Accounting For Manufacturing Overhead

Overheads:
CHAPTER
Estimation,
6
Accounting and
Disposition
CHAPTER LEARNING OBJECTIVES (CLO)

When you have finished studying the chapter, you should be able to:
1. Understand the importance of overhead on product costing

2. Calculate and apply overhead based on predetermined overhead rates
3. Find out over or under application of overheads and its implication
4. Identify different methods of disposing under or over applied overheads
5. Carry out the accounting treatment for overheads
6. Understand variances (spending and idle capacity) relating to overheads
7. Apply different methods of service department cost allocation
The Hidden Factory
While the worlds attention is focused on the fight to increase productivity and develop new
technologies, manufacturing managersespecially those in the electronics and mechanical
equipment (machinery) industriesare quietly waging a different battle: the battle to conquer
overhead costs. Indeed, our research shows that overhead costs rank behind only quality and
getting new products out on schedule as a primary concern of manufacturing executives.
The reason for this concern is obvious: high manufacturing overhead has a dramatic effect on
profit and competitiveness, and manufacturing managers believe themselves to be poorly
equipped to manage these costs well. As one senior executive told us, Weve been brought up
to manage in a world where burden rates [the ratios of overhead costs to direct labor costs] are
100% to 200% or so. But now some of our plants are running with burden rates of over 1,000%.
We dont even know what that means!
We are convinced that this renewed attention to overhead is not a cyclical phenomenon. No
doubt, low capacity utilization accounted for some increase in awareness during the last
recession; even so, awareness has remained high throughout the recovery. Overhead costs as a
percentage of value added in American industry and as a percentage of overall manufacturing
costs have been rising steadily for more than 100 years as the ratio of direct labor costs to value
added has declined (see Exhibit I). Moreover, in todays environment, production managers
have more direct leverage on improving productivity through cutting overhead than they do
through pruning direct labor.
As Americas factories step up the pace of automation, they find that they are being hit twice:
first, overhead costs grow in percentage terms as direct labor costs fall (everything has to add
up to 100%); and second, overhead costs grow in real terms because of the increased support
costs associated with maintaining and running automated equipment.
Exhibit II shows how overhead as a percentage of value added increases as a representative

industryelectronicsmoves down its product-process life cycle.1 Highly customized and low-
1
See Steven C. Wheelwright and Robert H. Hayes, Link Manufacturing Process and Product Life Cycles,
HBR JanuaryFebruary 1979, p. 133, and The Dynamics of Process-Product Life Cycles, HBR MarchApril
1979, p. 127.
volume specialty businesses, such as those in the government systems segment of the industry,
run job-shop-type operations with a relatively low ratio of overhead to direct labor. By contrast,
in businesses producing high-volume standardized products in automated environments, as in
the microcomputer segment of the industry, the ratio of overhead to direct labor cost is notably
greater.
Our data suggest that across the spectrum of U.S. industry, manufacturing overhead averages
35% of production costs; the comparable figure for Japanese products is 26%, despite the fact
that the Japanese industries have been rapidly automating. The differential is particularly large
in the electronics and machinery industries, where American overhead accounts for 70% to 75%
of value added, and Japans for 50% to 60%.
For managers, the critical step in controlling overhead costs lies in developing a model that
relates these costs to the forces behind them. Most production managers understand what it is
that drives direct labor and materials costs, but they are much less aware of what drives
overhead costs. True, we do have models that accountants use as they do engineering
standards and bills of material to relate overhead costs to products produced. But these
models do not so much explain overhead costs as allocate them.
Most of these efforts use the engineering standards and bills of material models that we do
understand as the basis for allocating overhead costs that we do not understand. These efforts
base overhead burden rates on direct labor, materials, or machine hours. The problem with this
approach is that the driving force behind most overhead costs is not unit output or direct labor.
Overhead costs do usually correlate with unit outputs, but that does not mean that unit outputs
cause overhead costs. In fact, acting as though they were causally related leads managers to
concentrate on output measures or on direct labor rather than on the structural activities that
determine overhead costs.
Source: Miller, Jeffrey G. and Vollmann, Thomas E. (1985). The Hidden Factory, Harvard Business
Review, September, 1985. Available at https://hbr.org/1985/09/the-hidden-factory retrieved on
April 18, 2017.
SCOPE Overheads
Introducing Estimation Accounting Disposition

Introduction Budgeted Factory Overhead Disposition of
Meaning of Overheads Control Account Overheads
Overheads Allocation Bases Applied Factory Income Statement
Classification of Predetermined Overhead vs. Balance Sheet
Overheads Overhead Rates Over and Under Effect
Importance of Types of Capacity Applied Overhead Administrative
Overheads Applied Overheads Actual, Standard Issues
Overhead Rates Cost Allocation: and Budgeted Variance Analysis:
Primary vs. Overheads Spending vs. Idle
Secondary Capacity Variance
6.0 Introduction
The excerpt of Hidden Factory with which the chapter starts explains the growing significance of
manufacturing overheads in production floor. Manufacturing overhead refers to all indirect cost
incurred in production floor in the process of manufacturing products. Irrespective of costing
systems, thus, the cost of manufacturing overhead must be assigned to all units produced along
with the costs of direct material and direct labor so that Inventory and Cost of Goods Sold are
valued and reported according to generally accepted accounting principles (GAAP).
Due to the application of science and technology at the highest level in manufacturing
environment, the significance of overhead cost increased tremendously. The cost that was
invisible one time now made other costs invisible. Manufacturing overhead includes such things
as the electricity used to operate the factory equipment, depreciation on the factory equipment
and building, factory supplies and factory personnel (other than direct labor). Some of the costs
that would typically be included in manufacturing overhead include:
a) Material handlers (forklift operators who move materials and units).
b) People who set up the manufacturing equipment to the required specifications.
c) People who inspect products as they are being produced.
d) People who perform maintenance on the equipment.
e) People who clean the manufacturing area.
f) People who perform record keeping for the manufacturing processes.
g) Factory management team.
(Note: For the seven items above, the company will incur costs for salaries, wages,
Social Security and Medicare taxes, unemployment compensation tax, worker
compensation insurance, health insurance, holiday pay, vacation pay, sick pay, pension
or retirement plan, seminars and training, and perhaps more.)
h) Electricity, natural gas, water, and sewer for operating the manufacturing facilities and
equipment.
i) Computer and communication systems for the manufacturing function.
j) Repair parts for the manufacturing equipment and facilities.
k) Supplies for operating the manufacturing process.
l) Depreciation on the manufacturing equipment and facilities.
m) Insurance and property taxes on the manufacturing equipment and facilities.
n) Safety and environmental costs.
Note that all of the items in the list above pertain to the manufacturing function of the business.
Since the costs and expenses relating to a companys administrative, selling, and financing
functions are not considered to be part of manufacturing overhead, they are not reported as
part of the final product cost on financial statements. Rather, nonmanufacturing expenses are
reported separately (as SG&A and interest expense) on the income statement during the
accounting period in which they are incurred. The following items, among others shall not form
part of overheads:
a) Direct Taxes levied by the Central Government, State Government or Local Authorities
that are in the nature of tax on profits such as Income Tax, Minimum Alternate Tax and
other direct taxes such as Wealth Tax.
b) Loss or gain on sale of assets.
c) Finance cost.
d) Foreign Exchange gains or losses.
e) Gain or Loss on inventory valuation.
f) Bad Debts
g) Donations and gifts including Political donations
6.1 Elements of Manufacturing Costs
Manufacturing costs are classified into three basic elements: (1) direct materials (2) direct labor
and (3) factory overheads.
Direct Materials: The materials that become part of and can be readily identified with a certain
manufacturing products can be classified as direct materials. Examples include, lumber used in
making furniture, fabric used in the production of clothing, iron ore used in the manufacture of
steel products, and rubber used in the production of athletic shoes.
Many types of materials and supplies necessary for the manufacturing process either cannot be
readily identified with any particular manufactured item or have a relatively insignificant cost.
Items such as sandpaper in sanding furniture, lubricants used on machinery, and other items for
general factory use are classified as indirect materials. Similarly classified are materials that
actually become part of the finished product, such as threads, screws, rivets, nails, and glue, but
whose costs are relatively insignificant making it not cost effective to trace them to specific
products.
Direct Labor: The labor of employees who work directly on the product manufactured, such as,
machine operators or assembly line workers, is classified as direct labor. The employees who are
required for the manufacturing process but who do not work directly on the units being
manufactured are considered indirect labor. This classification includes department heads,
inspectors, material handlers, and maintenance personnel. Payroll related costs such as payroll
taxes, group insurance, sick pay, vacation and holiday pay, retirement program contributions
and other fringe benefits, even for the direct laborers, are usually treated as indirect costs. As
manufacturing processes have become increasingly automated, direct labor cost as a
percentage of total product cost has decreased. Harley-Davidson, the motorcycle manufacturer,
stopped tracking direct labor as a separate cost category because it was only 10% of total
product cost but required an inordinate amount of accountants time to trace directly to
products (Turk, 1990).
Manufacturing Overheads: Manufacturing overhead has got numerous synonyms some of

