Supply Chain

The Modern Rules Of Manufacturing Overhead

January 13, 2021

Here’s how you can calculate and reduce manufacturing overhead expenses.

Anything worth having will cost you something. This principle rings true for businesses as much as it does for everyday life. Profit only comes after purchases. The old adage that you have to spend money to make money is a cliche, but that doesn’t make it any less true.

Manufacturers and factories refer to some of this spending as “manufacturing overhead.” Certain groups also call it “factory overhead,” “factory burden,” or “production overhead,” but they all mean the same thing. Each one deals with the indirect costs associated with a company's production process. The key word here is "indirect costs." These numbers do not include production costs like direct labor or raw materials.

Like any type of overhead expense, manufacturing overhead is unavoidable. But companies can practice wise habits when it comes to managing their production costs. 

That’s why we’ve created this guide that will help you understand all you need to know about manufacturing overhead and how to reduce it.

What is the definition of manufacturing overhead?

Do a quick Google search of manufacturing overhead and you’ll find an array of definitions and ideas of what it means. We’re going to keep it simple here: 

Manufacturing overhead is made up of the indirect costs a company undertakes in its production process. Other expenses such as direct labor hours, materials costs, and similar items directly involved in the actual manufacturing process, do not fall under the category of manufacturing overhead.

Because of this rather broad definition, it can help to understand the different types of manufacturing overhead costs including fixed, variable, and semi-variable.

Fixed manufacturing overhead costs never change. You can think of things like property taxes, rent of the manufacturing facility, set salaries, or recurring fees set by the government.

Variable costs include items that change depending upon the output of production. Items like gas or electricity bills will grow if a manufacturer all of a sudden starts producing a higher number of units. That makes them variable costs. The same can be said for expenses associated with shipping, marketing or advertising, and fluctuating legal fees.

Semi-variable costs are mainly fixed costs that have the potential to change with increasing or decreasing business activity. Consider this example: A company pays a certain amount for rent at a small facility. That’s a fixed cost. However, if the business activity is increasing at such a rate that they know they will outgrow their small space, that rent becomes a semi-variable cost because it could change in the near future. Other expenses like this might include salaries, utilities, and insurance.

What are some examples of manufacturing overhead?

With so many different expenses out there contributing to manufacturing overhead, it can be helpful to see clear examples. Here’s a quick, non-exhaustive list:

  • The electricity or gas that the factory uses
  • Water, trash services, and other miscellaneous utilities
  • Unpredictable repairs or maintenance
  • Employees who repair or maintenance machinery
  • The salaries for factory supervisors or managers
  • Depreciation of a building's value
  • Depreciation on equipment
  • Property taxes and rent
  • Miscellaneous operational supplies that do not directly relate to production
  • Janitorial staff and accountants

While other items certainly contribute to manufacturing overhead, this list should give you a decent starting point.

How do I calculate the manufacturing overhead rate?

Managing your manufacturing overhead means knowing what exactly your manufacturing overhead is, and to do that, you need to be able to calculate your manufacturing overhead rate. This formula is simple, but critical.

First, you need to establish your total manufacturing overhead costs. Add up all the indirect costs that make the production process run smoothly each month. 

After you’ve set this figure, you can calculate the manufacturing overhead rate (MOR). This number will give you a clear percentage of your monthly overhead costs.

To calculate this number, you will divide the total manufacturing overhead costs (TMOC) by total monthly sales (TMS) and then multiply that number by 100. The final formula will look like this:

(TMOC ÷ TMS) X 100 = MOR

So let’s say that your total costs for manufacturing overhead is $50,000 and your monthly sales reach $300,000. You would divide $50,000 by $300,000 to arrive at .167. Then, you would multiply that by 100 and find that your monthly overhead rate equals 16.7%. 

($50,000 ÷ $300,000) X 100 = 16.7%

This means that you can expect to allocate 16.7% of your monthly revenue to overhead costs. Having this number will help your team with predicting and planning better strategies to reduce manufacturing overhead.

8 ways to reduce manufacturing overhead

Companies can keep their rates down by learning to reduce their manufacturing overhead. This takes patience, organizational change, strategic allocation of resources, and a bit of creativity, but companies that are willing to give it a try tend to see great results. Lowering your manufacturing rate means increasing your revenue, so it’s worth giving a few things a shot, right? 

