MSE608C – Engineering and Financial Cost Analysis Calculating and Accounting for Overhead

Overhead Costs Overhead manufacturing costs are expenses that are difficult or too costly to assign directly to product. The method for allocating Overhead must be: –Rational –Able to identify a cause/effect relationship between costs and products –Applied consistently –Fair to responsible managers –Based on timely cost data –Based on accepted cost accounting rules and procedures.

Calculating the Overhead Rate When measuring and allocating Overhead there are three decisions that must be made by the Cost Accountant. 1. What costs become Overhead? 2. What will be the Cost-allocation base? 3. What will be the Overhead Rate? Different choices will result in different costs.

Calculating the Overhead Rate 1. What items become Overhead? –Identify the Prime Costs (Direct Labor and Direct Material); –all other Manufacturing costs will become Overhead. –Apply the Materiality concept. 2. What will be the Cost-allocation base? –Direct-labor hours –Direct-labor dollars –Material-dollars –Machine-hours –Units of Production

Calculating the Overhead Rate 3. What will be the Overhead (Burden) Rate? Step 1. Budget Overhead for the next accounting period Step 2. Budget cost-allocation base for the accounting period. Step 3. Calculate the applied Overhead Rate. Total Overhead Costs Overhead Rate = Total Cost-allocation base

Over-absorbed and Under- absorbed Overhead There is little chance the actual amount of Overhead incurred will equal the amount applied! –Applied Overhead was based on both budgeted overhead costs and budgeted utilization of the cost-allocation base. Under-absorbed Overhead –The amount applied is less than the actual amount spent on Overhead during the accounting period. Over-absorbed Overhead –The amount applied is more than the actual amount spent on Overhead during the accounting period.

The Overhead Variance Account In the Journal there is a special account called Overhead Variance. A credit variance = Over-absorbed Overhead A debit variance = Under-absorbed Overhead Overhead Variance Actual Overhead Expenses (Debit) Applied Overhead (Credit)

Journal Entries for Incurring Overhead Indirect Wages Payable $100 Allowance for Depreciation $200 Production Supplies $50 Factory Utilities $150 Overhead Variance $100 Finished Goods Inventory In-Process Inventory Cost-of-Goods-Sold $200 $50 $150

Allocating Overhead Indirect Wages Payable $100 Allowance for Depreciation $200 Production Supplies $50 Factory Utilities $150 Overhead Variance $100 Finished Goods Inventory $350 In-Process Inventory $75 $225 $50 Cost-of-Goods-Sold $200 $50 $150$225 $350 Direct Labor $75 Raw Material Inv. $$$$$$50 $$$$$ Wages Payable $$$$$ Accounts Payable $$$$$

Overhead Allocation Methods Full-absorption Costing –Allocates VARIABLE and FIXED Overhead costs. Variable Costing –Allocates only VARIABLE Overhead costs. Activity Based Costing (ABC) –Allocates overhead costs to the products that use them. Only useful when multiple products are manufactured in the same facility.

Assessment What is Overhead and why do we have to allocate it? Define Under-absorbed Overhead? Define Over-absorbed Overhead? Which is the only allowable method for reporting Overhead on financial reports, Full or Variable Absorption?