For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
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Introduction
In the world of manufacturing—as competition becomes more intense and customers demand more services—it is important that management not only control its overhead but also understand how it is assigned to products and ultimately reported on the company’s financial statements. We view overhead as two types of costs and define them as follows:
Manufacturing overhead (also referred to as factory overhead, factory burden, and manufacturing support costs) refers to indirect factory-related costs that are incurred when a product is manufactured. Along with costs such as direct material and direct labor, the cost of manufacturing overhead must be assigned to each unit produced so that Inventory and Cost of Goods Sold are valued and reported according to generally accepted accounting principles (GAAP).
Manufacturing overhead includes such things as the electricity used to operate the factory equipment, depreciation on the factory equipment and building, factory supplies and factory personnel (other than direct labor). How these costs are assigned to products has an impact on the measurement of an individual product’s profitability.
Nonmanufacturing costs (sometimes referred to as administrative overhead) represent a manufacturer’s expenses that occur apart from the actual manufacturing function. In accounting and financial terminology, the nonmanufacturing costs include Selling, General and Administrative (SG&A) expenses, and Interest Expense. Since accounting principles do not consider these expenses as product costs, they are not assigned to inventory or to the cost of goods sold. Instead, nonmanufacturing costs are simply reported as expenses on the income statement at the time they are incurred.
Nonmanufacturing costs include activities associated with the Selling and General Administrative functions. Examples include the compensation of nonmanufacturing personnel; occupancy expenses for nonmanufacturing facilities (rent, light, heat, property taxes, maintenance, etc.); depreciation of nonmanufacturing equipment; expenses for automobiles and trucks used to sell and deliver products; and interest expenses. (Note that factory administration expenses are considered part of manufacturing overhead.)
Although nonmanufacturing costs are not assigned to products for purposes of reporting inventory and the cost of goods sold on a company’s financial statements, they should always be considered as part of the total cost of providing a specific product to a specific customer. For a product to be profitable, its selling price must be greater than the sum of the product cost (direct material, direct labor, and manufacturing overhead) plus the nonmanufacturing costs and expenses.
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Manufacturing Overhead Costs
On financial statements, each product must include the costs of the following:
Direct material
Direct labor
Manufacturing (or factory) overhead
According to generally accepted accounting principles (GAAP), manufacturing overhead must be included in the cost of Work-in-Process Inventory and Finished Goods Inventory on a manufacturer’s balance sheet, as well as in the Cost of Goods Sold on its income statement.
As their names indicate, direct material and direct labor costs are directly traceable to the products being manufactured. Manufacturing overhead, however, consists of indirect factory-related costs and as such must be divided up and allocated to each unit produced. For example, the property tax on a factory building is part of manufacturing overhead. Although the property tax covers an entire year and appears as one large amount on just one tax bill, GAAP requires that a portion of this amount be allocated or assigned to each product manufactured during that year.
Some of the costs that would typically be included in manufacturing overhead include:
Material handlers (forklift operators who move materials and units)
People who set up the manufacturing equipment to the required specifications
People who inspect products as they are being produced
People who perform maintenance on the equipment
People who clean the manufacturing area
People who perform record keeping for the manufacturing processes
Factory management team
(Note: For the items above, the company will incur costs for salaries, wages, Social Security and Medicare taxes, unemployment compensation tax, worker compensation insurance, health insurance, holiday pay, vacation pay, sick pay, pension or retirement plan, seminars and training, and perhaps more.)
Electricity, natural gas, water, and sewer for operating the manufacturing facilities and equipment
Computer and communication systems for the manufacturing function
Repair parts for the manufacturing equipment and facilities
Supplies for operating the manufacturing process
Depreciation on the manufacturing equipment and facilities
Insurance and property taxes on the manufacturing equipment and facilities
Safety and environmental costs
Note that all of the items in the list above pertain to the manufacturing function of the business. Since the costs and expenses relating to a company’s administrative, selling, and financing functions are not considered to be part of manufacturing overhead, they are not reported as part of the final product cost on financial statements. Rather, nonmanufacturing expenses are reported separately (as SG&A and interest expense) on the income statement for the accounting period in which they are incurred.
