Explanation of the Topic...
Nonmanufacturing Overhead Costs|
Financial Reporting vs. Individual Products and Customers
Methods of Allocating Nonmanufacturing Overhead Costs
We use the term "nonmanufacturing overhead costs" or "nonmanufacturing costs" to mean the Selling, General & Administrative (SG&A) expenses and Interest Expense. Under generally accepted accounting principles (GAAP), these expenses are not product costs. (Product costs only include direct material, direct labor, and manufacturing overhead.) Nonmanufacturing costs are reported on a company’s income statement as expenses in the accounting period in which they are incurred. Expressed another way, nonmanufacturing costs are not allocated to products via overhead rates since they are not included in the amounts reported as inventory on the balance sheet or in the cost of goods sold that is reported on the income statement.
Even though nonmanufacturing overhead costs are not product costs according to GAAP, these expenses (along with product costs and profit) must be covered by the selling prices of a company’s products. In other words, selling prices must be large enough to cover SG&A expenses, interest expense, manufacturing overhead, direct labor, direct materials, and profit.
Some of the costs that would typically be included in nonmanufacturing costs include:
As mentioned above, nonmanufacturing costs cannot be included in inventory or the cost of goods sold; rather, nonmanufacturing costs are reported as SG&A expenses and Interest Expense in the accounting period in which they occur.
However, if management wants to determine the profitability of a specific product or customer, it is necessary to allocate or assign nonmanufacturing costs to the products and/or customers outside of the financial statements. This information stays within the company—it is only used internally to assist management with decisions such as pricing; choosing which products to promote or to phase out; choosing which products to review for possible production processing changes; etc. In the end, management should know whether each product’s selling price is adequate to cover the product’s manufacturing costs, nonmanufacturing costs, and required profit.
If management does not allocate the nonmanufacturing costs to specific products, a product that requires a significant amount of sales support and administrative costs may actually be unprofitable even though its gross profit (sales minus manufacturing costs) indicates that it is very profitable. On the other hand, a product with a low gross profit may actually be very profitable, since it uses only a minimal amount of administrative and selling expense.
As mentioned previously, nonmanufacturing costs are allocated internally to products and customers for the purpose of giving management information that is useful for decision-making, and not for the purpose of financial reporting. When doing the internal allocation of nonmanufacturing costs it is logical to follow these four steps: (1) identify the activities that cause the nonmanufacturing costs, (2) measure the cost of those activities, (3) identify the products and customers requiring the activities, and (4) assign the cost of the activities to those products and customers. In short, the best way to allocate nonmanufacturing costs is to use activity based costing (ABC).
Some activities involving nonmanufacturing expenses include:
It is likely that you will have to estimate the cost of these activities. Next, you will need to allocate the cost of the activities to the individual products. Estimates and allocations based on logical assumptions are better than precise amounts based on faulty assumptions.
If you want to learn more about overhead and activity based costing, we have prepared a short list of books that we have read and found to be very helpful. You can view our listing of recommended books by going to the following page: Recommended Books.
Because the material covered here is considered an introduction to this topic, many complexities have been omitted. You should always consult with an accounting professional for assistance with your own specific circumstances.
Get all of our materials in PDF format when you join AccountingCoach Pro.
Where Do I Go Next?
13 videos (2 hours total) taken from our Bookkeeping Basics Seminar.
These videos are only available in our new AccountingCoach Pro members area.
300 questions with answers
This exam is only available in our new AccountingCoach Pro members area.
Join our Newsletter
Receive our free 19-page accounting cheat sheet. Plus, stay up to date with the latest questions answered.
AccountingCoach.com is designed to help people without an accounting background easily understand accounting concepts at no cost.
By investing thousands of hours, we have created clear and concise accounting information for both business people and students of all ages.
We understand how difficult accounting can be. That's why each accounting topic includes a clear explanation, reinforcing quizzes, Q&A, puzzles, dictionary of terms, etc.