Manufacturing overhead costs are the indirect expenses necessary for production but not tied to a specific product. Direct costs are easy to identify; they’re the raw materials and components you use to make finished products and the wages you pay production workers. But calculating manufacturing overhead costs is trickier.
These costs significantly impact profitability and pricing strategies, so understanding and managing them is crucial to manufacturing productivity and financial planning. Let’s explore strategies for calculating and reducing manufacturing overhead.
Key takeaways
- Manufacturing overhead covers the indirect costs of production, including indirect labor, indirect materials, utilities, depreciation, insurance, and taxes.
- Learning how to calculate manufacturing overhead means dividing total overhead costs by an allocation base such as labor hours or machine hours.
- Accurate overhead allocation gives you a reliable cost of goods sold (COGS), which supports pricing that protects your margins.
- Lean processes, energy efficiency, supplier negotiations, and preventative maintenance are practical ways to reduce manufacturing overhead.
What are manufacturing overhead costs?
Manufacturing overhead costs are the behind-the-scenes expenses you incur to make production possible.
What do we mean by behind the scenes? Let’s look at some examples of manufacturing overhead.
You have the team responsible for physically making your products (a direct cost), but you also have to pay your supervisors and quality control team to keep things running smoothly and ensure the finished goods meet your standards (an indirect cost). You also pay for janitorial services and safety equipment to keep the factory clean (indirect costs).
Then there’s the money you spend on rent or mortgage payments. And don’t forget the bills for things like water and the electricity that powers your machines. It all adds up, so understanding these costs is the first step toward managing them and protecting your margins.
What costs are included in manufacturing overhead?
It’s easier to identify your overhead expenses when you break them into categories. Here are the five types of indirect costs that go into manufacturing:
- Indirect labor: The salaries and hourly wages of people like your supervisors, maintenance crew, quality control inspectors, and janitorial staff are all essential to your operation. But because their work isn’t directly tied to manufacturing your products, their wages are considered an indirect cost.
- Indirect materials: Much like indirect labor, indirect materials are the supplies that help production run without directly affecting the finished product, like lubricants to keep your machines in good working order, cleaning supplies to keep the facility tidy and sanitized, and personal protective equipment (PPE) to keep workers safe.
- Utilities and facility rent or mortgage: It takes money to keep the lights on, and that expense belongs to this category, along with your mortgage or rent for the building and utility bills for things like electricity, gas, water, and waste disposal.
- Depreciation: Your machines and equipment won’t last forever. Depreciation accounts for their wear and tear over time, spreading the loss in value out over the asset’s useful life.
- Insurance and taxes: Manufacturing overhead costs include insurance premiums for your building, equipment, and inventory, an expense that’s essential for protecting your investments. You’ll also file any property taxes you pay under this category.
How do you calculate manufacturing overhead costs?
A simple formula called the manufacturing overhead rate can help you allocate indirect costs to each unit you produce. Here’s the manufacturing overhead formula:
Manufacturing Overhead Rate = Total Manufacturing Overhead Costs / Total Allocation Base
Here’s how the formula breaks down:
- Total manufacturing overhead costs: This is the sum of costs like indirect labor and materials, utilities, depreciation, and insurance for a specific time period.
- Total allocation base: The allocation base is a measure related to how you incur overhead costs that allows you to divide those costs up, like the total number of labor hours or machine hours.
Once you’ve figured out these two numbers, just plug them into the formula to get your manufacturing overhead rate. You’ll then know how much overhead cost to assign to each unit of production based on your chosen allocation base.
Manufacturing overhead cost example calculation
Still confused? Don’t worry. We’re about to get less abstract. Here’s how the formula might play out in real life.
Say your total manufacturing overhead costs for the month totaled $50,000, and your employees worked a total of 10,000 labor hours. Your manufacturing overhead rate would be $5 per labor hour ($50,000 / 10,000 hours = $5/hour). That means that for every hour of labor that goes into making a product, you’d allocate $5 of overhead cost to that product.
Allocating overhead costs to individual units will help you accurately calculate your cost of goods sold (COGS), which includes direct materials, direct labor, and the allocated portion of manufacturing overhead. An accurate COGS is key to setting prices that cover all production expenses while ensuring profitability.
Why does calculating manufacturing overhead matter?
Manufacturing overhead flows directly into your cost of goods sold, so the way you calculate and allocate it shapes your pricing and margins. If you underestimate overhead, you risk pricing products too low to profit. Overestimate it, and you may price yourself out of a sale.
This challenge grows when input costs climb. According to NIST, producer prices for all manufacturing rose 33.4% between July 2020 and July 2022, compared with 27.1% over the prior 15 years.
Knowing how to calculate manufacturing overhead keeps your COGS accurate and your margins protected. When your rate goes stale, prices drift and profitability slips.
How can you reduce manufacturing overhead costs?
When it comes to improving your company’s profitability, knowing how to calculate your manufacturing overhead is only half the battle. Now that you know your costs, you need to find a way to reduce them, since lower overhead means higher profits. Follow these practical tips to help get your costs under control.
1. Lean manufacturing
You can significantly reduce overhead by refining your processes and optimizing your workflows. This goal is much more reachable if you embrace the lean philosophy, a manufacturing methodology that focuses on eliminating waste and maximizing value. Take things a step further by adopting approaches like lean accounting, a costing method that focuses on value streams and waste reduction for better cost visibility and control.
