Business Turnaround Basics – Understanding the Real Cost of Factory Overhead

In today’s businesses, manufacturing overhead is often a major portion of product costs. There are two elements to overhead – variable and fixed costs. In variable costs, these costs change with respect to volume and can include such items as utilities, expensed shop supplies, general freight and even recruiting and training costs. Fixed costs do not change with respect to volume and these could include facility payments or rents, insurance, and operating permits. However, both groups of costs can be allocated to the driving activity by using Activity-Based-Costing methods.

When we consider overhead costs, we need to factor in other items that can have an impact on the accuracy of these costs as they pertain to a specific product. Listed below are some areas that need analysis with respect to these costs. This is not an exhaustive list but it should provide a basis for discussion for identifying the costs that do matter for your business.


General Manufacturing Overhead

There are a variety of items that are often in this category that include facility and utility costs, capital investment costs, supplies, and support resources. Wherever these overhead costs can be closely tied to the driving behavior, this will improve the accuracy of the overall product costing process. This is the basis for using the Activity-Based Costing mentioned earlier. For example, if only a portion of the final product requires painting or finishing, then only those products using these processes should carry their unique facility, finishing supply, utilities, and environmental burden costs. If a process requires a great deal of floorspace or special environmental controls then these unique overhead costs need to be tied to these products only. The blending and averaging of these types of costs only hides the true cost behaviors and does not support good decision-making.


Technical Support

Manufacturing with high levels of automation will require a great deal of indirect labor to support the new processes. Although the automation may have eliminated a dozen jobs, it may take an additional technician, a setup person and greater portions of the Manufacturing Engineering and Maintenance Department to keep this new equipment tooled and maintained properly. Additionally, the consumable costs for tools and supplies may also be quite high. In these cases, these costs should be tied to the specific workcenter. In our first article in this series, the major portion of additional costs of the automated fabrication and machining centers were these elements of support costs.


Freight Out

Some products or markets require special handling or packaging requirements and these costs are often buried in general overhead accounts instead of allocating these directly to the products. If it cannot be tied to the bill of material, then developing some method of allocating this cost to the overhead used by each of these products may provide the proper cost visibility.


Inventory Carrying Costs

As stated in previous articles in this series, there are real costs associated with carrying inventory and they include the following:

  1. Cost of money for carrying the additional inventory.
  2. Facility costs for storing and handling the extra materials.
  3. Costs due to inventory handling damage.
  4. Costs associated with obsolescence risk.

If these costs are disproportionately driven by only some materials or products, then these costs should also be allocated.

Customer Support

Customer support could include assembly or operational instructions or support on warranty-related costs. Where these costs are not evenly distributed and can be segregated out from pools of costs, then these should be tied to the specific product so true costs and margins can be reflected.


In this final article in the series, I hope that you can see the many factors that make up product costing. Manufacturing overhead for most businesses is a catch-all account that is typically spread over labor hours. If you can separate all of the costs and tie them to the driving behavior, and ultimately to the product costs, then true product margins can be defined, providing clarity for decision-making. If product costing is an area that may be of concern to you, I encourage you to call us to see if we can help you bring clarity to this process and dramatically improve the performance of your business.

Posted in Blog Post, Restructuring Businesses and Struggling Businesses


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