How to calculate manufacturing overheads?

The calculation of manufacturing overheads is the sum of any indirect costs incurred in manufacturing a product or creating a service. They are, therefore, very high costs in determining the profitability of products in companies.

All indirect costs for materials, labor, machinery repair, etc., must be included when calculating manufacturing overhead costs. But also other equally important expenses such as supplies, insurance, electricity, and even the depreciation of installations and machinery.

Importantly, manufacturing overheads are also known as manufacturing support costs. Depending on the type of analysis performed, the terminology may change. However, overhead costs, including administrative fees or marketing costs, will not be included in manufacturing overhead.

What is included in the manufacturing costs?

As we saw previously, the range of manufacturing overheads is wide. That is important as there may be a tendency to think that manufacturing a product will require only labor and raw materials, but this is not the case.

Some common manufacturing overheads would be:

  • Rents for the buildings where production takes place.
  • Taxes, such as property taxes
  • Insurance of manufacturing facilities and equipment
  • Possible depreciation of the value of manufacturing equipment and machinery
  • Varied salaries for maintenance workers, management workers, material handlers, quality control workers, etc.
  • Supplies that are not directly associated with the manufactured product are necessary to create products.

All these elements (and more) are important for manufacturing a product. They are therefore considered to be directly related to manufacturing in the company. Variable costs, including direct labor and direct materials, are excluded.

How are overhead rates in manufacturing calculated?

The first step in correctly calculating manufacturing overheads is to identify the manufacturing overhead costs that the business applies.

That is a delicate process as variable costs can sometimes be confused with manufacturing costs.

Once the manufacturing overheads have been estimated for a given period (e.g., a month), the overhead rate for that month can be established.

We would calculate the overhead rate by dividing the monthly overhead by the total monthly sales and multiplying it by 100.

Thus, the formula would be as follows:

Monthly overheads/total monthly sales x 100

For example, if overheads are $100,000 and revenues are $300,000, the result would be: $100,000/300,000= 0.33 x100= 33.3%.

That means 33% of the company’s monthly income is spent on overheads. It is generally understood that low manufacturing overheads imply that the company is efficient. On the other hand, high manufacturing overheads may indicate efficiency problems or even poor cost/output ratios.

It is generally understood that it is necessary to use manufacturing overheads to create cost budgets. These budgets allow us to optimize the relationship between what it costs to make a product and the price at which we sell it.

Where and how are allocations counted and how are they calculated?

In GAAP accounting principles, manufacturing overhead is placed in direct labor and direct materials costs when determining the price of a good sold and an inventory value.

The calculation, when to comply with GAAP, requires some steps to be followed to ascertain each product’s final manufacturing cost.

The first step is the calculation of all indirect manufacturing costs. Some fixed expenses, such as rent, may have to be included, but others will vary depending on whether production is increased or decreased.

The next step would be to choose an allocation base. Allocation bases are those on which companies allocate costs to products. Typically, metrics such as machine hours or direct labor hours are used.

Afterward, the indirect cost must be divided by the allocation base. From this division comes the calculation of the number of indirect costs per unit of output.

Further, it is necessary to calculate the total allocation base through the maintenance and payroll records. The payroll records show the amount of direct labor during the period under analysis.

The last step would be dividing the base allocation value by the number of units produced. In this case, we get the additional manufacturing overhead for each branch of the selected allocation base.