Manufacturing overhead costs are a significant category of expenses for many manufacturers and job shops today.
Manufacturing overhead costs take on many definitions and can be allocated in several ways, thus getting a sense of what costs are in manufacturing overhead and just how much manufacturing overhead represents (for the company as a whole or its jobs, products, or services) can be a difficult challenge.
In this article we’ll define what exactly are manufacturing overhead costs, how to perform a basic allocation of those costs, and provide examples of allocating manufacturing overhead to jobs, products, and services.
Once establishing a basic understanding of manufacturing overhead and how it works, we’ll review the best way to reduce manufacturing overhead costs.
Manufacturing Overhead Defined
Manufacturing overhead is defined as the costs required to produce a job, product, or service that are not directly related and traceable to a specific job, product, or service which are apportioned to the jobs, products, or service based on some method of cost allocation.
Manufacturing overhead is also known as factory overhead, factory burden, production overhead and indirect cost.
There exist many forms of allocating manufacturing overhead (see our article on the various cost accounting methods). One method we discuss is ABC or Activity Based Costing.
Manufacturing Overhead Costs Include
Common questions given the broad definition of manufacturing overhead are questions such as:
- What costs go into manufacturing overhead?
- What costs are included in manufacturing overhead?
- What costs are excluded from manufacturing overhead?
- What does manufacturing overhead consist of?
Examples of What Manufacturing Overhead Includes
To answer these questions, let’s review a few types of cost that are included and some costs that are excluded in the chart below:
How to Calculate Manufacturing Overhead Costs
Other questions related to manufacturing overhead deal primarily with the manner of allocation, such as:
- When are manufacturing overhead costs allocated?
- How to calculate manufacturing overhead costs?
- How to allocate manufacturing overhead costs?
- How to calculate manufacturing overhead cost per unit?
- How to calculate manufacturing overhead cost applied to jobs?
Manufacturing Overhead Rate Formula
To answer this set of questions dealing with the method of allocation, we’ll briefly explain how the allocation process works.
For a more detailed discussion of the various allocation methods, see our article on costing methods.
Most forms of cost accounting take all the manufacturing costs and create a “cost pool.” This cost pool is then divided by the total unit number of a “cost driver.”
Typically, a cost driver would be direct labor hours, machine hours, or some other such basis for allocating costs.
Once this is done, the result is the manufacturing overhead rate. This rate is then applied to jobs, products, or services to establish the manufacturing overhead cost per unit (job, product, or service).
Manufacturing Overhead Rate Formula Example
As an example, suppose a company has $1,000,000 of manufacturing overhead annually.
Also, let us suppose it selects direct labor hours as its cost driver, which the company has 10,000 direct labor hours each year.
Thus, the $1,000,000 of manufacturing overhead divided by the 10,000 direct labor hours would yield a manufacturing overhead of $100 of manufacturing overhead per direct labor hour.
Manufacturing Overhead Examples
Now that we understand what is included and excluded from manufacturing overhead along with knowing how to do a basic allocation, let’s look at some examples of applying manufacturing overhead to jobs, products, and services.
After gaining an understanding from these examples we’ll take a step back and think about what these calculations are actually telling us as opposed to what we think they are telling us.
How to calculate Manufacturing Overhead for Jobs Example
To calculate manufacturing overhead for jobs, the first step would be to calculate the manufacturing overhead rate, as we did previously. For purposes of this and other examples we’ll utilize the $100 per direct labor hour we previously calculated.
Suppose Job #911 has 17.5 of direct labor hours reported on it. The formula to calculate the manufacturing overhead on the job would be:
|17.5 direct labor hours|
|x||$100 manufacturing overhead rate|
|=||$1,750 manufacturing overhead on job|
This is how manufacturing overhead is calculated for jobs.
How to calculate Manufacturing Overhead for Products Example
Calculating manufacturing overhead for products can be done the same way as for jobs. The total hours of the cost driver (direct labor in our examples) is multiplied by the manufacturing overhead rate to determine the manufacturing overhead on the job.
Alternatively, manufacturing overhead cost per product can be calculated for a production lot or batch of products.
Suppose Lot #626 yielded 3,400 units of product LZ4. It took 435 direct labor hours to produce Lot #626.
The formula to calculate the manufacturing overhead on the job would be:
|435 direct labor hours|
|x||$100 manufacturing overhead rate|
|=||$43,500 manufacturing overhead for Lot #626|
|÷||3,400 products produced in Lot #626|
|=||$12.79 manufacturing overhead cost per product|
This is how manufacturing overhead is calculated for jobs.
How to Calculate Manufacturing Overhead for Services Example
Services would not typically be thought of as having manufacturing overhead associated with them.
