A company incurs two types of expenses when manufacturing a product: operational and overhead costs. The direct costs associated with manufacturing a product are included in operational expenses (material, labor, etc.). Overhead costs are not directly related to production but are required to keep the company running. These costs include rent, utility bills, taxes, software, web services, and other digital services required to run a modern manufacturing business. Budgeting requires an accurate calculation of your company's manufacturing overhead costs. Because every business in every industry must incur some overhead costs, including only direct or "operational" expenses in your financial plan can leave your company in a significant cash crunch. Calculating these can help you plan better and avoid unexpected costs. This article will explain how to calculate manufacturing overhead and why it is essential.
Important Takeaways
- Manufacturing overhead costs are the indirect costs associated with production.
- Fixed, variable, and semi-variable overhead are the three broad categories of manufacturing overhead costs.
- You can determine your company's manufacturing overhead rate using a simple calculation.
- Total overhead costs are divided by total hours worked or total hours used by a machine to calculate allocated manufacturing overhead.
What Are Overhead Costs in Manufacturing?
Manufacturing overhead costs are the indirect expenses required to keep a business running. Even though all businesses have some manufacturing overhead costs, they are not all the same. Manufacturing overhead costs are classified into three types for clarity, based on how a company's manufacturing processes change with each production season and influence the company's spending.Fixed overhead expenses
Fixed overhead costs do not vary with production volume. Rental expenses (office/factory space), monthly or yearly repairs, and other consistent or "fixed" expenses that essentially remain the same are examples. For example, even if your company decides to reduce production for this quarter, you must continue to pay the same amount for office or factory space.Variable Overhead Expenses
The volume of output has a direct impact on variable overhead costs. As a result, the more goods you produce, the higher your costs. Shipping fees, bills for using machinery, advertising campaigns, and other expenses directly affected by manufacturing scale are examples of variable overhead costs.Costs of Semi-Variable Overhead
A few business expenses remain constant over time, but the exact amount varies depending on production. Companies, for example, must pay their electricity bill monthly, but the amount depends on the production scale. For example, during high production months, the bill rises; during the off-season, it falls.Note:
There will always be a bill (a fixed expense) with semi-variable overhead costs, but the amount will vary (a variable expense).How to Determine Manufacturing Overhead
Calculating your manufacturing overhead monthly or yearly can help you improve your company's financial plan and find ways to budget for such expenses. Companies with practical strategies for calculating and planning manufacturing overhead costs are more prepared for business emergencies than companies that never consider overhead expenses.Let's look at how you can begin calculating your manufacturing overhead.
Determine the Manufacturing Overhead Costs
To calculate manufacturing overhead, you must first identify the overhead costs (like the three types mentioned above). Sometimes these are obvious, such as office rent, but you may need to dig deeper into your monthly expense reports to figure out what's happening.Manufacturing Overhead Calculation Equation
Once you've identified your manufacturing expenses, total them or multiply the overhead cost per unit by the number of units produced. So, if you produce 500 units per month and spend $50 on overhead costs per unit, your manufacturing overhead would be around $25,000. This calculation will provide you with a starting point for financial planning. To calculate a percentage, divide this figure by your monthly sales and multiply the result by 100.2. Here's how the equation looks: Manufacturing Overhead Costs / Sales x 100 = PercentageHow Is Allocated Manufacturing Overhead Calculated?
It is critical to allocate your manufacturing overhead after calculating it correctly. Generally accepted accounting principles (GAAP or US GAAP), "all manufacturing costs—direct materials, direct labor, and overhead—should be assigned to products for inventory costing purposes."Tip:
To determine your allocated manufacturing overhead, first determine the allocation base, which functions as a unit of measurement. For example, you can calculate your allocated manufacturing overhead by using the hours worked or machinery used. Here's a formula to help you with this calculation: Total overhead costs/hours worked, or the machine used = allocated manufacturing overhead. So, if your total overhead cost per product is $50 and an employee works two hours to produce one of these units, the allocated manufacturing overhead is: $50 / 2 = $25 In this case, you allocate $25 in manufacturing overhead costs for each product you manufacture.Frequently Asked Questions(FAQs)
How does applied manufacturing overhead get calculated?
Calculate applied manufacturing overhead by multiplying the overhead allocation rate by the number of hours worked or machinery used. So, if your allocation rate is $25 and your employee works on the product for three hours, your applied manufacturing overhead for this product is $75.What is the standard overhead rate?
The predetermined overhead rate estimates the overhead costs applied to "work in progress" inventory during the accounting period. This is determined by dividing the estimated manufacturing overhead costs by the allocation base or the estimated volume of production in labor hours, labor cost, machine hours, or materials.