Manufacturing Overhead Is Applied To Each Job

Manufacturing overhead, a critical aspect of cost accounting, is applied to each job to accurately determine the total cost of production. Understanding how this process works is essential for effective cost management and pricing strategies in manufacturing.

Understanding Manufacturing Overhead

Manufacturing overhead encompasses all indirect costs incurred during the production process that cannot be directly traced to a specific job or product. These costs are essential for running the factory but are not directly part of the finished product like direct materials or direct labor.

What Constitutes Manufacturing Overhead?

Manufacturing overhead includes a wide range of costs, such as:

• Indirect Labor: Wages for factory supervisors, maintenance staff, and quality control personnel.
• Indirect Materials: Supplies used in the production process but not directly incorporated into the final product, like lubricants, cleaning supplies, and small tools.
• Factory Rent and Utilities: Costs associated with the factory building, including rent, electricity, heating, and water.
• Depreciation on Factory Equipment: The portion of the cost of factory equipment allocated to the current period.
• Factory Insurance: Insurance premiums for the factory building and equipment.
• Property Taxes on Factory: Taxes levied on the factory's real estate and equipment.
• Repairs and Maintenance: Costs associated with maintaining factory equipment and the building.

Why Apply Manufacturing Overhead?

Applying manufacturing overhead to each job is crucial for several reasons:

• Accurate Costing: It ensures that all costs associated with production are allocated to the products, providing a more accurate picture of the total cost of each job.
• Pricing Decisions: Accurate cost information is essential for setting competitive and profitable prices.
• Inventory Valuation: Manufacturing overhead is included in the cost of inventory, which is necessary for financial reporting.
• Profitability Analysis: By allocating overhead costs, businesses can better assess the profitability of individual jobs or products.
• Decision Making: Accurate cost data helps in making informed decisions about production processes, resource allocation, and cost control.

Methods for Applying Manufacturing Overhead

Several methods can be used to apply manufacturing overhead to each job, each with its own advantages and complexities. The most common methods include:

1. Predetermined Overhead Rate: This is the most widely used method due to its simplicity and practicality.
2. Activity-Based Costing (ABC): A more refined method that allocates overhead based on specific activities.

1. Predetermined Overhead Rate

The predetermined overhead rate is calculated at the beginning of the accounting period and is used to apply overhead costs to jobs throughout the period. This rate is based on an estimated overhead cost and an estimated activity level.

Formula:

Predetermined Overhead Rate = Estimated Total Manufacturing Overhead Costs / Estimated Total Activity Level

Steps to Apply Overhead Using the Predetermined Overhead Rate:

1. Estimate Total Manufacturing Overhead Costs:

   • Start by estimating all indirect costs expected to be incurred during the upcoming period. This includes indirect labor, indirect materials, factory rent, utilities, depreciation, insurance, and other factory-related expenses.
   • For example, a company might estimate its total manufacturing overhead costs to be $500,000 for the year.

2. Choose an Activity Base:

   • The activity base is a measure of activity that drives overhead costs. Common activity bases include:
     • Direct Labor Hours: The total number of hours worked by direct labor employees.
     • Direct Labor Cost: The total cost of direct labor.
     • Machine Hours: The total number of hours machines are used in production.
     • Units Produced: The number of units manufactured.
   • The choice of activity base depends on the nature of the production process. If overhead costs are driven by labor, direct labor hours or cost may be appropriate. If overhead costs are driven by machine usage, machine hours may be more suitable.
   • For instance, if a company determines that direct labor hours drive overhead costs, they might estimate 25,000 direct labor hours for the year.

3. Estimate the Total Activity Level:

   • Estimate the total amount of the chosen activity base expected to occur during the period.
   • In our example, the estimated total activity level is 25,000 direct labor hours.

4. Calculate the Predetermined Overhead Rate:

   • Divide the estimated total manufacturing overhead costs by the estimated total activity level.
   • Using the figures from our example:

   Predetermined Overhead Rate = $500,000 / 25,000 direct labor hours = $20 per direct labor hour
   

5. Apply Overhead to Jobs:

   • Multiply the predetermined overhead rate by the actual activity level incurred by each job.
   • For example, if Job #101 used 100 direct labor hours, the overhead applied to Job #101 would be:

   Overhead Applied = Predetermined Overhead Rate x Actual Activity Level
   Overhead Applied = $20 per direct labor hour x 100 direct labor hours = $2,000
   

Advantages of the Predetermined Overhead Rate Method:

• Simplicity: Easy to calculate and apply.
• Timeliness: Allows for timely application of overhead costs throughout the period, rather than waiting until the end of the period.
• Cost Control: Provides a basis for monitoring and controlling overhead costs.