However, for toll manufacturers this is their primary business, providing their manufacturing capabilities as a service to their customers.
Suppose Service Job #787 has 406.4 of direct labor hours reported on it. The formula to calculate the manufacturing overhead on the service job would be:
|406.4 direct labor hours|
|x||$100 manufacturing overhead rate|
|=||$40,6400 manufacturing overhead for the service|
This is an example of how manufacturing overhead can be allocated to services.
The Ultimate Way to Reduce Manufacturing Overhead Costs
(scroll up to read from the top of this article)
Now that we know what manufacturing costs are defined as, how to calculate them and have seen examples demonstrating how the manufacturing overhead allocation process works, let’s dive into the ultimate way to reduce manufacturing overhead costs.
The ultimate way to reduce manufacturing overhead costs is to simply make more.
More products. More jobs. More services. It’s just that simple.
When the level of production goes up the unit costs of jobs, products, and services go down. They must decrease. There is no mathematical alternative.
Recall the formula for manufacturing overhead per unit is:
Manufacturing Overhead Costs / Units Produced = Manufacturing Overhead Cost per Unit
Thus, if the denominator goes up, the quotient must go down. It’s a mathematical law that applies to manufacturing overhead costs as it does any other math equation.
Let’s now examine the magnitude of simply producing more to better understand its true impact.
For instance, suppose manufacturing overhead is $1,000,000 annually and our company produces 1,000 jobs. Each job would have an overhead cost of $1,000 (assuming a simple, flat allocation of manufacturing overhead costs over the number of completed jobs).
Suppose we completed 2,000 jobs. The manufacturing overhead per job drops to just $500. That’s cutting manufacturing overhead costs in half!
Now perhaps it seems a bit extreme to double the number of jobs completed and cut your manufacturing overhead costs in half. What if we have a 20% increase, that seems much more believable doesn’t it?
The same effect occurs. With a 20% increase in the number of jobs completed we would have the $1,000,000 of manufacturing overhead divided by 1,200 jobs, for a manufacturing overhead cost per job of $833.33.
This is why we’re so focused on creating flow. You have lower costs and earn more margin, both of which add up to making more money with the same people and resources.
In fact, Velocity Scheduling System has been designed to help job shops get more done with the same people and resources by managing the flow of jobs through you shop.
Nothing else can reduce manufacturing overhead costs to the extent that simply producing more can, both in terms of its magnitude of impact and in terms of the confidence we can have in the fact that costs will go down.
Furthermore, the results are the same, no matter the method of accounting you use.
If you use traditional cost accounting, the answer is very simple: more jobs, products, and services produced result in a smaller cost per job, product, or service.
If you utilize activity-based costing, it’s a very safe assumption that in order to produce more jobs, products, or services you will need more activities, across all levels of the organization.
More activities mean lower activity costs. Lower activity costs mean lower unit costs, for jobs, products, and services.
Simply producing more is indeed a surprising silver bullet to the problem of how to reduce manufacturing overhead costs.
Extending the case for making more (jobs, products, or services) would be examining what happens to jobs, products, and services as more is produced.
For instance, on jobs, as the manufacturing overhead cost per job decreases, the gross margin on the job increases.
Thus, as we produce more, our jobs become more profitable.
Not only that, as we produce more, we’re able to earn more gross profit in total using the same resources.
We have the same labor, same overhead, same building, same machines, etc.
So simply by producing more with the same resources we have created a virtuous cycle consisting of earning more profit per job as well as earning more gross margin in total by completing more job.
A true win-win.
Now there is one assumption underlying the solution of making more: we sell what we make!
It obviously would not be beneficial to simply park our efforts into inventory and watch as we pour more and more money into inventories each month.
Yes, the per unit costs are decreasing, but this does not actually generate more sales or total margin for us.
Problems Associated with Reducing Manufacturing Overhead
Now, it would not be unreasonable to assume that if cost accounting reports more gross margin per job and in total along with lower manufacturing overhead costs per job cost accounting would also encourage actions that lead to such results.
Unfortunately, nothing could be further from the truth.
How can this be?
It seems that I’m suggesting the same system can encourage different (and even contradictory!) actions.
It’s true. Dr. Goldratt would famously say, “A building cannot have two heights!”
So how then is it that cost accounting systems can lead us to increase production (make more) and at the same time lead us to decrease production (make less)?
I’m glad you asked.
We have laid out the case for making more: more margin in total, more margin per job, less overhead cost per job.
The case for making less emerges as we begin to take the actions at the local level that could lead to producing more.
What if you bought a more expensive raw material to use in your production process? Suppose this more expensive material allowed you to run your machines at a faster rate and complete more jobs.
What would cost accounting say?
