Accounting for Overhead Costs Introduction to Management Accounting Chapter 6

Manufacturing Costs The Product Direct Labor Manufacturing Overhead Direct Material

Example: Steel used to manufacture the automobile. Example: Steel used to manufacture the automobile. Cost of raw material that is used to make, and can be conveniently traced, to the finished product.

Cost of salaries, wages, and fringe benefits for personnel who work directly on manufactured products. Direct Labor Example: Wages paid to an automobile assembly worker. Example: Wages paid to an automobile assembly worker.

All other manufacturing costs Manufacturing Overhead Materials used to support the production process. Examples: lubricants and cleaning supplies used in an automobile assembly plant. Indirect Labor Indirect Material Other Costs

All other manufacturing costs Manufacturing Overhead Cost of personnel who do not work directly on the product. Examples: maintenance workers, janitors and security guards. Indirect Labor Indirect Material Other Costs

All other manufacturing costs Manufacturing Overhead Examples: depreciation on plant and equipment, property taxes, insurance, utilities, overtime premium, and unavoidable idle time. Indirect Labor Indirect Material Other Costs

Accounting for Factory Overhead Methods for assigning overhead costs to the products is an important part of accurately measuring product costs. Learning Objective 1

Budgeted Overhead Application Rates 1. Select one or more cost drivers. 2. Prepare a factory overhead budget. 3. Compute the factory overhead rate. 4. Obtain actual cost-driver data. 5. Apply the budgeted overhead to the products. to the products. 6. Account for any differences between the amount of actual and applied overhead. amount of actual and applied overhead.

Budgeted overhead application rate = Total budgeted factory overhead ÷ Total budgeted amount of cost driver Budgeted Overhead Application Rates Overhead rates are budgeted; they are estimates. The budgeted rates are used to apply overhead based on actual events.

Illustration of Overhead Application The company’s budgeted manufacturing overhead for the machining department is $277,800. Budgeted machine hours are 69,450. The budgeted overhead application rate is: $277,800 ÷ 69,450 = $4 per machine hour Enriquez Machine Parts Company selects a single cost- allocation in each department for applying overhead, machine hours in machining and direct-labor in assembly.

MachiningAssembly Budgeted manufacturing overhead$227,800$103,200 Budgeted machine hours 69,450 Budgeted direct-labor cost$206,400 Budgeted overhead rate, per machine hour$4 Budgeted overhead rate, per direct-labor dollar50%

Illustration of Overhead Application Suppose that at the end of the year Enriquez had used 70,000 hours in Machining and incurred $ of direct-labor cost in assembly How much overhead was applied the products produced? 70,000 * 4+190,000 * 0.5 = $ 375,000

Choice of Cost-Allocation Bases No one cost –allocation base is right for all situations. The accountant’s goal is to find the cost- allocation base that best links cause and effect.

Choice of Cost-Allocation Bases A separate cost pool should be Identified for each cost-allocation base. Base 1 Pool 1 Base 2 Pool 2

Choice of Cost-Allocation Bases rule 20% of the bases 80% of the overheads

Normalized Overhead Rates “Normal” product costs include an average or normalized chunk of overhead. Actual direct material + Actual direct labor + Normal applied overhead = Cost of manufactured product

Cost of Goods Mfd. Finished Goods Cost of Goods Sold Cost of Goods Mfd. Cost of Goods Sold Direct Material Direct Labor Overhea d Applied Work in Process Cost Flows

Disposing of Under-applied or Over-applied Overhead Suppose that Enriquez applied $375,000 to its products. Also, suppose that Enriquez actually incurred $392,000 of actual manufacturing overhead during the year. $392,000 actual –375,000 applied $ 17,000 Under-applied $ 17,000 Under-applied The $375,000 becomes part of Cost of Goods Sold when the product is sold. The $17,000 must also become an expense.

Disposing of Under-applied or Over-applied Overhead The applied overhead is $17,000 less than the amount incurred. It is: Over-applied overhead occurs when the amount applied exceeds the amount incurred.

Immediate Write-Off Manufacturing Overhead 392,000375,000 17,000 17,000 0 Cost of Goods Sold 17,000 Incurred Overhead (Actual) Applied Overhead (Budgeted) This method regards the $17,000 as a reduction in current income and adds it to Cost of Goods Sold.

