STEP-II Overhead Absorption

Overhead Application (or Absorption) the process of assigning manufacturing overhead costs to production jobs on some equitable basis RESULTS
cost of each product includes equitable share of total overheads

PROCESS
select absorbtion base calculate absorbtion rate per unit of base selected for each

production centre apply absorption rate to various products or jobs

STEP-II Overhead Absorption

PROCESS

I- SELECT ABSORBTION BASE which may be

DIRECT MATERIAL---------FACTORY OVHDS/DIRECT MATL
DIRECT LABOUR---------FACTORY OVHDS/DIRECT LABOUR

PRIME COST---------FACTORY OVHDS/PRIME COSTS

DIRECT LABOUR HOUR---------FACTORY OVHDS/UNITS

OF PRODUCTION

MACHINE HOUR RATE---------FACTORY

OVHDS/MACHINE HOURS

Overhead Accounting
Beginning of Accounting period End of Accounting period

Time
Budgeted overhead (and calculation of predetermined overhead rate)
Applied overhead

Actual overhead

Predetermined Overhead Rate

Budgeted manufacturing-overhead cost

Budgeted amount of cost driver (activity base)

Application of Manufacturing Overhead

The predetermined overhead rate (POHR) used to apply overhead to jobs is determined before the period begins.

This budgeted rate is used to apply overhead to all jobs completed during the year.
Estimated total manufacturing overhead cost for the coming period Estimated total units in the allocation base for the coming period

POHR =

Both the numerator and denominator Ideally, the allocation base of the predetermined overhead rate are is primary cost driver that causes overhead. based on estimated amounts.

Predetermined Overhead Rates

Estimated total factory overhead costs

Estimated activity base

= factory overhead rate

Predetermined

Why is the predetermined overhead rate calculated from estimated numbers at the beginning of the period?

It is a tradeoff between accuracy and timeliness. If a company waited until the end of an accounting period, when all overhead costs are known, the allocated factory overhead would be accurate but not timely.

Manufacturing Overhead Costs

Managers making decisions today cannot wait until the end of the year for product cost information.
To solve this problem accountants develop an estimated overhead allocation rate. Using a predetermined rate makes it possible to estimate total job costs sooner.

Actual overhead for the period is not known until the end of the period.

Job Cost Sheets Manufacturing Overhead Applied

Pear.Co applies overhead based on direct labor hours. Total estimated overhead for the year is $640,000. Total estimated labor cost is $1,400,000 and total estimated labor hours are 160,000. What is Pear.Cos predetermined overhead rate per hour?

Overhead Application Example

Overhead Application Example

POHR =
Estimated total manufacturing overhead cost for the coming period
Estimated total units in the allocation base for the coming period $640,000

POHR =

160,000 direct labor hours (DLH)

STEP-II Overhead Absorption

PROCESS

II- CALCULATE ABSORBTION RATE PER UNIT OF BASE SELECTED FOR EACH PRODUCTION CENTRE which may be
as % of direct material cost

as % of direct labour cost

as % of prime cost as % of labour hour rate

as % of machine hour rate

Overhead Application Example

POHR =
Estimated total manufacturing overhead cost for the coming period
Estimated total units in the allocation base for the coming period $640,000

POHR =

160,000 direct labor hours (DLH)

POHR = $4.00 per DLH

For each direct labor hour worked on a job, $4.00 of factory overhead will be applied to the job.

STEP-II Overhead Absorption

PROCESS

III- APPLYING ABSORBTION RATE TO VARIOUS PRODUCTS OR JOBS

Application of Manufacturing Overhead

Based on estimates, and determined before the period begins.

Overhead applied = POHR Actual activity

Actual amount of the cost driver such as units produced, direct labor hours, or machine hours. Incurred during the period.

Overhead applied = POHR Actual activity : Overhead applied = $4 per DLH 8 DLH = $32

Job-Order Cost Accounting

Overhead applied = POHR Actual activity Overhead applied = $4 per DLH 8 DLH = $32

Summarising the Two-Step Process to Apply Manufacturing Overhead to Products

Step One
Annual expected (budgeted) manufacturing overhead Predetermined = Annual expected (budgeted) activity level overhead rate (e.g., direct labor hours)

Step Two
Predetermined Actual activity Allocated manufacturing x = overhead rate level per job overhead assigned to job

Summarising the Two-Step Process to Apply Manufacturing Overhead to Products

POHR =

Estimated total manufacturing overhead cost for the coming period Estimated total units in the allocation base for the coming period

Work in Process

Allocation base examples

1. Direct labor hours 2. Direct labor dollars 3. Machine hours 4. Direct materials 5. Other
Overhead applied = POHR Actual activity

Based on estimates, and determined before the period begins.

