Catch Your Runaway Costs with the Manufacturing Overhead Formula
We’ve all been there.
Looking at your end of year balance to find it looking a lot slimmer than you expected.
The forgotten Netflix subscriptions and cheeky midday coffee cakes – they all add up.
And these hidden costs will keep on building up on your statement unless you take the time to reduce the unnecessary ones and take back control.
It’s the same thing when running a small manufacturing business.
You have to be aware of the extra costs of production that build in the background, otherwise they’ll just keep stacking up like there’s no tomorrow.
These invisible costs are known in the maker’s world as Manufacturing Overhead.
Manufacturing overhead is any indirect cost associated with your production. That could be anything from paying the cleaner to paying the water bills.
Often without these things you couldn’t run your manufacturing at all.
But by breaking down your indirect costs you can reduce those pesky bills that rarely come to the front of your mind.
It’s a calculation used for accounting purposes, but more importantly it’s a method with which you can begin to save on unnecessary costs.
Because like those cheeky midday coffee cakes, there’s always something that you can start cutting down on.
What is Included in Manufacturing Overhead?
When you think of what costs you have outside of direct materials, labor and manufacturing processes, you might be overwhelmed by the thoughts that cross your mind.
There are just so many details that cost your business money, right?
So, what is manufacturing overhead consisted of?
Well, the first thing to remember here is that we’re just looking at indirect costs that have some relation to manufacturing.
And it’s good to know what is manufacturing if you really want to get things right here.
But anyway, expenses linked to administration, sales, marketing and finance aren’t included in manufacturing overhead.
Those fall under the umbrella of administrative overhead.
Instead we can break down manufacturing overhead costs into four sections: Indirect labor, indirect materials, utilities and depreciation.
1. Indirect Labor
Here we’re talking about paying the salaries for anyone that works in your workshop but isn’t involved in the manufacturing process.
That means maintenance people, janitors, cleaners, security guards, supervisors, quality control workers and anyone else that helps keep the ball rolling.
As long as their job has some indirect effect on your production or production facility then you should include their salary in your manufacturing overhead costs.
It’s already adding up, isn’t it?
2. Indirect materials
What is an overhead cost example, when it comes to materials?
It might seem a strange concept to think about, but it makes a lot of sense when you draw it out.
Because there’s often lots of extra bits and pieces that go into the making of your product which wouldn’t stand out on first look.
This could be glues, tape, repair parts, general supplies, cleaning chemicals and even wasted materials.
Computer systems such as MRP and inventory management software would also fit underneath this category.
This is one of those areas where the costs are almost always inevitable and constant.
You’re going to have to pay bills wherever the work gets done, right?
Rent on the building, water bills, internet, electricity, gas, property tax and even insurance.
Every business is going to have its own set of utilities which need to be paid no matter what. Just remember that we’re looking at costs with relation to manufacturing, so your home office bills won’t be counted for here.
Okay, to be frank, this one is a little bit complicated.
But depreciation basically refers to how much an asset decreases in value over time. This applies to equipment and facilities which are subject to wearing down.
It’s a bit of a weird one because GAAP accounting requires this to be measured per product.
We'll show you an example of how to do this in the next section. But the general take away is that your equipment doesn’t last for ever and it’s always costing you something even if you don’t know it.
Working out an estimate of that is a useful addition to your manufacturing overhead. Plus, it can be used for tax claims deduction in certain cases too, so that’s a bonus!
How to Calculate Manufacturing Overhead
Generally manufacturing overheads are calculated per product annually.
If you’re a small business, it’s going to be useful to do it even more often than that. The effects of your overheads could be quite drastic throughout the year and you wouldn’t know until you checked.
The first thing to note is the basic manufacturing overhead formula:
Manufacturing Overhead = Total Indirect Costs / Total Units Produced
The thing is, how do we work out these total indirect costs?
Well, we go back to the four elements we referred to before.
Calculating each of them separately is going to make the whole process a lot easier, but also it means you have numbers for future comparison when you return to your manufacturing overhead.
But anyway, let’s take the example of a skateboard making business (because why not?) and see how to find the manufacturing overhead.
