What it means
A factory's costs fall into three buckets. Direct materials and direct labour attach cleanly to a specific unit, while everything else needed to keep the plant running is overhead.
Only factory-related costs qualify, so head office salaries, sales commissions and marketing sit outside the definition entirely. Overhead matters because it is often the largest and least visible slice of product cost.
If it is allocated carelessly, a business can price a low-volume, machine-heavy product as though it were cheap to make and sell it at a loss for years without noticing. Getting the allocation roughly right is usually worth more than getting the direct costs exactly right.
The standard approach is a predetermined overhead rate. You estimate total factory overhead for the year, estimate a sensible allocation base such as machine hours or direct labour hours, then divide one by the other.
Every unit then absorbs overhead in proportion to how much of that base it consumes. Because the rate is built from estimates, actual overhead almost never equals the amount applied to production.
The difference is described as under-applied or over-applied overhead and is cleared at the end of the period, usually against cost of goods sold. A persistent gap is a signal that the estimates need revisiting.
Activity-based costing is the more refined alternative. Instead of one rate, it uses several cost pools with different drivers such as machine setups, inspections or material movements.
It takes more effort to run, but it produces far better answers where the product mix varies widely in complexity.
In practice
Real-world examples.
Example
A furniture maker allocates overhead on direct labour hours because its work is largely handmade. When it installs a computer-controlled cutting machine, labour hours fall while depreciation rises, and the old rate starts to badly understate the cost of machine-heavy items. Management switches the base to machine hours.
Example
A food producer discovers that its factory rent and refrigeration costs make up 38% of total production cost. Because it allocates overhead per unit rather than per hour, its slow-moving speciality lines look artificially cheap, and a review shows two of them have been sold below true cost for three years.
Example
A contract electronics assembler wins a large low-complexity order and worries it will absorb too much overhead under the existing single rate. It moves to activity-based costing with separate pools for setups and testing, which shows the simple order should carry far less overhead than the blanket rate suggested.
Think of it
“Manufacturing overhead is like the shared costs of a commercial kitchen-utilities, equipment, and supervisor wages that support all dishes.
Formula
Calculation
Predetermined Overhead Rate = Estimated Total Manufacturing Overhead / Estimated Total Allocation Base
Overhead Applied per Unit = Predetermined Overhead Rate x Base Consumed per Unit
A components factory budgets total manufacturing overhead of $840,000 for the year and expects to run 24,000 machine hours.
Predetermined overhead rate = $840,000 / 24,000 = $35.00 per machine hour.
A particular product uses 1.5 machine hours per unit, so it absorbs $35.00 x 1.5 = $52.50 of overhead.
Adding direct materials of $18.00 and direct labour of $12.00, the full unit cost is $52.50 + $18.00 + $12.00 = $82.50.
At year end the factory has run exactly 24,000 machine hours, so applied overhead is $35.00 x 24,000 = $840,000. Actual overhead turns out to be $865,000, so overhead is under-applied by $865,000 - $840,000 = $25,000. That $25,000 is charged to cost of goods sold, and the rate is raised for the following year.Case study
Seen in the real world.
This is an illustrative and fictional example. Halden Forge, an invented maker of precision castings, produced two families of product: high-volume standard fittings and low-volume bespoke pieces. It used a single overhead rate based on direct labour hours, which had been unchanged for years, and reported a healthy overall gross margin of 31%.
A new finance manager rebuilt the costing on machine hours and separate cost pools for setup and inspection. The bespoke pieces, which needed frequent setups and long inspection cycles, turned out to absorb roughly three times the overhead previously charged to them. Standard fittings were carrying costs that belonged to the bespoke line.
Halden Forge repriced the bespoke range upward by an average of 22% and lost two customers who would not accept the increase, but overall factory profit rose because the remaining bespoke work now covered its true cost. The illustrative lesson is that overhead allocation is a pricing decision in disguise, not just a bookkeeping formality.
Watch out
Common mistakes.
- Including non-factory costs in manufacturing overhead. Administrative salaries, selling costs and distribution belong to period expenses, and putting them into product cost overstates inventory value.
- Keeping the same allocation base after the production process changes. Automating a labour-intensive line makes labour hours a poor driver, and the rate quietly distorts every product cost that follows.
- Treating under-applied or over-applied overhead as an error to be hidden. It is a normal consequence of using estimates, and the size of the gap is useful information about how good those estimates were.
Questions
People also ask.
Is manufacturing overhead fixed or variable?
It is usually a mixture: factory rent and supervision are largely fixed, while power, consumables and some maintenance vary with production volume.
Why not simply expense overhead as it is incurred?
Accounting standards require production overhead to be included in inventory cost, so it is only recognised in profit when the goods are sold rather than when the cost is paid.
What is a reasonable overhead rate?
There is no universal benchmark, because it depends entirely on how capital-intensive the process is; the meaningful comparison is against your own history and against how the rate moves as volume changes.
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