Generally accepted accounting principles (GAAP) rules state that both direct and indirect costs must be assigned to each product or item manufactured for inventory and cost of goods sold to be reported accurately.
Costs such as direct materials and labor are calculated in the cost of goods sold, and indirect costs also need to be factored into the final cost of the item manufactured. These indirect costs are manufacturing overhead.
Overview: What is manufacturing overhead?
Manufacturing overhead includes any cost related to a completed product, not considered a direct cost.
The first thing you need to do when calculating manufacturing overhead is familiarize yourself with a few accounting terms:
- Direct costs: An expense directly related to the production of goods or services. Direct labor, materials, and manufacturing supplies are direct expenses.
- Indirect costs: Costs not directly related to production, but still necessary, such as depreciation, rent, and administrative or management salaries.These should be included in manufacturing overhead.
- Inventory: Inventory includes products held by a business for resale, or materials used to produce the product.
To calculate the true cost of a manufactured item you need to calculate and allocate manufacturing overhead. Add all indirect costs and then determine the percentage of the cost that needs to be allocated to your final manufacturing overhead costs.
This may sound confusing, but remember the cost of goods sold only considers the direct materials involved in producing the items you’re manufacturing.
So, if your company manufactures wood desks, your cost of goods sold would include the cost of the wood to manufacture the desks, and the direct labor costs to build the desks such as line operator wages.
Manufacturing overhead also adds in indirect costs such as factory manager wages, utility costs for the factory, rent for the manufacturing facility, and depreciation expense on all the equipment used in the manufacturing process.
The managerial or cost accounting method is a more difficult accounting method to grasp, so those still struggling with accounting 101 may want to seek guidance from an experienced accountant or CPA when using it.
Examples of manufacturing overhead
When calculating manufacturing overhead expenses, make sure you’re including all the indirect business costs associated with manufacturing your products. Here are a few examples of manufacturing overhead that needs to be included in your calculation:
1. Depreciation expense
Include monthly depreciation expense for the manufacturing equipment used in your manufacturing facility. Don’t include all depreciation expenses, only those directly related to production.
For example, if you have a monthly depreciation expense of $1,600, and $1,000 of that is for manufacturing equipment, only include the $1,000 in your monthly manufacturing overhead costs.
Your direct labor costs from machine operators and assembly line staff are already included in your cost of goods sold.
But don’t forget indirect labor costs, which are costs incurred in the production process, but not considered direct labor. Indirect labor costs would include supervisor, management, and quality assurance wages.
You need gas and electricity to run the factory manufacturing your products. Include both expenses when calculating your manufacturing overhead expenses.
4. Rent or mortgage
Operating expenses such as rent or mortgage must be included in your calculation, as do any associated costs such as property tax and insurance.
Include supplies that are purchased specifically for the factory. This can include kitchen, breakroom, and bathroom supplies, and anything needed for the factory not included in the direct product cost.
How to calculate and allocate manufacturing overhead
Calculating manufacturing overhead is a necessary step, but you must also allocate those overhead expenses properly.
GAAP rules state manufacturing overhead costs must be included in both work in progress inventory and finished goods inventory on your company’s balance sheet, and in the cost of goods sold on your income statement.
Here are a few steps to make the entire process easier:
Step 1: Identify and calculate indirect manufacturing overhead costs
This may be the most important, because if you don’t include the indirect costs involved in the manufacturing process, you’ll never have the true cost of manufacturing.
Underestimating the production costs can lead to revenue loss by underpricing the product, while adding in costs that aren’t part of the production process can lead to overpricing and slower inventory movement.
Step 2: Calculate overhead rate percentage
Once you have calculated your indirect costs, you must complete another calculation, your manufacturing overhead rate. To do this, simply take the monthly manufacturing overhead and divide it by monthly sales, then multiply the total by 100.
For example, you recently determined that your company had monthly manufacturing overhead of $14,500, while your monthly sales were $200,000. Here is the formula for calculating your monthly manufacturing overhead rate:
$14,500 ÷ $200,000 x 100 = 7.25%
The calculation result means that 7.25% of sales revenue will need to go toward overhead manufacturing costs. A lower overhead rate means a more efficient manufacturing operation. The higher the number, the more important you review your manufacturing process to reveal inefficiencies.
Step 3: Determine which allocation base to use in calculating costs
Though allocation bases can vary, the most commonly used are direct machine hours and direct labor hours.
For a labor intensive manufacturing environment, direct labor hours is probably the most accurate base, while in a more automated manufacturing environment, machine hours is probably a better choice.
Step 4: Divide the amount of manufacturing overhead by the allocation base
If your company had 1,700 direct labor hours for the month, you would divide the overhead costs by the number of direct labor hours.
Using the totals above, if your overhead was $14,500 for the month of March, and you had 700 total labor hours, your calculation would be:
$14,500 ÷ 1,700 = $8.52
This means you will need to allocate an additional $8.52 for each hour worked besides the direct labor and materials costs to accurately calculate your total cost of goods sold.
Manufacturing overhead is important in production cost
If you’re running a small manufacturing operation, it’s important to accurately calculate manufacturing overhead costs.
Don’t factor and account properly for them, and your financial statements may be inaccurate and your products under or overpriced, all directly affecting profits the business may be earning.
It’s just as important not to include unrelated expenses, which can result in difficult-to-move, overpriced inventory. This is an important, core principle which you can master to improve your business.
If you’re looking for a better way to manage your inventory, accounting software is the way to go. Check out The Blueprint’s accounting software reviews and manage your inventory, overhead, and all associated costs the easy way.