It would say more material cost means less gross margin. Less gross margin is a negative result (i.e. DON’T BUY THE EXPENSIVE MATERIAL!)
Further, most folks would agree, if you put more workers on a job the job would get done faster and more jobs in total would be produced.
What would cost accounting say?
Cost accounting (no matter the method) would say it took “more labor cost” to complete the jobs, therefore, each job had a lower gross margin than if we were to simply put less workers on the jobs.
And what about reducing overheads? Well cost accounting would suggest increasing batch sizes. Now at first glance, this appears to be in the correct direction (make more).
However, what happens when batch size increases? It takes longer to process each batch.
What happens when it takes longer to process each batch? It takes longer to get a complete set of parts to a welding or assembly operation.
What happens when it takes longer to get all the necessary parts to a welding or assembly operation? We get less jobs finished.
Less, not more, is done.
You see, this is a problem that strikes to the heart of the problem with cost accounting, across all its various methods. The actions needed at a global level (make more) are not the actions needed at a local level (make less).
The same system gives different answers! And what do we intuitively know? The actions needed for the company as a whole should be the same actions needed at the shop floor level.
They are literally the same place! So why would the same place need different actions to produce the same result?!
That’s like saying you need to eat healthy and increase your daily intake of doughnuts to lose weight. It just doesn’t add up.
As mentioned earlier, let’s now stop, take a step back and truly think about what manufacturing overhead is really telling us.
|Job #911||Product LZ4||Service Job #787|
Each job, product, or service has overhead assigned to it from the examples. We performed the calculation correctly, yet the result is wrong.
Why is the result wrong? Well, think about what the result is actually telling us.
By placing overhead on the job, product, and service listed above, the result is saying that we have incurred these costs to provide the job, product, and service. But is that true? NO!
Think back to where we listed the examples of the costs which are included in overhead. Would any of these costs be saved by not producing the job, product, or service in the examples? NO!
So how then is it that cost accounting says manufacturing overhead is incurred for the job, product, or service yet we cannot save these same costs by not working on the job, product or service?
If doing the work causes the cost to be incurred, then surely NOT doing the would work would be we would NOT incur the cost?
Unfortunately, the story we get from allocating manufacturing overhead is not what happens in reality.
Manufacturing overhead creates confusion, distorted decisions, and conflict in many organizations and it’s easy to see why.
Think about the last time you quoted a job.
Was it quoted the same way as the the previous RFQ your responded to?
If this was a repeat job or part, was it quoted the same way as it was before (not likely, despite have the previous estimate!)?
It’s likely some costs were included that were previously excluded, or vice versa. It’s also likely each time you try to engage your estimators in a discussion to understand just how they arrived at their conclusions, they become defensive and provide an exhaustive justification of their “costing.”
You then walk away from the conversation worn out and you’re no closer to understanding their estimates than when you began.
The reason there are shifting definitions, methods, conclusions, and approaches to manufacturing overhead is that is not being managed in a consistent and logically correct manner (the same is true of direct labor in fact. See our course, “How Cost Accounting Distorts Decisions” for more information).
The Best Way to Reduce Manufacturing Overhead Costs
This now brings us to the best way to reduce manufacturing overhead costs. The best way to not have manufacturing overhead costs is simply to get rid of the entire concept of manufacturing overhead in the first place.
This is exactly what Throughput Accounting does and why it provides such a powerful foundation for Velocity Pricing System.
You see, Throughput Accounting does not define manufacturing overhead as a category of expense at all. Throughput Accounting has two types of expenses: Totally Variable Costs and Operating Expenses.
Totally Variable Costs (TVC) are those costs which are incurred to produce a job, product, or service and alternatively are saved if we do not produce a particular job, product, or service (unlike manufacturing overhead!).
Operating Expenses (OE) are all other costs that are not a TVC.
Pretty simple, right? It’s almost too simple at first glance.
However, Throughput Accounting with these simple definitions provide a tremendous amount of clarity and removes the barriers from seeing how actions and decisions will truly impact a company.
That’s why you’ll hear me say oftentimes, “It’s not the math, it’s the logic!”
What I mean by this is the math of cost accounting is built on bad logic, thus there is no way to get the right result – even if you do the calculations correctly. Alternatively, in Throughput Accounting the math simple, yet built on sound logic, thus it is easy to develop the correct answer – unlike with cost accounting methods.
So, there you have it, the best way to get rid of manufacturing overhead is simply to not have it and use it to make decisions with, but rather utilize Throughput Accounting for your decision-making needs.
To learn more about Throughput Accounting, check out our course, “The Fundamentals of Throughput Accounting.”
If you’re ready to really understand your costs and see what might be possible in YOUR shop, watch the webinar, then sign up for a free strategy session.