinery, and Equipment = $5,000.
- Insurance for Manufacturing Activity = $1,500.
- Property Tax = $1,800.
- Other Fixed Overhead Expenses = $500.
Let us see how to calculate manufacturing overhead for 9000 units of production:
Similarly, let’s calculate for 10000 and 11000 units of production.
In the above statement, the total variable cost of the company is $33,750 for 9000 units, $37,500 for 10000 units, and $41,250 for 11000 units, but the total fixed costFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity. is $18,800 for any number of units that it produces.
Below is an example of manufacturing overhead for Mercedes-Benz Cars. In 2018, the company manufactured 1000 units of Cars.
Below are the expenses of the company.
- The company has purchased $500 million of material, of which $100 million is for indirect material.
- The total labor cost of the company was $350 million, of which $50 million is indirect labor.
- Power, fuel, and electricity expenses incurred by the company were $80 million.
- The company’s comprehensive insurance was $20 million, of which $5 million was for other than manufacturing activity.
- Depreciation of plant, machinery, and equipment was $5 million.
- Research & development expenses incurred $5 million.
- Selling & distribution expenses incurred $10 million.
- Repair & maintenance expenses of $15 million.
In the above examples, research and developmentResearch And DevelopmentResearch and Development is an actual pre-planned investigation to gain new scientific or technical knowledge that can be converted into a scheme or formulation for manufacturing/supply/trading, resulting in a business advantage. of $5 million and sales & distribution expenses of $10 million are unrelated to manufacturing activity. Therefore, these expenses are not considered in the manufacturing overhead of Mercedes-Benz.
- Considering overhead as a part of the cost of each product helps price the product effectively.
- It is tax-deductible. A company should identify all these costs as part of its manufacturing expenses as it reduces the taxable incomeTaxable IncomeThe taxable income formula calculates the total income taxable under the income tax. It differs based on whether you are calculating the taxable income for an individual or a business corporation. and lower the tax burden.
- It helps to control the cost in the inflationary market by controlling the manufacturing cost. Failure to control overhead costs could increase the product cost.
- Assigning the overhead with products allows management to better plan, budget, and price products.
- It requires a workforce to assign the manufacturing unit to every production unit.
- Fixed manufacturing costs will continue even if there is no production. It means the company has to expand without any manufacturing activity, affecting itsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. and 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..
Frequently Asked Questions (FAQs)
Manufacturing expenses shed light on the company’s character. For instance, if a business hires many individuals for quality assurance or quality control, this suggests they have a good attitude toward their work. Keeping the safety of the production unit in mind.
It does not include all marketing and management activities. As a result, expenses related to corporate salaries, legal and audit fees, and bad debts are excluded from production overhead.
Here are the three steps involved in the calculation of such overhead costs:
Recording the actual costs.
Apportioning the cost part to a manufacturing overhead account.
Allocating the overhead to work in the process account.
This has been a guide to what is Manufacturing Overhead. Here we explain its types, calculation examples, advantages, and disadvantages. You can learn more about finance from the following articles –