It’s easy enough to find a simple formula to calculate your overhead costs in manufacturing, but the real trick is knowing exactly what things to include in your overhead and why.
This is because overhead is also known as the “indirect costs” associated with the product in question.
We’ll get to the formula in a little bit, but first let’s set up the building blocks of understanding exactly what is necessary for tracking overhead costs and why. This includes understanding what contributes to expenses rather than overhead or operational costs.
Then at the end, you can test your knowledge with a practice bookkeeping question so you can grasp the practical basics of calculating your own indirect costs.
What Is a Manufacturing Overhead Rate?
Everyone has expenses when running any kind of factory. Your manufacturing overhead is the expenses that are indirectly required to create your product.
This is separate from the literal material and labor costs required per item.
Overhead is tax-deductible and should also be included in income and product cost statements according to generally accepted accounting principles.
What’s Involved in Calculating Manufacturing Overhead?
The simplest way to approach quantifying your overhead costs is to divide all expenses into two groups: overhead and not overhead.
Overhead consists of expenses that contribute to product cost. Therefore, if it’s not directly related to the factory where production happens, it’s not part of the product cost and also not part of overhead.
What to Include
By definition, overhead costs include the following expenses:
- Indirect resources (materials & labor)
- Equipment depreciation and repair
- Plant necessities (power & insurance)
- Rent and taxes for your factory
- Software and digital service subscriptions
- Salaries: janitorial staff, QA staff, shop floor management
What to Exclude
Also by definition, the following costs are never included in overhead:
- Administrative costs
- Advertising costs
- Direct labor (non-managerial factory workers)
- Direct materials costs
What Are Operational Costs?
As opposed to overhead cost, which is indirect, operational cost is direct.
If you are baking a cake, operational costs would be flour, eggs, milk, sugar, etc.
An overhead cost for baking a cake would be a cake stand to display and store your finished product.
What Are Overhead Costs?
There are 3 subtypes of overhead (indirect) costs:
- Fixed Overhead is when costs do not fluctuate even when output may. An example of fixed overhead is facility rental.
- Variable Overhead is when costs are dependent upon output. An example of variable overhead is preventive machine maintenance (because the more frequently they are used, the quicker they degrade).
- Semi-Variable Overhead is when costs are partially variable and partially fixed. An example of semi-variable overhead is electricity.
How to Tell the Difference Between Operational vs Overhead Costs
With practice, you’ll get better at identifying the difference between these two types of costs, but here’s a thought experiment hack to help you remember:
Imagine your factory sells the single most coveted product in the world. It’s so incredible, so successful, that even though you haven’t done any advertising, people are going out of their way to line up at your factory doors to get their hands on your product.
This scenario represents the shortest possible route that product travels from factory floor to customer. Things like sales teams, distribution, HR, and administrative teams are unnecessary to your making a profit.
However, you still have costs, from the gas powering the machines that manufacture your incredible product to the wages of the plant managers keeping an eye on the assembly line. Heck, even in this imaginary world there’s still a landlord waiting for your rent check for the production facility (bummer). These costs are your overhead.
(monthly indirect costs) / (total monthly sales) x 100 = %
You can use this formula to calculate manufacturing overhead, which should appear on your cost of goods income statement as well as any other relevant balance sheets.
Why Do We Calculate Overhead Costs?
Plus, why can’t we calculate all this and be done? Surely it can’t change much year over year.
But that’s where you’re mistaken.
You may keep the same staff on payroll year over year, but your production is sure to be variable depending on many factors: supply & demand, materials availability, absenteeism due to a wave of illness, etc.
There are so many factors at play; almost no company has consistent output year after year.
There’s a second, more practical reason to record overhead properly, too: overhead costs are tax-deductible, so calculating them will allow you to free up extra cash flow.
Test Your Knowledge: An Example with a Solution
Take a look at the spreadsheet of total expenses below. Highlight or take note of which items should be included in overhead costs.
Are you ready for the answer? Highlighted in yellow are the overhead costs.
Breakdown of the Solution
Staff wages for maintenance, security, and quality control personnel are necessary for plant operations. Therefore they are direct overhead costs.
In contrast, the head office personnel are located off-site and while they do important work, it is not directly related to the factory and therefore not included in overhead costs.
Expenses for trade shows go towards displaying and marketing your products, which are indirect costs and thus not included in overhead costs.
Taxes, insurance, and electricity bills fall into the same category as factory maintenance and upkeep to combat machine degradation; all of these examples are indirect costs that ensure proper operation of the factory and so are counted within overhead costs.
Raw materials are a direct cost associated with the product itself, so they are operational and not overhead costs.
