Manufacturing Overhead Costs

Manufacturing overhead costs represent all such costs which are incurred in production of goods excluding direct materials and direct labor. Manufacturing overhead costs are further classified into fixed manufacturing overhead costs and variable manufacturing overhead costs.

Manufacturing overhead are also called factory overheads or indirect manufacturing costs. These costs are indirect in that it is impractical to directly trace them to each product. This is why manufacturing overhead costs are applied to cost of a product based on a pre-determined overhead absorption rate. An overhead absorption rate represents manufacturing overhead costs per unit of activity base (also called cost driver). Typical cost drivers are labor cost, labor hours and machine hours.

Manufacturing overhead costs are product costs (inventoriable costs) because they are not expensed out in the period in which they are incurred but are capitalized as part of the cost of inventories.

Sum of direct materials and manufacturing overhead costs equals conversion costs.

Typical examples of manufacturing overhead costs include:

• Indirect labor such as salaries of plant repairs and maintenance engineers, supervisory staff, etc.
• Indirect materials such as materials consumed in periodic maintenance of plant and machinery or any other costs which can’t be directly traced to products.
• Plant depreciation, insurance, property taxes, rent of manufacturing facilities, etc.
• Power, heating, natural gas and other utilities consumed in manufacturing.

Plant depreciation, insurance, property taxes, rent, etc. are examples of fixed manufacturing overhead costs. Typical variable manufacturing overhead costs are indirect labor, utilities, etc.

Numerical Example

You work as a Management Accountant at Silver Dragon, Inc. which manufacture articulated buses. During the last year, the company manufactured 3,000 buses and it incurred the following costs:

• Total purchases of materials amounted to $200 million, $20 million out of which can’t be directly traced to individual products/units.
• Total labor cost of $150 million including $30 million indirect labor.
• Power, fuel, rent and insurance expenses of $25 million including $5 spent on non-manufacturing activities.
• Plant depreciation of $20 million.
• Plant repairs and maintenance expense of $15 million.
• Bus customization expense of $5 million
• Transportation research and development expense of $6 million.
• Delivery costs of $4 million.

Average wage of a worker is $40 per hour and total direct labor hours worked during the year equal 3 million.

You need to work out the invoice value of one order of 50 non-customized buses delivered to Markhor Travels, Inc. Total direct materials and total direct labor hours charged to this order are $3,500,000 and 48,000 respectively.

Let’s identify which of the costs listed above are manufacturing overhead costs and arrive at a price to be charged to Markhor Travels, Inc.

Solution

The following table shows the total manufacturing overhead costs incurred by Silver Dragon, Inc.:

The direct raw materials of $180 million (=$200 million – indirect materials of $20 million), direct labor of $120 million (=$150 million - $30 million), direct bus customization cost of $5 million are not part of the manufacturing overhead costs because they can be traced directly to each order.

All of the transportation R&D and delivery costs and $5 million of power, fuel, rent and insurance are selling and general overheads but not manufacturing overhead costs. Hence, they are excluded from manufacturing overhead costs.

Because we can’t directly trace the manufacturing overhead costs to each product or unit and since direct labor hours is a good cost driver, we can find out an overhead rate as follows:

Overheads Allocation Rate = TMO/C = $105 million ÷ 3 million = $35

Where TMO represents the total manufacturing overheads and C stands for units of cost driver (activity/allocation base).

Using this rate, we can work out invoice value of the buses delivered to Markhor:

by Obaidullah Jan, ACA, CFA and last modified on Mar 23, 2019