Manufacturing overhead, which is also known as factory overhead, burden, and indirect manufacturing costs, needs to be allocated to products for the following reasons:
- Some of the goods manufactured are not sold in the same period in which they were produced.
- The goods not sold must be reported at their cost in the company's asset entitled Inventory.
- Accounting principles require that each product's inventory cost include both direct and indirect manufacturing costs.
- Indirect costs by definition mean they are not directly traceable to a product and will require an allocation.
- 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 indirect manufacturing costs) plus the company's selling, general and administrative expenses and a profit for the company's owners.
If a company never has inventory (because each period it sells all of its production) 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 still choose to allocate the manufacturing overhead for internal pricing decisions or to comply with a government contract.