An important metric for any small business owner whose company manufactures products is the unit cost of production. Unfortunately, this figure can sometimes be elusive to calculate and the costs not so clear. The most obvious production costs and the easiest to identify are the direct materials and labor hours used to make the product. But, other expenses are necessary to the manufacturing process: the non-direct fixed overhead costs.
TL;DR (Too Long; Didn't Read)
A common way to calculate fixed manufacturing overhead is by adding the direct labor, direct materials and fixed manufacturing overhead expenses, and dividing the result by the number of units produced.
What Is Fixed Manufacturing Overhead?
Every business has two types of costs: fixed and variable. In a manufacturing business, the variable costs are the labor man-hours and materials used directly to make and assemble the products. When someone mentions the fixed overhead of a business, they usually are referring to fixed expenses that are not directly related to a manufacturing process. Examples of these kinds of costs are office rent, administrative salaries, accounting fees, insurance, licenses and permits, etc. However, a manufacturing business also has fixed expenses that support the production process. Several of these types of fixed costs are as follows:
- Rent for manufacturing facilities.
- Factory office rent and supplies.
- Factory administrative office salaries.
- Depreciation of production equipment.
- Salaries paid to non-hourly employees such as production floor supervisors.
- Materials management staff compensation.
- Quality assurance staff salaries.
- Insurance and property taxes on plant equipment, inventory and facilities.
- Machine supplies.
- Repairs and maintenance.
- Sanitation personnel.
How to Apply Manufacturing Overhead
Accountants use two methods to keep track of manufacturing overhead: absorption costing and variable costing. Under absorption costing, product costs include direct labor, direct materials and fixed manufacturing overhead expenses. With the variable costing method, direct labor and materials costs are listed separately from fixed manufacturing overhead expenses. To simplify this, let's use an example of the Flying Pigs Corporation, which makes roller skates for the swine market.
The Flying Pigs Example
The annual manufacturing figures for the Flying Pigs Corporation are as follows:
- Annual production volume: 40,000 pairs of skates
- Material cost of wheels, steel and leather straps: $700,000
- Direct labor costs: $560,000
- Total fixed manufacturing overhead costs: $420,000
The product unit cost under the absorption method:
- Materials: $700,000
- Labor: $560,000
- Fixed overhead: $420,000
- Total product costs: $1,680,000
- Product cost per unit: $1,680,000/40,000 = $42
The variable costing approach gives the following result:
- Materials: $700,000
- Labor: $560,000
- Total variable costs: $1,260,000
- Product cost per unit: $1,260,000/40,000 = $31.50
Which Method is Better?
Either one is correct as long as management understands the sources of the figures they are looking at and how they intend to use this information. You might look at these calculations and wonder where the fixed manufacturing costs went under the variable method. These costs didn't disappear; they just get posted in a different place on the income statement.
The calculation of fixed manufacturing overhead expenses is an important factor in the determination of unit product costs. Simply using the variable costs of direct materials and labor is not enough when calculating the "true" cost of production. Fixed overhead costs of production must be included; it's just a question of how and where.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for National Funding, bizfluent.com, FastCapital360, Kapitus, Smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.