which are factory burden, manufacturing expenses, indirect costs, factory overheads, and
factory expenses and includes all costs related to the manufacture of a product except direct
materials and direct labor. Thus, factory overhead includes the previously mentioned indirect
materials and indirect labor, plus other manufacturing expenses, such as depreciation on the
factory building and the machinery and equipment, heat, light, power, maintenance, insurance,
taxes, and factory-payroll related costs. As factories have become more automated, factory
overhead as a percentage of total manufacturing cost has increased dramatically.
6.2 Classification of Overheads

Overhead is the core element of research in cost and management accounting arena now-a-
days. Most of the innovations in management accounting are centering to overheads. Thus, the
scope of overhead is very wide. However, to keep the text simple, overheads are classified
below (Figure 6.1) considering the significance of the topic and relevance of the text.
(1) On the Basis of Nature

One of the important classifications of overhead is on the basis of nature or elements. Based
on nature, the aggregate of all indirect material cost, indirect labor cost and other indirect
expenses are known as overheads. Accordingly, overheads are grouped into (a) Indirect Material
Cost (b) Indirect Labor Cost and (c) Other Indirect Expenses.
(a) Indirect Material Cost: Indirect materials do not form part of the finished products.
Indirect materials are indirectly or generally used for production which cannot be
identified directly. For example, oil, lubricants, cotton waste, tools for repairs and
maintenance etc. are indirect materials.
(b) Indirect Labor Cost: Indirect labor is for work in general. The importance of the
distribution lies in the fact that whereas direct labor can be identified with and
charged to the job, indirect labor cannot be so charged and has, therefore, to be
treated as part of the factory overheads to be included in the cost of production.
Examples are salaries and wages of supervisors, storekeepers, maintenance labor etc.
(c) Other Indirect Expenses: Any expenses that are not specifically incurred for or can be
readily charged to or identified with a specific job. These are the expenses incurred in
general for more than one cost centre. Examples of indirect expenses are rent,
insurance, lighting, telephone, stationery expenses etc.
Overheads
Nature Behavior Function
1. Indirect Material 1. Variable Overhead 1. Manufacturing Overhead

2. Indirect Labor 2. Fixed Overhead 2. Administrative Overhead
3. Other Indirect Expenses 3. Semi-variable overhead 3. Marketing Overhead
Figure 6.1: Types of Overheads
(2) On the Basis of Function

The classification of overheads on the basis of the various function of the business concern is
known as function wise overheads. Here there are four important functional overheads such as:
(a) Production Overhead
(b) Selling Overhead
(c) Administration Overhead
(d) Distribution Overhead
(a) Production Overhead: Production overhead is also termed as manufacturing overhead or
works overhead or factory overhead. It is the aggregate of all indirect expenses which are
incurred for work in operation or factory. These costs are normally incurred during the period
when the production process is carried on. For example, factory rent, factory light, power,
factory employees' salary, oil, lubrication of plant & machinery, etc.
(b) Administrative Overhead: Administrative expenses are incurred in general for management to
discharge its functions of planning organizing, controlling, co-ordination and directing. These
expenses are not specifically incurred and cannot be identified with the specific job. It is also
termed as office cost. For example, office rent, rates, printing, stationery, postage, telegram,
legal expenses etc. are the office and administrative costs.
(c) Selling Overheads: Selling expenses are overheads which are incurred for promoting
sales, securing orders, creating demand and retaining customers. For example, salesmen's
salaries, advertisement, rent and rates of show room, samples, commission etc.
(d) Distribution Overhead: Distribution overhead are incurred for distribution of products or
output from producers to the ultimate consumers. For example, warehouse staff salaries,
expenses of delivery van, storage expenses, packing etc. Sometimes both selling and
distribution overheads are considered aggregately as a part of marketing overhead.
(3) On the Basis of Behavior

One of the important classifications of overhead is on the basis of behavior, i. e., how does cost
move as production volume changes. According to this, the expenses can be grouped into (a)
Fixed Overhead (b) Variable Overhead and (c) Semi-Variable Overhead.
(a) Fixed Overhead: Fixed cost or overhead incurred remain constant due to change in the volume
output or change in the volume of sales. For example, rent and rates of buildings, depreciation
of plant, salaries of supervisors etc.
(b) Variable Overhead: Variable overhead may be defined as "they tend to increase or decrease in
total amount with changes in the volume of output or volume of sales." Accordingly the
change is in direct proportion to output. Indirect materials, Indirect labor, repair and
maintenance, power, fuel, lubricants etc. are examples of variable overhead costs.
(c) Semi-Variable Overheads: Semi-variable overheads are incurred with a change in the volume
of output or turnover. They neither remain fixed nor do they tend to vary directly with the
output. These costs remain fixed up to a certain volume of output but they will vary at
other part of activity. Semi-variable overheads are mixed cost, i.e., partly fixed and partly
variable. For example, power, repairs and maintenance, depreciation of plant and machinery
telephone etc.
Behavioral classification of cost is very important for control purpose. Variable overhead costs,
such as power and supplies, move in direct proportion to changes in production. Fixed overhead
costs, such as property taxes, insurance, and straight-line depreciation, remain unchanged as
production levels change. Semi-variable overhead costs have characteristics of both variable and
fixed costs. They are sometimes called mixed costs or semi-fixed, if the cost is more fixed than
variable. Type A (Figure 6.2 - A) semi-variable costs, also known as step-variable costs, change
as certain levels of production are reached (for example, inspection and handling costs). If the
steps are especially wide before moving up to the next level of costs, such as the salaries of
factory supervisors, they are known as step-fixed costs. Those costs that vary continuously, but
not in direct proportion to volume changes (for example, maintenance costs), are Type B semi-
variable costs (Figure 6.2 - B).
Cost
Variable
Cost
Variable
Fixed
Fixed
Volume Volume
Figure 6.2 (A): Step Variable or Step Fixed Cost Figure 6.2 (B): Semi Variable Cost
6.3 Overhead Rates
Overhead rate is a technique to charge product for overhead costs consumed by it. It is a rate
computed by keeping the resource consumption pattern of unit of products. Thus the rate
depends on the nature of production process. In order to determine the absorption of overhead
in costs of jobs, products or process, a rate is calculated and it is called as "Overhead Absorption
Rate" or "Overhead Rate." A formula may be prescribed to compute overhead rate which goes
as following:
Manufacturing Overhead Expenses
Overhead Rate =
Allocation Base (Quantity or Value)
In numerator, the formula captures manufacturing overhead expenses which is divided by

appropriate allocation base in denominator. Allocation base represents the driver of overhead
expense which is set through cause-effect analysis. Different overhead rates are applied based
on the features and objectives of the business organization. Some important overhead rates are:
a) Actual Overhead Rate
b) Pre-determined Overhead Rate
c) Blanket Overhead Rate
d) Multiple Overhead Rates
e) Normal Overhead Rate
Each of the above mentioned overhead absorption rates have been explained below for the
easy reference to the readers:
a) Actual Overhead Rate: Actual overhead rate is the historical rate. Such rate is used in actual
costing. This rate is calculated by dividing the actual overhead absorbed by the actual
quantity or value of the base selected for a particular period. Assuming that overhead rate
is calculated on monthly basis, the following formula results actual rate:
Actual Overhead Expenses for the Month

