When a company manufactures a product, it incurs two major types of expenses: operational costs and overhead costs. Operational expenses include the direct costs associated with manufacturing a product (material, labor, etc.). Overhead costs are not directly related to production but are necessary for the company to remain operational. These expenses can include rent, utility bills, taxes, software, web services, and other digital services essential for running a modern manufacturing business.
Accurately calculating your company’s manufacturing overhead costs is important for budgeting. Including only direct or “operational” expenses in your financial plan can leave the company in a major cash crunch, as every business in every industry has to incur some overhead costs. Calculating these beforehand can help you plan better and reduce unexpected expenses.
In this article, we will discuss how to calculate manufacturing overhead and why it matters.
- Manufacturing overhead costs are indirect costs necessary for production.
- Manufacturing overhead costs are divided into three broad categories: fixed overhead, variable overhead, and semi-variable overhead.
- There’s a fairly simple calculation you can use to determine your business’s manufacturing overhead rate.
- Allocated manufacturing overhead is derived from dividing total overhead costs by total hours worked or total hours a machine was used.
What Are Manufacturing Overhead Costs?
Manufacturing overhead costs are the indirect expenses required to keep a company operational. Even though all businesses have some manufacturing overhead costs, not all of them are equal.
For a better understanding, manufacturing overhead costs are classified into three types, depending on how a business’s manufacturing processes change every production season and influence the company’s spending.
Fixed Overhead Costs
Fixed overhead costs don’t change based on the volume of production. These include rental expenses (office/factory space), monthly or yearly repairs, and other consistent or “fixed” expenses that mostly remain the same. For example, you have to continue paying the same amount for renting office or factory space even if your company decides to lower production for this quarter.
Variable Overhead Costs
Variable overhead costs are directly affected by the volume of output. So the more goods you manufacture, the bigger your expenses. Such variable overhead costs include shipping fees, bills for using the machinery, advertising campaigns, and other expenses directly affected by the scale of manufacturing.
Semi-Variable Overhead Costs
There are a few business expenses that remain consistent over time, but the exact amount varies, based on production. For example, companies have to pay the electricity bill every month, but how much they have to pay depends on the scale of production. For instance, during months of heavy production, the bill goes up; during the off season, it goes down.
With semi-variable overhead costs, there will always be a bill (a fixed expense), but the amount will vary (a variable expense).
How to Calculate Manufacturing Overhead
Calculating your monthly or yearly manufacturing overhead can help you improve your company’s financial plan and find ways to budget for such expenses. Companies with effective strategies to calculate and plan for manufacturing overhead costs tend to be more prepared for business emergencies than businesses that never consider overhead expenses.
Let’s see how you can start calculating your manufacturing overhead.
Identify Manufacturing Overhead Costs
To calculate manufacturing overhead, you have to identify all the overhead expenses (like the three types mentioned above). Sometimes these are obvious, such as office rent, but sometimes, you may have to dig deeper into your monthly expense reports to understand what’s happening.
Equation for Calculating Manufacturing Overhead
Once you have identified your manufacturing expenses, add them up, or multiply the overhead cost per unit by the number of units you manufacture. So if you produce 500 units a month and spend $50 on each unit in terms of overhead costs, your manufacturing overhead would be around $25,000. This calculation will give you a basic figure for financial planning.
If you want to calculate a percentage, divide this number by your monthly sales and multiply the figure by 100. Here’s what the equation looks like:
Manufacturing Overhead Costs / Number of Sales x 100 = Percentage
How Do You Calculate Allocated Manufacturing Overhead?
After calculating your manufacturing overhead, it’s important to allocate it properly. The generally accepted accounting principles (GAAP or U.S. GAAP) state that “all manufacturing costs—direct materials, direct labor, and overhead—be assigned to products for inventory costing purposes.”
To calculate your allocated manufacturing overhead, start by determining the allocation base, which works like a unit of measurement.
For example, you can use the number of hours worked or the number of hours machinery was used as a basis for calculating your allocated manufacturing overhead.
Here’s a formula that can help simplify this calculation:
Allocated manufacturing overhead = Total overhead costs / Total hours worked or total hours machine was used
So if your total overhead cost per product is $50 and an employee works two hours to manufacture one such unit, the allocated manufacturing overhead would be:
$50 / 2 = $25
In this case, for every product you manufacture, you allocate $25 in manufacturing overhead costs.
Frequently Asked Questions
How do you calculate applied manufacturing overhead?
You can 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 for three hours on the product, your applied manufacturing overhead for this product would be $75.
What is the predetermined overhead rate?
The predetermined overhead rate is an estimation of overhead costs applicable to “work in progress” inventory during the accounting period. This is calculated by dividing the estimated manufacturing overhead costs by the allocation base, or estimated volume of production in terms of labor hours, labor cost, machine hours, or materials.