Most businesses overcome these variations and the waiting by using a predetermined or estimated overhead rate. Applied manufacturing overhead signifies manufacturing overhead expenses that have been applied to units of a product during a specific period.
The predetermined overhead rate is typically calculated using direct labor hours as a basis. The company will use , direct labor hours as its basis. Many companies choose to use a formula that is established by dividing the expected overhead costs for a period by the standard labor costs. They can assign overhead costs at the same time they assign direct raw materials and direct labor.
Since the future overhead costs and amount of direct labor costs or hours cannot be known with certainty, there will always be a difference between the actual overhead costs incurred and the amount of overhead applied to the manufactured goods. Manufacturing companies hope the differences will not be significant at the end of the accounting period.
So far, everything has been calculated using a predetermined rate to apply manufacturing overhead figures to individual jobs. But what happens when the actual bills start coming in on all those indirect costs? In most manufacturing organizations, the applied overhead is added to the materials and direct labor to calculate the cost of goods sold on every job during a specified period.
At the same time, accountants are also recording the actual bills. They keep a running total of these costs and hold them aside for later.
Manufacturing costs other than direct materials and direct labor are known as manufacturing overhead or factory overhead. It usually consists of both variable and fixed components.
Examples of manufacturing overhead cost include indirect materials , indirect labor , factory and plant depreciation, salary of production manager, property taxes, fuel, electricity, grease used in machines, and insurance expenses etc. Unlike direct materials and direct labor, manufacturing overhead is an indirect cost that cannot be directly assigned to individual jobs or units of products.
This problem is solved by using an allocation rate which is computed at the beginning of each period. This rate is known as predetermined overhead rate. As stated earlier, the predetermined overhead rate is computed at the beginning of the period and is used to apply manufacturing overhead cost to jobs throughout the period. Suppose the GX company has completed a job order.
The time tickets show that the workers have worked for 27 hours to complete the job. The expected overhead is estimated, and an allocation system is determined.
The actual costs are accumulated in a manufacturing overhead account. The overhead is then applied to the cost of the product from the manufacturing overhead account. The overhead used in the allocation is an estimate due to the timing considerations already discussed. The application rate that will be used in a coming period, such as the next year, is often estimated months before the actual overhead costs are experienced. Often, the actual overhead costs experienced in the coming period are higher or lower than those budgeted when the estimated overhead rate or rates were determined.
At this point, do not be concerned about the accuracy of the future financial statements that will be created using these estimated overhead allocation rates. You will learn in Determine and Disposed of Underapplied or Overapplied Overhead how to adjust for the difference between the allocated amount and the actual amount. Despite improvements in technology and information flow, using the actual overhead to calculate the application rate is usually not possible because the actual overhead information is available too late for management to make decisions.
Also, as you will learn, the results of the actual overhead costs, if they were available, could be misleading. Therefore, most manufacturing companies use predetermined overhead rates for these reasons:. As previously described, a predetermined overhead rate is established prior to the beginning of the fiscal year and typically is not changed during the year.
The predetermined rate is calculated as shown and is used to apply overhead costs to work in process:. The movie industry uses job order costing, and studios need to allocate overhead to each movie.
Their amount of allocated overhead is not publicly known because while publications share how much money a movie has produced in ticket sales, it is rare that the actual expenses are released to the public. The estimated or budgeted overhead is the amount of overhead determined during the budgeting process and consists of manufacturing costs but, as you have learned, excludes direct materials and direct labor.
Examples of manufacturing overhead costs include indirect materials, indirect labor, manufacturing utilities, and manufacturing equipment depreciation. Another way to view it is overhead costs are those production costs that are not categorized as direct materials or direct labor.
As you have learned, the overhead needs to be allocated to the manufactured product in a systematic and rational manner. Examples can include labor hours incurred, labor costs paid, amounts of materials used in production, units produced, or any other activity that has a cause-and-effect relationship with incurred costs.
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.
In other words, the products that involve more direct labor hours, direct labor dollars, or machine hours also increase utility expenses, supervisor time and thus indirect labor , equipment usage and the related depreciation expense, and so forth.
Traditionally, direct labor hours were used as the activity base, but technology continually decreases the amount of direct labor used in production, and machine hours or units produced have become more common activity bases. Management analyzes the costs and selects the activity as the estimated activity base because it drives the overhead costs of the unit.
Over the fiscal year, the actual costs are recorded as debits into the account called manufacturing overhead. When the overhead is applied to the jobs, the amount is first calculated using the application rate. The entry to record the overhead for Job MAC is:. That amount is added to the cost of the job, and the amount in the manufacturing overhead account is reduced by the same amount. At the end of the year, the amount of overhead estimated and applied should be close, although it is rare for the applied amount to exactly equal the actual overhead.
For example, Figure shows the monthly costs, the annual actual cost, and the estimated overhead for Dinosaur Vinyl for the year. While the total amounts are close to each other, they are not exact. Companies need to make certain the sales price is higher than the prime costs and the overhead costs. This can be a difficult task in industries in which overhead costs change. In some industries, the company has no control over the costs it must pay, like tire disposal fees.
To ensure that the company is profitable, an additional cost is added and the price is modified as necessary.
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