BEC Overhead Accounting for Overhead Accounting for manufacturing overhead is an important part of job-order costing and any

y other costing system. Overhead consists of all manufacturing costs other than direct materials and direct manufacturing labor. The distinguishing feature of manufacturing overhead is that while it must be incurred in order to produce goods, it cannot be directly traced to the final product as can direct materials and direct manufacturing labor. Therefore, overhead must be applied, rather than directly charged, to goods produced. The overhead application process is described below.

1. Overhead items are grouped by cost behavior (e.g., fixed and variable). 2. The fixed and variable overhead costs are estimated for the forthcoming period (e.g., $200,000 for variable overhead and $400,000 for fixed overhead). 3. A denominator (activity) base is chosen (see discussion below). A common choice is direct labor hours or machine hours. 4. The actual activity level is estimated for the forthcoming year (e.g., 80,000 hours). 5. A determine the normal capacity of the facility (e.g., 100,000 hours).

6. Determine the predetermined overhead rates. a. For variable overhead use actual activity level Estimated overhead costs $2.50/hour Estimated activity level b. For fixed overhead use normal capacity Estimated overhead costs = $4.00/hour Estimated activity level = $400,000 = $200,000 =

80,000 hours

100,000 hours

NOTE: Alternatively, the variable overhead may simply be estimated on a per unit basis based on past history (e.g., $2.50 per unit). 7. As actual overhead costs are incurred, they are debited to the factory overhead accounts. Various factory overhead (actual) Various accounts 900 900

Fixed factory overhead (actual) 1,000 Various accounts 1,000

8. As jobs are completed, the predetermined overhead rate(s) is used to apply overhead to these jobs. For example, if job 17 used 52 direct labor hours, $338 of overhead [$130 (52 x $2.50) for variable overhead and $208 ($52 $4) for fixed overhead] of overhead would be charged to work in process and entered on the job cost sheet.

Worked in process control 338 Variable factory overhead (applied) Fixed factory overhead (applied) 130 208

Accounting standards require the allocation of fixed production overhead to inventory based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved over a number of periods or seasons under normal circumstances. The actual level of production may be used if it approximates normal capacity. Therefore, for financial reporting purposes companies must use normal capacity to allocate fixed overhead but the actual activity level is used to allocate variable overhead.

To allocate the costs of overhead to units produced, an activity base must be chosen for use in the computation of a predetermined overhead rate. This activity base should bear a causal relationship to the incurrence of overhead costs. Examples of activity bases are

1.

Direct manufacturing labor hours 2. Direct manufacturing labor cost 3. Machine hours For example, overhead may result from (be a function of) hours worked regardless of who works, which would mean that direct manufacturing labor hours should be the activity base. If, on the other hand, more overhead costs were incurred because of heavily automated operations, machine hours might be a more appropriate activity base.

However for internal purposes, management may use a number of approaches to determine the activity level, as shown below.

Note that theoretical capacity is larger than practical capacity, which is larger than normal volume. Expected annual capacity fluctuates above and below normal volume.

At year-end fixed overhead may be

1.

OverappliedMore is applied than incurred because

a. Overhead costs were overestimated, b. Actual activity was greater than normal capacity, and/or c. Actual overhead costs were less than expected.

2. UnderappliedLess overhead is applied than incurred because

a. Overhead costs were underestimated, b. Actual activity was less than normal capacity, and/or c. Actual overhead costs were more than expected.

Joint products incur common, or joint costs, before the split-off point. The split-off point is the point of production at which the joint products can be individually identified and removed from the joint, or common, process. The joint products can then be sold or processed further. Costs incurred after the split-off point for any one of the joint products are called separable costs. Common costs are allocated to the joint products at the split-off point, usually on the basis of sales value at the split-off point, estimated net

realizable value (NRV) at split-off point, or some physical measure. The estimated net realizable value method allocates joint costs using the estimated sales values of the joint products after further processing less the separable processing costs. Of the first two methods listed, the sales value at split-off method must be used if a sales value at split-off point exists.

Process Costing Process costing, in contrast to job-order costing, is applicable to a continuous process of production of the same or similar goods, for example, oil refining and chemical production. Since the product is uniform, there is no need to determine the costs of different groups of products and each processing department becomes a cost center. Process costing computations can be broken down into the 5 steps listed below. 1. Visualize the physical flow of units 2. Compute the equivalent units of production 3. Determine costs to allocate 4. Compute unit costs 5. Allocate total costs to a.Goods completed b.Ending work in process

Note that the five steps above can be memorized using the acronym: PECUA (Physical Flow, Equivalent Units of Production, Costs to Allocate, Unit Costs, Allocate Costs). Flow of Units

The cost flow diagram shown under Section B in this module is the same for process costing except there will typically be several WIP accounts (i.e., one for every department). When solving a process costing problem, it is helpful to visualize the physical flow of units, as illustrated in the diagram below.