Actual Overhead Rate = 100
Actual Allocation Base for the Month
b) Predetermined Overhead Rate: Predetermined overhead rate is determined in advance of

actual production and the rate is computed by dividing the budgeted overhead for the
accounting period by the budgeted base for the period. It is used in standard costing system.
The formula to compute predetermined overhead rate is:
Budgeted Overhead Expenses for the Period

Predetermined Overhead Rate = 100
Budgeted Base for the Period
c) Blanket Overhead Rate: Blanket overhead rate is also termed as single overhead rate. A
single overhead rate when computed for the entire factory is known as Blanket Rate. Single
rate may be applied suitably in small concerns and only where a single product is
manufactured. It is calculated as:
Overhead expenses of the Entire Factory

Blanket Rate =
Total Quantum of the Base Selected
d) Multiple Overhead Rates: Multiple overhead rates involve computation of separate rates
for each production department, service department, cost centre, each product or line
and for each production factor. The following formula is used for calculating multiple
overhead rates:
Overhead Cost Allocated and Apportioned to Each Cost Center

Multiple Overhead Rates =
Corresponding Base for the Center
e) Normal Overhead Rate: Normal overhead rate is a predetermined rate calculated

with reference to normal capacity. It is calculated as:
6.4 Predetermined Overhead Rates

Out of different overhead rates as mentioned in last section, predetermined overhead rate is
highly used due to its suitability and other advantages. Management needs to know the cost of a
job or process soon after its completion due to the very reason of setting the price for ultimate
sale. Thus the job must be charged with an estimated amount of overhead upon completion rather
than at the end of the period when the actual overhead is known. The predetermined factory
overhead rate is determined by dividing the budgeted factory overhead by the budgeted
production for the period. Budgeted production usually is expressed in terms of direct labor costs,
direct labor hours, machine hours or any other suitable bases representing cost driver. In a
departmentalized company, a separate predetermined factory overhead rate should be used for
each production department. The cost allocation base used should reflect how the overhead costs
are incurred.
Instead of using a pre-determined rate based on estimates, why not base the overhead rate on
the actual total manufacturing overhead cost and the actual total amount of the activity
base incurred on a monthly, quarterly, or annual basis? If an actual rate is computed monthly or
quarterly, seasonal factors in overhead costs or in the activity base can produce fluctuations in
the overhead rate. For example, the costs of heating and cooling a factory in Illinois will be
highest in the winter and summer months and lowest in the spring and fall. If the overhead rate
is recomputed at the end of each month or each quarter based on actual costs and activity, the
overhead rate would go up in the winter and summer and down in the spring and fall. As a
result, two identical jobs, one completed in the winter and one completed in the spring, would
be assigned different manufacturing overhead costs. Many managers believe that such
fluctuations in product costs serve no useful purpose. To avoid such fluctuations, actual
overhead rates could be computed on an annual or less-frequent basis. However, if the
overhead rate is computed annually based on the actual costs and activity for the year, the
manufacturing overhead assigned to any particular job would not be known until the end of the
year. For these reasons, most companies use predetermined overhead rates rather than actual
overhead rates in their cost accounting systems.
The use of such a rate enables an enterprise to determine the approximate total cost of each job
when completed. In recent years increased automation in manufacturing operations has
resulted in a trend towards machine hours as the activity base in the calculation. Such rate may
be single or multiple. When a single predetermined overhead rate is used for entire factory it is
called plant wide overhead rate. This is fairly common practice - particularly in smaller
companies. But in large companies, multiple predetermined overhead rates are often used. In a
multiple predetermined overhead rate system, each production department may have its own
predetermined overhead rate. Such a system, though more complex, is considered to be more
accurate. Since it can reflect differences across departments in how overhead costs are incurred.
For example, overhead might be allocated based on machine-hours in departments that are
relatively machine intensive. When multiple predetermined overhead rates are used, overhead
is applied in each department according to its own overhead rate as a job proceeds through the
department.
Exhibit 6.1: In Business

Only 34% of surveyed manufacturing firms reported that they used a single, plant wide
overhead rate. The use of multiple overhead rates to obtain more accurate product costs was
reported by 44% of the firms. The remaining 22% use activity based costing, an even more
complex, and presumably more accurate, approach to the allocation of overhead costs to
products.
Source: Eun-Sup Shim and Joseph M. Larkin, "A survey of current managerial accounting
practices: Where do we stand," Ohio CPA Journal, February 1994, p. 21 (4 pages).
As products are charged for overheads at predetermined overhead rate which is calculated even
before the production starts, the accuracy of product cost largely depends on the accuracy of
the rate. Now, predetermined overhead rate is based on budgeted overhead and allocation
base. As a cost accountant, it is very important to ensure maximum accuracy in budgeting
overhead costs and choosing appropriate allocation bases. The next section deals with allocation
bases.
6.5 Allocation Bases

Allocation bases mean the driver which causes the cost. Wrong choice of the base will lead to a
wrong rate and distort the product cost significantly. There are numerous bases used in practical
life due to heterogeneity of the nature of production. Some of such bases are
Sl. Allocation Base Nature of the rates

1. Direct Material Cost
2. Direct Labor Cost As a percentage of cost
3. Prime Cost
4. Direct Labor Hours
Rate per hour
5. Machine Hours
6. Unit of Output Rate per unit
Direct Material Cost: Under this method, the rate of absorption is calculated on the basis of
direct material cost. The rate of manufacturing overhead absorption is determined by dividing
the manufacturing overhead by the direct material cost. Here, it is assumed that manufacturing
overhead depends on direct material. Usually in a material intensive production process where
direct material cost accounts for say, 60% to 70% of total cost, this may be an appropriate base
for use. The calculated rate is presented as a percentage (overhead cost is a certain percentage
of direct material cost). And the rate is computed using the following formula:
Factory Overheads
Direct Material Percentage Rate = 100
Direct Material Cost
For example, manufacturing overhead is budgeted at $40,000 for the year 2012 where cost of
direct material is $160,000. Thus, direct material percentage rate will be 25%[($40,000/
$160,000) 100] with the meaning that manufacturing overhead is 25% of direct material
cost.
Direct Labor Cost: Direct labor cost is used mostly in manual production process where
production is characterized by heterogeneous category of workers e.g., skilled, semi-skilled and
unskilled and obviously labor cost is significant. The rationale behind the use of such base is that
overhead cost is caused by direct labor cost and thus overhead should be a certain percentage
of labor cost. The following formula is used for calculating the rate.
Factory Overheads
Percentage of Direct Labor Rate = 100
Direct Labor Costs
For example, direct labor cost incurred in factory amounts to $20,000 during the year 2012
when factory overhead incurred during the same period was $6,000. Thus, percentage of direct
labor rate will be 30%[($6,000/$20,000) 100] with the meaning that manufacturing
overhead is 30% of direct labor cost.
Prime Cost: Under this method, both direct material cost and direct labor cost are taken into
account for determining the absorption rate. It sounds good as irrespective of production
process, indirect cost depends on direct costs. The actual or predetermined rate of factory
absorption is computed by dividing actual or budgeted overhead expenses by the aggregate of
direct material or direct labor cost of the department. The following formula is used for
calculation of overhead recovery rate which is stated as a percentage:
Factory Overheads
Overhead Recovery Rate = 100
Prime Cost
Direct Labor Hours: Under this method the rate is determined by dividing the production
overheads by direct labor hours of each department. This base is comparatively easy to use as
the requirement of information is less; however, the risk of distortion is significant where the
quality of labor hour varies significantly. One labor hour of skilled worker and one hour of
unskilled worker is not same. This method is most suitable in such industries where the
production is carried out manually or by skilled labors. The rate will be calculated by applying
the following formula:
Factory Overheads
Direct Labor Hour Rate = 100
Direct Labor Hours
Example 6.1
You are required to find out overhead rates considering the allocation bases like direct material
cost, direct labor cost, direct labor hours and prime cost based on the following particulars:
1. Factory overhead expense for the period $ 25,000

