Accounting for Overhead Costs

Overhead Costs Manufacturing costs that cannot be traced directly to specific units produced. Examples Indirect labor Wages paid to employees who are not directly involved in production work. Examples: maintenance workers, janitors and security guards. Indirect materials Materials used to support the production process. Examples: lubricants and cleaning supplies used in the automobile assembly plant. Other indirect manufacturing costs Factory rental, factory utilities, factory plant and equipment depreciation, Amortization of patent etc . Characteristics Deals with relationship to the product and the volume of production (i.e. OH is invisible part of the product) --INDIRECT Deals with how different items of overhead change in response to change in production volume --- COST BEHAVIOR Cost allocation methods Actual costing Normal Costing Standard Costing
Product Cost
DM

Formula

Numerator Overhead is typically budgeted for one year. Denominator Relationship between the overhead cost and the activity aka Cost Driver Companies should use an activity base that is logically related to actual overhead cost incurrence. Factors considered in selecting OHrates 1. Based to be used 2. Activity level selection 3. Including or excluding fixed overhead 4. Use of single rate or several rates 5. Use of separate rates for service activities Based to be used cost driver a. Physical output b. Direct materials cost c. Direct labor cost d. Direct labor hours e. Machine hours f. Transactions or activities (ABC)

Actual vs Normal vs Standard

Actual Cost System Actual Actual Actual Normal Cost System Actual Actual Predetermined Overhead Rate Standard Cost System Standard Standard Standard

DL Overhead

What is Predetermined OH rate? A budgeted, constant charge per unit of activity used to assign overhead to production or services Four primary reasons for using predetermined overhead rates in product costing. 1. A predetermined overhead rate allows overhead to be assigned during the period to the goods produced or sold and to the services rendered. We sacrifice some precision for timeliness. 2. Predetermined overhead rates adjust for variations in actual overhead costs that are unrelated to activity. For example, electricity costs run higher in the summer because of the costs of air conditioning. 3. Predetermined overhead rates overcome the problem of fluctuations in activity levels that have no impact on actual fixed overhead costs. a. Fixed cost per unit varies when activity levels change. b. To minimize such variations in unit cost, we use an annual predetermined overhead rate for fixed overhead for all units produced during the year. 4. Using predetermined overhead rates allows managers to be more aware of individual product or product line profitability as well as the profitability of doing business with a particular customer or vendor.

Desmond Corp. estimates that its production for the coming year will be 10,000 widgets, which is 80% of normal capacity, with the following unit costs: materials, $40; direct labor, $60. Direct labor is paid at the rate of $24 per hour. The widget shaper, the most expensive piece of machinery, must be run for 20 minutes to produce one widget. Total estimated overhead is expected to be $800,000. Required Compute the overhead rate for each of the following bases, using the expected actual capacity activity level: (1) physical output (2) materials cost (3) direct labor cost (4) direct labor hours (5) machine hours Activity level selection a. Theoretical capacity b. Practical Capacity c. Expected Actual Capacity d. Normal Capacity Theoretical capacity The capacity to produce at full speed without interruptions or downturns 100% of its rated capacity Not realistic Practical Capacity Theoretical capacity reduced by allowance for unavoidable interruptions such as crew changes, preventive maintenance, repairs, setups, failures, unsatisfactory materials, delay in deliveries of materials, labor shortages, absences, holidays etc 75% to 85% of theoretical capacity

Expected actual capacity Amount of output expected to be produced during the period Planned production Usually results in a different POHR for each period because of increases and decreases in planned production Normal Capacity Average activity over time period long enough to level out highs and lows Stabilize pOHr that would fluctuate as facilities are used to different degrees in different periods Desmond Corp. estimates that its production for the coming year will be 10,000 widgets, which is 80% of normal capacity, with the following unit costs: materials, $40; direct labor, $60. Direct labor is paid at the rate of $24 per hour. The widget shaper, the most expensive piece of machinery, must be run for 20 minutes to produce one widget. Total estimated overhead is expected to be $800,000. Required Compute the overhead rate for each of the following bases, using the normal capacity activity level: (1) physical output (2) materials cost (3) direct labor cost (4) direct labor hours (5) machine hours St. Louis Sounds Inc. manufactures audio equipment. The company estimates the following costs at normal capacity and other items for the coming period: Direct materials $300,000 Direct labor 520,000 Factory overhead (fixed) 300,000 Factory overhead (variable) 240,000 Normal capacity 100,000 direct labor hours Expected production 80,000 direct labor hours

Variable Manufacturing Overhead xxx Fixed Manufacturing Overhead T-account

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Differences Actual OH > Applied OH underapplied Actual OH < Applied OH Overapplied Disposition of OH differences Immaterial close to COGS Material prorated and assigned to WIP, FGI and COGS Disposition of OH differences If overhead is underapplied Cost of Goods Sold increases Income decreases If overhead is overapplied Cost of Goods Sold decreases Income increases Entries - immaterial Manufacturing OH COGS To close overapplied OH COGS Manufacturing OH To close underapplied OH Entries - material Manufacturing OH WIP FGI COGS To close overapplied OH WIP FGI COGS xxx xxx xxx xxx xxx xxx xxxx xxx xxx xxxx xxx

Compute the overhead application rate for fixed, variable, and total overhead per direct labor hour, using both the normal capacity and the expected actual capacity activity levels. OH Application Applied overhead is the amount of overhead assigned to Work in Process Inventory using the activity that was employed to develop the application rate. For convenience, both actual and applied overhead are recorded in a single general ledger account. The amount of applied overhead is determined by multiplying the predetermined rate by the actual activity level. Actual activity level x POHR = overhead applied 4,300 machine hours x $7.50 = $32,250 overhead applied Debits to the overhead account represent actual overhead Credits to the overhead account represent applied overhead (see text Exhibit 3-2). Entries Actual Overhead (combined journal entry) Variable Manufacturing Overhead Fixed Manufacturing Overhead Various Accounts Apply Overhead (combined journal entry) Work in Process Inventory

Manufacturing OH To close underapplied OH

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