Overhead Vs. Direct Labor Costs

Manufacturing companies incur various costs in the course of their operations. They have to buy material and components to produce their products. They have to pay their factory workers and run the factory. To earn income, they have to sell the products. There are administrative costs such as accounting, human resources, management, and the cost of office supplies. To operate efficiently, a company has to identify these costs and assign them to the revenue-producing activities that generate them. Only then can the company determine which activities are profitable and optimize its operations.

Manufacturing companies have direct and indirect costs. The company generates direct costs in the factory where it manufactures its products, while indirect costs are the costs it generates everywhere else. Direct costs consist of the materials used to make the products and the labor used to assemble them. Direct labor usually is paid hourly, and the costs consist of wages, payroll taxes, and benefits. They are variable costs, since they depend on the number of units produced; the greater the amount of production, the greater number of man-hours required.

Typical direct labor costs include the cost of workers that make the product, of warehouse workers that handle factory inventory, of technicians that test the finished products, and of supervisors. The challenge for the company is to assign these costs to particular products so it can calculate prices and profitability. When companies manufacture in batches, they can assign costs based on the time frames when a particular batch was in process. It is more difficult to assign costs for custom jobs that are on the factory floor simultaneously. Companies have to implement special systems, such as time sheets, to track hours and costs.

Company overhead costs are all costs that are not direct costs. Companies typically divide them into manufacturing overhead and other overhead because they carry out activities other than manufacturing. Manufacturing overhead is directly related to the production of goods and includes items like the cost of the facilities and equipment. Other overhead includes administration and marketing. Companies consider overhead costs as fixed costs because, in the short term, they remain constant no matter how many products the factory manufactures.

Companies assign overhead costs based on a percent applied to a base quantity such direct labor cost. They have to distinguish between manufacturing overhead, all of which they must apply to the manufactured products, and other overhead, which is also applicable to other revenue-generating activities. Company budgets specify overhead and direct costs, and calculate the required percentages to ensure that the budget covers all overhead costs. As a result, the cost of a manufactured product may include direct material costs, direct labor costs, a factory overhead charge as a percent of labor costs, and a general overhead charge as a percent of labor costs.