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To run a successful business, particularly in a time of great economic uncertainty, you need to be able to make informed decisions. And that can only happen if you have the necessary information at your disposal.
In manufacturing, overhead costs are one of those critical pieces of information.
Given the current business environment, more and more manufacturers are looking to optimize their production processes in an effort to increase efficiency and reduce costs. As such, manufacturers require a clear picture of how much they spend on their production efforts before refining their operations to cut costs.
While costs that are directly related to the production process can be fairly straightforward to track, overhead costs, which aren’t directly attributable to a product on the line, but are necessary for production to continue running smoothly, are a bit more obscure.
In this post, we’ll review which items are commonly classified as manufacturing overhead, and how businesses are leveraging digital solutions to track and manage overhead as a component of their total production costs.
What is manufacturing overhead?
Manufacturing overhead refers to the many indirect costs businesses spend to run their operations.
When it comes to understanding the profitability of a business, executives will commonly refer to the cost of goods sold. However, accurately calculating COGS requires manufacturers to factor in the direct cost of manufacturing goods as well as any indirect costs associated with the production process.
Traditionally, manufacturing costs are comprised of the cost of raw materials used in the production process. Additionally, manufacturers also consider wages paid to personnel directly working on the production line.
Conversely, manufacturing overhead covers costs that don’t tie into the production process directly. For instance, to keep shop-floor machines in optimal working condition, businesses must invest in materials like lubricants, repair tools, as well as maintenance personnel. These various indirect expenses make up manufacturing overhead.
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Types of manufacturing overhead
As discussed, manufacturing overhead includes expenses unrelated to the physical production process. The different indirect manufacturing expenses include:
Indirect labor: Indirect labor includes employees who aren’t stationed along the production line directly involved in the manufacturing process. Instead, this type of labor supports the production process indirectly.
Indirect labor consists of maintenance and repair technicians, janitors, production planners, supervisors, managers, quality control officers, and factory security personnel.
Indirect materials: These are items that aren’t listed on the product’s Bill of Materials (BOM). In other words, these indirect materials don’t go into the final product. Despite this, such items are essential to the production process.
Indirect materials include lubricants, personal protective equipment (PPE), repair tools, spare replacement parts, janitorial supplies, fittings, and adhesives.
Utilities: A manufacturing facility requires various different utilities to function correctly. Therefore, manufacturing businesses spend on electricity, water, and gas. In addition, companies install internet connections in more modern manufacturing facilities to enable digital systems used in the production process.
Depreciation: Production operations contain several assets whose value can depreciate over time. This is a passive cost that manufacturing businesses must incorporate into overhead calculations for more accuracy.
Examples of depreciating assets in a manufacturing environment include factory machinery, fixtures and fittings, vehicles like forklifts, computer equipment, and the factory building itself.
Other associated financial costs: Some manufacturing businesses rent their production space – a significant indirect manufacturing cost. Alternatively, a manufacturing business might have mortgage payments for their property.
Related costs might include property taxes, insurance, as well as audit and legal fees.
How to calculate overhead costs
Calculating manufacturing overhead allows businesses to keep track of expenses, enabling them to price products accurately. Manufacturers can calculate overhead costs for the entire operation or do so on a per-unit basis. For instance, this unit (allocation base) might be total items produced, direct labor hours, or machine hours.
Here’s how to calculate:
Track and sum up all indirect costs to obtain the overhead. For example, indirect costs amount to $100,000 in a given month.
Select an allocation base to use.
For example, a company produces 4,000 items a month. Therefore, you can divide total indirect expenses by the number of units produced.
Manufacturing overhead = $100,000/4,000.
In this instance, manufacturing overhead is $25 per item.
Overhead costs can also be calculated using direct labor hours. For example, the same company uses 500 labor hours.
Manufacturing overhead = $100,000/500
Here, manufacturing overhead is $200 per direct hour worked.
How digital solutions can help in reducing manufacturing overhead
High overhead costs can eat into a manufacturing business’ profit margin. Therefore, companies must reduce overhead to protect and boost profitability. One way to lower manufacturing overhead is by utilizing digital systems to track and manage manufacturing overhead.
For instance, businesses can use digital systems to optimize shift scheduling for indirect labor. This reduces overtime hours that count towards manufacturing overhead through indirect labor costs.
Additionally, manufacturers apply digital tools as part of their inventory management. This allows businesses to have just enough inventory, preventing the company from spending more than necessary on storage space.
Digital manufacturing technologies help manufacturers regulate utility usage at the plant. For example, distributed sensors oversee room occupancy, automatically turning off heating and lights in unused spaces. This significantly reduces overhead costs associated with utilities.
Furthermore, internet- and AI-enabled manufacturing solutions enable predictive maintenance. As such, maintenance personnel spends fewer hours fixing machinery, reducing overtime wages and lowering the company’s manufacturing overhead.
Manufacturing overhead is a key component of your business’s profitability. Tracking overhead allows you to identify cost overruns or under-runs in a timely manner and correct them before they become a bigger issue. Having an accurate understanding of overhead allows businesses to determine whether or not it makes sense to produce certain products at all.
If you’re interested in learning how Tulip can help you identify opportunities to optimize processes and reduce overhead costs, reach out to a member of our team today!
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