2. Direct labor cost $ 8,000
3. Direct material cost $ 10,000
4. Direct labor hours 2,000
Solution:
Predetermined overhead rates under different allocation bases:
Allocation Bases Formula Rate

1. Direct Material Cost ($25,000/$10,000)100 250%
2. Direct Labor Cost ($25,000/$8,000)100 312.5%
3. Direct Labor Hour ($25,000/2,000) $12.5 per labor hour
4. Prime Cost ($25,000/$18,000)100 138.89%
Machine Hours: Machine hour rate is used when it is believed that it is machine that drives
overhead cost in the factory. In an automated manufacturing system where the requirement of
labor force is very negligible and which requires significant investment in production facilities,
machine hour is believed to be the appropriate allocation base. It is one of the scientific
methods of absorbing factory expenses where the process of manufacturing are carried out by
machines. Under this method overhead costs are allocated on the basis of the number of hours
a machine or machines are used for a particular job. According to the Institute of Cost and
Management Accountants, England a machine hour rate is "an actual or predetermined rate of
cost apportionment or overhead absorption, which is calculated by dividing the cost to be
apportioned or absorbed by the number of machine hours expended or to be expended." Thus,
the machine hour rate is determined by dividing the amount of overhead cost to be apportioned
or absorbed by the number of machine hours. Machine hour rate can be calculated by using the
formula as given below:
Factory Overheads
Machine Hour Rate =
Machine Hours
Calculation of Machine Hour Rate: The following steps are required for computing the machine
hour rate:
a) Identify the overhead expenses relating to a specific machine or group of machines in
order to compute machine hour rate.
b) Each machine or group of machines is treated as a cost centre.
c) Manufacturing overhead or machine expenses are grouped into two types: fixed or
standing charges and variable machine expenses. Fixed or standing charges remain
constant irrespective of the use of machine, e. g., rent, insurance charges, rates,
supervision etc. Variable machine expenses are variable with the use of the machine, e.
g., power, depreciation, repairs etc.
d) An hourly rate of fixed or standing charges will be calculated by totaling of fixed
charges and dividing by the number of normal hours worked by machine.
e) Normal working hours are calculated by adding the cost relating to non-productive
time, i.e., normal ideal time for maintenance and setting up etc.
f) Separate hourly rate for each machine expenses will be calculated.
g) The total of the standing charges rate and the machine expenses rates per hour will
give the machine hour rate.
Unit of Output: It is true that cost depends of volume of production. Thus volume or units are
also considered to compute overhead absorption rate assuming that overhead cost changes
proportionately as volume changes. This may be wrong when different products consume
resources differently. This base is most suitable in such industries where the production of same
grade is carried out. A manufacturing firm producing different line of products with varying level
of resource consumption pattern within same product line should use this base very carefully.
Otherwise, serious product cost distortion may take place. Under this method absorption rate is
determined on the basis of number of units produced. The recovery rate is thus calculated by
dividing the actual or budgeted factory overheads by the number of units produced. The
formula is:
Factory Overheads
Rate per Unit =
Number of Units Produced
Exhibit 6.2: Choose Appropriate Allocation Base
There are many ways that can be used to determine the right basis for a given order. These
bases may be chosen from:
Direct Material Costs: This base is likely to be useful for absorbing material handling related
expenses.
Direct Labor Cost: This base is used when manufacturing is labor intensive. It is similar to
direct labour hour basis. Only suitable where there are uniform wage rates, in which case it
will give the same amount of overhead as direct labour hour basis.
Direct Labor Hours: It is used when workers are paid on the basis of their working hours. This
is suitable in a labor intensive cost centre which has a good time recording system.
Prime Cost: The prime cost is used when the factory produces only one kind of product. As
this is a combination of direct wages and direct materials it is unlikely to be suitable.
Machine Hours: This basis is used when manufacturing is mostly automated. It is suitable in a
mechanized cost centre. A lot of the overheads will relate to the use of machinery e.g. power,
repairs, depreciation etc. so you want to reflect this in the overhead absorption base.
Cost unit: This allocates the same amount of overhead to each unit. Therefore it is only likely
to be suitable where all the units produced are identical.
Example 6.2: Data relating to the Machine Shop for October 2017 are given below:
Total Overhead $ 6,000
Total Direct Labor hours 800 hours
Total Direct Wages $ 1,600
Total Direct Material used $ 3,000
Total Machine hours 1,200 hours
Total Units produced 45 units
Predetermined Overhead Rates

Overhead Overhead Base Data Rate
Allocation Bases Costs
Direct Labor Hour $ 6,000 800 hours $ 7.50 per direct labor hour
Direct Wages $ 6,000 $1,600 $ 3.75 per $ of wages or 375% of wages
Direct Material $ 6,000 $3,000 $ 2.00 per $ of materials or 200% of materials
Prime Cost (PC) $ 6,000 $4,600 $ 1.30 per $ of PC or 130% of PC
Machine hour $ 6,000 1,200 hours $ 5.00 per machine hour
Physical unit $ 6,000 45 units $ 133 per unit produced
The above example is extended further to show how the predetermined overhead rates are
used to absorb overhead expenses by cost objects.
Example 6.3: Consider the following information of Unit X in the machine shop:
Direct materials used $ 23.00
Direct wages $ 27.50
Direct labor hours 12 hours
Machine hours 17 hours
To calculate the full manufacturing cost of unit X using a direct labor hour overhead absorption
rate:
Direct Labor 27.50
Direct Materials 23.00
Prime cost 50.50
Overheads:
12 hours @ $7.50 per hour (as computed before in Example 6.2) 90.00
Full manufacturing cost 140.50
Comparison of alternative bases

Absorption base Rates Cost data Calculation Overhead absorbed
Direct labor hour $ 7.50 12 hours 12 x $ 7.50 90.00
Direct wages 375% $ 27.50 3.75 x $ 27.50 103.13
Direct material 200% $ 23.00 2 x $ 23.00 46.00
Prime cost 130% $ 50.50 1.3 x $ 50.50 65.65
Machine hour $ 5.00 17 hours 17 x $ 5.00 85.00
Cost unit $ 133.00 1 unit 1 x $ 133.00 133.00
6.6 Production Capacity Levels

