Lesson 31 of 33 · Free
Contents
- 1 Manufacturing Overhead
- 1.1 What is manufacturing overhead?
- 1.2 What goes into manufacturing overhead
- 1.3 The absorption problem
- 1.4 The predetermined overhead rate
- 1.5 The accounting entries
- 1.6 Nonmanufacturing overhead — the other bucket
- 1.7 Why blanket overhead rates can mislead
- 1.8 Lesson recap
- 1.9 Practitioner Insights
- 1.10 Worked Example — Ferrosteel Foundry Overhead Allocation
- 1.11 Common Overhead Mistakes
- 1.12 Frequently Asked Questions
- 1.13 Cost Records Compliance and ICMAI Standards
Manufacturing Overhead
Factory costs that can’t be traced to a single product — and how to absorb them into inventory using a predetermined rate.
What is manufacturing overhead?
Direct material and direct labour are easy — you can trace them to a specific product. But there’s a third bucket of costs that’s necessary to produce the goods but can’t be traced to any single unit: factory rent, depreciation of machinery, supervisor salaries, plant utilities, indirect materials like lubricants and bolts. That’s manufacturing overhead (also called factory overhead or burden). Allocating it correctly to products is one of cost accounting’s central challenges.
What goes into manufacturing overhead
| Category | Examples |
|---|---|
| Indirect materials | Lubricants, cleaning supplies, small tools, fasteners |
| Indirect labour | Supervisors, quality inspectors, maintenance staff, janitors |
| Facility costs | Factory rent, building insurance, property tax, depreciation |
| Utilities | Factory power, water, fuel, telephone |
| Repairs & maintenance | Equipment service contracts, spare parts |
| Other | Plant manager salary, factory canteen subsidy |
Note: anything related to selling, administration, or distribution is NOT manufacturing overhead — those are “nonmanufacturing” overheads and flow directly to the P&L rather than into inventory.
The absorption problem
Under GAAP, IFRS, and Ind AS, full absorption costing is required for inventory valuation. That means manufacturing overhead must be allocated to each unit produced — it can’t sit in a pool. The unit then carries: direct material + direct labour + a share of manufacturing overhead. This is the cost that flows into inventory and later into COGS when sold.
The predetermined overhead rate
Actual overhead is known only at year-end. But you need to cost products in real time. The fix: at the start of the year, compute a predetermined overhead rate based on budgets.
Common activity bases:
- Direct labour hours (DLH) — most traditional
- Direct labour cost in ₹
- Machine hours — better when production is automation-heavy
- Units produced — when products are homogeneous
Example: Factory budgets ₹50,00,000 overhead and 1,00,000 direct labour hours. Rate = ₹50 per DLH. Every product gets charged ₹50 × hours it consumed.
The accounting entries
1. Apply overhead to products as work proceeds.
Dr. Work-in-Progress (WIP) 12,50,000
Cr. Manufacturing Overhead Applied 12,50,000
2. Record actual overhead costs as they’re incurred.
Dr. Manufacturing Overhead Control 12,75,000
Cr. Various (Cash, Accrued, Depr, etc.) 12,75,000
3. At year-end, close the variance.
Applied was ₹12,50,000 but actual was ₹12,75,000 — under-applied by ₹25,000. If immaterial, write to COGS:
Dr. COGS 25,000
Cr. Manufacturing Overhead Control 25,000
If material, allocate proportionally between WIP, Finished Goods, and COGS.
Nonmanufacturing overhead — the other bucket
Everything not related to making the product: selling and marketing salaries, head-office rent, executive compensation, depreciation of office equipment, customer-support costs. Under GAAP/IFRS, these are period costs — expensed in the period they’re incurred, not capitalised into inventory.
This split matters: a manufacturer that builds a lot of inventory at year-end will have manufacturing overhead sitting in the inventory balance, but nonmanufacturing overhead all flows through P&L immediately.
Why blanket overhead rates can mislead
If a factory produces both a high-volume simple product (a screw) and a low-volume complex product (a custom valve), a blanket DLH-based rate over-costs the simple product and under-costs the complex one. The simple product appears unprofitable; the complex one appears highly profitable. Reality: opposite.
That’s why activity-based costing (next lesson) exists — to allocate overhead more accurately when products differ wildly in complexity.
