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

While useful, the manufacturing overhead rate has some inherent problems, which are as follows:

Lack of allocation accuracy. Using a single cost driver (e.g., labor hours) can result in inaccurate allocations if overhead costs are driven by multiple factors.
Cost to update. Calculating and updating the rate requires ongoing tracking and adjustments to reflect actual costs.
Changes in activity levels. If production levels change drastically, the predetermined rate may no longer be accurate.
Limited usefulness. The rate focuses on overhead cost allocation, rather than understanding or controlling those costs.
Not useful in complex environments. Companies with diverse product lines may find the rate too simplistic, leading to over- or under-costing certain products. Further, customized or low-volume products may consume overhead differently, making the single rate inadequate.
Distorts product costs. Incorrect overhead cost allocations can lead to flawed pricing decisions, uncompetitive pricing, or incorrect profitability analyses.