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Overhead Costing

overhead

Overhead refers to ongoing or operating expenses necessary to running a business, outside of labor. Essentially, it concerns indirect costs such as fees related to legal or accounting, insurance, rent, supplies, utilities, and advertising.

Manufacturing overhead refers to the costs necessary to running a factory, outside of material acquisition and labor. Examples of manufacturing overhead include property rent and taxes, equipment depreciation, salaries, and utilities. This does not include administrative costs related to corporate actions such as bad debts expenses and corporate salaries.

According to generally accepted accounting principles within the United States, manufacturing overhead must be paired with costs associated with each unit. This is conducted for reporting cost of goods sold on an income statement and costs in inventory asset accounts on a balance sheet. How costs are allocated varies by business.

Each product sold by a business has costs associated due to direct material acquisition, direct labor, and manufacturing overhead. Unlike direct material acquisition and direct labor, which have a definite trace to products sold, manufacturing overhead is an indefinite expense which must be accounted for.

In order to determine the true cost of manufacturing a single product, manufacturing overhead must be accurately distributed. When the true expense of an item is determined and deducted from the item’s total profit, business owners will see if the revenue generated is enough to cover manufacturing costs, administrative costs, and generate a profit. If manufacturing costs erroneously assigned to products are too high, the higher prices might drive customers away. If manufacturing costs erroneously assigned to products are too low, the business may be selling the product for a loss.

There are several methods of assigning manufacturing overhead to product costs. The first is by assigning it based on direct labor hours worked per product. In this method, there are few variations between the products being manufactured, so hours worked are often constant. Manufacturing overhead and direct labor hours directly correlate, with more hours yielding higher overhead costs per product.

The second method of assigning manufacturing overhead is by comparing it with machine hours, as opposed to direct hours worked. Due to the variety of costs associated with purchasing, maintaining, and repairing equipment, overhead is associated with more expenses upfront. For example, if the same type of equipment is used in two factories and for different periods of time, the manufacturing overhead will be different for each according to this method. The greater the cost of the factory and equipment, the higher the overhead.

Nonmanufacturing costs, or administrative overhead, cover corporate costs necessary for running a business.  This includes selling, general, and administrative expenses as well as interest accrued. Examples include utilities for facilities outside of factories, salaries and wages for employees outside of management, and expenses associated with delivery vehicles. Nonmanufacturing costs do not need to be paired with units sold and have no influence on cost of goods sold or inventory asset accounts, as specified by generally accepted accounting principles in the United States for financial reporting. Instead, nonmanufacturing costs are reported in sales, general, and administrative expenses, and as interest expenses when incurred.

However, internally, nonmanufacturing costs are applied to products to determine pricing and whether certain products should be removed or promoted, all to determine if the product is profitable. To determine where nonmanufacturing costs should be placed, it is important to tally and measure nonmanufacturing costs. Next, determine where those costs should be assigned and then assign accordingly in the form of activity based costing. Nonmanufacturing activities include preparing and receiving invoices, financial statements, and reports, both internal and external. The costs of many of these activities must be estimated before being internally assigned to a product.

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