Another important consideration to produce accurate predetermined overhead rate is choosing
the right capacity level for the selected allocation base. For example, let us consider that we
have chosen machine hour as the allocation base as the production is characterized as
automated. Now, how many machine hours we should use at the time of computing
predetermined rate? is an important question to answer where machine will have different
capacity levels. Such capacity may either be theoretical, practical, expected actual or normal.
Theoretical capacity is the maximum level of capacity without allowance for unavoidable
interruptions and is therefore unattainable. This capacity comes from the manufactures
specification sheet for machine, for example. Practical capacity is the highest unattainable
capacity for it is equal to theoretical capacity minus allowances for unavoidable interruptions
such as machine breakdowns, oiling, cleaning and brownouts. Expected actual capacity is the
estimated volume of production for a given period of time in the immediate future. Normal
capacity is the average expected production level for a budget year considering the production
facilities and the seasonal variation in the demand for the product. As used in budgeting, the
normal capacity is the planned level activity for one year. On a monthly basis, the latter is
divided by twelve.
Example 6.4
Lets assume that a company operates eight hours per day for five days a week and for fifty
weeks in one year, net of official holidays. During the fourth quarter of 2017, it plans to buy
three machines with each of them capable of processing 10 units of companys product in one
hour. Each machine requires one hour for setting up and heating before it can be operated
every working day. Estimated allowance for oiling, cleaning and brownouts is 20% of theoretical
capacity. The employees are given breaks of 15 minutes every mid-morning and mid-afternoon.
Considering the demand for the product, the company is preparing financial plans based on
36,000 units of production. For the first quarter of 2017, it expects to produce 8,000 units only.
The computation of theoretical, practical, normal and expected actual capacities in terms of
factory working hours, machine hours and units of production is as follows:
Factory Machine Units of

Working Hours (3 Production
Hours* Machines)
Theoretical capacity per annum: 2,000 (3) 6,000 (10) 60,000
50 weeks 5 days 8 hours
Less: Unavoidable interruptions
Setting up (250** working days one hour) 250 750 7,500
Oiling, cleaning and brownouts (20% of 400 1,200 12,000
theoretical capacity)
Snack breaks (250 working days 1/2 hours) 125 375 3,750
775 2,325 23,250
Practical Capacity 1,225 3,675 36,750
Normal Capacity 1,200 3,600 36,000
*
or machine hours per machine
**
50 weeks 5days
Expected actual production capacity for the first quarter of 2017 is 8,000 units. Companies
typically base their predetermined overhead rates on the estimated, or budgeted, amount of
allocation base for the upcoming period. This is the method mostly used; however, it has
recently been criticized severely. An example will be helpful to understand the reasons.
Example 6.5
Lets assume that Music Corporation manufactures CDs for local recording studios. The
company's CD duplicating machine is capable of producing a new CD every 10 seconds from a
master CD. The company leases the CD duplicating machine for $180,000 per year, and this is
the company's only manufacturing overhead cost. With allowances for setups and maintenance,
the machine is theoretically capable of producing up to 900,000 CDs per year. However due to
weak retail sales of CDs the company's commercial customers are unlikely to order more than
600,000 CDs next year. The company uses machine time as the allocation base for applying
manufacturing overhead. These data are summarized below:
Music Corporation Data

Total manufacturing overhead cost $180,000 per year
Allocation base: machine time per CD 10 seconds per CD
Capacity 900,000 CDs per year
Budgeted output for next year 600,000 CDs
If corporation follows common practice and computes its predetermined overhead rate using
estimated or budgeted figures then its predetermined overhead rate for next year would be
$0.03 per second of machine time computed as: Predetermined overhead rate = Estimated total
manufacturing overhead cost/ Estimated total units in the allocation base: $180,000 / (600,000
CDs 10 seconds per CD) = $0.03 per second.
Since the CD requires 10 seconds of machine time, each CD will be charged for $0.30 of
overhead cost. Critics charge that there are two problems with this procedure. First, if
predetermined overhead rates are based on budgeted activity, then the unit product cost will
fluctuate depending on the budgeted level of activity for the period. For example, if the
budgeted output for the year was only 300,000 CDs, the predetermined overhead rate would be
$0.06 per second of machine time or $0.60 per CD rather than $0.30 per CD. In general if
budgeted output falls, the overhead cost per unit will increase; it will appear that the CDs cost
more to market. Managers may then be tempted to increase prices at the worst possible time,
just as demand is falling.
Second critics charge that under traditional approach, products are charged for resources they
don't use. When the fixed costs of capacity are spread over estimated activity, the units that are
produced must shoulder the costs of unused capacity. That is why the applied overhead cost per
unit is increases as the level of activity falls. The critics argue that products should be charged
only for the capacity that they use; they should not be charged for the capacity they don't use.
This can be accomplished by basing the predetermined overhead rate on capacity as:
Predetermined overhead rate based on capacity = Estimated total manufacturing overhead cost
at capacity / Estimated total units in the allocation base at capacity = $180,000 / (900,000 CDs
10 seconds per CD) = $0.02 per second.
Since the predetermined overhead rate is $0.02 per second, the overhead cost applied to each
CD would be $0.20. This charge is constant and would not be affected by the level of activity
during a period. If output falls, the charge would still be $0.20 per CD. This method will almost
certainly result in under-applied overhead. If actual output at the music corporation is 600,000
CDs, then only $120,000 of overhead cost would be applied to products ($0.20 per CD 600,000
CDs). Since the actual overhead cost is $180,000, then there would be under-applied overhead
of $60,000. In another departure from tradition, the critics suggest that the under-applied
overhead that results from idle capacity
should be separately disclosed on the Impact of Activity Level on Product Cost
income statement as the cost of unused
capacity, a period expense. Disclosing Theoretical lowest product cost
this cost as a lump sum on the income Practical low product cost
statement, rather than burying it in cost Normal higher product cost*
of goods sold or ending inventories, Expected highest product cost
*
makes it much more visible to assuming normal exceeds expected capacity
managers.
Official pronouncements do not prohibit basing predetermined overhead rates on capacity for
external reports. Nevertheless, basing the predetermined overhead rate on estimated or
budgeted, activity is a long-established practice in industry, and some managers and
accountants may object to the large amounts of under-applied overhead that would often result
from using capacity to determine predetermined overhead rates. And some may insist that the
under-applied overhead be allocated among cost of goods sold and ending inventories which
would defeat the purpose of basing the predetermined overhead rate on capacity, however, we
will cover this discussion next.
Exhibit 6.3: How to Calculate Overhead Cost per Unit
Pricing is one of the most important factors in competition. Those companies with a better
business model have an automatic advantage over the competition. The ability to create an
equivalent product at a lower cost provides greater operational flexibility as well. You can
pass these cost savings on to your clients, purchase higher quality materials, pay your
workforce higher wages, pay your investors a higher return, pay down debts faster, etc. No
matter what, being able to cut your costs without sacrificing quality is a worthy cause in the
business world. Understanding how to calculate your fixed costs, specifically overhead costs
per unit, is the first step toward cost reduction.
Instructions
1. Define overhead costs and expenses. These are all costs associated with direct labor and
materials. Overhead expenses include accounting, depreciation, interest, legal fees, rent,
telephone, taxes and utilities. Basically, anything cost that doesn't change with changes
in production output is considered overhead.
2. Determine average hourly wage. Each employee's contribution should be classified as
either direct or indirect labor. Direct labor works directly with product, whereas indirect
labor supports direct labor, i.e., accounting or other corporate functions. You are only
interested in salaried direct labor and indirect labor.
3. Estimate the number of workdays available in a given calendar year. Subtract the
average number of days labor will not be working (holidays, weekends, vacations, sick
leave, etc.) from 365.
4. Multiply the number of workdays available for labor by eight (for an eight-hour work
day). This gives you an estimate for the total number of labor hours worked.
5. Multiply number of total labor hours by average labor wage determined in Step 2.
6. Add all overhead expenses, as defined in Step 1, to the dollar amount in Step 5. This is
your total overhead cost.
7. Look up the average number of units sold per month and multiply by 12.
8. Divide total overhead costs by average number of units. This is your overhead cost per
unit.
Courtesy: Bradley James Bryant, http://www.ehow.com/how_5166514_calculate-overhead-

cost-per-unit.html accessed on November 15, 2012.
Idle Capacity vs. Excess Capacity

