Overheads Absorbtion

7/29/2019 Overheads Absorbtion

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STEP-II Overhead Absorption

Overhead Application (or Absorption) the process of

assigning manufacturing overhead costs to production jobson 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


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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/UNITSOF PRODUCTION

MACHINE HOUR RATE---------FACTORYOVHDS/MACHINE HOURS


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Overhead AccountingBeginning of

Accounting periodEnd of

Accounting period

TimeBudgeted

overhead

(and calculation of

predetermined

overhead rate)

Applied

overheadActual

overhead

Predetermined

Overhead Rate

Budgeted manufacturing-overhead cost

Budgeted amount of cost driver (activity base)=

f f O


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Estimated total manufacturing

overhead cost for the coming period

Estimated total units in theallocation base for the coming period

POHR =

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 jobscompleted during the year.

Application of Manufacturing Overhead

Ideally, the allocation baseis primary cost driver thatcauses overhead.

Both the numerator and denominator

of the predetermined overhead rate are

based on estimated amounts.


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Predetermined Overhead Rates

Estimated total

factory overhead costs

Estimated activity base

Predeterminedfactory overhead rate

=

Why is the predetermined overhead rate calculated fromestimated 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 factoryoverhead would be accurate but not timely.


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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 estimatedoverhead allocation rate.

Using a predetermined rate makes it

possible to estimate total job costs sooner.

Actual overhead for the period is notknown until the end of the period.

$


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Job Cost SheetsManufacturing Overhead Applied


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Pear.Co applies overhead based on direct

labor hours. Total estimated overhead for theyear is $640,000. Total estimated labor cost is

$1,400,000 and total estimated labor hoursare 160,000.

What is Pear.Cos predetermined overheadrate per hour?

Overhead Application

Example


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Overhead ApplicationExample

$640,000

160,000 direct labor hours (DLH)POHR =

Estimated total manufacturingoverhead cost for the coming period


POHR =


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PROCESS

II- CALCULATE ABSORBTION RATE PER UNITOF 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


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For each direct labor hour worked on ajob, $4.00 of factory overhead will be

applied to the job.

Overhead ApplicationExample

POHR = $4.00 per DLH

$640,000

160,000 direct labor hours (DLH)POHR =



POHR =

STEP II O h d Ab i


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Application of Manufacturing Overhead

Overhead applied = POHR Actual activity

Actualamount of the cost driver such asunits produced, direct labor hours, or

machine hours. Incurred during the period.

Based onestimates, and

determined before the periodbegins.

STEP-II Overhead AbsorptionPROCESS

III- APPLYING ABSORBTION RATE TO VARIOUS

PRODUCTS OR JOBS

:Overhead applied = $4 per DLH 8 DLH = $32



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Job-Order Cost Accounting

Overhead applied = $4 per DLH 8 DLH = $32



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Summarising the Two-Step Process to ApplyManufacturing Overhead to Products

Step One

Annual expected (budgeted)

manufacturing overheadAnnual expected (budgeted) activity level

(e.g., direct labor hours)

= Predeterminedoverhead rate

Step Two

Predeterminedoverhead rate

xActual activitylevel per job

=Allocated manufacturingoverhead assigned to job

S i i th T St P t A l


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POHR =


Based onestimates, and

determinedbefore the period

begins.

Actualamount of the cost driversuch as units produced, direct laborhours, or machine hours. Incurred

during the period.

Work in Process

Job1

Job2

Job3

Allocation baseexamples

1. Direct labor hours2. Direct labor dollars3. Machine hours4. Direct materials

5. Other

Summarising the Two-Step Process to ApplyManufacturing Overhead to Products


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Learning Objective

Understand the process of

accounting for overhead.

O h d R t


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Actual Overhead

Actual annual manufacturing overhead

costs. Needed for accurate determination of

income.

Recorded as debit to ManufacturingOverhead.

