Every day, competition becomes fiercer, and customers demand more of manufacturers. This is why it’s extremely important for managers and organization leaders to understand overhead so that they can control it. There needs to be an awareness of how overhead cost is assigned to products and eventually reported on financial statements.
Overhead can be broken down into two categories: manufacturing overhead and non-manufacturing costs or administrative overhead. Manufacturing overhead refers to the costs of materials and labor and should be assigned to every unit that is produced. Administrative overhead represents any costs that occur apart from the actual function of manufacturing: the compensation of non-manufacturing staff, expenses for non-manufacturing facilities, non-manufacturing equipment depreciation, costs for vehicles that are used to transport products, and interest expenses.
The Manufacturing Overhead Formula
It’s easy to calculate your manufacturing overhead rate. First, you must identify any costs that help production to run as smoothly as possible. Then you add any indirect costs to find the total manufacturing overhead.
Once you have estimated the monthly costs of overhead, you will then need to determine what the overhead rate is. This is the monthly percentage that you will need to pay for overhead. To get this number, you divide your monthly overhead costs by the number of total monthly sales. Then, you multiply this number by 100.
Manufacturing Overhead Rate = Overhead Costs/ Sales x 100
Determining Production Costs
When calculating manufacturing overhead, one of the things you will need to do is determine production costs. Direct production costs must be related to generating revenue for the organization; this would be raw materials needed or labor costs. For example, the production costs for manufacturing automobiles would be the cost of materials like plastic or metal and also any salaries paid to the workers.
Total production costs and manufacturing overhead costs will help you to determine the cost per unit. Add up the sum of the production costs and manufacturing overhead, and divide this number by the number of units that will be manufactured in the period of time covered by these expenses.
Allocating Manufacturing Overhead
n the 1900s, it made sense to allocate manufacturing overhead as it related to direct labor expenses. There was no automation to account for, and customers didn’t demand just-in-time (JIT) deliveries. If manufacturers increased direct labor, there was also likely to be an increase in supervisors, space, and materials. If there were 15 hours of direct labor needed per unit, for example, and the manufacturing overhead costs per direct labor hour were $2, there would be $30 of manufacturing overhead allocated towards each unit.
As manufacturers began to replace direct labor with machines, factory overhead increased due to machine setup, maintenance, and depreciation. Manufacturing overhead was then allocated not on direct labor hours but on machine hours. You started to see other departments developing within manufacturing like quality control, factory administration, and maintenance. Then manufacturing overhead rates had to be developed for each production department.
Why Manufacturing Overhead Matters
Understanding manufacturing overhead costs gives you insight into the prices of materials charged by suppliers. You’ll be able to negotiate better prices with your suppliers if you have a better understanding of manufacturing overhead.
Additionally, manufacturing overhead expenses directly impact your organization, and your accounting system will require you to keep track of them. It will be important to allocate these costs to the units that your organization produces to ensure that you remain profitable.
At POWERS, we have a strong understanding of manufacturing overhead, and we focus on helping organizations to be more efficient so that they can reduce all of their expenses. Contact us today to learn more.