Idle capacity results from underutilization of installed capacity due to downturn in market for
multiple reasons like scarcity of productive factors (e.g., raw material, labor, machinery, power
etc.), aging technology, less demand, entrants of new competitor etc. A prolonged idle capacity
is a bad signal which demands Strategic attention. However, temporary idle capacity
management requires effective planning. Usually treatment of idle capacity is very much
straightforward which is included in budgeted amount of overhead and thus absorbed by
regular products through applied overhead. If it is not budgeted, idle capacity generates factory
overhead idle capacity variance. Costs associated with idle facilities like workers (if committed)
are included in the spending variances. Accounting treatment of idle capacity variance should be
either;
a) Period cost if immaterial, it is charged against current years profit.
b) Product cost if material, it is allocated between inventories and cost of goods sold.
Excess capacity generates from installing more capacity than required with the objective of
utilizing the same in coming years when there will be additional demand. Sometimes, it may
arise due to wrong synchronization of production facilities where capacity of one machinery
doesnt math with another in the product line. It is better to dispose of the excess capacity or
finding alternative use of such capacity. Cost of excess capacity should not be included with
budgeted cost which will increase the cost of regular product irrationally. Rather these costs
should be treated as period cost and should be charged against profitability.
6.7 Factory Overhead: Actual and Applied

The actual overhead refers to the indirect manufacturing costs actually occurring and recorded.
These include the manufacturing costs of electricity, gas, water, rent, property tax, production
supervisors, depreciation, repairs, maintenance, and more. Thus, incurrence of actual overhead
doesnt have any pattern i. e., it may incur at any time within the period. However, the applied
overhead refers to the indirect manufacturing costs that have been assigned to the goods
manufactured. Manufacturing overhead is usually applied, assigned, or allocated by using a
predetermined annual overhead rate. For example, a manufacturer might estimate that in its
upcoming accounting year there will be $2,000,000 of manufacturing overhead and 40,000
machine hours. As a result, this manufacturer sets its predetermined annual overhead rate at
$50 per machine hour.
Exhibit 6.4: Actual Costing Versus Normal Costing

Normal costing requires that MOH be applied instead of actual MOH costs being used to
determine product costs. The main difference in actual and normal costing is how MOH is
included as part of product costs.
Actual costing = Actual MOH costs are debited directly to WIP.
Normal costing = Actual MOH costs are debited to MOH expense. Based on a
predetermined rate, MOH is applied with a debit to WIP.
Only three primary amounts are debited to WIP in normal costing: DM used, DL
incurred, MOH applied.
Only three primary amounts are debited to WIP in actual costing: DM used, DL incurred,
MOH incurred.
Thus actual overhead is the overhead cost that incurred actually whereas applied overhead is
the part of overhead that is applied to product based on a predetermined overhead rate under
standard costing. Thus, there exists a difference between actual overhead and applied overhead
which is required to be minimum to keep the distortion in product pricing within tolerable limit.
In actual costing, overhead is applied at actual rate creating no difference between actual
overhead and applied overhead and product is accurately priced. However, the application of
actual costing is very rare due to the time lags between product costing and incurrence of actual
overhead.
6.8 Overhead Accounting

There are different methods of keeping record of overheads into books of accounts. This section
presents the most common methods of keeping records of overhead. Usually all the actual
overhead expenses are accumulated in factory overhead control account. Factory overhead is
applied in a temporary account. At the end of the period, over or under applied overhead is
figured out and disposed. The steps in overhead accounting are presented in Exhibit 6.5 below:
Exhibit 6.5: Steps in Overhead Accounting

1. Selection of one or more cost-allocation bases for applying overhead costs to product or
services.
2. Preparation of a factory-overhead budget for the planning period, ordinarily a year. The
two key items are (a) budgeted factory overhead and (b) budgeted volume of the cost-
allocation base.
3. Computation of budgeted/predetermined factory overhead rate(s) by dividing the
budgeted total overhead for each cost pool by the budgeted cost-allocation base level.
4. Obtain actual cost-allocation base data (such as machine hours) used for each product.
5. Apply the budgeted overhead to the products or services by multiplying the
predetermined rate(s) in step 3 times the actual cost-allocation base data from step 4.
6. At the end of the year, account for any differences between the amount of overhead
actually incurred and overhead applied to products (i.e. over-applied / under-applied
factory overhead).
6.8.1 Factory Overhead Control Account

The Factory Overhead Control account is not a typical account. It does not represent an asset,
liability, expense, or any other element of financial statements. Instead, it is a type of suspense
or clearing account. Amounts go into the account and are then transferred out to other
accounts. In this case, actual overhead goes in, and applied overhead goes out! The credits to
this account are generated when overhead is applied to production; now focus on the debits
which represent the actual amounts being spent on overhead. As the cost components of
overhead are actually incurred, the Factory Overhead control account is debited, and the
logically offsetting accounts are credited. The table below provides representative examples of
factory overhead items.
Overhead Expense Debit Credit

Indirect labor Factory Overhead Control Salaries or Wages Payable
Indirect material Factory Overhead Control Inventory or Supplies
Insurance Factory Overhead Control Prepaid Insurance
Factory depreciation Factory Overhead Control Accumulated Depreciation
Property Taxes Factory Overhead Control Property Taxes Payable
Utilities Factory Overhead Control Utilities Payable
The indirect labor would relate to the cost of factory staff not directly involved in production.
This can include break-time of line workers, shop managers, maintenance, guards, and so forth.
The indirect materials relates to supplies and components that are not a significant cost item.
Importantly, selling and administrative costs not related to production (e.g., advertising, salaries
for non-production related staff, sales commissions, rent of the corporate offices, etc.) are
separately expensed, and are not part of factory overhead. Lets follow the following continuous
example.
Example 6.6
Actual factory overhead costs incurred in Azax Machining for the month of June, 2017 are:
salaries, $50,000; supplies, $15,000; insurance, $5,000; depreciation, $11,000; property taxes,
$9,000; and utilities, $10,000. Pass journal entry in the book of Azax on June 30, 2017. Azax will
make the following entry:
Date Accounts Title & Explanation Ref Debit ($) Credit ($)
June 30, Factory Overhead Control 100,000
2017 Salaries Payable 50,000
Supplies 15,000
Prepaid Insurance 5,000
Accumulated Depreciation 11,000
Property Taxes Payable 9,000
Utilities Payable 10,000
[To record various factory overhead costs]
6.8.2 Factory Overhead Applied Account

Another important account relating to factory overhead is factory overhead applied account.
Factory overhead applied is based on predetermined overhead rate and actual activity recorded
in line with the selected bases for a certain period. A mere multiplication of actual activity with
the predetermined overhead rate will result the amount of factory overhead applied. This is the
amount that a product is actually charged for. Lets assume that Azax applies overhead based on
machine hours. During the period Azax has recorded the use of 15,000 machine hours. The
predetermined overhead rate for Azax is $6 per machine hour. Azax will make the following
entry to apply overhead into production.
June 30, Work in Process 90,000
2017 Factory Overhead Applied 90,000
[To record applied factory overhead]
6.8.3 Over and Under-applied Overhead

