Indirect Manufacturing Costs

Indirect manufacturing costs are the costs of operating a production facility that are necessary to make products but cannot be traced to particular units, batches or jobs in a practical way. They include indirect materials, indirect labor and all other factory costs, such as depreciation of the plant and machinery, factory rent, utilities, property taxes and insurance on production assets, equipment maintenance and the cost of the quality control function. Taken together, indirect manufacturing costs are usually referred to as manufacturing overhead, factory overhead or factory burden.

The term distinguishes these costs from the two direct manufacturing costs, direct materials and direct labor, which can be traced to products. All three are product costs: under absorption costing, which US GAAP and IFRS require for external financial reporting, they are included in the cost of inventory and expensed as cost of goods sold only when the products are sold. Costs outside the factory, such as selling and head-office costs, are not manufacturing costs and are expensed in the period incurred.

Indirect manufacturing costs commonly include:

• Indirect materials, which are supplies used in production but too small or difficult to trace, such as lubricants, screws, thread and cleaning materials.
• Indirect labor, which is the pay of supervisors, maintenance staff, material handlers and inspectors.
• Facility costs, such as factory rent or depreciation of the building, property taxes, insurance and security.
• Equipment costs, such as depreciation, repairs and maintenance of production machines.
• Utilities, such as electricity, gas and water used in the plant.

Some of these costs are fixed, such as rent and supervisors' salaries, while others vary with production, such as power for machines. Many are mixed. Understanding this cost behavior helps with budgeting and with interpreting overhead variances.

Because actual overhead is known only after the period ends, most manufacturers apply it to products during the year using a predetermined overhead rate. The rate is estimated total overhead for the year divided by an estimated allocation base, such as direct labor hours or machine hours. A packaging plant that budgets $1,440,000 of indirect manufacturing costs and 48,000 machine hours sets a rate of $30 per machine hour. A production run that uses 300 machine hours receives $9,000 of overhead, which is added to its direct materials and direct labor to give its total product cost.

At year end, actual overhead is compared with applied overhead. If actual overhead was $1,500,000 but the plant used 49,000 machine hours, applied overhead was $1,470,000 and overhead is underapplied by $30,000. Small differences are usually charged to cost of goods sold, while larger ones are allocated among work in process, finished goods and cost of goods sold. Companies with diverse products often use departmental rates or activity-based costing to assign overhead more accurately than a single plant-wide rate.

Under IAS 2 and US GAAP (ASC 330), fixed indirect manufacturing costs must be allocated to inventory based on the normal capacity of the production facilities. If production is abnormally low, the unallocated portion is expensed in the period rather than added to the cost of the units made, which prevents inventory from being inflated in slow periods. Abnormal waste, storage costs not needed in production, and administrative overheads unrelated to production are also excluded from inventory and expensed.

Indirect manufacturing costs can be a large share of total product cost, especially in automated or capital-intensive industries, so the way they are allocated affects reported inventory values, gross margins and pricing decisions. Allocating too much overhead to high-volume products and too little to complex, low-volume ones can lead to mispricing. Because overhead is often largely fixed, producing more than can be sold also spreads it over more units and temporarily raises reported profit, which is one reason managers and auditors watch inventory build-ups closely. For decisions, managers often use direct costing internally, which treats fixed overhead as a period cost, alongside conversion costs analysis and a review of fixed costs by department.