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Financial Reporting vs. Individual Products and Customers
As mentioned above, in order for a manufacturer’s financial statements to be in compliance with GAAP, a portion of the manufacturing overhead must be allocated to each item produced. Even when allocations are arbitrary and inaccurate, the totals of the amounts reported as inventory and cost of goods sold on the financial statements can still be reasonably correct. For example, if a manufacturer’s inventory is minimal or if the beginning and ending inventories are similar in amount, this indicates that the company is selling nearly all of the units it produced in a given year. If that is the case, then as long as most of the manufacturing overhead appears on the income statement as part of the cost of goods sold, the financial statements will be correct—even if the amounts allocated to the individual products are inaccurate. The message here is this: Even if each product’s costs are wrong due to inaccurate allocations of manufacturing overhead, it is still possible that the financial statements will be accurate and receive a clean audit report.
However, if management wants to know the true cost of manufacturing an individual item, it is essential that the manufacturing overhead be allocated in a precise and logical manner. In addition to knowing the true cost of manufacturing each item, management needs to know the true expense of all of the other business functions associated with an individual item. In this way, management will know if each product and each customer is generating sufficient sales revenue to cover not the only manufacturing costs but also the selling, general and administrative expenses, interest expense, and some profit. This means that management will need to allocate/assign nonmanufacturing costs to individual products and customers (even though this type of allocation is not allowed for external financial statements).
In short, the company’s financial statements could be accurate with improper allocation to individual products, but for management’s decisions (1) the allocations of manufacturing overhead must be accurate and (2) the nonmanufacturing costs must be accurately assigned to individual products and customers. For example, if an inaccurate allocation results in too much cost assigned to some products, management might seek price increases on those products when in reality such price increases are not necessary. If customers react to the proposed unnecessary price increases by seeking bids from other manufacturers, the company may end up losing sales, profits, and customers. Conversely, if inaccurate allocations result in too few costs assigned to some products, a company may not realize that a specific product’s selling price is inadequate to cover the true costs needed to produce and sell that product. If the company does not pursue a price increase or improvements in efficiency, the company might be selling that product at a loss.
Although a company doesn’t need precise, detailed allocations for purposes of preparing your company’s financial statements, the odds are that at some point down the road those inaccurate allocations may result in poor pricing decisions. That’s something a company cannot afford to do in an increasingly competitive global market.
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Traditional Methods of Allocating Manufacturing Overhead
Let’s look at several of the traditional methods for allocating manufacturing overhead. Keep in mind that if the method does not allocate the true amount of factory overhead, the cost per unit of product will be wrong and could result in management making a flawed decision. As you review these methods, ask yourself for each given product, will the allocated amount of overhead reflect the actual amount of overhead used in that item’s production? If a cause-and-effect relationship is not evident, is there at least an obvious correlation between manufacturing overhead and the basis for the allocation (such as production machine hours)? If there is no correlation, the allocation method is suspect and could result in the improper amount of overhead being assigned to individual products.
Allocating Manufacturing Overhead Via Direct Labor
In the early 1900s (and in some labor intensive production) it was logical to allocate manufacturing overhead on the basis of direct labor hours (or direct labor cost). The manufacturing process was not automated, there were hardly any variations in the products made (think Model T cars), and customers did not demand such things as just-in-time (JIT) deliveries or bar coding. In those days, when manufacturers increased the amount of direct labor, there was likely to be a related increase in such things as the number of factory supervisors, the factory space to be maintained, and factory supplies and utilities consumed. In other words, there was a high degree of correlation between the quantity of direct labor used and the cost of the manufacturing overhead. By allocating manufacturing overhead on the basis of direct labor hours, a product requiring 30 direct labor hours would be allocated twice as much manufacturing overhead as a product requiring 15 direct labor hours.
