How to Calculate Manufacturing Overhead Costs

Step 1: List the Overhead Costs
Step 2: Choose an Activity Base

How to calculate manufacturing overhead costs

To calculate manufacturing overhead, add up the production costs that aren't direct materials or direct labor, such as indirect materials, indirect labor, factory utilities, rent and equipment depreciation. To assign that overhead to jobs or products, divide the overhead you expect for the year by the activity you expect, such as machine hours, to get a predetermined overhead rate. Multiply each job's use of that activity by the rate. At year-end, compare the overhead you applied with the overhead you actually incurred, and adjust cost of goods sold for the difference.

Billed publishes this page. Quotes are from OpenStax, Principles of Accounting, Volume 2: Managerial Accounting, sections 4.2, 4.4 and 4.6 and the chapter 4 key terms, opened on October 30, 2026. For what overhead is, see what is overhead cost. For how overhead fits with materials and labor in a product's full cost, see production costs.

Step 1: List the Overhead Costs

Overhead is the production cost left after direct materials and direct labor. OpenStax, section 4.2, describes the overhead itself: "These costs are necessary for production but not efficient to assign to individual product production. Examples of typical overhead costs are production facility electricity, warehouse rent, and depreciation of equipment."

Two other kinds of cost go into manufacturing overhead:

Indirect materials: the chapter 4 key terms define them as "materials used in production but not efficiently traceable to a specific unit of production".
Indirect labor: pay for people who support production without making the product, such as a supervisor or a maintenance technician. See indirect labor cost for what counts and how to total it.

Selling and administration costs aren't manufacturing overhead, so keep them out of the total. The indirect labor page quotes how OpenStax classes them.

Step 2: Choose an Activity Base

The overhead rate needs an activity that rises and falls with overhead. OpenStax, section 4.4: "Direct labor hours, direct labor dollars, or machine hours are often chosen as the allocation base because those costs are associated with each product, and as the activity increases, so does the manufacturing overhead."

Step 3: Set the Predetermined Overhead Rate

Predetermined overhead rate = estimated overhead for the year ÷ estimated activity for the year

Section 4.4 explains the timing: "a predetermined overhead rate is established prior to the beginning of the fiscal year and typically is not changed during the year."

Step 4: Apply Overhead to Each Job

Overhead applied to a job = the job's actual activity × the predetermined overhead rate

Add the result to the job's direct materials and direct labor to get the job's cost.

Step 5: Compare Applied and Actual Overhead at Year-End

Section 4.4 says "it is rare for the applied amount to exactly equal the actual overhead." The chapter 4 key terms define the two results:

Underapplied overhead: "situation when the overhead applied to the individual jobs is less than the actual overhead"
Overapplied overhead: "situation when the overhead applied to the individual jobs is greater than the actual overhead"

Section 4.6 says "the year-end balance is eliminated through an adjusting entry, offsetting the cost of goods sold." It adds: "If manufacturing overhead has a debit balance, the overhead is underapplied, and the resulting amount in cost of goods sold is understated." Ask your accountant how your business records the adjustment.

Worked Example: One Year in a Furniture Workshop (sample figures)

These are sample figures for a fictional furniture workshop, invented for this example.

Estimated overhead for the year:

Indirect materials (glue, screws, sandpaper): $6,000
Indirect labor (the workshop supervisor): $30,000
Workshop rent: $24,000
Utilities: $9,000
Equipment depreciation: $11,000
Total: $6,000 + $30,000 + $24,000 + $9,000 + $11,000 = $80,000

Rate: the workshop expects 4,000 machine hours, so $80,000 ÷ 4,000 = $20 per machine hour.

One job: a dining table uses 30 machine hours, so it's charged 30 × $20 = $600 of overhead. With $900 of direct materials and $750 of direct labor, the job costs $900 + $750 + $600 = $2,250.

Year-end: the machines ran 4,100 hours, so the overhead applied was 4,100 × $20 = $82,000. Actual overhead was $84,500. Applied is less than actual, so overhead is underapplied by $84,500 − $82,000 = $2,500, and cost of goods sold is understated by that amount until the adjusting entry is made.

Where Billed Fits

Billed's expense tracking page says: "The expense report shows what you spent over a date range, and the income vs expense report compares income with expenses so you can see how profitable the business is." An expense report for the year gives you the actual spending to compare with the overhead you applied.

When This Guide Isn't for You

If one rate doesn't fit your products, because some use far more machine time and others far more labor, see what is activity-based costing. For how overhead is treated in your inventory and tax figures, ask your accountant.

Frequently Asked Questions

What costs are included in manufacturing overhead?

Production costs that aren't direct materials or direct labor, such as indirect materials, indirect labor, factory utilities, rent and equipment depreciation.

How do you calculate a predetermined overhead rate?

Divide the overhead you expect for the year by the activity you expect, such as machine hours, before the year starts. In this page's sample, $80,000 ÷ 4,000 machine hours = $20 per machine hour.

What is underapplied overhead?

Overhead is underapplied when the overhead charged to jobs during the year adds up to less than the overhead actually incurred. OpenStax says cost of goods sold is then understated, and the year-end balance is cleared with an adjusting entry against cost of goods sold.

Which activity base should I use?

OpenStax names direct labor hours, direct labor dollars and machine hours as bases that are "often chosen", because overhead rises as those activities rise. Pick an activity that rises and falls with your overhead, and ask your accountant if you're unsure.

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