Why is factory overhead applied to products and jobs by manufacturing companies?

What is Manufacturing Overhead?

Manufacturing overhead is all indirect costs incurred during the production process. This overhead is applied to the units produced within a reporting period. Examples of costs that are included in the manufacturing overhead category are as follows:

• Depreciation on equipment used in the production process

• Property taxes on the production facility

• Rent on the factory building

• Salaries of maintenance personnel

• Salaries of manufacturing managers

• Salaries of the materials management staff

• Salaries of the quality control staff

• Supplies not directly associated with products (such as manufacturing forms)

• Utilities for the factory

• Wages of building janitorial staff

Since direct materials and direct labor are usually considered to be the only costs that directly apply to a unit of production, manufacturing overhead is (by default) all of the indirect costs of a factory.

What is Factory Overhead?

Factory overhead is the costs incurred during the manufacturing process, not including the costs of direct labor and direct materials. Factory overhead is normally aggregated into cost pools and allocated to units produced during the period. It is charged to expense when the produced units are later sold as finished goods or written off. The allocation of factory overhead to units produced is avoided under the direct costing methodology, but is mandated under absorption costing. The allocation of factory overhead is required when producing financial statements under the dictates of the major accounting frameworks.

Examples of Factory Overhead

Examples of factory overhead costs are noted below:

• Production supervisor salaries

• Quality assurance salaries

• Materials management salaries

• Factory rent

• Factory utilities

• Factory building insurance

• Fringe benefits

• Depreciation

• Equipment setup costs

• Equipment maintenance

• Factory supplies

• Factory small tools charged to expense

• Insurance on production facilities and equipment

• Property taxes on production facilities

The range of possible factory overhead costs can be quite extensive, depending upon the size and complexity of a factory operation and the level of detail at which costs are recorded.

Factory Overhead Variances

After factory overhead is allocated to inventory, the amount actually allocated will vary from the standard amount that had been budgeted to be allocated. This difference is caused by either a spending variance or an efficiency variance. The spending variance occurs because the actual amount of factory overhead expenditure incurred in the period was different from the standard amount that had been budgeted at some point in the past. The efficiency variance occurs because the the amount of units to which the factory overhead was allocated varied from the standard amount of production that had been expected when the allocation rate was set up.

Factory Overhead Best Practices

The use of factory overhead is mandated by accounting standards, but does not bring real value to the understanding of overhead costs, so a best practice is to minimize the complexity of the factory overhead allocation methodology. Ideally, there should be a small number of highly aggregated factory overhead accounts that are pooled into a single cost pool, and then allocated using a simple methodology. Also, the amount of factory overhead analysis and recordation work can be mitigated by charging all immaterial factory costs to expense as incurred.

Terms Similar to Factory Overhead

Factory overhead is also known as manufacturing overhead or manufacturing burden.

By definition, overhead cannot be traced directly to jobs.  Most company use a predetermined overhead rate (or estimated rate) instead of actual overhead for the following reasons:

•A company usually does not incur overhead costs uniformly throughout the year. For example, heating costs are greater during winter months. However, allocating more overhead costs to a job produced in the winter compared to one produced in the summer may serve no useful purpose.

•Some overhead costs, like factory building depreciation, are fixed costs. If the volume of goods produced varies from month to month, the actual rate varies from month to month, even though the total cost is constant from month to month. The predetermined rate, on the other hand, is constant from month to month.

•Predetermined rates make it possible for companies to estimate job costs sooner. Using a predetermined rate, companies can assign overhead costs to production when they assign direct materials and direct labor costs. Without a predetermined rate, companies do not know the costs of production until the end of the month or even later when bills arrive. For example, the electric bill for July will probably not arrive until August. If Creative Printers had used actual overhead, the company would not have determined the costs of its July work until August. It is better to have a good estimate of costs when doing the work instead of waiting a long time for only a slightly more accurate number.

Predetermined overhead rates

Predetermined overhead rates are used to apply overhead to jobs until we have all the actual costs available.  To create the rate,  we use cost drivers to assign overhead to jobs. A cost driveris a measure of activities, such as machine-hours, that is the cause of costs. To assign overhead to jobs, the cost driver should be the cause of the overhead costs, or at least be reasonably associated with the overhead costs. Just as automobile mileage is a good cost driver for measuring the cause of gasoline consumption, machine-hours is a measure of what causes energy costs. By assigning energy costs to jobs based on the number of machine-minutes or hours the job uses, we have a pretty good idea of the energy costs required to produce the job.

Most manufacturing and service organizations use predetermined rates.

To calculate a predetermined overhead rate, a company divides the estimated total overhead costs for a period by an estimated base (or expected level of activity). This activity could be total expected machine-hours, total expected direct labor-hours, or total expected direct labor cost for the period. Companies set predetermined overhead rates at the beginning of the year in which they will use them.  This formula computes a predetermined rate:

Notice how the predetermined rate is based on ESTIMATED overhead and the ESTIMATED base or level of activity.  To apply overhead, we will use the actual amount of the base or level of activity x the predetermined overhead rate.  Again, to apply overhead use this formula:

To demonstrate, assume the accountants at Creative Printers estimated overhead related to machine usage to be $ 120,000 for the year and estimated the machine usage for the year to be 60,000 machine-hours. Thus, the predetermined overhead rate would be calculated as follows:

If we want to apply overhead to jobs.  Job 106 had 875 machine hours and Job 107 had 4,050 machine hours.  The calculation for actual overhead for each job would be:

Actual Overhead

Actual Overhead costs are the true costs incurred and typically include things like indirect materials, indirect labor, factory supplies used, factory insurance, factory depreciation, factory maintenance and repairs, factory taxes, etc.  Actual overhead costs are any indirect costs related to completing the job or making a product.  Next, we look at how we correct our records when the actual and our applied (or estimated) overhead do not match (which they almost never match!).

Why is manufacturing overhead applied to products?

Why is it important to include manufacturing overhead in the cost of a job?

Is manufacturing overhead applied to all jobs?

When manufacturing overhead is applied to jobs it is added to?