Generally accepted accounting principles require that cost of direct material cost, direct labor, and manufacturing overhead be considered as the cost of products for valuing inventory and for determining the cost of goods sold. (Expenses that are outside of the factory, such as selling, general and administrative expenses, are not product costs and are not inventoriable. They are reported as expenses on the income statement in the accounting period in which they occur.)
Examples of manufacturing overhead include the depreciation or the rent on the factory building, depreciation on the factory equipment, supervisors in the factory, the factory quality control department, factory maintenance employees, electricity and gas for the factory, indirect factory supplies, etc.
Because manufacturing overhead is an indirect cost, accountants are faced with the task of assigning or allocating overhead costs to each of the units produced. This is a challenging task because there may be no direct relationship. (For example, the property tax on the factory building is based on its assessed value and not on the number of units produced. Yet the property tax must be assigned to the units manufactured.)
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