Disadvantages of the Predetermined Overhead Rate Method:

• Inaccuracy: Based on estimates, which may not accurately reflect actual costs.
• Over- or Under-Application: Can result in over- or under-applied overhead, which needs to be adjusted at the end of the period.
• Single Activity Base: May not accurately allocate overhead costs if multiple activities drive overhead costs.

2. Activity-Based Costing (ABC)

Activity-Based Costing (ABC) is a more refined method that allocates overhead costs based on the specific activities that drive those costs. This method recognizes that different activities consume different amounts of resources and allocates overhead accordingly.

Steps to Apply Overhead Using Activity-Based Costing:

1. Identify Activities:

   • Identify the major activities that drive overhead costs in the production process.
   • Examples of activities include:
     • Machine Setup: Preparing machines for production runs.
     • Material Handling: Moving materials within the factory.
     • Quality Inspection: Inspecting products for defects.
     • Engineering Changes: Making changes to product designs.

2. Assign Overhead Costs to Activity Cost Pools:

   • Group overhead costs into cost pools based on the activities that drive those costs.
   • For example:
     • Machine Setup Cost Pool: Includes costs associated with machine setup, such as setup labor, setup materials, and depreciation on setup equipment.
     • Material Handling Cost Pool: Includes costs associated with material handling, such as forklift operator wages, forklift maintenance, and storage costs.

3. Identify Cost Drivers:

   • Identify the cost driver for each activity cost pool. The cost driver is the factor that causes the activity to occur.
   • Examples of cost drivers include:
     • Machine Setup Cost Pool: Number of setups.
     • Material Handling Cost Pool: Number of material moves.
     • Quality Inspection Cost Pool: Number of inspections.
     • Engineering Changes Cost Pool: Number of engineering change orders.

4. Calculate Activity Rates:

   • Calculate the activity rate for each cost pool by dividing the total cost in the cost pool by the total amount of the cost driver.
   • Formula:

   Activity Rate = Total Cost in Cost Pool / Total Amount of Cost Driver
   

   • For example, if the Machine Setup Cost Pool has a total cost of $100,000 and there are 500 setups, the activity rate would be:

   Activity Rate = $100,000 / 500 setups = $200 per setup
   

5. Apply Overhead to Jobs:

   • Multiply the activity rate for each cost pool by the amount of the cost driver consumed by each job.
   • For example, if Job #101 required 10 machine setups, 5 material moves, 2 quality inspections, and 1 engineering change, the overhead applied to Job #101 would be:

   Overhead Applied = (Activity Rate for Machine Setup x Number of Setups) + (Activity Rate for Material Handling x Number of Material Moves) + (Activity Rate for Quality Inspection x Number of Inspections) + (Activity Rate for Engineering Changes x Number of Engineering Changes)
   

   • Assuming the following activity rates:

     • Machine Setup: $200 per setup
     • Material Handling: $50 per move
     • Quality Inspection: $100 per inspection
     • Engineering Changes: $500 per change

   • The overhead applied to Job #101 would be:

   Overhead Applied = ($200 x 1) + ($50 x 5) + ($100 x 2) + ($500 x 1)
   Overhead Applied = $200 + $250 + $200 + $500 = $1,150
   

Advantages of Activity-Based Costing:

• Accuracy: Provides a more accurate allocation of overhead costs compared to the predetermined overhead rate method.
• Better Cost Control: Helps identify and control the activities that drive overhead costs.
• Improved Decision Making: Provides more accurate cost information for pricing, product mix, and other strategic decisions.

Disadvantages of Activity-Based Costing:

• Complexity: More complex and time-consuming to implement than the predetermined overhead rate method.
• Costly: Can be more expensive to implement and maintain.
• Requires Detailed Data: Requires detailed data on activities and cost drivers.

Example Scenarios

Scenario 1: Predetermined Overhead Rate

A manufacturing company, Alpha Manufacturing, estimates its total manufacturing overhead costs for the year to be $800,000. The company uses direct labor hours as its activity base and estimates total direct labor hours to be 40,000.

