Well, the fact that you've survived the fundamentals of cost accounting far enough to reach this level where you're questioning the concepts of manufacturing overhead is good news! No, seriously! I remember those early days of my commerce graduation years when I had a tough time getting a hold of the various accounting concepts and principles while, at the same time, trying to hold on to my sanity! Trust me, I know exactly how you feel at this juncture.
Before getting to the details of manufacturing overhead, let's first try and understand what accounting overheads are. In cost accounting parlance, overheads are those costs and expenses incurred for the production of goods and services which cannot be directly allocated to and charged on any particular cost center or unit. Owing to this reason, overheads are also known as indirect expenses and, as such, mainly comprise operational, administrative and maintenance costs that are incurred by an organization to keep the production process going.
There are, precisely, four major categories of accounting overheads - manufacturing overhead (all expenses incurred to run the manufacturing division, plant and equipment), administrative overhead (office expenses and all expenses incurred for conducting the regulatory and decision-making processes), selling overhead (cost of advertising, marketing and all other activities that are undertaken to create and stimulate demand and increase sales) and distribution overhead (all expenses incurred in making the final product available to customers including packing, packaging, dispatch, transport, warehousing, etc.).
What is Manufacturing Overhead and What Does it Include?
If you have been taught how to prepare cost sheet, you probably know the way in which the cost is broken up into direct and indirect cost. Direct cost consists of the cost of direct materials and direct labor that are involved in manufacturing the product. All other expenses coming under indirect costs are the various overheads. Manufacturing overhead is comprised all those indirect costs that are incurred for and because of the manufacturing process itself.
This overhead includes indirect expenses such as rent/lease of premises/ building/ plant, depreciation of machinery, plant and equipment, electricity charges of factory and plant, cost of fuel, rates and taxes on various factory works, factory welfare expenses like cost of running the canteen, recreational activities, medical expenses incurred in case of illness or injury on the manufacturing site, expenses relating to floating assets, etc.
Manufacturing overhead can be fixed or variable. Fixed manufacturing overhead includes all those expenses that must be incurred, irrespective of the volume of production or activities on the production premises. Examples of fixed manufacturing overheads are rent, lease or loan installment payable on premises, plant or machinery that must be paid whether or not you use these assets. Variable manufacturing overheads (like holding and carrying cost of raw material) form a part of total variable cost.
How to Calculate Manufacturing Overhead?
Manufacturing overhead is the sum total of all indirect costs that are discussed under the immediately preceding section of this article. After this sum is calculated, it is divided by the number of units of the output in an attempt to allocate these indirect expenses to each product unit as these costs cannot be directly traced to them. This is done to determine the total cost of producing each unit of the product, so as to fix its price by adding a profit percentage to the total cost.
That should clear out all doubts regarding the basic concept of manufacturing overhead, its constituents and how to arrive at the composite figure. A good hold on the basic accounting principles and concepts coupled with a clear understanding of the fundamentals of cost accounting during these college years would go a long way into strengthening your hold on the subject. Also, once you've understood how things work, you won't need to spend those pre-examination sleepless nights trying to mug up seemingly incomprehensible data!