Manufacturing Overhead

Manufacturing overhead is the total of all costs of operating a production facility other than direct materials and direct labor. It includes utilities for the plant, depreciation and maintenance of machinery, factory rent and property taxes, insurance on production assets, quality control, supervisors' salaries and small supplies that are not traced to individual products. These costs cannot be linked to specific units in a practical way, so they must be assigned to products by allocation.

The term is used interchangeably with factory overhead, whose entry explains how overhead is applied to jobs with a predetermined rate and how over- and underapplied amounts are closed. This entry focuses on the behavior of overhead costs, how they are budgeted and controlled, and how they are treated in external financial statements.

Overhead costs behave differently as production volume changes:

• Variable overhead rises and falls with output. Examples are power for machines, indirect materials, and machine maintenance that depends on running hours.
• Fixed overhead stays the same within a normal range of activity. Examples are factory rent, straight-line depreciation of the building, property insurance and supervisors' salaries.
• Mixed overhead has both elements, such as a utility bill with a fixed monthly charge plus a usage charge.

Separating overhead this way allows managers to build a flexible budget that shows what overhead should be at any level of production, rather than comparing actual costs with a single fixed figure.

In a standard costing system, the gap between actual and budgeted overhead is broken into variances. For variable overhead the main ones are:

• $\text{AR}$ is the actual variable overhead rate per hour.
• $\text{SR}$ is the standard rate per hour.
• $\text{AH}$ is the actual machine or labor hours worked.

A plant budgets variable overhead at $8 per machine hour. In a month it runs 5,000 hours and spends $42,500 on variable overhead, an actual rate of $8.50. The spending variance is ($8.50 minus $8.00) times 5,000, which is $2,500 unfavorable. If the standard for the month's actual output was 4,800 hours, the efficiency variance is (5,000 minus 4,800) times $8, which is $1,600 unfavorable, because the machines ran longer than they should have. Fixed overhead is analyzed separately, through a budget (spending) variance and a volume variance, the latter showing whether production was above or below the level used to set the rate. These figures are reviewed as part of normal budget variance reporting.

Traditional systems spread overhead over a single base such as direct labor hours or machine hours. Where products use support activities very differently, this can distort costs: high-volume, simple products are overcharged and low-volume, complex ones undercharged. Activity-based costing (ABC) addresses this by grouping overhead into activity pools, such as machine setups, purchasing and inspections, each with its own cost driver. A product that requires many setups then bears more of the setup cost.

Under GAAP and IFRS, manufacturing overhead is a product cost and must be included in inventory under absorption costing. It reaches the income statement through cost of goods sold as goods are sold. Fixed overhead is allocated on the basis of normal capacity. Under ASC 330 and IAS 2, unallocated overhead caused by abnormally low production, such as during a plant shutdown, and abnormal waste must be expensed as incurred rather than added to inventory, so that unit costs are not inflated by idle capacity. Overhead is also part of conversion costs and is distinct from selling and administrative expenses, which are never included in inventory. For internal decisions, many companies prefer direct costing, which treats fixed overhead as a period expense and shows how profit responds to sales volume.