Let’s illustrate an overhead rate based on direct labor hours for a company that manufactures just two products, X and Y. (An annual rate is developed in order to have a constant overhead rate even when production volumes fluctuate from month to month.) For the upcoming year the company expects the following:
As shown in the above table, each unit of Product X will be assigned $30 of overhead, and each unit of Product Y will be assigned $60 of overhead. This is reasonable so long as there is a correlation between the quantity of direct labor hours and the cost of manufacturing overhead.
Allocating Manufacturing Overhead Via Departmental Machine Hours
As the 20th century moved on, manufacturers studied and controlled direct labor’s time and motion (think of Frederick Taylor’s work) and began replacing direct labor with machines. The increased use of machines resulted in an increase in factory overhead due to such things as additional depreciation of the machinery, maintenance of the machinery, and machine setups. With direct labor being reduced and manufacturing overhead increasing, the correlation between direct labor and manufacturing overhead began to wane. A logical response was to begin allocating manufacturing overhead on the basis of machine hours instead of direct labor hours.
Companies also began to create new departments to help manage the changing character of the factories. Production departments such as machining, finishing, and assembling were established. Other departments such as quality control, maintenance, and factory administration were designated as service departments (or production service departments), since these departments served the production departments. The company’s costs were contained in the accountant’s general ledger, which was organized by departments so as to mirror the organization chart and to provide for budgeting and control. Because some of the production departments used more of some service departments’ efforts/costs than others, accountants responded by first allocating the service department costs to the production departments, and then developing manufacturing overhead rates for each of the production departments. These rates were computed by dividing each production department’s costs (its own direct costs plus the service departments’ costs allocated to it) by its machine hours.
Basing the manufacturing overhead rates on a company’s production departments was an improvement over using just one rate for the entire plant—particularly when companies began manufacturing a greater variety of products. Some products being manufactured may have required many machine hours in one department but very few hours in another department, while other products may have used a much different combination of machine hours.
Let’s illustrate this method by assuming just two products (X and Y) are being manufactured in a factory that has one service department (Factory Administration, S1) and two production departments (Machining, P1; Finishing, P2).
Had the company used a plant-wide rate, the manufacturing overhead rate would have been $33.33 per MH ($500,000 divided by 15,000 MH), instead of $40 for the machining department and $20 for the finishing department. By using departmental rates, products requiring more machine hours in a high-cost department will be assigned a higher cost than would be assigned if using one established plant-wide rate. Products requiring more time in a low-cost department will be assigned a lower cost as compared to one plant-wide rate.
Where to Go From Here
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Usually financial statements refer to the balance sheet, income statement, statement of cash flows, statement of retained earnings, and statement of stockholders’ equity.
The balance sheet reports information as of a date (a point in time). The income statement, statement of cash flows, statement of retained earnings, and the statement of stockholders’ equity report information for a period of time (or time interval) such as a year, quarter, or month.
A current asset whose ending balance should report the cost of a merchandiser’s products awaiting to be sold. The inventory of a manufacturer should report the cost of its raw materials, work-in-process, and finished goods. The cost of inventory should include all costs necessary to acquire the items and to get them ready for sale.
When inventory items are acquired or produced at varying costs, the company will need to make an assumption on how to flow the changing costs. See cost flow assumption.
If the net realizable value of the inventory is less than the actual cost of the inventory, it is often necessary to reduce the inventory amount.
Cost of goods sold is usually the largest expense on the income statement of a company selling products or goods. Cost of Goods Sold is a general ledger account under the perpetual inventory system.
Under the periodic inventory system there will not be an account entitled Cost of Goods Sold. Instead, the cost of goods sold is computed as follows: cost of beginning inventory + cost of goods purchased (net of any returns or allowances) + freight-in – cost of ending inventory.
This account balance or this calculated amount will be matched with the sales amount on the income statement.
The general guidelines and principles, standards and detailed rules, plus industry practices that exist for financial reporting. Often referred to by its acronymn GAAP.
The systematic allocation of the cost of an asset from the balance sheet to Depreciation Expense on the income statement over the useful life of the asset. (The depreciation journal entry includes a debit to Depreciation Expense and a credit to Accumulated Depreciation, a contra asset account). The purpose is to allocate the cost to expense in order to comply with the matching principle. It is not intended to be a valuation process. In other words, the amount allocated to expense is not indicative of the economic value being consumed. Similarly, the amount not yet allocated is not an indication of its current market value.