The units in BWIP are either completed or become spoiled. Units started during the period but not completed become EWIP.

2. Equivalent Units of Production (EUP)

An EUP is the amount of work equivalent to completing one unit from start to finish. In a process costing system, products are assigned costs periodically (usually monthly). At any one moment some units are incomplete which makes the EUP calculations necessary to allocate manufacturing costs between

1. Goods finished during the period (cost of goods manufactured) 2. Ending work in process The two primary EUP methods used for process costing are first-in, first-out (FIFO) and weighted-average (WA). Past questions on the exam have emphasized the weighted-average method. Under the weighted-average approach, current costs are combined with prior period costs, and all units are carried at an average cost of production. Importantly, the method assumes that all units completed during a period are started and completed during that period. As a result, the percentage of work done last period on the beginning work in process inventory is ignored. Simple Process Costing Example The BW Toy Company uses a weighted-average process cost system to collect costs. Data relevant to 2005 production is given below. Assume we begin with 800 units 25% complete for labor and overhead (conversion

costs), and 100% complete for materials because they are introduced at the start of the process. We start 4,200 units. 4,000 units are completed, while 1,000 remain in EWIP (20% complete for labor and overhead and 100% complete for materials). No spoilage exists. The costs are summarized in the following T-account:

Step 1: The physical flow of units is accounted for. BWIP Started To account for Units completed EWIP Accounted for 800 4,200 5,000 4,000 1,000 5,000

Step 2: The units completed and ending work in process are converted to equivalent units. Equivalent units Direct Conv. mtls.

Description

Total

Physical units to account for Beginning 800 inventory Units 4,200 started Units to 5,000 be accounted for Equivalent units of production Good units completed 4,000 4,000* and transferred out

4,000**

WIP

Ending

1,000 1,000* 5,000 5,000

200 4,200

Units accounted for

* These units are 100% complete with respect to materials because materials are introduced at the start of the process. ** These units are 100% complete with respect to conversion because all units completed are assumed to be started and completed during the period.

Step 3 and 4: Determine costs to allocate and equivalent unit costs. Manufacturing costs Beginning $ 1,432 $ 900 $ 532 inventory Current 18,200 4,200 14,000 costs Total costs to $ 19,632 $ 5,100 $ 14,532 account for Cost per $ 1.02*$ 3.46** equivalent unit * Notice the resulting costs are averages: $5,100 5,000 equivalent units = $1.02. ** $14,532 4,200 equivalent units = $3.46 Step 5: Allocate total costs to goods completed and ending work in process. Units completed [4,000 ($1.02 + $3.46)] Ending WIP: Mat. (1,000 $1.02) Conv.

$ 17,920

$1,020 692 1,712

(200 $3.46) Total costs accounted for

$ 19,632

The allocation is accomplished by multiplying the individual equivalent unit figures by the unit costs. 4. EUP for Material In the above example, material was assumed to be added at the beginning of the production process. Material can also be added at different points in the process (e.g., 10%, 70%) or gradually during the process.

Computer-integrated manufacturing (CIM) is a highly automated and integrated production process that is controlled by computers.

a. A flexible manufacturing system (FMS) is a series of computer controlled manufacturing processes that can be easily changed to make a variety of products. Activity-Based Costing Activity-based costing (ABC) is based upon two principles. First, activities consume resources. Second, these resources are consumed by products, services, or other cost objectives (output). ABC allocates overhead costs to products on the basis of the resources consumed by each activity involved in the design, production, and distribution of a particular good. This is accomplished through the assignment of costs to homogeneous cost pools that represent specific activities and then the allocation of these costs, using appropriate cost drivers, to the product.
This answer is correct because activity-based costing (ABC) is based upon two principles. First, activities consume resources. Second, these resources are consumed by products, services, or other cost objectives (output). ABC allocates overhead costs to products on the basis of the resources consumed by each activity involved in the design, production, and distribution of a particular good.

Calculating Overhead Variances 1. A predetermined overhead rate is computed. Estimated overhead costs $500,000 Estimated overhead costs = = $500,000 $6.25/hour

Estimated activity level 80,000 hours 2. As actual overhead costs are incurred, they are debited to the factory overhead account (e.g., $400). Factory overhead (actual) Various accounts 3. As jobs are completed, the predetermined overhead rate is used to apply overhead to these jobs. For example, if job 17 used 52 direct labor hours, $325 of overhead (52 x $6.25) would be charged to work in process and entered on the job cost sheet. Worked in process control 325 325 400 400

Factory overhead (applied) At year-end overhead may be 1.

