Definition of Manufacturing Overhead
Manufacturing overhead can be termed as the costs/expenses related to all manufacturing activities that occur during the course of production other than direct materials and direct labor.
Thus, Manufacturing costs can be termed as an indirect cost. For example, depreciation, rents and property taxes, salaries, repairs and maintenance, electricity bills are indirect costs. Manufacturing overheads are indirect in nature, and hence to some expense, these are fixed and are not affected by the number of units produced in the production facility.
Constituents of manufacturing overheads can be summed up as follows:
It incurred during the production process comes under indirect costs. It is applicable during the production of any product. Let’s go through the following types of manufacturing overheads.
- Depreciation or amortization calculated on Fixed assets like machinery, property, Land, buildings, etc.
- Taxes related to the property of any factory where production commences.
Rent of the factory or the production facility, if any
- Salaries paid to the maintenance
- Salaries paid to managers, who conduct the manufacturing
- Salaries paid to the materials management staffs
Salaries paid to quality control staff
Supplies not directly associated with products (such as manufacturing forms)
Examples of Manufacturing Overhead
Examples of manufacturing overhead are given below:
Example #1
Expenses related to a production facility are given below as –
Rent and taxes, wages to labor, salary to production manager, direct material costs, the salary of cost control personnel, depreciation of the machinery, depreciation of the car used in logistics purpose. Segregate manufacturing overhead from the above costs.
Solution:
The above costs can be categorized as:
Manufacturing Overhead: Rent and taxes, a salary of cost control personnel, depreciation of the machinery, depreciation of the car used in logistics purpose.
Others are direct costs as wages paid to labor, direct material costing are included within costs of goods sold and are termed as direct costs or direct expense.
Example #2
When salaries of employees (under manufacturing overhead) rise, the fixed costs per product also increase. Thus, the price of the product also tends to be higher. The above phenomenon leads to create abnormal pricing of the product and a decrease in the demand for the product. In such cases, leveraging tools like CPQ for manufacturing can help streamline pricing configurations, allowing manufacturers to adjust prices based on overhead and production costs more efficiently.
Advantages and Disadvantages
Here we discuss the advantages and disadvantages:
Advantages
Some of the advantages are as follows:
- Manufacturing overhead is basically indirect costs and is not directly related to the production process.
- Direct costs are most of the time variable in nature, while indirect costs remain constant. For example, insurance paid for the manufacturing facilities is fixed and does not depend on the number of units produced, while payment made of labor and quantity of raw materials are variable in nature. Hence, the cost is also variable.
- The expense related to manufacturing overheads is always fixed. Thus, finance managers who allocate the budget get a clear idea about the budget required for the manufacturing overheads even if they are unaware of the production status for the entire calendar year. This expense also plays a critical role in production planning, as it allows managers to forecast future costs and allocate resources accordingly.
- Manufacturing overheads gives an idea about the business entity. For example, if the business employs many personnel for quality check or quality control, then it gives a brief about the employer’s mindset, which appears to be good. As the person is focusing on the safety of the production unit.
- Manufacturing overhead is fixed in nature and is not related to the business’s number of units manufactured. In the case of overproduction, the costs of manufacturing overhead remain fixed, and thus it does not hinder the employer’s pocket. For example, Depreciation related to a production facility is fixed, no matter how much quantity is produced.
- The manufacturing overheads are subjected to tax deductible in nature, and hence it saves a good amount for the business.
Disadvantages
Some of the disadvantages are as follows:
- When the costs are fixed, the business has to manufacture a certain number of units to reach break-even. For example, if a business has a fixed manufacturing overhead of $1,000 and the product’s sell price is $10/ unit, then the number of units that needed to be produced will be $1000/10 or 100 units. Thus, manufacturing at least 100 units and selling all the units will allow the business to receive the minimum production costs.
- Sometimes a wrong budgetary estimate can lead to higher manufacturing overhead. Manufacturing overheads are fixed in nature, and they do not have any co-relation with the unit manufactured. If the cost accountants do a wrong calculation in doing cost sheets, then it may end up to higher expenses irrespective of the number of units produced.
- Higher manufacturing overheads leads to higher prices of the products. Thus, if the industry is giving a higher amount to overheads, there is bound to be an inflationary condition in the economy.
- Sometimes there is a negative correlation between the manufacturing overheads and the direct costs. Thus, in this scenario, the labor class tends to suffer while the salaried personnel remains on the safer side. On the other hand, the prices of the products across every segment tend to increase; thus, the real value of money falls.
- Higher product prices may lead to a shrinking in demand. We all know the demand curve in Economics. When the prices tend to go higher, the demand for the products shrinks as the affordability of the consumer decreases and consumers shift towards substitutes.
Limitations of Manufacturing Overhead
Some of the Limitations are as follows:
- In most cases, the cost accountants are involved with the budgetary allocations and unaware of the products’ current market scenario and hence fail to determine the overall demand of the product, which leads to higher manufacturing overheads and higher selling prices of the product.
- It’s fixed in nature, so the business will tend to run through losses in case of under production.
- Most of the cases constitute a higher part of the overall expenses, which might lead to lower variable costs.
Recommended Articles
This is a guide to Manufacturing Overhead. Here we discuss the introduction and example of manufacturing overhead along with its advantages and disadvantages. You can also go through our other suggested articles to learn more –
