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This article discusses the process of calculating and allocating overhead costs in engineering and financial cost analysis. It covers the decisions that need to be made by cost accountants, such as determining what costs become overhead, choosing the cost-allocation base, and calculating the overhead rate. The article also explains the concepts of under-absorbed and over-absorbed overhead and discusses different methods of overhead allocation.
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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 In-Process Inventory $200 Overhead Variance $100 Cost-of-Goods-Sold Production Supplies $200 $50 $50 $150 Finished Goods Inventory Factory Utilities $150
Allocating Overhead Wages Payable $$$$$ Indirect Wages Payable Direct Labor $$$$$ $75 $100 Allowance for Depreciation In-Process Inventory Overhead Variance $200 $100 $75 $225 $50 $350 $200 Cost-of-Goods-Sold $50 Production Supplies $350 $50 $150 $225 Raw Material Inv. Finished Goods Inventory Factory Utilities $$$$$ $50 $150 $350 $350 Accounts Payable $$$$$
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?
