What is Manufacturing Overhead? An In-Depth Look at Costs, Categories, and Examples

Manufacturing overhead, often simply referred to as overhead, encompasses all indirect costs associated with the production process that cannot be directly traced to specific products. While direct materials and direct labor represent the primary inputs to manufacturing, manufacturing overhead includes all the necessary but indirect expenses that enable production to run smoothly. Properly accounting for manufacturing overhead is crucial to accurately calculating the total cost of producing goods, setting competitive prices, and achieving profitability.

This article will explore the concept of manufacturing overhead in detail, including its components, examples of different types of overhead costs, and how companies calculate and allocate overhead to determine the true cost of their products.

Understanding Manufacturing Overhead: Definition and Importance

Manufacturing overhead refers to the indirect costs of production, which include expenses that are essential to the production process but are not directly associated with any specific product. These costs include things like utilities, maintenance, depreciation of machinery, and the salaries of supervisors. While these expenses don’t directly contribute to the creation of products, they are critical for maintaining the production environment, enabling the efficient and continuous operation of production activities.

Why Manufacturing Overhead Matters

Accurate accounting for manufacturing overhead is essential for several reasons:

1. Determining Product Costs: Manufacturing overhead affects the total cost of goods manufactured (COGM). Without factoring in overhead, companies would underestimate production costs, leading to potential losses if products are sold at prices that do not cover these hidden costs.

2. Pricing and Profitability: By accurately determining the total cost of production, companies can set prices that ensure profitability. Ignoring or underestimating manufacturing overhead can lead to incorrect pricing strategies, affecting a company’s ability to compete.

3. Budgeting and Cost Control: Tracking manufacturing overhead allows businesses to budget for indirect costs and identify areas where they may be overspending, which is crucial for maintaining cost efficiency.

4. Evaluating Operational Efficiency: By analyzing overhead costs, companies can make informed decisions about improving operational efficiency, such as upgrading equipment to reduce energy usage or optimizing labor allocation.

Components of Manufacturing Overhead

Manufacturing overhead includes a variety of expenses that fall into different categories. Here are the primary components:

1. Indirect Materials

Indirect materials are items used in the production process that are not a part of the final product or are too insignificant in cost to be tracked individually. While direct materials, such as the wood used to make furniture, can be traced to a specific product, indirect materials are more general and include things like lubricants, cleaning supplies, and small tools.

Example of Indirect Materials

Consider a car manufacturing plant where lubricants and cleaning solvents are used to maintain machinery. While these materials are essential to production, they are not part of the cars themselves and are used in small quantities across multiple units. These indirect materials are classified under manufacturing overhead.

2. Indirect Labor

Indirect labor includes the wages of employees who support the production process but do not work directly on the products. Indirect labor costs often include the salaries of maintenance workers, quality control inspectors, and factory supervisors. While their work is crucial to the manufacturing environment, these employees’ efforts cannot be directly linked to any single product.

Example of Indirect Labor

In a clothing factory, supervisors oversee the entire production line to ensure efficiency and quality, but they are not involved in sewing or cutting fabric directly. The wages of these supervisors are considered indirect labor, as their contributions benefit all products rather than specific items.

3. Factory Utilities

Factory utilities cover the cost of electricity, water, heating, and cooling used to operate the production facility. Since these utilities are necessary for creating a conducive production environment, they are included in manufacturing overhead.

Example of Factory Utilities

A bottling plant uses substantial electricity to run conveyor belts, bottle-filling machines, and refrigeration units. While the electricity cost is essential for production, it is not tied to any specific product. As a result, it is classified as manufacturing overhead and allocated across all units produced.

4. Depreciation of Factory Equipment

Depreciation is the gradual reduction in value of long-term assets, such as factory equipment, over time due to wear and tear. In manufacturing, machinery, tools, and other equipment depreciate, and this loss of value is recorded as part of manufacturing overhead. Depreciation is a non-cash expense but must be accounted for to reflect the true cost of production assets.

Example of Depreciation

A furniture manufacturer uses wood-cutting machinery that costs $100,000 and has a useful life of 10 years. The annual depreciation expense would be $10,000, which is treated as an overhead cost. This amount is spread across all furniture produced in the year, reflecting the use of the machine in the production process.

5. Maintenance and Repairs

Maintenance and repair expenses include routine upkeep and unexpected repairs for equipment, machinery, and facilities used in production. Regular maintenance ensures that production machinery remains functional and efficient, minimizing the risk of costly breakdowns.