Lesson recap
- Manufacturing overhead = factory costs not traceable to individual products.
- Required to be absorbed into inventory under GAAP / IFRS / Ind AS.
- Predetermined rate = budgeted overhead ÷ budgeted activity base.
- Under-/over-applied variance resolved at year-end.
- Nonmanufacturing overhead is a period cost — not inventoriable.
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Practitioner Insights
Cost compliance resources: Companies (Cost Records and Audit) Rules 2014 with industry-specific guidelines; ICMAI’s Cost Accounting Standards (CAS); CRA-1, CRA-3, CRA-4 forms for cost audit filings; Tally Prime Cost Centre module; specialised cost-audit software like CAS Pro and Inform-it.
Worked Example — Ferrosteel Foundry Overhead Allocation
Imagine Ferrosteel Foundry, Chennai, has monthly factory overhead ₹12,00,000. Total normal machine hours in a month = 4,000. Pre-determined overhead rate = ₹12,00,000 / 4,000 = ₹300 per machine hour. A specific product takes 8 machine hours; overhead allocated = ₹2,400 per unit. In the actual month, total machine hours used = 3,800 and actual overhead = ₹12,40,000. Applied overhead = 3,800 × ₹300 = ₹11,40,000. Under-absorbed = ₹1,00,000 — written off to COGS at month end (or pro-rated to inventory and COGS if material). The variance is investigated: was production lower than planned, or did overhead inflate?
Common Overhead Mistakes
- Loading administrative overhead onto product cost (only manufacturing OH should go)
- Using actual rates instead of pre-determined for daily costing
- Not investigating large under/over-absorption variances
- Missing Cost Records compliance under Rule 5 of Cost Records and Audit Rules 2014
Frequently Asked Questions
What is the difference between direct cost and overhead?
Direct costs can be traced to a unit (raw material, direct labour); overheads cannot be traced economically and must be allocated.
Why use pre-determined rates rather than actual?
To enable timely product costing for pricing, quotations and inventory valuation — waiting for actual overhead each month would delay decisions.
Are administrative and selling costs overheads?
Yes, but they are usually shown separately as ‘Administrative Overhead’ and ‘Selling & Distribution Overhead’; only Manufacturing Overhead is loaded onto product cost.
Cost Records Compliance and ICMAI Standards
Cost Records Rules 2014 under Section 148 of the Companies Act 2013 mandate detailed manufacturing cost records for specified industries — cement, steel, sugar, fertiliser, electricity, drugs, telecom, textiles, paper, automobiles. The Institute of Cost Accountants of India (ICMAI) issues Cost Accounting Standards (CAS) that govern overhead absorption. CMA reports for bank working-capital limits use standard cost templates. Indian manufacturing plants typically allocate factory overhead via machine hours (capital-intensive) or direct labour hours (labour-intensive), with predetermined rates revised annually at budget time. Hero MotoCorp’s Gurgaon plant has monthly factory OH ₹15 cr. Normal monthly machine hours = 1,20,000. Pre-determined OH rate = ₹1,250/machine hour. A specific Splendor bike model uses 25 machine hours = ₹31,250 of OH per bike.
Practical Resources
Run under-absorption vs over-absorption analysis monthly. If actual overhead consistently exceeds applied (under-absorbed), either revise the predetermined rate or investigate operational inefficiency. If consistently over-absorbed, the rate is too high — revise downward at next budget cycle. Annual variance review combined with cost audit recommendations under Section 148 of the Companies Act drives continuous improvement.
Activity-Based Manufacturing Costing
Modern Indian manufacturing applies layered cost allocation: direct material + direct labour at unit level; manufacturing overhead via activity-based costing for high-mix lines; energy + maintenance allocated by machine-time. The combination produces granular per-SKU cost that supports pricing decisions, product mix optimisation, and capacity planning. Software packages (SAP CO Module, Oracle Hyperion Profitability and Cost Management, Tally TDL customisation) automate the allocations once configured. Cost audit reports filed under Companies (Cost Records and Audit) Rules 2014 evaluate these methodologies — auditors check whether the allocation drivers chosen are economically rational and consistently applied. For multi-plant companies, comparative cost analysis across plants reveals efficiency gaps that drive continuous improvement initiatives.