Manufacturing overhead, often referred to as factory overhead or production overhead, refers to all the indirect costs incurred in the factory necessary to run the manufacturing operation while the product is being produced. Any overhead incurred after the product has been produced or outside the factory is a non-manufacturing overhead.
The reason for the distinction is that manufacturing overhead needs to be included in the cost of the product so that it is matched to revenue when the product is sold (matching concept), or included as part of the inventory cost if the product is not sold.
Examples of Manufacturing Overhead
Overhead costs can either be fixed or variable and are normally separated into three main components as shown below:
Examples of indirect labor costs forming part of overhead include the salaries, wages, and associated on-costs for the following factory employees:
- Materials handling
- Quality Control
Remember that it is only the costs relating to factory personnel which are included. So for example, the management salaries will only include the cost of employees involved in the management of the factory production and manufacturing facilities.
The majority of material costs can be directly attributed to a particular product and will therefore be included in direct materials. However, there are certain materials such as glue, oil and grease, machine coolant, fuel, screws, stationery, paper towels etc. which cannot be directly allocated to a product either because it not practicable or because the costs involved in allocation are prohibitive, these materials are recorded as indirect materials and form part of the overhead cost.
Examples of other factory costs included in overhead are as follows:
- Rent, insurance, property tax, and other occupancy costs of the factory.
- Depreciation on factory property, plant, and equipment
- Utility costs for the factory such as electricity, gas, water etc.
- Factory telephone and internet costs
Apportioning Manufacturing Overhead
When deciding how to calculate factory overhead it is often necessary to apportion the total overhead cost and allocate only part of it to manufacturing.
For example the annual rent on a building might be 9,000. However, the building might include a manufacturing unit and office accommodation for selling and administration staff. In this example, a suitable method of apportioning the overhead between manufacturing and non-manufacturing might be to use the relative floor areas of the two units. If the area of the manufacturing unit is 8,500 and the office accommodation is 1,500, then the rent apportioned to manufacturing would be 9,000 x 8,500 / 10,000 = 7,650, with the balance 1,350 being classified as a non-manufacturing overhead.
Applied Manufacturing Overhead
Having accumulated the total amount of overhead, the next step is to find a suitable method of applying the overhead to the products. This is normally achieved by calculating a predetermined overhead rate and then allocating the overhead to the product based on the number of direct labor hours or costs used in the manufacture of the product multiplied by the overhead rate. This topic is more fully discussed in our post on applied overhead.
Manufacturing Overhead Journals
In a standard costing system the process of recording manufacturing overhead is split into three steps:
- Record the actual costs
- Apportion part of the cost to a manufacturing overhead account
- Allocate the overhead to the work in process account.
Using our property rent example from earlier.
Step 1: Rent invoice received
The rent invoice is received from the supplier and charged to the rent expense account.
Step 2: Apportion part of the rent to manufacturing overhead
The correct proportion relating to the manufacturing unit is allocated to overhead. The balance remains on the rent expense account as a non-manufacturing overhead.
Obviously in a lot of cases, the entire cost relates to manufacturing and the apportionment is unnecessary.
Step 3: Manufacturing overhead allocated to the products
Assuming for simplicity there is no under or over absorption of factory overhead (see our standard costing tutorial), the overhead would be allocated to work in process, and subsequently to finished goods, cost of sales and inventory.
|Work in process||7,650|
In reality there will be an under of over absorption of production overhead resulting in a standard costing variance, this is more fully discussed in our standard costing tutorials.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.