Why is manufacturing overhead allocated to products?

Definition of Manufacturing Overhead Allocated to Products

Manufacturing overhead refers to the indirect production costs of producing goods, products, component parts, etc. The manufacturing overhead costs are also known as factory overhead costs, burden, indirect manufacturing costs, and indirect product costs.

Since manufacturing overhead is an indirect product cost, it needs to be allocated or assigned to the products manufactured and will cling to the products. Hence, the manufacturing overhead costs (along with the cost of the direct materials and direct labor) will be part of the cost of the items in inventory and the cost of the items sold. Accountants refer to this as full absorption costing. Accountants will also say that the manufactured goods must absorb both the variable and fixed manufacturing overhead costs.

Reasons for Allocating Manufacturing Overhead to Products

  • US GAAP and US income tax regulations require manufacturers to assign variable and fixed manufacturing costs to the products they manufacture so that the units in inventory follow full absorption costing.
  • Some companies set their products' selling prices based on their costs. In the long run, the products' selling prices must be large enough to cover all of a company's manufacturing costs (including the variable and fixed indirect manufacturing costs) plus the company's selling, general and administrative expenses and interest expense plus a profit for the company's owners.

If a company never has inventory at the end of the accounting periods, the allocation of manufacturing overhead could be avoided. The reason is that all of the manufacturing costs will be reported as the cost of goods sold. (However, the company may choose to allocate the manufacturing overhead for internal pricing decisions or to comply with a government contract.)