In our research and experience, we’ve found eight specific ways for companies to reduce manufacturing overhead. 

  1. Aim high when it comes to budgeting 

Nailing your manufacturing budget is critical - which is why we suggest aiming a little higher than lower. 

Take your established overhead rate and put a little more aside just in case you need it. If you know you usually spend 16.7% on overhead expenses, go ahead and plan on 17%. Allocating that extra little bit can help you if your projections were a bit off or it can help you further save the excess, giving you an extra cushion for an eventual month when you will need it.  

  1.  Take care of your equipment before it’s too late

The old saying “if it’s not broke, don’t fix it,” doesn’t really work when it comes to factory machinery. Preventative maintenance is one of those frustrating necessities in the manufacturing world, but when performed regularly it can extend your equipment’s life span. You can get many more machine hours out of a piece of equipment that has been well taken care of.

Most preventative maintenance tasks don’t require much from you or your staff, either. Adding some lubricants and keeping the machines clean alone will go a long way. Take the extra time and spend that little bit of money up front to save you the headaches and the expenses later on.

  1. Salvage what you can when you can

We all want the newest and coolest things as often as we can get them, but sometimes tried-and-true existing resources can go further than we think. Most warehouses and storerooms are full of salvageable pieces of old equipment just waiting to be found. Look for these safe-to-use, functional parts when a piece of machinery needs some repair. It might buy you some time before you need to spend all that money on a new piece of equipment. 

If you do decide to salvage an old part, just make sure the piece you found is totally compatible and in working condition, otherwise you could cause worse damage in the long run. 

  1. Bring the maintenance support in-house

It takes lots of money to repair equipment and perform the right maintenance procedures, especially when companies source the work to other organizations. Hiring an in-house team or individual professional may seem like a big expense to undertake, but doing so could save on the expenses dedicated to fixing and keeping up with the machines. It also creates a more predictable budget because of the consistency of the expense, instead of unforeseen large chunks. 

An in-house maintenance person would have the ability to perform routine maintenance and emergency repairs, making it easier to keep your machines in good shape for longer.

  1. Let the staff know about overhead reduction goals

Communication goes a long way in organizational change, and letting the team know about overhead reduction goals can help inspire them to work together. 

Manufacturing staff may also pleasantly surprise leaders with ideas they bring to the table. The professionals on the floor likely have thoughts about how the process can run more efficiently, but if leaders never ask, the staff may never talk about it. They likely see the little quirks and mishaps that higher-ups miss. Invite some high-performing members of the staff into a brainstorming session or two and see what everyone can come up with together.

This can also help with morale as the staff feels more valued from the leadership. Everyone wants their voice to be heard, and this gives them an opportunity to speak up. 

  1. Develop great relationships with vendors and suppliers

Vendors need great, reliable buyers. They’ll go the extra mile to retain those relationships they find mutually valuable. 

The key is becoming a mutually valuable customer of theirs. By paying up front and agreeing to longer contracts you begin to prove your value. It may start out with something simple like buying in bulk or contributing to a case study, but it could lead to large discounts or special contracts later down the line. 

  1. Minimize your office supply usage

Going green is a common practice these days. It helps the environment, and it can also help reduce overhead costs. Think about ways you can go paperless in your manufacturing facility. Would emails be more efficient ways to communicate instead of physical memos and announcements? Could a digital bulletin board reduce waste better than one hanging in the break room? These little changes can ultimately go a long way as you save not just on paper but on ink, pens, and other small office supplies as well. By implementing Industry 4.0 technologies, you can save time and money. 

  1. Repurpose any extra space

Got a few extra square footage in your building? Try renting them out to smaller businesses or local organizations. The extra little boost could help offset your price of rent and give you enough of an edge to reduce your overhead budget. Just make sure this is allowed in your building contracts!

Managing your manufacturing overhead takes work, but putting in that effort can help your company reduce its spending and increase its revenue. Following these 8 simple steps will help you get started so you can see results quickly. If you’re looking to take your analysis to the next level, read our complete value chain analysis piece to dive deeper. 


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Author

Kathryn Kosmides

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