Nonmanufacturing Overhead (Explanation Part 1)

Nonmanufacturing Overhead Costs

We use the term nonmanufacturing overhead costs or nonmanufacturing costs to mean the Selling, General & Administrative (SG&A) expenses and Interest Expense. Under generally accepted accounting principles (GAAP), these expenses are not product costs. (Product costs only include direct material, direct labor, and manufacturing overhead.) Nonmanufacturing costs are reported on a company’s income statement as expenses in the accounting period in which they are incurred. Expressed another way, nonmanufacturing costs are not allocated to products via overhead rates since they are not included in the amounts reported as inventory on the balance sheet or in the cost of goods sold that is reported on the income statement.

Even though nonmanufacturing overhead costs are not product costs according to GAAP, these expenses (along with product costs and profit) must be covered by the selling prices of a company’s products. In other words, selling prices must be large enough to cover SG&A expenses, interest expense, manufacturing overhead, direct labor, direct materials, and profit.

Some of the costs that would typically be included in nonmanufacturing costs include:

• Salaries and fringe benefits of selling, general and administrative personnel. This would include the company president, vice presidents, managers, and other employees in the nonmanufacturing functions of the company.
• Rent, property taxes, utilities for the space used by the nonmanufacturing functions of the company.
• Insurance for areas outside of the factory.
• Interest on business loans.
• Marketing and advertising.
• Depreciation and maintenance of equipment and buildings outside of manufacturing.
• Supplies for the offices.

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Financial Reporting vs. Individual Products and Customers

As mentioned above, nonmanufacturing costs cannot be included in inventory or the cost of goods sold; rather, nonmanufacturing costs are reported as SG&A expenses and Interest Expense in the accounting period in which they occur.

However, if management wants to determine the profitability of a specific product or customer, it is necessary to allocate or assign nonmanufacturing costs to the products and/or customers outside of the financial statements. This information stays within the company—it is only used internally to assist management with decisions such as pricing; choosing which products to promote or to phase out; choosing which products to review for possible production processing changes; etc. In the end, management should know whether each product’s selling price is adequate to cover the product’s manufacturing costs, nonmanufacturing costs, and required profit.

If management does not allocate the nonmanufacturing costs to specific products, a product that requires a significant amount of sales support and administrative costs may actually be unprofitable even though its gross profit (sales minus manufacturing costs) indicates that it is very profitable. On the other hand, a product with a low gross profit may actually be very profitable, if it uses only a minimal amount of administrative and selling expense.

Methods of Allocating Nonmanufacturing Overhead Costs

As mentioned previously, nonmanufacturing costs are allocated internally to products and customers for the purpose of giving management information that is useful for decision-making, but not for the purpose of financial reporting. When doing the internal allocation of nonmanufacturing costs it is logical to follow these four steps: (1) identify the activities that cause the nonmanufacturing costs, (2) measure the cost of those activities, (3) identify the products and customers requiring the activities, and (4) assign the cost of the activities to those products and customers. In short, the best way to allocate nonmanufacturing costs is to use activity based costing (ABC).

Some activities involving nonmanufacturing expenses include:

• Servicing existing accounts (product designs and other needs)
• Invoicing customers for shipments of products
• Processing payments from customers
• Maintaining the company’s computer information system
• Financing the inventories and other business assets
• Prospecting for new accounts
• Preparing financial statements and reports to government agencies
• Overall management of the company

It is likely that you will have to estimate the cost of these activities. Next, you will need to allocate the cost of the activities to the individual products. Estimates and allocations based on logical assumptions are better than precise amounts based on faulty assumptions.

Recap

1. Allocations are, by definition, arbitrary. Allocations of manufacturing overhead to inventory and the cost of goods sold are required by generally accepted accounting principles (GAAP). However, for financial reporting under GAAP, nonmanufacturing costs are not allocated to products; rather, they are expensed when they occur.
2. Information provided to management on the profitability of specific products and customers will require the allocation of nonmanufacturing costs in addition to the allocation of manufacturing overhead.
3. Allocations based on a single factor—such as direct labor hours or machine hours—are too simplistic for today’s complex manufacturing environment. Hence, activity based costing (ABC) came into existence. ABC can be used for allocating both manufacturing overhead and nonmanufacturing costs.