Prorating Among Inventories This method prorates the $17,000 of Under-applied overhead to Work-In Process (WIP), Finished Goods, and Cost of Goods Sold accounts assuming the following ending account balances: Work-in-Process Inventory$ 155,000 Finished Goods Inventory 32,000 Cost of Goods Sold 2,480,000 Total$2,667,000

Account balanceAllocating $17000 (under- applied) Work-in-Process Inventory $ 155,000 $17,000 × 155/2,667 = 988 Finished Goods Inventory 32,000 32,000 $17,000 × 32/2,667 = $204 Cost of Goods Sold 2,480,000 2,480,000 $17,000 × 2,480/2,667 = $15,808 Total$2,667,000

Variable and Fixed Application Rates The presence of fixed costs is a major reason of costing difficulties. Some companies distinguish between variable overhead and fixed overhead for product costing.

Variable Versus Absorption Costing Variable costing excludes fixed manufacturing overhead from the cost of products. Absorption costing includes fixed manufacturing overhead in the cost of products. VariablecostingAbsorptioncosting Learning Objective 2

Variable costing Direct material Direct labor Variable manufacturing overhead  costs to account for inventoried costs expense on income  on balance sheet statement Initially applied to inventory as product costs Become expenses when the inventory is sold Fixed manufacturing overhead Become expenses immediately

absorption costing Direct material Direct labor Variable manufacturing overhead Fixed manufacturing overhead  costs to account for inventoried costs expense on income  on balance sheet statement Initially applied to inventory as product costs Become expenses when the inventory is sold

Facts and Illustration Basic Production Data at Standard Cost Direct material$205 Direct labor 75 Variable manufacturing overhead 20 Standard variable costs per unit$300

Facts and Illustration The annual budget for fixed manufacturing overhead is $1,500,000 Budgeted production is 15,000 computers. Sales price = $500 per unit $20 per computer is variable overhead. Sales commissions = 5% of dollar sales Fixed S&A expenses = $650,000

Facts and Illustration Units 20X7 20X8 Opening inventory – 3,000 Production17,00014,000 Sales14,00016,000 Ending inventory 3,000 1,000 There are no variances from the standard variable manufacturing costs, and the actual fixed manufacturing overhead incurred is exactly $1,500,000.

Variable- Costing Method Cost of Goods Sold Variable expenses: Variable manufacturing cost of goods sold of goods sold Opening inventory, at –$ 900 Opening inventory, at –$ 900 standard costs of $300 standard costs of $300 Add: variable cost of goods manufactured at standard, manufactured at standard, 17,000 and 14,000 units ,000 and 14,000 units Available for sale, 17,000 units Ending inventory, at $ ¹ 300² Variable manufacturing cost of goods sold$4200$4800 cost of goods sold$4200$4800 (thousands of dollars) 20X7 20X8 ¹3,000 units × $300 = $900,000 ²1,000 units × $300 = $300,000

Variable-Costing Method Comparative Income Statement Sales, 14,000 and 16,000 units$7,000$8,000 Variable expenses: Variable manufacturing cost of goods sold cost of goods sold Variable selling expenses, at 5% of dollar sales at 5% of dollar sales Contribution margin$2,450$2,800 Fixed expenses: Fixed factory overhead$1,500$1,500 Fixed selling and admin. expenses Operating income, variable costing$ 300$ 650 (thousands of dollars) 20X7 20X8 from Cost of Goods Sold previous calculation 1 from Cost of Goods Sold previous calculation

Fixed-Overhead Rate The fixed-overhead rate is the amount of fixed manufacturing overhead applied to each unit of production. $1,500,000 ÷ 15,000 = $100 budgeted fixed manufacturing overhead expected volume of production expected volume of production Fixed overhead rate =

Beginning inventory$ –$1,200 Add: Cost of goods manufactured at standard, of $400* 6,800 5,600 at standard, of $400* 6,800 5,600 Available for sale$6,800$6,800 Deduct: Ending inventory 1, Cost of goods sold, at standard$5,600$6,400 (thousands of dollars) 20X7 20X8 Absorption-Costing Method Cost of Goods Sold *Variable cost$300 Fixed cost 100 Fixed cost 100 Standard absorption cost $400 Standard absorption cost $400

Absorption-Costing Method Comparative Income Statement *Based on expected volume of production of 15,000 units: 20X7: (17,000 – 15,000) × $100 = $200,000 F 20X7: (17,000 – 15,000) × $100 = $200,000 F 20X8: (14,000 – 15,000) × $100 = $100,000 U 20X8: (14,000 – 15,000) × $100 = $100,000 U 1From Cost of Goods Sold previous calculation Sales$7,000$8,000 Cost of goods sold, at standard 5,600 6,400 1 Cost of goods sold, at standard 5, ,400 1 Gross profit at standard$1,400$1,600 Production-volume variance* 200 F 100 U Gross margin or gross profit “actual”$1,600$1,500 Selling and administrative expenses 1,000 1,050 Operating income, variable costing$ 600$ 450 (thousands of dollars) 20X7 20X8

Variable Costing and Absorption Costing The difference between income reported under these two methods is entirely due to the treatment of fixed manufacturing costs.

