Beyond the direct costs of raw materials and labor, every product also presents a company with additional costs behind the scenes to keep the production lines rolling. They are called manufacturing overhead costs, and understanding them is essential for managing profitability and ensuring the accuracy of the prices of products.
What is Manufacturing Overhead?
In other words, manufacturing overhead (sometimes referred to as factory overhead or production overhead) is the total amount of indirect costs that are associated with the production process. These are the costs that assist production and cannot be directly traced to a particular item.
For example, salaries of factory supervisors, machine maintenance costs, factory rent, and electricity used in production comprise part of the manufacturing overhead. Though these are not directly put into one unit of product, they are vital in ensuring that operations flow as smoothly as possible.
These costs fall under indirect manufacturing costs in accounting terminology, which, when added to direct labor and direct materials, give you the total manufacturing cost.
Components of Manufacturing Overhead
To fully understand manufacturing overhead, it's helpful to know what comprises it. Some common components are:
- Indirect labour: Salaries of the employees who assist in production and who do not touch the product directly, for instance, supervisors or maintenance employees.
- Indirect materials: These are items used in the production process but not part of the final product; examples include lubricants, cleaning supplies, and small tools.
- Factory utilities: Electricity, water, and heating used in the manufacturing area.
- Depreciation of Machines and Equipment of the Factory: Wear and Tear.
- Factory rent and insurance: The cost of maintaining the production facility.
All these together form the foundation of your manufacturing overhead.
The Manufacturing Overhead Formula
The formula commonly used is the manufacturing overhead rate, which helps a firm allocate overhead to products effectively.
Formula:
Manufacturing Overhead Rate = (Total Manufacturing Overhead ÷ Total Direct Labor Cost) × 100
This rate indicates the overhead applied for every rupee or dollar of direct labor cost.
Example:
If your total manufacturing overhead is ₹500,000 and your total direct labor cost is ₹1,000,000, then:
Manufacturing Overhead Rate = (₹500,000 ÷ ₹1,000,000) × 100 = 50%
This means that for every ₹1 spent on labor, ₹0.50 is added as overhead cost.
Accounting for Manufacturing Overhead
Accounting for manufacturing overhead ensures that each indirect cost is properly recorded and distributed across products. Here's how it generally works:
- Budgeting and Estimation: companies estimate annual overhead costs and calculate an overhead rate.
- Application: The estimated overhead during production is applied to each product using this rate.
- Adjustment: At the end of the accounting period, the actual overhead costs are compared with the applied amount. In case there is any difference, the adjustment is made as overapplied or underapplied overhead.
Accurate overhead accounting assists in determining the true cost of production to avoid either underpricing or overpricing goods.
Examples of Manufacturing Overhead
Let's consider a small furniture factory. It has the following costs:
- Factory rent: ₹1,00,000 per month
- Machine maintenance: ₹25,000
- Factory supervisor salary: ₹50,000
- Indirect materials: ₹10,000
- Utilities: ₹15,000
The total manufacturing overhead = ₹2,00,000.
If the firm's total direct labour cost amounts to ₹4,00,000, then its overhead rate would be 50%. In other words, for every ₹1 spent on labour, ₹0.50 in overhead costs is added to the price of the product.
Automating Overhead Calculations with ERP
Manually tracking the overhead could get very complicated, especially for bigger operations. This is where an ERP system, such as Bigsun ERP, proves its value.
Bigsun simplifies accounting for manufacturing overhead through:
- Automating the tracking of indirect costs.
- Real-time calculation of manufacturing overhead rates.
- Integration with production and accounting modules to ensure accurate costing.
- Easy reporting to analyze trends in costs and improve efficiency.
With Bigsun ERP, businesses can avoid manual errors, keep full transparency, and make data-driven pricing decisions that reflect true production costs.
Final Thoughts
Manufacturing Overhead: While manufacturing overhead does not appear on the production floor, this overhead has a major role in determining the actual cost of goods. It helps a business understand how to keep budgets in check, control waste, and set competitive pricing. By automating the tracking of overheads using tools like Bigsun ERP, companies can focus more on efficiency improvements rather than manual calculations and thus achieve smarter operations with healthier profits.
