How to Measure and Optimize Manufacturing Overhead Costs

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Everybody knows about the direct costs of their inventory, such as paying a vendor to stock your shelves or labor costs to manufacture the final product. But it can be easy to overlook manufacturing overhead costs—behind-the-scenes labor and production needed to create the final product.

Often referred to simply as “overhead costs,” these are indirect expenses incurred in the production process of goods or services. Overhead costs are applied to the units produced within a reporting period and capitalized as part of the finished good to be recognized on the balance sheet until sold.

Manufacturing Overhead Costs Examples

Examples of overhead costs include, but are not limited to:

  • Depreciation: Usage cost (wear and tear) of the machinery, equipment, and buildings used in the production process over their useful life.
  • Property taxes assessed on the assets used in the production process, and insurance premiums for the facilities and equipment.
  • The cost of renting or leasing the manufacturing facility and equipment, as well as expenses for utilities such as electricity, water, and gas required for the production process.
  • Indirect labor: The wages and benefits of employees who do not work on the production line directly but are essential for the manufacturing process. These may include maintenance personnel, supervisors, quality control inspectors, janitorial staff, human resources, accounting, and management.

Methods for Allocating Overhead

Methods of allocating overhead are up to the individual company. They can be based on fixed inputs generated during the production process such as the labor content of a product, the machine production hours, or the square footage used by production equipment. Management can also use multiple allocation methods, depending on the inputs, as long as their approach is consistent. Using the fixed inputs of production and applying them to indirect costs is known as the calculated overhead rate.

Calculating Manufacturing Overhead

The calculation of the overhead rate is based on the period of production. For example, if you wanted to evaluate the overhead rate for the inventory produced during one week, you would need to total the indirect overhead costs for that week, then divide by the fixed inputs used to measure productivity for the same period. If you use direct labor as your fixed measure, you could analyze the efficiency of overhead costs for every dollar spent on direct labor for the week.

Why Are Overhead Costs Important?

For financial statement reporting, Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) require the assignment of manufacturing overhead as part of production costs. Overhead costs must be capitalized as part of the inventory asset account on the balance sheet. They are subsequently recognized on the income statement as the operating cost of goods sold once the finished product has been sold to the customer.

By tracking and recognizing overhead costs and applying them to the manufactured inventory, management is able to ensure several factors:

  • Costs associated with production are matched to the point of sale of the manufactured product.
  • Unsold inventory is recognized at the accurate value for the acquisition cost and associated inputs.
  • Management will ensure goods can be marked up at a proper margin to ensure they perform at a profitable level.

Everything flows to the bottom line, and understanding your overhead costs can lead to improved operating efficiencies and a larger profit. Proper cost management and overhead cost awareness can help management and owners ensure they are prepared for whatever the market throws at them.

The Future of Cost Tracking

Tracking fixed inputs and overhead costs manually can be a time-consuming and tedious project. If not already implemented, you should consider investing in a time and material inventory and accounting ERP system that can integrate and automatically apply overhead costs to production inventory.

Further, developing AI technologies can be used to increase cost savings across overhead inputs by identifying inefficiencies and streamlining processes, allowing organizations to better recognize growth opportunities. AI tools are being readily adopted into:

  • Defect monitoring: the ability to identify and correct defects before completion, minimizing scrap, rework, and replacements.
  • Predictive and preventative maintenance: Using machine learning to identify and prevent costly maintenance issues in a timely manner before disaster strikes.
  • Forecasting accuracy: Analyzing historical data and current market trends to generate predictive modeling and improve forecasted margins to manage the supply chain and operating metrics.

The rise of AI in production capacities offers limitless opportunities for owners to expand their future capabilities.

To learn more about calculating and optimizing manufacturing overhead costs, contact us.