Manufacturing overhead (also known as factory overhead, factory burden, production overhead) involves a company's manufacturing operations. It includes the costs incurred in the manufacturing facilities other than the costs of direct materials and direct labor. Hence, manufacturing overhead is referred to as an indirect cost.

Generally accepted accounting principles require that a manufacturer's inventory and the cost of goods sold shall consist of:

• the cost of direct materials
• the cost of direct labor
• the cost of manufacturing overhead

Note: Expenses that are outside of the manufacturing facilities, such as selling, general and administrative expenses, are not product costs and are not inventoriable. They are reported as expenses on the income statement in the accounting period in which they occur.

Some examples of manufacturing overhead costs include the following:

• depreciation, rent and property taxes on the manufacturing facilities
• depreciation on the manufacturing equipment
• managers and supervisors in the manufacturing facilities
• repairs and maintenance employees in the manufacturing facilities
• electricity and gas used in the manufacturing facilities
• indirect factory supplies, and much more

Because manufacturing overhead is an indirect cost, accountants are faced with the task of assigning or allocating overhead costs to each of the units produced. This is a challenging task because there may be no direct relationship. For example, the property taxes and insurance on the manufacturing buildings are based on the assets' value and not on the number of units manufactured. Yet these and other indirect costs must be allocated to the units manufactured.

Is the rental cost of a building considered overhead?

The rental cost of a building that is not used for manufacturing (e.g. rent for a sales office, rent for the general administrative office) is not part of the manufacturing overhead. This rent does not cling to the products and will not be part of the cost of an item in inventory. The rent for non-manufacturing facilities is immediately expensed in the accounting period when the building is rented.

If a rented building is used for both manufacturing and nonmanufacturing activities, the rent should be allocated to each (perhaps on the basis of square footage).

What is the major weakness of the traditional method of allocating factory overhead?

In reality there are many drivers of the factory overhead: machine setups, unique inspections, special handling, special storage, and so on. The more diversity in products and/or in customer demands, the bigger the problem of allocating all the costs of these various activities via only one activity such as the production machine's hours.

Under the traditional method, the costs of performing all of the diverse activities will be contained in one cost pool and will be divided by the number of production machine hours. This results is one average rate that is applied to all products regardless of the number of activities and the complexity of those activities. Since the cost of many of the diverse activities do not correlate at all with the number of production machine hours, the resulting allocations are misleading.

Is the depreciation of delivery trucks a period cost or is it manufacturing overhead?

The depreciation on the trucks used to transport materials or work-in-process between the facilities of a manufacturer is a component of manufacturing overhead. In other words, the depreciation on trucks used in the manufacturing process is assigned to the goods produced rather than being expensed directly.

Why is manufacturing overhead allocated to products?

1. Some of the goods manufactured are not sold in the same period in which they were produced.
2. The goods not sold must be reported at their cost in the company's asset entitled Inventory.
3. Accounting principles require that each product's inventory cost include both direct and indirect manufacturing costs.
4. Indirect costs by definition mean they are not directly traceable to a product and will require an allocation.
5. Some companies set their products' selling prices based on their costs. In the long run, the products' selling prices must be large enough to cover all of a company's manufacturing costs (including the indirect manufacturing costs) plus the company's selling, general and administrative expenses and a profit for the company's owners.

If a company never has inventory (because each period it sells all of its production) the allocation of manufacturing overhead could be avoided. The reason is that all of the manufacturing costs will be reported as the cost of goods sold. However, the company may still choose to allocate the manufacturing overhead for internal pricing decisions or to comply with a government contract.

What are the advantages of departmentalizing manufacturing overhead costs?

The departmentalizing of manufacturing overhead costs also allows for the computation and application of several departmental overhead cost rates instead of having a single, plant-wide overhead rate. This is important when there are a variety of products and some require many operations in a department with high overhead rates, while other products require very few operations in the high cost department. There may also be products which require many hours of processing, but they occur in low cost departments.  For instance, the assembly and packing departments of a manufacturer are likely to have very low overhead cost rates. On the other hand, the fabricating and milling departments will likely have much higher overhead cost rates.