Here are our fantasy numbers:
Indirect Labor -
Making skateboards can be a messy affair...so much paint and sawdust everywhere.
There’s a cleaner that comes in to sort out all the mess that’s left at the end of the month. That comes to $2000 a year.
Indirect Materials -
Lots of bits and pieces get used in the workshop that aren’t necessarily considered as direct costs; tapes for temporary fixes and bleach for cleaning.
Not a whole lot of machinery needed here, but there’s a jigsaw involved which needs its saw replacing every so often.
$500 a year (yes, everything in this dream world happens to come to perfectly round numbers).
Well this one’s a biggy.
Unfortunately, you can’t make hundreds of skateboards in your living room.
Got to pay for workshop rent, bills, taxes and the whole shebang. $12000 a year.
It’s quite a strange one, having to calculate how much value is being lost on your assets.
Since we’re renting the workshop there’s no property to account for, but we do have some machinery.
If the jigsaw is estimated to last seven years and it cost 1050 dollars, then we could say that the annual depreciation is:
1050 / 7 = $150.
It might seem a little off the wall, but to be fair this is a legitimate cost to your business.
Now that we have all the numbers worked out, we can add them together and get our total indirect costs.
2000 + 500 + 12000 + 150 = $14650 a year.
And in this fantasy skateboard shop, there are 800 skateboards made a year.
So, what is the total manufacturing overhead?
Finally, we get to apply the manufacturing overhead cost formula:
Manufacturing Overhead = Total Indirect Costs / Total Units Produced = 17650 / 800 = $18.31
There we have it. Our manufacturing overhead comes to around 18 dollars per skateboard.
The accountant is happy, but that seems like quite a lot of extra costs, right?
Now comes the golden question...
How to Reduce Manufacturing Overhead
We got the numbers down, but what do we do with them?
Well of course the aim is to run them down.
Every little difference we make here is going to have positive background effects throughout the year.
Here are some tips for hammering your manufacturing overheads down:
Shop around – you’ll find that not all energy and water suppliers were created equal. You might well be paying more than you should for your utilities, especially if you are taking them all from one place;
Set budgets – once you got your indirect costs worked out, start setting targets for getting them down. If you review these every few months, by the end of the year you will be surprised at the difference you have made;
Reduce waste – if your materials get broken or damaged, then they end up as indirect materials costs. Try to see where the biggest waste is coming from and tackle your production planning strategy head on;
Clean after yourself – if every worker takes responsibility for their area and are accountable for it, this will reduce the amount of money that needs spending on cleaning;
Become more energy efficient – use energy saving light-bulbs and encourage everyone to be frugal with their water usage. Every drop counts, and mother nature will be pleased too;
Ask around – the best people to help reduce indirect costs are the people that spend most time in your workshop. More than likely they’ll have some unique ideas for tweaks here and there;
Consult with your accountant – how do you determine manufacturing overhead cost? Well aside from following our steps, it’s going to be a good idea talking to your accountant who also knows the law of the land;
Don’t overpay for software – implementing ERP systems can be totally overkill, both in terms of features and the cost. That’s why maker-focussed systems like Smart Workshop Software are much more appropriate for the small manufacturer.
The sneaky thing about manufacturing overhead costs is that they are rarely the first costs that come to your mind.
Like a little ghost that plays with your facts and figures behind your back.
That’s why, apart from the accounting purposes, it’s good to always keep these costs in the corner of your eye.
It’s not going to be a core piece of information for your running of business, but the effects on your profit margins are going to be there.
But by breaking it down, you get to see how you can increase your profit margins through some very simple changes.
One of those changes is by using an affordable inventory management system, rather than the big bucks ERP systems.
Katana Smart Workshop Software has been designed with the maker’s needs in mind, so you won’t be paying for features you’ll never use.
That means a focus on things like:
-Finished products and raw materials inventory management
-Moving on from inventory Excel sheets
-Inventory Integration with e-commerce channels like Shopify
-Having your entire order fulfillment cycle in one place
You’ll be saving on manufacturing overhead costs whilst tackling your direct costs at the same time.
That means more control on what you spend your money and resources on.
Maybe those cheeky midday coffee cakes won’t end up being such a problem after all...