Job 1
Actual amount of the cost driver such as units produced, direct labor hours, or machine hours. Incurred during the period.

Job 2

Job 3

Learning Objective
Understand

the process of accounting for overhead.

Overhead Rates Actual vs Predetermined or standard rate

Actual Overhead Actual annual manufacturing overhead

costs. Needed for accurate determination of income. Recorded as debit to Manufacturing Overhead.

Overhead Rates Actual vs Predetermined or standard rate

ACTUAL OVERHEAD RATES
Known only after end of accounting period when all costs/production figures have been collected

Disadvantages Variation due to seasonal nature of some overhead costs e.g. change in volume of production, efficiency Overheads paid in advance Fire insurance premium It should be charges to all works manufactured during the year How should absorbtion be done?

Overhead Rates Actual vs Predetermined or standard rate

Predetermined Overhead Amount of overhead applied to products

using the predetermined overhead rate. Recorded as credit to Manufacturing Overhead.

Overhead Rates Actual vs Predetermined or standard rate

PREDETERMINED/APPLIED OVERHEAD RATES
Generally used Calculated in advance of the period by estimated production overhead to be absorbed estimated period production (may be based on any absorbtion base such as prime cost, labour cost) Advantages Constant unit cost Avoid unit cost fluctuation Results in UNDERABSORBTION/UNDERAPPLICATION OR OVERABSORBTION/OVERAPPLICATION

Underapplied and Over applied Overhead

Under applied Overhead the amount by which a periods actual manufacturing- overhead exceeds applied manufacturing- overhead Actual manufacturing-overhead $29,050 Applied manufacturing-overhead $28,800 Under applied overhead $ 250 Over applied Overhead the amount by which a periods applied manufacturing- overhead exceeds actual manufacturing- overhead
Manufacturing Overhead Actual 10 Applied 20 Manufacturing Overhead

Actual

Applied

(Cost of job is overstated)

20 10 (Cost of job is understated)

PearCos actual overhead for the year was $650,000 for a total of 170,000 direct labor hours. How much total overhead was applied to Pear Cos jobs during the year? Use Pear Cos predetermined overhead rate of $4.00 per direct labor hour.

Overhead Application Example

PearCos actual overhead for the year was $650,000 for a total of 170,000 direct labor hours. How much total overhead was applied to PearCos jobs during the year? Use PearCos predetermined overhead rate of $4.00 per direct labor hour.

Overhead Application Example

SOLUTION
Applied Overhead = POHR Actual Direct Labor Hours
Applied Overhead = $4.00 per DLH 170,000 DLH = $680,000

PearCos actual overhead for the year was $650,000 for a total of 170,000 direct labor hours. How much total overhead was applied to PearCos jobs PearCo has overapplied during the year? Use PearCos predetermined overhead overheadrate of $4.00 per direct labor hour, for the year by $30,000. What will PearCo do?

Overhead Application Example

SOLUTION
Applied Overhead = POHR Actual Direct Labor Hours
Applied Overhead = $4.00 per DLH 170,000 DLH = $680,000

Treating Applied Overhead

Two methods for treating over- and underapplied MOH: - Disposition : Close over- or underapplied overhead directly to Cost of Goods Sold. - Easier and more commonly used, especially if amount is small. - Debit MOH, Credit COGS. - Proration : Allocate over- or underapplied manufacturing overhead to Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold on the basis of the ending balances in these three accounts. - More accurate; any difference is allocated proportionately. - More complicated; requires detailed calculations.

Overapplied and Underapplied Manufacturing Overhead

PearCos Method $30,000 may be allocated to these accounts. $30,000 may be closed directly to cost of goods sold.

OR
Work in Process Finished Goods Cost of Goods Sold

Cost of Goods Sold

Overapplied and Underapplied Manufacturing Overhead

PearCos Cost of Goods Sold
Unadjusted Balance $30,000 Adjusted Balance

PearCos Mfg. Overhead

Actual Overhead overhead Applied costs to jobs

$650,000
$30,000

$680,000
$30,000 overapplied

Overapplied and Underapplied Manufacturing Overhead - Summary

PearCos Method
If Manufacturing Overhead is . . . UNDERAPPLIED (Applied OH is less than actual OH) OVERAPPLIED (Applied OH is greater than actual OH) DECREASE Cost of Goods Sold Alternative 1 Close to Cost of Goods Sold INCREASE Cost of Goods Sold Alternative 2 Allocation INCREASE Work in Process Finished Goods Cost of Goods Sold DECREASE Work in Process Finished Goods Cost of Goods Sold

Actual and Normal Costing

Actual direct material and direct labor combined with actual overhead. Actual direct material and direct labor combined with predetermined overhead.

Using a predetermined rate makes it possible to estimate total job costs sooner.

Actual overhead for the period is not known until the end of the period.