Manufacturing and Non-Manufacturing Overheads
Overhead costs are indirect costs — costs that cannot be directly traced to a specific product or service, but must still be accounted for as part of the total cost of production or operations. Correctly allocating overheads is essential for accurate product costing, pricing decisions, and profitability analysis.
Manufacturing Overhead (Factory Overhead)
All manufacturing costs except direct materials and direct labour:
- Factory rent and utilities
- Depreciation on production equipment
- Factory supervisor salaries
- Factory insurance
- Machine maintenance and repairs
- Indirect materials (lubricants, small tools)
Overhead Absorption: Applying Overhead to Products
Since overheads cannot be directly traced to products, they are allocated using a predetermined overhead rate (POHR):
POHR = Budgeted Overhead ÷ Budgeted Activity Base
Common activity bases: direct labour hours, machine hours, direct labour cost.
Budgeted factory overhead: $1,200,000. Budgeted direct labour hours: 40,000.
POHR = $1,200,000 ÷ 40,000 = $30 per direct labour hour
If a product uses 2 DLH, it absorbs $60 of manufacturing overhead.
Over/Under-Absorbed Overhead
If actual overhead differs from absorbed overhead, the difference is “over-absorbed” or “under-absorbed” and is adjusted at year-end (charged to cost of goods sold or spread across work-in-progress, finished goods, and COGS).
Non-Manufacturing Overhead
Costs incurred outside the factory floor — selling expenses, administrative expenses, and distribution costs. Under absorption costing (required for external reporting), only manufacturing costs are inventoried; non-manufacturing costs are period costs, expensed immediately in the income statement.
| Cost Type | Examples | Treatment |
|---|---|---|
| Manufacturing overhead | Factory rent, depreciation | Product cost — inventoried |
| Selling expenses | Sales salaries, advertising | Period cost — expensed immediately |
| Admin expenses | CEO salary, office rent | Period cost — expensed immediately |
Lesson Summary
- Manufacturing overheads are allocated to products via a predetermined overhead rate.
- POHR = Budgeted Overhead ÷ Budgeted Activity Base (DLH, machine hours, etc.).
- Non-manufacturing costs are period costs and never inventoried under absorption costing.
Product Costs vs. Period Costs: The Manufacturing Distinction
| Category | Definition | When Expensed | Examples |
|---|---|---|---|
| Product Costs (inventoriable) | Costs that ‘attach’ to the product and go onto the balance sheet as inventory | When inventory is sold (COGS) | Direct materials, direct labor, manufacturing overhead |
| Period Costs | Costs expensed immediately as incurred — not tied to production | In the period incurred | Sales commissions, CEO salary, advertising, office rent |
Overhead Allocation: The Full Process
| Step | Action | Example |
|---|---|---|
| 1. Identify overhead costs | List all indirect manufacturing costs for the period | Factory rent $120K, supervisor wages $80K, utilities $40K = $240K total |
| 2. Choose allocation base | Select a driver that correlates with overhead consumption | Machine hours, direct labor hours, or direct labor cost |
| 3. Calculate predetermined rate | POHR = Budgeted Overhead ÷ Budgeted Activity Level | $240,000 ÷ 20,000 machine hours = $12/machine hour |
| 4. Apply to jobs/products | Multiply POHR × actual activity for each job | Job #201 used 150 hrs → $12 × 150 = $1,800 overhead applied |
| 5. Reconcile at year-end | Compare applied overhead to actual overhead | Applied $236,000 vs actual $240,000 → $4,000 underapplied |
Product Cost Build-Up: Job #201 Example
| Cost Element | Amount |
|---|---|
| Direct Materials | $8,500 |
| Direct Labor (200 hrs × $18) | $3,600 |
| Manufacturing Overhead Applied (150 mach hrs × $12) | $1,800 |
| Total Product Cost (Job #201) | $13,900 |
Waiting until year-end to know actual overhead before pricing products would make it impossible to set selling prices. Predetermined rates let businesses price jobs in real-time using estimates, then reconcile at year-end. This is standard practice across manufacturing, construction, and professional services.
Manufacturing Overhead Practice Worksheet — Download, print, and complete to reinforce this lesson.