Variable Costing and Absorption Costing On a variable-costing income statement, costs are separated into the major categories of fixed and variable. Revenue less all variable costs (both manufacturing and non-manufacturing) is the contribution margin. On an absorption-costing income statement, costs are separated into the major categories of manufacturing and non-manufacturing. Revenue less manufacturing costs (both fixed and variable) is gross profit or gross margin.

Sales, 14,000 and 16,000 units $7,000$8,000 Variable expenses: Variable manufacturing cost of goods sold cost of goods sold Variable selling expenses, at 5% of dollar sales at 5% of dollar sales Contribution margin$2,450$2,800 Fixed expenses: Fixed factory overhead$1,500$1,500 Fixed selling and admin. expenses Operating income, variable costing $ 300 $ 650 Sales $7,000 $8,000 Cost of goods sold, at standard 5,600 6,400 Gross profit at standard $1,400 $1,600 Production-volume variance* 200 F 100 U Gross margin or gross profit “actual” $1,600 $1,500 Selling and administrative expense 1,000 1,050 Operating income, variable costing $ 600 $ 450 (thousands of dollars) 20X7 20X8

Why Use Variable Costing?

Sales, (1000unites,$6 per unit)$6,000$6,000 Costs of goods sold: direct costs & variable overhead (1000unites,$2per unit) $2,000$2,000 (1000unites,$2per unit) $2,000$2,000 fixed overhead $4,800$1,600 Gross profit$ (800)$2,400 Selling and admin. expenses ,000 Operating income, variable costing$(1,800)$1,400 production 1000 units3000 units (thousands of dollars) 20X1 20X2

Why Use Variable Costing? One reason is that absorption-costing income is affected by production volume while variable-costing income is not. Another reason is based on which system the company believes gives a better signal about performance.

Effects of Sales and Production on Reported Income Production > Sales Variable costing income is lower than absorption income. Production < Sales Variable costing income is higher than absorption income.

F Used for production of large, unique, high-cost items. F Built to order rather than mass produced. F Many costs can be directly traced to each job. FTWO TYPES: FJob-shop operations FProducts manufactured in very low volumes or one at a time. F Batch-production operations FMultiple products in batches of relatively small quantity. Process Costing Job-Order Costing Types of Product-Costing Systems

Job-Order Costing and Process Costing Job-order costing allocates costs to products that are identified by individual units or batches. Job-order costing allocates costs to products that are identified by individual units or batches. Process costing averages costs over large numbers of nearly identical products. Process costing averages costs over large numbers of nearly identical products. Leaning Objective 3

F Typical job-order cost applications: v Special-order printing v Building construction F Also used in service industry v Hospitals v Law firms Process Costing Job-Order Costing Types of Product-Costing Systems

Process Costing Job-Order Costing F Used for production of small, identical, low cost items. F Mass produced in automated continuous production process. F Costs cannot be directly traced to each unit of product. FTypical process cost applications: FPetrochemical refinery FPaint manufacturer FPaper mill Types of Product-Costing Systems

Date Started: 1/7/20X7Job Number: 963 Date Completed: 1/14/20X7Units completed: 12 CostDateRef. Quantity Amount Summary Direct Materials: 6” Bars1/7N Casings1/9K Direct Labor: Drill1/87Z /97Z Grind1/139Z Overhead: Applied1/149.0 mach. hrs Total cost Unit cost Date Started: 1/7/20X7Job Number: 963 Date Completed: 1/14/20X7Units completed: 12 CostDateRef. Quantity Amount Summary Direct Materials: 6” Bars1/7N Casings1/9K Direct Labor: Drill1/87Z /97Z Grind1/139Z Overhead: Applied1/149.0 mach. hrs Total cost Unit cost Job-Cost Record

Contracts Missions Programs Cases THE JOB Job-Order Costing in Nonmanufacturing Organizations

Process Cost Flows