OverappliedMore is applied than incurred because a.

Overhead costs were overestimated, b. More than expected activity took place, and/or c. Actual overhead costs were less than expected

2. UnderappliedLess overhead is applied than incurred because a. Overhead costs were underestimated, b. Less than expected activity took place, and/or c. Actual overhead costs were more than expected.

Prime costs are easily traceable to specific units of production and include direct manufacturing labor and direct materials. Direct costs are those easily traced to a specific business segment (e.g., product, division, department). Indirect costs are not easily traceable to specific segments and include factory overhead.

The high-low method separates a mixed cost into its variable and fixed components. The initial step in the high-low method utilizes a formula to find the variable rate. The formula used in developing the variable rate is Cost at high point Cost at low point High activity point Low activity point =Variable rate In this problem, the cost of steam is given at several levels of the designated activity, direct manufacturing labor hours (DMLH).

Substituting into the formula gives the variable cost of steam per direct manufacturing labor hour. $19,000 $13,000 3,650 DLH 2,050 DMLH = $4.00/DMLH

factory overhead is averaged over production in both job-order costing and process costing. Because the actual costs associated with factory overhead are generally not known until after the accounting period, a predetermined overhead rate is calculated based on an estimate of overhead cost. This rate is then used to apply overhead to production for both job-order costing and process costing. The difference between the two methods is that job-order costing allocates the applied overhead to the number of units in each job (generally a small number of units) while process costing allocates overhead to the number units in each processing center (generally a much larger number of units). Spoilage in Process Costing The following terms are commonly used: 1. SpoilageInferior goods either discarded or sold for disposal value 2. Defective unitsInferior goods reworked and sold as normal product A major distinction is made between normal and abnormal spoilage. a. Normal spoilage is the cost of spoiled units caused by the nature of the manufacturing process (i.e., which occur under efficient operating conditions). (1)Normal spoilage is a necessary cost in the production process and is, therefore, a product cost. b. Abnormal spoilage is the cost of spoiled units which were spoiled through some unnecessary act, event, or condition. (1) Abnormal spoilage is a period cost (e.g., loss on abnormal spoilage). (2)Abnormal spoilage costs should not be included in cost of goods

sold. Spoilage must be considered in EUP calculations. For example, if spoilage is discovered at the 60% point in processing and 100 units of abnormal spoilage are discovered, 60 EUP have occurred. The amount of abnormal loss would be the cost of 60 EUP (processing) plus the materials added to 100 units of production up to the 60% point. In contrast, if the spoilage was considered normal in nature, the spoilage cost would be treated as a product cost and simply added to the cost of the good units completed.

Hybrid-Costing System Because of the nature of their operations certain manufacturers use costing systems that blend characteristics of both the job-order and process costing systems. Such so-called hybrid-costing systems are often used by firms that manufacture a relatively large number of closely related standardized parts (e.g., automobile manufacturers). An example of a hybrid-costing system is the operation-costing system that applies costs to batches of similar, but not identical, products.

High-Low Method. The high-low method computes the slope for the variable rate based on the highest and lowest observations. Slope = Change in cost between high and low points

Change in activity between high and low points This method is illustrated using the following observations for factory maintenance costs (DMLH = Direct manufacturing labor hours). Month Month 123 4 5 6 DMLH Factory maintenance cost $ 110,000 115,000

45,000 (low) 50,000 70,00 158,000 60,000

135,000

75,000 (high) 170,000 65,000 145,000

The difference in cost is divided by the difference in activity to obtain the variable cost. The fixed cost can then be computed by using either the high observation or the low observation. The same result will be obtained with either one. The computation for separating factory maintenance cost is detailed below. Variable rate Computation computation $170,000 110,000 $20,000 75,000 45,000 = or $110,000 (45,000 $2) = $20,000 $2/DMLH Fixed rate $170,000 (75,000 $2) =

The high-low method is a rather crude technique compared to regression analysis. For example, this method may be inaccurate if the high and low points are not representative (i.e., are outliers) as illustrated in the following chart by the solid line Manufacturing Overhead
the use of indirect materials would be recorded by a credit to Stores

control (i.e., inventory of direct and indirect materials) and a debit to manufacturing overhead (MOH) control. Debiting MOH control increases the balance of this account.