Example of Maintenance and Repairs

In a metalworking factory, machines undergo regular servicing every six months to prevent wear and tear. The cost of parts and labor associated with these maintenance activities is considered manufacturing overhead, as these expenses benefit the entire production process rather than specific products.

6. Factory Rent and Property Taxes

The cost of renting or leasing production facilities is classified as manufacturing overhead. Property taxes on the factory premises also fall under overhead, as they represent a necessary expense for operating a production environment.

Example of Factory Rent and Property Taxes

A bakery rents a commercial space for $2,000 per month to house its production line. This rent expense is part of manufacturing overhead, as it is a necessary cost for production but cannot be attributed to individual baked goods. Similarly, any property tax on the space is also considered an overhead cost.

7. Insurance Costs

Insurance costs that cover the factory building, equipment, and liability are included in manufacturing overhead. This insurance protects against unexpected losses, such as fire, theft, or accidents, ensuring that the production environment is safeguarded.

Example of Insurance Costs

A chemical manufacturing plant carries an insurance policy covering potential damages to its facility and equipment. The annual insurance premium is $5,000, which is recorded as manufacturing overhead and allocated across all products manufactured.

Calculating Manufacturing Overhead

Manufacturing overhead costs are often grouped into a single pool and allocated to production based on a specific cost driver, such as direct labor hours or machine hours. Here’s how to calculate and allocate manufacturing overhead.

Step 1: Determine Total Manufacturing Overhead

First, add up all the indirect costs associated with the production process. This includes indirect materials, indirect labor, utilities, depreciation, maintenance, rent, and other factory expenses.

Example

Consider a manufacturing facility with the following annual indirect costs:

• Indirect Materials: $10,000
• Indirect Labor: $50,000
• Utilities: $15,000
• Depreciation: $20,000
• Maintenance: $5,000
• Factory Rent: $30,000
• Insurance: $5,000

The total manufacturing overhead is:

   

Step 2: Choose a Cost Driver

The next step is to select a cost driver that accurately reflects how overhead costs are incurred. Common cost drivers include direct labor hours, machine hours, or units produced. The choice of cost driver depends on the nature of production.

Example

Assume the facility records 10,000 machine hours over the year, making machine hours an appropriate cost driver.

Step 3: Calculate the Overhead Rate

Divide the total manufacturing overhead by the total cost driver to calculate the overhead rate. The overhead rate represents the amount of overhead applied per unit of the cost driver.

   

Example

Using the total manufacturing overhead of $135,000 and 10,000 machine hours, the overhead rate is:

   

This rate means that for each machine hour, $13.50 in manufacturing overhead is allocated to production.

Step 4: Apply Overhead to Products

To allocate manufacturing overhead to specific products, multiply the overhead rate by the cost driver used for each product.

Example

Suppose a batch of products requires 200 machine hours. The overhead allocated to this batch is:

   

This $2,700 represents the manufacturing overhead cost associated with the batch of products, allowing the company to calculate a more accurate total cost for pricing and profitability analysis.

Examples of How Manufacturing Overhead Impacts Pricing and Profitability

Accurate overhead allocation is essential for pricing products correctly. Let’s explore a few examples:

Example 1: Impact on Pricing

Consider a company that manufactures custom furniture. If it only accounts for direct material and labor costs in its pricing, it may set prices too low, leading to losses. By including manufacturing overhead, the company ensures that the total cost of production is covered, allowing it to set prices that achieve profitability.

If the direct materials and labor cost for a table are $150, and the allocated overhead is $50, the total production cost is $200. By pricing the table at $300, the company ensures a margin that covers overhead and contributes

to profit.

Example 2: Assessing Operational Efficiency

Suppose a company’s manufacturing overhead has been steadily rising over several quarters due to increased utility costs and maintenance expenses. Management conducts an efficiency review and identifies opportunities to reduce overhead, such as investing in energy-efficient lighting and equipment.

Reducing these costs can improve profit margins, as lower manufacturing overhead means less is allocated per product, allowing the company to maintain competitive pricing.

Conclusion

Manufacturing overhead encompasses a wide range of indirect costs essential for supporting the production process. By accurately tracking and allocating these costs, companies can determine the true cost of their products, set appropriate prices, and maintain profitability. With components like indirect materials, indirect labor, utilities, depreciation, maintenance, and rent, manufacturing overhead reflects the unseen but critical expenses that keep production running smoothly.

Proper management of manufacturing overhead enables businesses to optimize costs, enhance efficiency, and make informed decisions about resource allocation. For companies aiming to remain competitive and profitable, understanding and effectively managing manufacturing overhead is key to long-term success.