What is Manufacturing Overhead?

Manufacturing overhead is all indirect costs incurred during the production process. This overhead is applied to the units produced within a reporting period. Examples of costs that are included in the manufacturing overhead category are as follows:

Depreciation on equipment used in the production process
Property taxes on the production facility
Rent on the factory building
Salaries of maintenance personnel
Salaries of manufacturing managers
Salaries of the materials management staff
Salaries of the quality control staff
Supplies not directly associated with products (such as manufacturing forms)
Utilities for the factory
Wages of building janitorial staff

What is the Manufacturing Overhead Rate?

A manufacturing overhead rate is the standard amount of factory overhead cost assigned to each unit of production. This information is used in accrual-basis accounting to assign factory overhead costs to units that have been sold and to units that are stored in inventory. When goods are sold, the factory overhead costs assigned to them are then charged to expense. The concept is not used for any decision-making activities, since it is a made-up number that is only intended to apply overhead costs as per the dictates of the accounting standards.

How to Calculate the Manufacturing Overhead Rate

The manufacturing overhead rate is derived from the most recent history of factory overhead costs actually incurred, perhaps for the past year or (more accurately) for the past three months on a rolling basis. These overhead costs are then divided by an estimate of the average number of units expected to be produced in the forecast period to arrive at the manufacturing overhead rate. This amount is loaded into the bill of materials for each product that a business manufactures, so that the standard rate is automatically assigned to each unit as it is produced.

Problems with the Manufacturing Overhead Rate

It is quite possible for the manufacturing overhead rate to diverge from the actual amount of overhead incurred, due to estimation errors. The result is either the over-application or under-application of factory overhead to units produced. This will require a correcting entry to bring the applied amount of manufacturing overhead into alignment with the actual amount of manufacturing overhead costs incurred.