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What Is Manufacturing Overhead?

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Last editedSep 20222 min read

To create a realistic budget, your business needs to have a clear-cut idea of its operating expenses, including manufacturing costs. Manufacturing overhead encompasses all the indirect costs involved with production. Keep reading to learn how to find manufacturing overhead and account for these costs in your financial statements.

What is manufacturing overhead?

There are three components of manufacturing costs:

  1. Direct materials

  2. Direct labor

  3. Manufacturing overhead

Direct materials include the raw elements used to create your products, such as steel being used in auto manufacturing. Direct labor includes the costs of the workers who put these products together. So, what is manufacturing overhead? This term describes all the remaining indirect factor-related costs involved in manufacturing. 

What costs are included in manufacturing overhead?

There are numerous indirect costs that should be included when calculating manufacturing overhead. Factories and production units need electricity and supplies. Here’s a non-exhaustive list of manufacturing overhead costs:

  • Rental costs of production unit or factory

  • Utilities (water, electricity, internet connectivity)

  • Electronic devices and computers for the facility

  • Property taxes and building insurance

  • Depreciation of machinery and equipment

  • Factory supplies not directly related to production

  • Salaries of staff not directly related to production (maintenance crews, management team)

Manufacturing overhead doesn’t include general administrative and marketing expenses, however. The manufacturing overhead formula also doesn’t consider things like legal fees, audits, or corporate salaries. These expenses are included under a different category as they aren’t relevant to the manufacturing process.

How to find manufacturing overhead

To calculate manufacturing overhead for a specific accounting period, you’ll need to first identify all relevant costs and then add these together. The manufacturing overhead formula is quite simple:

Manufacturing Overhead = Total Indirect Costs

However, if you want to determine your overhead rate, you’ll need to divide the monthly overhead costs by your total monthly sales. Multiply this result by 100 to arrive at a percentage.

Here’s an example of how to find manufacturing overhead rate:

Company A spends $75,000 in monthly manufacturing overhead. It takes in $400,000 in monthly sales.

Manufacturing Overhead Rate = $75,000 / $400,000 x 100

The overhead percentage would be 18.75% in this case. In other words, 18.75% of monthly revenue goes towards these overhead costs. Generally, the lower the manufacturing overhead rate, the more efficient the business. A higher rate indicates that there is a lag between production and sales that might be impacting your cash flow. This figure is also helpful in budgeting because you can ensure you have set aside enough to adequately cover overhead costs each month.

How to account for manufacturing overhead

Manufacturing overhead is added to the total cost of direct labor and direct materials to calculate the cost of goods sold (COGS). This follows the generally accepted accounting principles (GAAP) used by most US businesses. You’ll need to report the COGS on your income statement and balance sheet.

Allocation is another component of manufacturing overhead accounting to be aware of. You’ll need to allocate a percentage of manufacturing overhead to each item your facility produces. To allocate this cost, calculate the overhead rate percentage and apply this to each item’s cost. This can sometimes be challenging when looking at something like property taxes, which bear no relation to the final product. This is why a straightforward overhead percentage is usually applied across the board in proportion to labor hours per unit or other easily quantifiable values.

Using accounting software like Xero helps you track and record these manufacturing overhead costs. GoCardless integrates with hundreds of accounting partners for a streamlined payments and accounting workflow, greater compliance, and accurate recordkeeping.

Understanding manufacturing overhead is essential for any business, so it’s well worth learning how to use this formula in budgeting. You’ll then be able to remove any unnecessary costs for future revenue growth.

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