# (3 of 8) Allocation of Manufacturing Overhead Costs

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􀀹 overview 􀀹 calculation of overhead rate 􀀹 over/under-applied overhead 􀀹 Activity-Based Costing using cost pool rates http://www.principlesofaccounting.com/chapter%2019.htm

### Indirect costs

Also called overhead or administrative costs, these are expenses not directly related to the event. They can include salaries, rent, and building and equipment maintenance.
All manufacturing costs that are related to the cost object (work in process and then finished goods) but that cannot be traced to that cost object in an economically feasible way.

Is an indirect cost and difficult to trace directly into specific jobs or units. The total cost of items such as rent, depreciation, heat, light, power, insurance, supplies and indirect labor used in a factory.
For example, the cost of an automobile repair job should include a fair share of all indirect costs [i.e., overhead costs (some times supervision, tools/ machinery used)] in addition to the direct parts (materials) and labor used. Factory overhead (indirect costs) includes all manufacturing costs other than the costs of direct materials and direct labor. Costs are then assigned to jobs in proportion to this other factor. So now we need to find the factor that would provide a reasonable basis to allocate overhead. This objective may be accomplished by charging factory overhead to jobs in proportion to direct labor costs, direct labor hours, or machine hours.,

The process of assigning overhead costs to the jobs or units.
An ____ application rate expresses the relationship of total factory overhead to some other factor that can be traced directly to specific units of output.

= Overhead Cost / Allocation Base
Alternative bases include:
• Direct labor hours
• Direct labor cost
• Machine hours
• Direct material cost.
The important point to remember here is that the allocation base used should be strongly associated (correlated) with overhead costs and, ideally, should drive the variable portion of the overhead costs. Used to assign a reasonable portion of factory overhead costs to each job.

To determine the overhead application rate in advance (predetermined overhead rate), we first estimate the expected total factory overhead for the year. This estimated amount is called budgeted overhead. We then estimate the direct labor costs, direct labor hours or machine hours, whichever is to be used as the basis for applying overhead costs to production.
The predetermined overhead application rate is equal to the budgeted overhead divided by the application base. It is not necessary to wait until the end of the period to know the factory overhead chargeable to goods produced.

### For example, suppose Betty Queen Motorboat Company anticipates \$200,000 of manufacturing overhead and 36,364 direct labor hours during the year. How can we calculate the overhead rate?

An overhead allocation rate is calculated by dividing estimated overhead costs by the estimated quantity of the allocation base. [\$5.50 overhead will be applied to the relevant job for every hour of direct labor work on that job.]
A)= Estimated overhead Costs/Allocation base (direct labor hours)
B) = \$200,000/36,364
C) = \$5.50

### \$5.50 overhead will be applied to the relevant job for every hour of direct labor work on that job.Betty Queen Motorboat Company used 400 direct labor hours (200 hrs for job #257, 150 hrs for job #258, and 50 hrs for job #259). What is the manufacturing overhead for each job?

Look at our illustration above for direct labor:
With an overhead rate of \$5.50 and 400 hours, \$2,200 of manufacturing overhead will be assigned to the
following jobs:
Job #257 200 hrs @ 5.50 = \$1,100
Job #258 150 hrs @ 5.50 = \$825
Job #259 50 hrs @ 5.50 = \$275
Total: 400 hrs @5.50 = \$2,200

### A typical entry to record factory overhead costs would be as follows:

Cr. Salaries Payable..................50,000
Cr. Supplies .............................15,000
Cr. Prepaid Insurance ..................5,000
Cr. Accumulated Depreciation ....11,000
Cr. Taxes Payable ......................9,000
Cr. Utilities Payable ..................10,000

### Remember: Overhead is applied to production based on the predetermined overhead rate.

-If actual > applied, a debit balance results; thus the overhead is under-applied.
-If actual < applied a credit balance results; thus the overhead is over-applied.
-Manufacturing Overhead must be zeroed out at year-end; so it must be closed out either to Cost of Goods Sold or allocated to the various related accounts depending upon its materiality.

### Suppose a company had \$52,000 of actual overhead and applied \$50,000 to jobs using a predetermined overhead rate. In this case, overhead is?

Is under-applied by \$2,000, represented by the debit balance in the Manufacturing Overhead account. Under-applied overhead is charged to Cost of Goods Sold [if the amount
is immaterial (relatively small)]. The following journal entry is made:
Dr Cost of Goods Sold \$2,000.00

### actual overhead costs of \$650,000 and the overhead applied to jobs amounted to \$680,000. That means we over-applied the overhead costs by \$30,000. The over-applied overhead cost is credited to?

Cost of Goods Sold, reducing it.

### Activity-Based Costing or simply ABC

In these highly automated, flexible manufacturing environments, we need to look at a more refined costing
system so we can achieve a fair and equitable allocation of costs. There is a need for new approaches to
tracing overhead costs. If we can identify the causes of costs by activities, we can more accurately assign overhead costs based on the amount of overhead each product truly consumes. This approach/method has given accountants and managers a better understanding of what drives overhead costs.

Cost Pool: pooling of overhead costs that relate to a specific activity.
Now let's summarize the procedure of the ABC costing system so far:
• Activities are identified and grouped into activity pools.
• Costs are assigned to these activity pools, called activity-cost pools.
• Cost drivers are used to allocate the overhead costs from the activity-cost pools to the specific
products or services. Please note that, there should be a high degree of correlation between the cost
driver and

### d

ABC is a costing technique that uses a two-stage allocation process:
1. The first stage identifies activities and assigns the overhead costs on the basis of activities that
have consumed resources;
2. In the second stage, costs are allocated from each activity-cost pool to each product line in
proportion to the amount of products consumed by the product line.

### d

indirect cost are allocated derectely to the cost object by 1) Traditional Coasting or 2) Active Based Costing
Consept of active-based-costing
Stage 1: Overheads are assigned to activities (costs are first pooled according to activities, and than activei cost driver rates)
Stage 2: Products Charge with Cost of activities

Ex 1. Activity-Based Costing = Set up cost; Cost Drive = No. of set ups; Cost Driver Rate = Set up cost/No. of Set ups
Ex. 2. Active Cost Pool = Ordering Cost; Cost Drive = No. of orders; Cost Driver Rate = Ordering Cost/No. of orders
Important to keep in mind that overhead cost are increasing day by day wereas ABC costing is becoming more relevant.

Example: