Manufacturing overhead

Manufacturing overhead is the aggregate of all indirect costs incurred during the production process that cannot be directly traced to specific products, including factory rent, equipment depreciation, utilities, and indirect labor (Horngren C.T. et al. 2015, p.34)^[1]. The welding rod that joins two metal parts is direct material—you can measure exactly how much goes into each unit. The electricity powering the welding machine? That's overhead. It supports production but doesn't attach neatly to any single product.

Getting overhead right matters for pricing, profitability analysis, and inventory valuation. Under Generally Accepted Accounting Principles, manufacturing overhead must be absorbed into product costs. Underestimate it and you'll underprice products. Allocate it poorly and you'll misunderstand which products actually make money. Factory managers live with overhead decisions daily.

Components of manufacturing overhead

Overhead encompasses various indirect costs:

Indirect materials

Production support items. Lubricants for machinery, cleaning supplies, safety equipment, small tools—items consumed in production that aren't part of finished products themselves^[2].

Consumables. Light bulbs, packaging materials for internal handling, maintenance supplies. These support production without becoming components of output.

Tracking difficulty. Unlike direct materials measured per unit, indirect materials are consumed across the factory floor without specific product attribution.

Indirect labor

Support personnel. Factory supervisors, quality control inspectors, maintenance technicians, material handlers, security guards—essential workers who don't physically transform products.

Production management. Plant managers, production schedulers, industrial engineers. Their salaries support manufacturing without attaching to specific units.

Janitorial and maintenance. Cleaning crews, equipment repair technicians, groundskeepers. The factory can't run without them, but their costs spread across all production^[3].

Facility costs

Rent or depreciation. Whether leased or owned, factory space costs money. These costs continue regardless of production volume—a classic fixed overhead.

Property taxes and insurance. Annual obligations tied to facility ownership or occupancy.

Utilities. Electricity, natural gas, water, sewage. Some varies with production; some doesn't. The lights stay on even during slow periods.

Equipment costs

Depreciation. Machines wear out. Accounting spreads their cost over useful lives through depreciation—a non-cash overhead expense.

Maintenance and repair. Keeping equipment running requires ongoing expenditure.

Equipment insurance. Protecting against equipment damage or loss^[4].

Fixed versus variable overhead

Overhead behavior differs:

Fixed overhead

Unchanging with volume. Factory rent stays constant whether you produce 1,000 units or 100,000. Supervisor salaries don't flex with daily output.

Capacity costs. Fixed overhead represents the cost of having production capacity available. You pay for potential output.

Per-unit variation. While total fixed overhead stays constant, per-unit fixed overhead decreases as volume increases—spreading fixed costs over more units.

Variable overhead

Volume-sensitive. Some overhead rises and falls with production. More machine hours mean more electricity. More production runs mean more supplies consumed^[5].

Cost drivers. Variable overhead correlates with activity measures—machine hours, labor hours, units produced, production runs.

Mixed overhead

Semi-variable costs. Some overhead has both fixed and variable components. Utility bills include base charges (fixed) plus usage charges (variable).

Step costs. Supervision may be fixed within a production range but jumps when adding shifts or expanding capacity.

Overhead allocation

Assigning overhead to products requires systematic methods:

Predetermined overhead rate

Rate calculation. Before the period begins, calculate a rate: Predetermined Rate = Estimated Overhead / Estimated Activity Base. If estimated overhead is $500,000 and estimated machine hours are 50,000, the rate is $10 per machine hour.

Application. As production occurs, apply overhead to products based on actual activity. A job using 100 machine hours absorbs $1,000 in overhead^[6].

Annual timing. Using annual estimates smooths seasonal variations in actual overhead, avoiding monthly fluctuations in product costs.

Cost drivers

Traditional bases. Direct labor hours, direct labor dollars, machine hours—simple volume-based measures that correlate reasonably with overhead consumption.

Activity-based costing. ABC uses multiple cost drivers reflecting actual consumption patterns. Setup costs allocated by number of setups. Material handling by number of moves. More accurate but more complex.

Over- and underapplied overhead

Variance. Actual overhead rarely equals applied overhead precisely. The difference is overapplied (applied > actual) or underapplied (actual > applied).

Disposition. Year-end variances are typically closed to Cost of Goods Sold or allocated among Work in Process, Finished Goods, and Cost of Goods Sold based on relative balances^[7].

GAAP requirements

Accounting standards govern overhead treatment:

Full absorption costing. For external financial reporting, product costs must include direct materials, direct labor, and manufacturing overhead. Variable costing (excluding fixed overhead from products) isn't GAAP-compliant for external reporting.

Inventory valuation. Manufacturing overhead in ending inventory appears as an asset on the balance sheet—the cost of products not yet sold.

Cost of goods sold. When products sell, their overhead component flows to the income statement as part of cost of goods sold.

Overhead in decision-making

Managers use overhead information carefully:

Pricing decisions. Products must recover their overhead to be profitable long-term, but short-term pricing decisions should focus on contribution margin.

Make-or-buy analysis. Comparing in-house production costs (including overhead) against outsourcing options requires careful analysis of which overhead costs would actually disappear^[8].

Product profitability. Poor overhead allocation can make profitable products appear unprofitable and vice versa. Activity-based costing helps, but complexity has costs too.

Capacity decisions. Fixed overhead represents capacity costs. Adding capacity adds fixed overhead; reducing capacity may or may not reduce it depending on cost stickiness.

Manufacturing overhead — recommended articles

Cost accounting — Production management — Financial accounting — Cost management

References

• Horngren C.T., Datar S.M., Rajan M.V. (2015), Cost Accounting: A Managerial Emphasis, 15th Edition, Pearson.
• Garrison R.H., Noreen E.W., Brewer P.C. (2021), Managerial Accounting, 17th Edition, McGraw-Hill.
• AccountingCoach (2023), Manufacturing Overhead Explanation.
• AccountingTools (2023), Manufacturing Overhead Definition.

Footnotes

1. ↑ Horngren C.T. et al. (2015), Cost Accounting, p.34
2. ↑ Garrison R.H. et al. (2021), Managerial Accounting, pp.56-67
3. ↑ AccountingCoach (2023), Manufacturing Overhead Explanation
4. ↑ Horngren C.T. et al. (2015), Cost Accounting, pp.89-102
5. ↑ Garrison R.H. et al. (2021), Managerial Accounting, pp.78-89
6. ↑ AccountingTools (2023), Manufacturing Overhead Definition
7. ↑ Horngren C.T. et al. (2015), Cost Accounting, pp.112-124
8. ↑ Garrison R.H. et al. (2021), Managerial Accounting, pp.134-145

Author: Sławomir Wawak