Since the predetermined overhead rate is established before a period begins and is based
entirely on estimated data, the overhead cost applied to work in process (WIP) will generally
differ from the amount of overhead cost actually incurred during a period. The difference
between the overhead cost applied to work in process (WIP) and the actual overhead costs of a
period is termed as either under-applied overhead or over-applied overhead. For example, in
case of Azax, it calculates predetermined overhead rate as $6 per machine hour. 15,000
machine hours are actually worked and overhead applied to production is therefore $90,000
(15,000 hours $6). However, actual factory overhead recorded by Azax is $100,000 which
results under-applied overhead of $10,000 ($100,000 $90,000). If the situation is reverse and
the company applies $100,000 and actual overhead is $90,000 the over-applied overhead would
be $10,000. To compute the amount of over or under applied overhead amount, it is important
to transfer Factory Overhead Applied account to Factory Overhead Control account through a
journal entry as given below:
June 30, Factory Overhead Applied 90,000
2017 Factory Overhead Control 90,000
[To record applied factory overhead]
However, this transfer is not important if separate factory overhead control account is not
maintained. For example, all actual overhead cost is recorded in debit side of Factory Overhead
account and applied overhead is recorded in credit side of the same account as shown below:
Actual Overhead Applied Overhead

Factory Overhead 100,000 Work in Process 90,000
Salaries Payable 50,000 Factory Overhead 90,000
Supplies 15,000 [To record applied
Prepaid Insurance 5,000 factory overhead]
[To record various factory
overhead costs]
Under this method of accounting, Factory Overhead ledger will result a balance if there exists
any difference between actual and applied overheads. However, it is advised to maintain
separate Factory Overhead Control account that will record actual overhead cost once it
incurred. Factory Overhead Applied will be a separate account to charge products for overhead
at predetermined rate and usually it is done when products are transferred from work in
process to finished goods inventory. At the end of the period, applied overhead is transferred to
factory overhead control to find out any difference that will be either over or under applied
overhead (Exhibit 6.6). A flow to the accounts is shown in Figure 6.3:
Exhibit 6.6: Over or Under Applied Overhead

The estimated factory overhead is applied to production by a debit to Work in Process and a
credit to Applied Factory Overhead. At the end of the period, the applied factory overhead
account is closed to the factory overhead control account. If the factory overhead control
account has a debit balance after the applied factory overhead is closed to it, that means the
actual factory overhead (debits) was greater than applied factory overhead (credits) and
overhead is said to be under-applied. A credit balance in Factory Overhead, after closing
Applied Factory Overhead to it, indicates that more overhead was applied than was actually
incurred and overhead is said to be over-applied.
Account Balance Over or Under Applied Pricing
Factory Overhead Debit Under Applied Under Priced
Control Credit Over Applied Over Priced
Finally, Factory Overhead Control account results over or under applied amount of overhead. If,
applied overhead is more than actual than it results over applied amount and vice versa. Over
applied overhead means that product is overpriced and under applied overhead means
underpriced. Debit balance of factory overhead control account results under applied overhead
and credit balance of factory overhead control account results over applied overhead. None of
the situation is good and thus it is better to keep it minimal. However, it depends on the
expertise of cost accountant who computes the pre-determined overhead rates.
Factory Overhead Control
Factory Overhead Control 100,000
Salaries Payable 50,000 Entry to record
Supplies 15,000 actual factory
Prepaid Insurance 5,000 overhead
Factory Overhead Control

Factory
Debit Amount Credit Amount
Overhead
Actual 100,000 Applied 90,000
Control ledger
Under-applied 10,000
Total 100,000 Total 90,000
Factory Overhead Applied

Entry to apply
Work in Process 90,000
factory overhead
Factory Overhead Applied 90,000
Factory Overhead Applied Closed to Control Account

Figure 6.3: Flow of overhead expenses
6.8.4 Reasons of under applied or over applied overhead

The reasons of under or over-applied overhead can be complex. Nevertheless the basic problem
is that the method of applying overhead to jobs using a predetermined overhead rate assumes
that actual overhead costs will be proportional to the actual amount of the allocation base
incurred during the period. If, for example, the predetermined overhead rate is $6 per machine
hour, then it is assumed that actual overhead cost incurred will be $6 for every machine hour
that is actually worked. There are actually two reasons why this may not be true. First, much of
the overhead often consists of fixed costs that do not grow as the number of machine hours
incurred increases. Second, spending on overhead items may or may not be under control. If
individuals who are responsible for overhead costs do a good job, those costs should be less
than were expected at the beginning of the period. If they do a poor job, those costs will be
more than expected. However, the following reasons for over and under absorption of
overheads may be pointed here to note:
a) Actual overhead cost incurred may be more or less than the budgeted overhead;
b) Actual machine hours, labor hour and output may be lower or higher than the budgeted
or predetermined base;
c) Seasonal fluctuations;
d) Wrong computation of overhead absorption rate, output and machine hours;
e) Under or over utilization of production capacity.
At the beginning of the period
Estimated total
Estimated total units in the Predetermined overhead
manufacturing overhead =
allocation base rate
cost
During the period
Actual total units of the
Predetermined overhead Total manufacturing
allocation base incurred =
rate overhead applied
during the period
At the end of the period
Total manufacturing Under-applied (over-
Actual total manufacturing
overhead = applied)
overhead cost
applied overhead
Example 6.7
Suppose that two companies A and B have prepared the following estimated data for the
coming year:
Particulars Company
A B
Allocation Bases Machine-hours Direct materials cost
Estimated manufacturing overhead $300,000 $120,000
Estimated machine-hours 75,000 -
Estimated direct materials cost - $80,000
Predetermined overhead rate $4 per machine hour 150% of direct materials cost
Now assume that because of unexpected changes in overhead spending and changes in demand
for the companies' products, the actual overhead cost and the actual activity recorded during
the year in each company are as follows:
Company
Particulars
A B
Actual manufacturing overhead costs $290,000 $130,000
Actual machine-hours 68,000 -
Actual direct materials costs - $90,000
For each company, the actual data for both cost and activity differ from the estimates used
in computing the predetermined overhead rate. This results in under and over applied overhead
as follows:
Company (Figure in $)
Particulars
A B
Actual manufacturing overhead costs 290,000 130,000
Applied manufacturing overhead costs:
Company A: 68,000 actual machine hours $4 per machine hour 272,000
Company B: $90,000 actual direct materials cost 150% 135,000
Under (over) applied overhead 18,000 (5,000)
For Company A, notice that the amount of overhead cost that has been applied to work in
process ($272,000) is less than the actual overhead cost for the year ($290,000). Therefore the
overhead is under-applied. Also notice that original estimate of overhead in company A
($300,000) is not directly involved in this computation. Its impact is felt only through the
$4 predetermined overhead rate that is used. For Company B, the amount of overhead cost that
has been applied to work in process (WIP) ($135,000) is greater than the actual overhead cost
for the year ($130,000), and so overhead is over-applied.
6.9 Disposal of Under or Over Applied Overhead

Factory overhead control is a temporary account and needs to be closed at the end of the
period. However, closing the account needs careful consideration of its impact in different
accounts. The disposal addresses materiality of the amount, responsibility of different
departments, reporting etc. Recall from financial accounting that small amounts that will not
affect one's decision are considered immaterial. Amounts that are large enough to impact one's
decision are considered material. Usually, the amount of over-applied and under-applied
overhead is disposed of in two different ways: with an end of the year write-off to the period or
proration over inventories.
6.9.1 Immediate Write-off

If the over-applied and under-applied overhead is relatively small, as it typically is, the entire
amount is treated as an adjustment of the years net income.
a. This means that it is simply written off directly to cost of goods sold (an addition, if
factory overhead is under-applied, a subtraction, if over-applied) or income summary.
COGS is used because it is the product account that contains the largest amount of MOH
expense at year end.
b. Such an immediate write-off is largely justified because most of the manufactured
products usually have been sold by the end of the year.
c. Another justification for such treatment is that when there is under-applied overhead, it
is due mostly to inefficiencies or to the underutilization of available facilities (which
would not be appropriate costs to the inventory assets).
The treatment of the adjustment may be based on management responsibility for the over or
under applied factory overhead: if it is considered as a responsibility of manufacturing
managers, it is reported in the cost of goods sold statement; if it is considered as a responsibility
of general management, it is reported in the income statement. The end of period adjustment is
based on the balance in the MOH account.
1. If the balance in MOH is a debit (under-applied), close with: Debit COGS or IS and Credit
MOH Control
2. IF the balance in MOH is a credit (over-applied), close with: Credit COGS or IS and Debit
MOH Control
After closing the MOH Control account, its balance should be zero.
Under Applied Over Applied