2. Energy efficiency
Take a close look at your energy consumption to identify opportunities for savings. The U.S. Energy Information Administration reports that U.S. manufacturers spent $191.7 billion on purchased energy in 2022. Electricity accounted for the largest share at 36%. Consider replacing things like old windows or insulation and upgrading to energy-efficient lighting, equipment, and HVAC systems to save on utility bills.
3. Supplier negotiations
Optimize your supply chain by building strong relationships with your suppliers and exploring opportunities for collaboration and cost savings. Don’t be afraid to shop around or haggle with suppliers for better deals on indirect materials and services. Every penny saved on these expenses adds to your bottom line.
4. Preventative maintenance
Maintaining machines costs money, but you’ll spend a lot less on preventative maintenance than you would on repairs and downtime if your equipment broke down. NIST puts U.S. manufacturers’ spending on maintenance and repair at $58.6 billion in 2021, so preventing breakdowns protects both your budget and your uptime. An asset management system helps you stay on top of your machines’ conditions and maintenance needs.
5. Employee cross-training
Using cross-training to empower your employees with multiple skills optimizes your workforce and reduces reliance on overtime or temporary labor when a department is short-handed.
6. Technology upgrades
Investing in automation and new technologies might not seem like a smart move when you’re trying to curb your spending. But the right tools help you streamline processes, reduce errors, and improve your efficiency. And when you combine those benefits, you’ll be surprised how much money you save in the long run.
7. Inventory optimization
Carrying excess inventory increases storage costs and ties up cash you could be spending more strategically. A good inventory management system will make it easier to conduct regular reviews of your inventory levels to identify slow-moving or obsolete items, which you can then discount or liquidate to free up space and capital. You can also reduce carrying costs and minimize waste by implementing just-in-time (JIT) inventory management, a strategy that brings the right materials in at just the right time to reduce the need for money-draining supply stockpiles.
8. Strategic outsourcing
If your indirect labor costs seem disproportionately high, consider outsourcing non-core activities like cleaning or maintenance. Hiring out these types of tasks is sometimes more cost-effective than handling them in-house.
9. Regular reviews
Overhead cost management isn’t a one-time task. Make it a habit to review your indirect expenses monthly, quarterly, or on a schedule that works for you. During reviews, analyze expenses to identify trends and pinpoint areas where you might be overspending so you can proactively address any cost creep. When it’s time to report on those trends, Fishbowl AI Insights lets you pull overhead reports in plain language, without SQL or custom report requests, and manufacturers report a 10% reduction in reporting hours with Fishbowl. Continue to refine your strategies for efficiency and savings to stay as profitable as possible.
Manage your overhead costs with Fishbowl
Once you know how to calculate manufacturing overhead, managing those costs is easier with Fishbowl, the all-in-one inventory management solution designed to help you maintain assets, run your supply chain, simplify production processes, and get real-time visibility into your inventory levels and costs. Fishbowl’s accounting-first QuickBooks sync helps you track expenses, allocate landed cost, and keep COGS clean. AJ Manufacturing, an HVAC manufacturer in Kansas City, experienced a 5% decrease in operational costs with Fishbowl. As one Fidalgo Coffee Roasters reviewer put it, “I have my costing down to the penny.” Are you ready to take control of your overhead expenses and gain end-to-end visibility over your operations? Schedule a demo of Fishbowl, the intuitive, scalable, and user-friendly inventory management platform.
Frequently asked questions about manufacturing overhead
What is not included in manufacturing overhead?
Manufacturing overhead excludes direct costs, which are tied to a specific product. That means direct materials, such as raw materials and components, and direct labor, such as production wages. It also excludes non-manufacturing costs like sales commissions, marketing, and administrative salaries, since overhead only covers the indirect costs of running production.
What’s the difference between fixed and variable manufacturing overhead?
Fixed manufacturing overhead stays the same regardless of output, such as facility rent, insurance premiums, and equipment depreciation. Variable manufacturing overhead rises and falls with production volume, like utilities or indirect materials that scale with usage. Separating the two helps you forecast costs and see how production changes affect your total expenses.
What is a good manufacturing overhead rate?
There’s no single “good” manufacturing overhead rate, because it varies by industry, product complexity, and automation level. A capital-intensive plant with expensive machinery naturally carries a higher rate than a labor-intensive shop. Instead of chasing a universal benchmark, track your own rate over time and watch for a downward trend, which usually signals improving efficiency.
Does COGS include manufacturing overhead?
Yes, cost of goods sold (COGS) includes three parts: direct materials, direct labor, and the allocated portion of manufacturing overhead. You apply your overhead rate to each unit, then fold that amount into COGS alongside direct costs. Leaving overhead out understates production costs and can push prices too low, eroding your margins.
What is manufacturing overhead cost per unit?
Manufacturing overhead cost per unit is the indirect cost assigned to a single product. You calculate it by applying your overhead rate to the allocation base each unit consumes. For example, at a $5 per labor hour rate, a product that takes two labor hours carries $10 in overhead, which helps you price accurately and compare product profitability.
Related posts
Explore these related guides for more on manufacturing costs, pricing, and inventory:
- How to Calculate Labor Cost in Manufacturing: Complete Guide
- How To Calculate (and Reduce) Your Cost of Sales
- Process Costing: Types, Benefits, Steps, and Examples
- How To Calculate Retail Price: Formulas, Examples, and Strategies
- How To Reduce Overhead Costs: 7 Strategies
- Landed cost: The hidden factor in your pricing formula
- Job costing: A complete guide for business owners
- How to Automatically Calculate Landed Costs
- The backbone of production: Exploring manufacturing inventory management