September 09, 2020

Manufacturing Overhead Costs

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Manufacturing Overhead Costs

Any business activity involves costs. Money is spent on diverse processes and purchases: equipment maintenance, raw materials, packaging, transportation, etc. Three are also costs associated with management processes, where wages and salaries are a big percentage of these spendings. Such a diverse nature of costs indicates the need for their classification and separate accounting. Today, we are going to talk about manufacturing overhead.

Definition

Overhead costs are those that are associated with the production of all products of the enterprise at once, management, and sales. This is a diverse set of costs that cannot be directly attributed to specific types of finished products. Overhead costs are indirect costs that are associated with the costing and accounting item/s, but it is not economically feasible to directly attribute them to it. They are accumulated on special accounts throughout the month and then distributed between all the products manufactured in the factory. 

The most obvious goal of accounting for manufacturing overhead costs is financial planning for future profits, which are influenced by all the costs incurred by the business. If overhead costs are incorrectly accounted for, they exceed planned or necessary amounts, the cost of products or services is overstated/understated, and the level of the factory profit is reduced. Control of costs allows for their effective planning and, therefore, improves the economic situation of the company.

Components of Overheads

What is included in the manufacturing overhead? In contrast to direct costs, consisting of costs of raw materials, components and materials for production and salaries of key production personnel, overhead costs include a wider list of general production and general business costs:

  • depreciation of fixed assets, expenses for their maintenance and repair (buildings, structures, transport, etc.)
  • rent of an office and other non-production premises
  • salary of the administrative and managerial staff and taxes
  • office supplies, equipment, cleaning supplies, etc. 
  • communication services and internet
  • property and employee insurance
  • hospitality expenses
  • travel expenses
  • ensuring normal working conditions, safety measures
  • staff recruitment, training, and retraining of employees
  • advertising and information and consultation services
  • security services and fire protection.
Manufacturing Overhead Costs

Explanation of Overhead Costs Allocation

The specificity of overhead costs is such that they cannot be immediately attributed to any specific type of products or services provided, but they cannot be ignored, since this can lead to inaccuracy in pricing. Therefore, in order to determine the cost per unit of production, the overhead costs must be allocated:

  • in proportion to the salary of the main personnel,
  • in proportion to the cost of raw materials and materials,
  • in proportion to revenue, sales volumes, etc.

The organization decides on its own how this distribution will take place:

  • If the company has a large number of key production personnel, it makes sense to calculate production overheads in proportion to the payroll of the main production employees;
  • With a small number of main workers (for example, with fully automated production), it is better to distribute overhead costs in proportion to sales volumes or the operating time of production equipment (machine-hours);
  • The ratio of direct costs incurred per unit of production to the total amount of costs can also serve as the basis for distribution. This method is convenient for enterprises where direct costs significantly exceed indirect costs;

Methods of distributing overhead costs can be applied in combination, which is applicable in large enterprises that produce a very wide range of goods or provide many different services.

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Author: Charles Lutwidge

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