Definition
Factory overhead, also known as manufacturing overhead, refers to all the indirect factory-related costs incurred while producing a product. These costs may include utilities, materials, labor, and depreciation that are not directly tied to the production of the specific goods. The sum of these costs is applied to a business’s production process to understand their total cost and maintain a suitable pricing strategy.
Key Takeaways
- Factory Overhead refers to all the indirect costs associated with manufacturing a product. These costs typically include utilities, depreciation, maintenance and repair, and salaries of non-direct employees who contribute to the production process.
- Factory Overhead costs cannot be directly tied to a specific item or product being produced, therefore, accounting for factory overhead can be complex. It is typically allocated based on an estimated overhead rate.
- Failing to properly manage and account for factory overhead can significantly distort a company’s understanding of their cost structure, thus affecting pricing decisions, profitability analysis, and strategic planning.
Importance
Factory overhead, also known as manufacturing overhead, is crucial in financial accounting because it includes all the indirect costs associated with manufacturing a product.
This can include costs such as salaries of supervisors, maintenance of the factory, and utility costs.
Understanding factory overhead allows companies to accurately determine the total cost of production, which ultimately helps in pricing products, budgeting, and financial planning.
Without considering factory overhead, a company may underprice its products, which could potentially lead to financial losses.
Therefore, it is an essential element in cost accounting and financial management.
Explanation
Factory overhead, also known as manufacturing overhead or production overhead, plays a significant role in evaluating the total production cost in a manufacturing setting. It includes all the indirect costs that are associated with manufacturing a product, such as depreciation on equipment, factory rent, utility bills, equipment repair costs, factory maintenance, indirect materials, and indirect labor.
These indirect costs, although they cannot be directly attached to a product, supplement and facilitate the manufacturing process. The primary purpose of factory overhead is to impart a comprehensive picture of total production costs.
Aside from the direct materials and direct labor costs, identifying, monitoring, and controlling the overhead costs is crucial for efficient cost management and improving profitability. Assigning overhead costs to individual units produced ensures each product carries a proportionate share of the overhead costs, allowing more accurate product costing, pricing decisions, and profitability analysis.
Examples of Factory Overhead
Depreciation on Manufacturing Equipment: This refers to the reduction in value of the machinery used in production due to wear and tear over time. This depreciation is treated as a manufacturing overhead cost because it is indirectly associated with the manufacturing process.
Utility Costs: Electricity, water, gas, and other utilities used in the production area are also considered as factory overhead. For example, a furniture company must pay for electricity to power its machines or for gas to heat its factories. These expenses don’t directly contribute to a single piece of furniture, but they are necessary for production.
Factory Rent or Mortgage: The cost of owning or renting a manufacturing facility is a factory overhead cost as well. If a clothing company, for instance, rents a facility to house its manufacturing operations, this rent cost is an overhead because, while it isn’t directly tied to a specific garment’s production, it is essential for all production to occur.
FAQs About Factory Overhead
What is Factory Overhead?
Factory overhead, also known as manufacturing overhead or work overhead, refers to the indirect factory-related costs that are incurred when a product is manufactured. These costs include a variety of expenses such as utilities, maintenance, and supplies that are used in the production process.
Why is Factory Overhead Important?
Factory Overhead plays a significant role in the valuation of inventory and the cost of goods sold. Understanding these costs is crucial to pricing products appropriately and achieving profitability.
What are the Elements of Factory Overhead?
The main components of factory overhead include indirect materials, indirect labor, and other indirect costs related to the production process. Indirect materials include supplies used in the maintenance of equipment. Indirect labor includes salaries of supervisors, janitors, and other factory workers who do not directly contribute to the production. Other indirect costs can include depreciation, insurance, repairs, and maintenance on factory equipment and facilities.
How is Factory Overhead Calculated?
Factory overhead is typically calculated based on a predetermined overhead rate. This rate is derived by dividing estimated overhead costs for a period by the estimated activity base (like direct labor hours or machine hours) for the same period.
Can Factory Overhead be Reduced?
Yes, factory overhead costs can be reduced by implementing efficient production methods, reducing energy consumption, regular maintenance of the machinery to prevent breakdowns, and careful monitoring and control of other indirect costs.
Related Entrepreneurship Terms
- Indirect labor
- Variable overhead costs
- Fixed overhead costs
- Job costing
- Depreciation in manufacturing plant
Sources for More Information
- Investopedia: A comprehensive resource for understanding finance and investment terms.
- Accounting Tools: Contains thousands of pages of content on accounting, investing, and finances.
- Accounting Coach: Offers free and paid resources for learning accounting.
- The Balance Small Business: A source of practical advice for small businesses on a variety of topics including finances, accounting, and management.
