Whenever compiling a monthly report about the company’s finances, you’ll inevitably have to include the costs of production in there somewhere. This line accounts for exactly how much you had to spend to create your products during that month.
This account includes both direct costs and indirect costs. Direct costs are pretty straightforward – they include money you had to pay for materials and money you had to pay your workers to work. All the indirect costs for the production process itself are called ‘manufacturing overhead’.
What is Manufacturing Overhead?
Manufacturing overhead is an account that includes all those costs incurred for anything other than those two direct expenditures listed above, namely:
- Direct materials expenditure
- Direct labor expenditure.
If over the course of creating a product, you had to pay extra, then this will be included in the overhead costs. It’s important that companies keep account of these things because without splitting the product costs into direct and indirect, they can mount significantly (at least nominally) without reflecting the real picture.
That being said, only the costs incurred during the production process itself are considered overhead. Administrative costs, non-operating costs, debts, and others don’t really have much to do with production itself, even though they have a say in the company’s success, of course.
Basically, if you have to pay extra so that the products can be finalized (except for direct labor and materials), then these extra payments are indirect production costs, which means they are manufacturing overhead costs. Don’t go calling all indirect production costs ‘overhead’, though, because it’s not really correct to do it.
They are usually included in the financial statements under the ‘production costs, and then listed one-by-one alongside the amount of money that went into them that month. Most companies mention them in their Balance sheets each month.
What’s included in the Overhead?
The overhead includes expenditures that directly affect the production costs of products per unit. The most common examples of overhead expenses are:
- Depreciation and amortization
- Wages for maintenance workers
- Wages for janitors
- Cost of quality control
- Factory premises rent
- Utilities.
There are many more than just these, but the most common is by far the depreciation costs. These costs are associated with the equipment (or other assets, such as materials) losing value over time. It mostly means their quality deteriorates, which increases the difficulty of creating one unit of production and also means additional repair costs.
That being said, the manufacturing overhead costs differ from business to business. These are also called ‘factory overhead costs’ because they are most often encountered with industry-oriented businesses. Although companies rarely don’t have overhead costs, they always vary in size, proportion, and composition.
Why are they needed?
It’s equally useful for the business as it is for the outsiders because production costs are obviously expenditures that the company has to incur to create a month’s quota of products. If they know exactly how much they spend on secondary expenses, then it’s much easier for them to manage these expenditures and cut their losses.
Excessive production costs, in turn, increase the price of products when customers buy them. If the producer is able to understand where they dump their money and which of these losses are not essential, then they’ll also be able to reduce the price of products without decreasing the quality of their products.
Needless to say, companies might manipulate these accounts to increase the prices without much real justification. If indirect costs are included in overall production costs without pointing out that they are, in fact, indirect, then they’ll have carte blanche for increasing the prices.
If some of them actually published what these indirect costs consist of, outsiders would see that the third of their costs are janitorial services, for some reason. That’s partially why overhead exists – so you could keep companies in check.