Manufacturing Overhead: A Small Business Guide

March 3, 2021

These expenses are found on the income statement and are components of operating income. Most income statements exclude interest expenses and income taxes from operating expenses. Such a method is useful to calculate the overhead rate for operations that do not make use of large machinery. In this method, you use the cost of direct material as the measure for determining the absorbed overhead cost.

As per the Percentage of Prime Cost Method, the below formula is used to calculate the overhead rate. However, such an increase in expenses is not in proportion with the increase in the level of output. For example, depreciation of plant and machinery, stationery, repairs, and maintenance. Thus, Direct Selling Expenses are the costs incurred at the time when the sale is made. For example, the commissions paid for selling goods or services, transaction costs, etc.

Indirect materials

To calculate overall overhead costs, divide the total overhead costs of the business in a month by its monthly sales. Direct costs required to create products and services, such as labor and materials, are excluded from overhead costs. Overhead refers to the ongoing, day-to-day expenses of operating a business that aren’t directly attributed to the level of output or specific business activity. It remains constant regardless of revenue and can have a direct impact on the sustainability, the breakeven, and the profitability of a business.

This is quite a challenging task as these are indirect costs that have no direct relation with the goods manufactured. Still, the accountant needs to allocate these indirect costs to the goods manufactured. Such non-manufacturing expenses are instead reported separately as Selling, General, and Administrative Expenses and Interest Expense on your income statement. Now, you must remember that factory overheads only include indirect factory-related costs. These do not include costs such as General Administrative Expenses, Marketing Costs, and Financing Costs. Furthermore, these costs decrease with an increase in output and increase with a decrease in output.

  • The $10,000 of manufacturing rent is part of the manufacturing overhead, which is an indirect product cost that must be assigned to units of product manufactured on a logical basis.
  • For example, the salaries for security guards, janitors, machine repairmen, plant managers, supervisors, and quality inspectors are all indirect labor costs.
  • Indirect Labor includes quality control staff, purchasing officers, supervisors, security guards, etc.
  • This is because it completely considers the time element in absorbing the overhead expenses.

Thus, the general overhead cost formula involves calculating the overhead rate. This method of classifying overhead costs goes by the definition of overheads. As stated earlier, the overhead costs are the indirect costs that cannot be directly assigned to a particular product, job, process, or work order. Semi-variable overhead is a combination of fixed and variable overhead where some costs are incurred regardless of business activity but may also increase if business activity grows. For utilities, a base amount is charged and the remainder of the charges are based on usage.

How To Categorize Overhead Expenses?

Some common examples of overhead costs companies must assume are rent, utilities, administrative costs, insurance, and employee perks. The rental cost of a building used in manufacturing is part of manufacturing overhead. As a result, the units produced include part of the rent of the manufacturing building. These items can be essential to production but do not
qualify as parts of specific products, therefore they should be accounted for
as indirect materials. This means you will need to allocate an additional $8.52 for each hour worked besides the direct labor and materials costs to accurately calculate your total cost of goods sold. Your direct labor costs from machine operators and assembly line staff are already included in your cost of goods sold.

So, for every unit the company makes, it’ll spend $5 on manufacturing overhead expenses on that unit. These costs include the physical items which are essential for manufacturing. They usually include the cost of the property where the virtual bookkeeping services manufacturing is taking place and its depreciation, purchasing new machines, repair costs of new machines and other similar costs. Accountants calculate this cost by either the declining balance method or the straight line method.

Definition of a Period Cost

The loss is reflected in the net income line item (the bottom line) whereby Tesla reported a -$389 million loss for Q and a -$742 million loss for Q2 2018. There are three ways to allocate manufacturing overhead,
each with a specific process and purpose. This can include kitchen, breakroom, and bathroom supplies, and anything needed for the factory not included in the direct product cost.


In the scenario with the soda bottler above, the facility lease payments are still owed even if no current production takes place within the facility. Likewise, the company still incurs other business expenses, such as insurance payments and administrative and management salaries. Manufacturing overhead does not include any of the selling or administrative functions of a business.

Administrative overheads

These measures include machine-hours, labor hours, direct material cost, direct labor cost, prime cost, and the number of units produced. The reason why manufacturing overhead is referred to by indirect costs is that it’s hard to trace them to the product. A final product’s cost is based on a pre-determined overhead absorption rate.

The overall taxes that are not directly tied to production would be listed separately and deducted when calculating net income or the net profit for the company. For some industries, net sales may be used in place of revenue because net sales include deductions from returned merchandise and any discounts. Revenue is the top line on the income statement whereby costs, expenses, and other items are subtracted to achieve net income or the bottom line. Manufacturing overhead is comprised of indirect costs
related to manufacturing products. It is an essential part of manufacturing
accounting and as such, it should be one of the key factors in determining the
prices of your products. For most businesses, however, administrative overhead and manufacturing overhead are two of the most common types of operating expenses.

Semi-variable costs, meanwhile, start at a baseline number and increase proportionally to output. For instance, the cost of running a manufacturing plant starts at a certain level and increases as more goods are produced. 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.

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