Factory overhead is an accounting term for all production costs that relate to multiple items. Accountants often lump in costs for security, maintenance, indirect production labor and indirect materials needed to produce goods. Depreciation associated with production equipment or facilities is also a part of factory overhead. Accountants track these costs for each production cycle.
Depreciation expense represents the value used of a fixed asset. A company purchases equipment and records the item as a fixed asset, meaning the equipment brings value to the firm for multiple accounting periods. Accountants calculate depreciation following specific guidelines in generally accepted accounting principles (GAAP). The Internal Revenue Service also provides guidelines for depreciating fixed assets.
Cost accounting systems typically provide numerous methods for applying factory overhead to manufactured goods. A common method is the standard costing process. Companies will estimate their factory overhead costs and expected production output. Dividing expected factory overhead by the expected production output allows accountants to determine how much factory overhead will go into the per-unit cost of manufactured goods.
While cost accounting techniques do not have to follow GAAP, companies must report cost accounting data using absorption costing. This places all factory overhead costs in a company’s work-in-process inventory account. Companies that do not follow this process violate GAAP. Released financial statements will then have material misstatements that report incorrect financial information.
Depreciation will eventually go away from a company’s fixed factory overhead costs. As equipment nears the end of its useful life, companies will be unable to record depreciation as the item’s cost becomes zero. At this point, accountants drop the depreciation expense from the factory overhead calculations. The company can continue to use the machine or purchase a new one, which allows for continuing the inclusion of depreciation in factory overhead.