Manufacturing Overhead (Explanation Part 1)

Introduction to Manufacturing Overhead

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:

1. 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.

2. 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.

For a further discussion of nonmanufacturing costs, see Nonmanufacturing Overhead Costs.

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Manufacturing Overhead Costs

On financial statements, each product must include the costs of the following:

1. Direct material
2. Direct labor
3. 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.