When business managers talk about manufacturing overhead, they mean expenses other than direct labor and materials that are part of the cost of producing a good. It's important to understand manufacturing overhead for two reasons. As a manager, you need this information to make informed decisions about production and product pricing. Also, an amount for manufacturing overhead must be allocated to each unit produced to comply with generally accepted accounting principles. Sometimes you may want to calculate an estimate of manufacturing overhead for work-in-process as well as the finished products in inventory.
Overview: Manufacturing Overhead and Work-in-Process
Manufacturing overhead is the term used to designate indirect costs associated with manufacturing a product. These expenses are added to direct labor and direct materials to determine the total manufacturing cost. Examples of manufacturing overhead include the electricity used, indirect labor like maintenance work, factory machine depreciation, repairs and property taxes. A portion of these costs must be assigned or allocated to each unit produced. There are two traditional approaches to allocate manufacturing overhead. You can assign costs in proportion to the labor hours needed to produce one unit, which works well when the manufacturing process is labor intensive. When a factory is largely automated, using machine hours per unit is often more appropriate. The idea is to choose an allocation scheme that correlates closely with the actual proportion of overhead expenses that should be assigned to each unit of production.
Work-in-process or work-in-progress refers to goods that are partially completed. Typically, you calculate the ending balance for WIP at the end of each year or other accounting periods. This ending balance then becomes the beginning balance for the next period. WIP is reported as part of inventory in the assets section of the firm's balance sheet.
Before you can calculate manufacturing overhead for WIP, you need to determine the WIP ending balance. The formula is the WIP beginning balance plus manufacturing costs minus the cost of goods completed. Suppose you start the year with $25,000 worth of WIP and incur $300,000 in manufacturing costs. The cost of completed goods comes to $305,000. The ending WIP balance equals $20,000.
Calculation of Manufacturing Overhead for WIP
To calculate the manufacturing overhead for WIP, start by finding the proportion of manufacturing overhead for a unit of production. Suppose you have allocated $10 per widget for overhead and the direct labor and materials costs total $40, giving a unit production cost of $50. The proportion of the unit cost is the overhead of $10 divided by the $50 total cost, or 0.20. Multiply the balance of work in process by 0.20. If your ending WIP equals $20,000, you have $20,000 times 0.20. The manufacturing overhead for WIP comes to $4,000.