Factory overhead—also known as manufacturing overhead or production overhead—refers to the indirect costs associated with producing goods. These are expenses that cannot be directly attributed to a single unit of output but are essential for maintaining day-to-day manufacturing operations.
While many businesses focus on direct costs like raw materials and labor, overhead costs can significantly influence overall profitability, pricing strategies, and operational efficiency. Misunderstanding or neglecting them can lead to mispricing and budget shortfalls.
This guide covers the full scope of factory overhead: its components, how to calculate it, how to manage it wisely, and how to avoid common misconceptions.
What Is Factory Overhead?
Factory overhead includes all manufacturing costs that are not directly tied to a specific product. Think of the support systems, equipment, and personnel that keep the factory running—but do not touch the product directly.
Examples of Factory Overhead:
- Electricity to power production machinery
- Depreciation on factory equipment and buildings
- Wages for janitorial staff and security personnel
- Insurance on manufacturing facilities
- Lubricants, cleaning supplies, and safety equipment
Unlike direct materials or direct labor, these costs are not traceable to a single finished unit. However, they must be allocated across units produced to determine total manufacturing cost accurately.
Components of Factory Overhead
Factory overhead is generally divided into three categories:
1. Indirect Materials
These are consumables used in the production process that do not become part of the final product or are too minor to track individually.
Examples: Cleaning supplies, machine lubricants, small replacement parts.
2. Indirect Labor
Labor that supports the production process but does not involve hands-on manufacturing work.
Examples: Factory supervisors, quality control inspectors, maintenance workers.
3. Other Indirect Costs
Includes all remaining overhead costs necessary to maintain production capability.
Examples: Utilities, depreciation, rent for factory space, factory insurance, property taxes.
Step-by-Step Example: How to Calculate Factory Overhead
Let’s consider a mid-sized furniture manufacturing company. The accounting team is preparing the year-end report and needs to calculate total factory overhead.
After reviewing the year’s expenses, they find:
- Indirect materials: $20,000
- Indirect labor: $30,000
- Utilities: $15,000
- Depreciation of machinery: $25,000
- Insurance: $10,000
Total Factory Overhead =
$20,000 + $30,000 + $15,000 + $25,000 + $10,000 = $100,000
This total is then used in product costing models to determine the full cost of goods manufactured (COGM).
Common Misconceptions
1. Factory overhead includes direct costs.
False. Direct materials like wood or steel, and direct labor like carpenters or machinists, are not part of overhead. They are tracked separately.
2. Lowering overhead always increases profit.
Not necessarily. Indiscriminate cost-cutting—like reducing machine maintenance or laying off support staff—can decrease productivity or quality. Overhead should be optimized, not slashed.
3. Overhead costs are fixed and unchangeable.
While some overhead costs (e.g., rent) are fixed, many are variable or semi-variable. For example, energy usage or overtime for support staff can fluctuate with production volume.
Why Factory Overhead Matters
Accurate factory overhead accounting ensures:
- Product pricing reflects total costs
- Profit margins are realistic
- Strategic decisions (like outsourcing or investing in automation) are based on full cost visibility
It also helps in calculating absorption costing, where both direct and indirect costs are included in inventory valuation—vital for financial reporting under GAAP and IFRS standards.
Reducing Factory Overhead Without Compromising Efficiency
While overhead is unavoidable, smart strategies can optimize it:
- Invest in energy-efficient equipment to reduce utility bills.
- Cross-train staff to reduce reliance on overtime or temporary help.
- Use predictive maintenance tools to prevent costly equipment downtime.
- Negotiate better rates for insurance or utility contracts.
- Implement lean manufacturing practices to streamline indirect processes.
FAQs
Q: How is factory overhead different from operating expenses?
Factory overhead relates only to production-related indirect costs, while operating expenses cover broader business costs, including sales, marketing, and administrative functions.
Q: Is factory overhead part of cost of goods sold (COGS)?
Yes—when using absorption costing, factory overhead is included in COGS. In variable costing, only variable manufacturing overhead is included.
Q: Can factory overhead be allocated based on labor hours?
Yes. Common allocation bases include direct labor hours, machine hours, or units produced. The choice depends on the business model and cost behavior patterns.
Conclusion
Factory overhead is more than just a background figure on a budget—it’s a vital part of understanding your true cost structure. Businesses that carefully track, calculate, and optimize their overhead can make better decisions, set smarter prices, and maintain healthier margins.
Ignoring overhead or failing to allocate it properly can lead to misleading cost analysis, underpricing, or inefficiencies that harm long-term profitability. The key is balance—understand the cost, manage it strategically, and revisit it regularly as the business grows.
Key Takeaways
- Factory overhead includes indirect costs essential to production but not tied to individual units.
- Major components: indirect materials, indirect labor, and other indirect costs (e.g., depreciation, utilities).
- It’s a crucial element in determining the total cost of goods manufactured.
- Overhead should be optimized—not simply reduced—to maintain efficiency and product quality.
- Accurate allocation supports better pricing, financial reporting, and strategic planning.
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