How to calculate factory overhead
Factory overhead, also known as manufacturing overhead or production overhead, is a key aspect of managing manufacturing operations. It encompasses all the indirect costs associated with producing goods, such as salaries, utilities, and maintenance expenses. It’s necessary to calculate factory overhead to determine product costs and make well-informed decisions that ultimately improve profitability. In this article, we will guide you through the steps for calculating factory overhead.
Step 1: Identify Overhead Costs
The first step in calculating factory overhead is identifying all indirect costs associated with production. These costs can vary depending on your manufacturing environment, but common examples include:
– Depreciation and maintenance of machinery and equipment
– Rent and utilities for the production facilities
– Salaries of indirect labor (e.g., supervisors, maintenance personnel)
– Factory insurance and property taxes
– Indirect material costs such as factory supplies
Step 2: Choose an Overhead Allocation Base
You need to choose an appropriate allocation base to distribute overhead costs among the products being manufactured. Common allocation bases include:
– Direct labor hours
– Machine hours
– Direct labor costs
– Units produced
The choice of allocation base depends on how closely it correlates with the overhead costs within your specific operation.
Step 3: Calculate the Factory Overhead Rate
To calculate the overhead rate, divide total estimated overhead costs by the total estimated quantity of the chosen allocation base. This will give you a rate that can be applied uniformly across your products to allocate factory overhead.
Factory Overhead Rate = Total Estimated Overhead Costs / Total Estimated Quantity of Allocation Base
Step 4: Apply Factory Overhead to Each Product
Using the calculated overhead rate, apply it to each product based on their share of the chosen allocation base. For example, if you’re using direct labor hours as the allocation base, multiply each product’s direct labor hours by the overhead rate to determine the allocated overhead cost for that product.
Allocated Overhead Cost per Product = (Product’s Share of Allocation Base) × Factory Overhead Rate
Step 5: Analyze and Adjust as Needed
Regularly analyze your factory overhead costs to identify any potential areas for cost reduction or efficiency improvements. Make necessary adjustments based on any changes in your manufacturing operations, such as adding new machinery or hiring additional staff. Keep in mind that your overhead rate should be updated each accounting period to maintain accuracy.
Calculating factory overhead is crucial for understanding production costs and ensuring profitability. By following these steps, you can effectively allocate indirect manufacturing expenses to your products, helping you make informed decisions about pricing and resource allocation. Continuously evaluate and adjust your calculations to ensure accuracy and adapt to changes in your operations over time.