Costs that are matched with revenues on the income statement. For example, Cost of Goods Sold is an expense caused by Sales. Insurance Expense, Wages Expense, Advertising Expense, Interest Expense are expenses matched with the period of time in the heading of the income statement. Under the accrual basis of accounting, the matching is NOT based on the date that the expenses are paid.
Expenses associated with the main activity of the business are referred to as operating expenses. Expenses associated with a peripheral activity are nonoperating or other expenses. For example, a retailer’s interest expense is a nonoperating expense. A bank’s interest expense is an operating expense.
Generally, expenses are debited to a specific expense account and the normal balance of an expense account is a debit balance. When an expense account is debited, the account credited might be Cash (if cash was paid at the time of the expense), Accounts Payable (if cash will be paid after the expense is recorded), or Prepaid Expense (if cash was paid before the expense was recorded.)
Also referred to as SG&A. For a manufacturer these are expenses outside of the manufacturing function. (However, interest expense and other nonoperating expenses are not included; they are reported separately.) These expenses are not considered to be product costs and are not allocated to items in inventory or to cost of goods sold. Instead these expenses are reported on the income statement of the period in which they occur. These expenses are sometimes referred to as operating expenses.
This account is a non-operating or “other” expense for the cost of borrowed money or other credit. The amount of interest expense appearing on the income statement is the cost of the money that was used during the time interval shown in the heading of the income statement, not the amount of interest paid during that period of time.
The standards, rules, guidelines, and industry-specific requirements for financial reporting.
In manufacturing, the product cost includes direct materials, direct labor, and manufacturing overhead. A retailer’s product cost is the net cost from suppliers plus costs to get the product in place and ready for use (e.g. freight-in).
One of the main financial statements (along with the balance sheet, the statement of cash flows, and the statement of stockholders’ equity). The income statement is also referred to as the profit and loss statement, P&L, statement of income, and the statement of operations. The income statement reports the revenues, gains, expenses, losses, net income and other totals for the period of time shown in the heading of the statement. If a company’s stock is publicly traded, earnings per share must appear on the face of the income statement.
A word used by accountants to communicate that an expense has occurred and needs to be recognized on the income statement even though no payment was made. The second part of the necessary entry will be a credit to a liability account.
That part of a manufacturer’s inventory that is in the production process and has not yet been completed and transferred to the finished goods inventory. This account contains the cost of the direct material, direct labor, and factory overhead placed into the products on the factory floor. A manufacturer must disclose in its financial statements the cost of its work-in-process as well as the cost of finished goods and materials on hand.
The products in a manufacturer’s inventory that are completed and are awaiting to be sold. You might view this account as containing the cost of the products in the finished goods warehouse. A manufacturer must disclose in its financial statements the amount of finished goods, work-in-process, and raw materials.
One of the main financial statements. The balance sheet reports the assets, liabilities, and owner’s (stockholders’) equity at a specific point in time, such as December 31. The balance sheet is also referred to as the Statement of Financial Position.
Insurance often required by states and paid for by the employer to compensate workers who were injured on the job. The amount of the insurance premiums vary by type of work performed. For example, rates are higher for operators of machinery and are lower for office employees.
A revenue account that reports the sales of merchandise. Sales are reported in the accounting period in which title to the merchandise was transferred from the seller to the buyer.
An effort to have materials delivered by suppliers just as the materials are needed, thereby eliminating the need for the buyer to store inventories of component parts. Obviously, the buyer is relying on the dependability of the supplier.
A department that is directly involved in manufacturing products. Examples are the machining, finishing, and assembling departments.
A department within a factory that does not directly produce a product. Examples are the factory maintenance department, factory administrative department, and quality assurance department.
A department within a factory that does not directly produce a product. Examples are the factory maintenance department, factory administrative department, and quality assurance department.
That part of the accounting system which contains the balance sheet and income statement accounts used for recording transactions.
For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