1. Calculate the Predetermined Overhead Rate:

Predetermined Overhead Rate = Estimated Total Manufacturing Overhead Costs / Estimated Total Activity Level
Predetermined Overhead Rate = $800,000 / 40,000 direct labor hours = $20 per direct labor hour

2. Apply Overhead to a Specific Job:

Job #201 used 200 direct labor hours. The overhead applied to Job #201 would be:

Overhead Applied = Predetermined Overhead Rate x Actual Activity Level
Overhead Applied = $20 per direct labor hour x 200 direct labor hours = $4,000

Scenario 2: Activity-Based Costing

Beta Corporation uses Activity-Based Costing (ABC) to allocate overhead costs. The company has identified the following activities and cost drivers:

• Activity: Machine Setup
  • Cost Pool: $150,000
  • Cost Driver: Number of setups
  • Total Setups: 750
• Activity: Material Handling
  • Cost Pool: $100,000
  • Cost Driver: Number of material moves
  • Total Moves: 1,000
• Activity: Quality Inspection
  • Cost Pool: $50,000
  • Cost Driver: Number of inspections
  • Total Inspections: 500

1. Calculate Activity Rates:

• Machine Setup: $150,000 / 750 setups = $200 per setup
• Material Handling: $100,000 / 1,000 moves = $100 per move
• Quality Inspection: $50,000 / 500 inspections = $100 per inspection

2. Apply Overhead to a Specific Job:

Job #301 required 5 machine setups, 10 material moves, and 2 quality inspections. The overhead applied to Job #301 would be:

Overhead Applied = (Activity Rate for Machine Setup x Number of Setups) + (Activity Rate for Material Handling x Number of Material Moves) + (Activity Rate for Quality Inspection x Number of Inspections)
Overhead Applied = ($200 x 5) + ($100 x 10) + ($100 x 2)
Overhead Applied = $1,000 + $1,000 + $200 = $2,200

Addressing Over- or Under-Applied Overhead

At the end of the accounting period, it is common to have either over-applied or under-applied overhead. This occurs because the predetermined overhead rate is based on estimates, and actual costs and activity levels may differ from these estimates.

Over-Applied Overhead

Over-applied overhead occurs when the amount of overhead applied to jobs is greater than the actual overhead costs incurred.

Example:

• Actual Manufacturing Overhead Costs: $750,000
• Overhead Applied to Jobs: $800,000
• Over-Applied Overhead: $50,000

Under-Applied Overhead

Under-applied overhead occurs when the amount of overhead applied to jobs is less than the actual overhead costs incurred.

Example:

• Actual Manufacturing Overhead Costs: $850,000
• Overhead Applied to Jobs: $800,000
• Under-Applied Overhead: $50,000

Methods for Disposing of Over- or Under-Applied Overhead

There are two common methods for disposing of over- or under-applied overhead:

1. Write-Off to Cost of Goods Sold (COGS):

• This is the simpler method and is typically used when the amount of over- or under-applied overhead is immaterial.
• The over- or under-applied overhead is simply written off to Cost of Goods Sold.
• If overhead is over-applied, COGS is decreased.
• If overhead is under-applied, COGS is increased.

2. Allocation to Work-in-Process, Finished Goods, and Cost of Goods Sold:

• This method is more accurate and is typically used when the amount of over- or under-applied overhead is material.
• The over- or under-applied overhead is allocated to Work-in-Process (WIP) inventory, Finished Goods inventory, and Cost of Goods Sold based on the proportion of overhead included in each account.

Example of Write-Off to COGS:

• Under-Applied Overhead: $50,000

Debit: Cost of Goods Sold $50,000
Credit: Manufacturing Overhead $50,000

Example of Allocation Method:

Assume the following balances:

• Work-in-Process Inventory: $100,000 (includes $20,000 of overhead)
• Finished Goods Inventory: $200,000 (includes $40,000 of overhead)
• Cost of Goods Sold: $500,000 (includes $100,000 of overhead)
• Total Overhead in Accounts: $20,000 + $40,000 + $100,000 = $160,000
• Under-Applied Overhead: $50,000

1. Calculate Allocation Percentages:

• Work-in-Process: ($20,000 / $160,000) = 12.5%
• Finished Goods: ($40,000 / $160,000) = 25%
• Cost of Goods Sold: ($100,000 / $160,000) = 62.5%

2. Allocate Under-Applied Overhead:

• Work-in-Process: 12.5% x $50,000 = $6,250
• Finished Goods: 25% x $50,000 = $12,500
• Cost of Goods Sold: 62.5% x $50,000 = $31,250

3. Journal Entry:

Debit: Work-in-Process Inventory $6,250
Debit: Finished Goods Inventory $12,500
Debit: Cost of Goods Sold $31,250
Credit: Manufacturing Overhead $50,000

Conclusion

Applying manufacturing overhead to each job is a crucial aspect of cost accounting. It ensures that all costs associated with production are allocated to the products, providing a more accurate picture of the total cost of each job. Whether using the predetermined overhead rate method or the more refined activity-based costing, businesses can make informed decisions about pricing, profitability, and resource allocation. Addressing over- or under-applied overhead at the end of the accounting period is also essential to maintain accurate financial reporting. By understanding and effectively managing manufacturing overhead, companies can enhance their cost control and improve their overall financial performance.