Overhead Rates

Actual vs Predetermined or standard rate

O h d R t


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Overhead Rates


ACTUAL OVERHEAD RATESKnown only after end of accounting period when all

costs/production figures have been collected

DisadvantagesVariation due to seasonal nature of some overhead costs

e.g. change in volume of production, efficiency

Overheads paid in advance

Fire insurance premiumIt should be charges to all works manufactured during the

year

How should absorbtion be done?

O h d R t


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Predetermined Overhead

Amount of overhead applied to products

using the predetermined overhead rate. Recorded as credit to Manufacturing

Overhead.

Overhead Rates


O erhead Rates


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Overhead Rates


PREDETERMINED/APPLIED OVERHEAD RATESGenerally used

Calculated in advance of the period by

estimated production overhead to be absorbed

estimated period production (may be based on anyabsorbtion base such as prime cost, labour cost)

Advantages

Constant unit cost

Avoid unit cost fluctuationResults in UNDERABSORBTION/UNDERAPPLICATION

OR

OVERABSORBTION/OVERAPPLICATION

U d li d d O li d O h d


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Underapplied and Over applied Overhead

Under applied Overhead the amount by which a periods actual

manufacturingoverhead exceeds applied manufacturingoverhead

Over applied Overhead the amount by which a periods appliedmanufacturing- overhead exceeds actual manufacturingoverhead

Actual manufacturing-overhead $29,050

Applied manufacturing-overhead $28,800

Under applied overhead $ 250

Manufacturing Overhead

Actual

10

Applied

20


Actual20

Applied10

(Cost of job is overstated) (Cost of job is understated)


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ExamplePearCos 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 Pear Cospredetermined overhead rate of $4.00 per

direct labor hour.


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Example

SOLUTIONApplied 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 atotal of 170,000 direct labor hours.

How much total overhead was applied to PearCos jobs

during the year? Use PearCos predetermined overheadrate of $4.00 per direct labor hour.


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SOLUTIONApplied 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 atotal of 170,000 direct labor hours.

How much total overhead was applied to PearCos jobs

during the year? Use PearCos predetermined overheadrate of $4.00 per direct labor hour,


Example

PearCo hasoverappliedoverhead for the yearby $30,000. What will

PearCo do?


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Treating Applied OverheadTwo methods for treating over- and underapplied MOH:

- Proration :Allocate over- or underapplied manufacturingoverhead to Work-in-Process Inventory, Finished Goods

Inventory, and Cost of Goods Sold on the basis of theending balances in these three accounts.

- More accurate; any difference is allocatedproportionately.

- More complicated; requires detailed calculations.

- Disposition :Close over- or underapplied overheaddirectly to Cost of Goods Sold.

- Easier and more commonly used, especially if

amount is small.- Debit MOH, Credit COGS.

O li d d U d li d


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Work in

Process

Finished

Goods

Cost ofGoods Sold

$30,000may be allocated

to these accounts.

$30,000 may beclosed directly to

cost of goods sold.

Cost ofGoods Sold

Overapplied and UnderappliedManufacturing Overhead

PearCos Method

OR


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Overapplied and Underapplied


PearCos

Mfg. OverheadActual

overheadcosts

$650,000

$30,000overapplied

PearCos Cost

of Goods SoldUnadjusted

Balance

$30,000

$30,000

AdjustedBalance

OverheadAppliedto jobs

$680,000


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Overapplied and Underapplied

Manufacturing Overhead - Summary

Alternative 1 Alternative 2

If Manufacturing Close to Cost

Overhead is . . . of Goods Sold Allocation

UNDERAPPLIED INCREASE INCREASE

Cost of Goods Sold Work in Process

(Applied OH is less Finished Goods

than actual OH) Cost of Goods Sold

OVERAPPLIED DECREASE DECREASE

Cost of Goods Sold Work in Process

(Applied OH is greater Finished Goods

than actual OH) Cost of Goods Sold

PearCosMethod


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Actual and Normal Costing

Actual direct materialand direct labor

combined withactual overhead.

Actual direct materialand direct labor

combined withpredetermined overhead.

Using a predetermined rate makes it

possible to estimate total job costs sooner.

Actual overhead for the period is notknown until the end of the period.

Overheads Absorbtion

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