Factory Overhead

Factory overhead is the total of all costs of running a production facility other than direct materials and direct labor. It includes items such as factory rent or depreciation on the factory building, depreciation and maintenance of machines, power and utilities for the plant, property taxes and insurance on production assets, the wages of supervisors, cleaners and maintenance staff, and small supplies such as lubricants and glue. It is also called manufacturing overhead, factory burden or production overhead.

These costs are necessary to make products, but they cannot be traced to individual units in an economical way. Under absorption costing, which US GAAP and IFRS require for external reporting, factory overhead must nonetheless be included in the cost of inventory. It is one half of conversion costs, the other half being direct labor, and is one of the three basic elements of product cost in cost accounting.

Overhead contains both fixed costs, such as rent and salaried supervision, and variable costs, such as electricity for machines, which rise with output. Some costs are mixed. What overhead does not include is equally important: selling costs, such as sales commissions and advertising, and general administrative costs, such as the head-office finance team, are period expenses charged directly to the income statement rather than to inventory. Only costs connected with the factory belong in factory overhead.

Because actual overhead is not known until the end of the year and fluctuates from month to month, most companies apply it to production using a predetermined overhead rate set at the start of the year:

The $\text{Estimated total factory overhead}$ is the budgeted overhead for the year, and the $\text{Estimated total allocation base}$ is a measure of activity believed to drive overhead, such as direct labor hours or machine hours. Suppose a furniture maker budgets $600,000 of overhead and 40,000 machine hours. Its rate is $600,000 divided by 40,000, or $15 per machine hour. A batch of tables that uses 120 machine hours is charged $1,800 of overhead, which is added to its direct materials and direct labor to give its total product cost. Firms with many products and varied processes often refine this approach with activity-based costing, which uses several cost pools and drivers instead of one plant-wide rate.

At year end, the overhead applied to products rarely matches the overhead actually incurred. If the furniture maker actually used 42,000 machine hours, it applied $630,000 of overhead. If actual overhead was $612,000, overhead is overapplied by $18,000; if it had been $645,000, overhead would be underapplied by $15,000. Small differences are usually closed out to cost of goods sold. Large ones are prorated among work in process, finished goods and cost of goods sold so that each reflects actual cost more accurately.

Managers investigate the difference as part of variance analysis. A spending variance shows whether actual costs were higher or lower than expected for the activity level achieved, while a volume variance shows the effect of producing more or less than the normal or budgeted capacity. Under IFRS (IAS 2) and US GAAP, fixed overhead must be allocated based on normal capacity, so the cost of unused capacity in a slow year is expensed rather than piled into inventory.

Overhead is often the largest and fastest-growing part of product cost in automated factories, so the way it is spread can change which products look profitable. A single rate based on labor hours can overcost simple, high-volume products and undercost complex, low-volume ones. Poor allocation can lead to mispricing, misleading margins and bad decisions about which product lines to drop. For financial reporting, the main risk is that overhead is inconsistently applied, causing inventory and profit to be misstated from one period to the next.