Credit
Credit
Debit
Debit
Date Accounts Title Date Accounts Title

Ref
Ref
(1) Cost of Goods Sold (1) Factory Overhead Control

Factory Overhead Control Cost of Goods Sold
(under-applied overhead is (over-applied overhead is
closed to cost of goods sold) closed to cost of goods
sold)
(2) Income Summary (2) Factory Overhead Control

Factory Overhead Control Income Summary
closed to income summary) closed to income
summary)
6.9.2 Proration
If there is relatively large amount of over-applied or under-applied overhead, it may be
prorated.
a. This means that amount is allocated to the three balances that were affected by the use
of budgeted overhead rates: work-in-process inventory, finished-goods inventory and
cost of goods sold. Such proration shifts the impacts over the years.
Status Accounts Affected Statements reported Years Affected
a) Units produced Cost of goods sold Income statement Current Year
and sold out
b) Units not Work in Process Balance Sheet Following Year(s)
produced yet
c) Units produced Finished Goods Balance Sheet Following Year(s)
and remains Inventory
unsold
b. This method tends to adjust applied costs to an actual basis and is therefore
conceptually appealing if the difference is due to large forecasting error.
c. If the amount of under-applied or over-applied overhead is material, many accountants
would insist to use proration.
Under Applied Over Applied

Credit
Credit
Debit
Debit
Date Accounts Title Date Accounts Title
Ref
Ref
(1) Finished Goods Inventory (1) Factory Overhead Control

Work-in-Process Inventory Finished Goods Inventory
Cost of Goods Sold Work-in-Process Inventory
Factory Overhead Control Cost of Goods Sold
closed to inventory and cost closed to inventory and
of goods sold) cost of goods sold)
Disposal entries in different situations and the possible impact of disposals are exemplified
below considering an example.
Example 6.8
Consider the below information of Sudenshna Cement Ltd:
Inventories Beginning Ending
Raw Material 0 0
Work in Process 30,000 72,000
Finished Goods 10,000 49,500
Other information
Direct materials $50,000
Direct labor $60,00
Actual overhead $100,000
Predetermined overhead rate per DLH $6.00
Direct Labor Hour used 15,000
Show the impact of overhead application in different accounts with critical note on its impact.
Solution:
Statement of Cost of Goods Manufactured
Particulars Amount ($)
Direct materials 50,000
Direct labor 60,000
Prime Cost 150,000
Manufacturing overhead applied (15,000 $6 per DLH) 90,000
Total Manufacturing cost 200,000
Add: Beginning work in process 30,000
230,000
Deduct: Ending work in process inventory 72,000
Cost of goods manufactured 158,000
Schedule of Cost of Goods Sold

Particulars Amount ($)
Finished goods inventory, beginning 10,000
Cost of Goods Manufactured 158,000
Cost of Goods available for sale 168,000
Deduct: Finished goods inventory, ending 49,500
Unadjusted cost of goods sold 118,500
Add: Under applied overhead ($100,000 - $90,000) 10,000
Adjusted cost of goods sold $128,500
The under-applied overhead has been adjusted with COGS statement above which increases
the value of COGS. The following journal entry has been made:
Cost of Goods Sold 10,000
(under-applied overhead is closed to cost of goods sold)
In other way, it may be closed to income summary with the following journal:
Income summary 10,000
(under-applied overhead is closed to income summary)
In both of the above cases, under-applied amount of overhead has been absorbed in a single
account which may result an adverse impact on bottom line. Alternatively, the amount may be
allocated between cost of goods sold and inventories to spread the impact over the years.
Allocation of under or over-applied overhead between work in process (WIP),finished goods and
cost of goods sold (COGS) is more accurate than closing the entire balance into cost of goods
sold or income summary. The reason is that allocation assigns overhead costs to where they
would have gone in the first place had it not been for the errors in the estimates going into the
predetermined overhead rate. Lets consider the additional data below to allocate the amount
of under-applied amount of $10,000 between accounts.
Account Balances
Work in Process Inventory $ 10,000
Finished Goods Inventory 20,000
Based on the data above, we need to compute the respective percentage of different accounts
and allocate $10,000 accordingly as shown in the table below:
Balance % Under-applied OH = Adjustment Amount
WIP Inventory $ 10,000 10 $10,000 = $ 1,000
FG Inventory 20,000 20 $10,000 = 2,000
COGS 70,000 70 $10,000 = 7,000
Total $ 100,000 100 $ 10,000
Journal entry to record the disposal of under-applied amount of overhead through different
inventory accounts and cost of goods sold will be as follows:
Finished Goods Inventory 2,000

Work-in-Process Inventory 1,000
(under-applied overhead is closed to inventory and cost of
goods sold)
If the amount of under-applied or over-applied overhead is significant, it should be allocated

among the accounts containing applied overhead: Work in Process Inventory, Finished Goods
Inventory, and Cost of Goods Sold. A significant amount of under-applied or over-applied
overhead means that the balances in these accounts are quite different from what they would
have been if actual overhead costs had been assigned to production. Allocation restates the
account balances to conform more closely to actual historical cost as required for external
reporting by generally accepted accounting principles. A single overhead account is used in this
illustration. Theoretically, under-applied or over-applied overhead should be allocated based on
the amounts of applied overhead contained in each account rather than on total account
balances. Use of total account balances could cause distortion because they contain direct
material and direct labor costs that are not related to actual or applied overhead. In spite of this
potential distortion, use of total balances is more common in practice for two reasons: First, the
theoretical method is complex and requires detailed account analysis. Second, overhead tends
to lose its identity after leaving Work in Process Inventory, thus making more difficult the
determination of the amount of overhead in Finished Goods Inventory and Cost of Goods Sold
account balances.
6.10 Variance Analysis

Variance analysis is an off-shoot of over or under applied factory overhead. Over or under
applied overhead amount essentially reflects the dispersion of overhead absorbed in product as
compared with the actual overhead costs incurred. Analysis of over or under applied overhead
results two different types of variances (Figure 6.4). They Are,
a) Spending variances a variance due to budget or expense factors (dollar).
b) Idle capacity variance ma variance due to volume or activity factors (non-dollar).
Actual Factory Budgeted Allowance Based on Applied Factory

Overhead Actual Capacity Overhead
Actual Rate Budgeted Fixed Factory Overhead Predetermined Rate
+ [Budgeted Variable Rate
Actual Activity Actual Activity] Actual Activity
Spending Variance Idle Capacity Variance
Figure 6.4: Spending vs. idle capacity variance
Spending Variance: This variance is the difference between actual overhead costs incurred and
budgeted overhead costs for actual activity level. If actual overhead cost is more than budgeted
overhead cost, the spending variance becomes unfavorable and vice versa. A further analysis of
this variance may bring extra merit to cost control motive of a company. Separating overhead
cost into fixed and variable and identifying each cost categories with reference to line items
offers microscopic analysis opportunity to ensure particular attention to variance, particularly
when it is unfavorable. To understand the calculation let us follow the example as given below.
Example 6.9
Agility Machining apply overheads based on machine hours. Its normal capacity of machine
hours is set at 20,000 machine hours which is 75% of theoretical capacity. Actual machine hours
utilized during 2017 is 18,000 machine hours (90% of normal capacity). The company produces
following overhead cost formula along with the actual overhead cost incurred during the year:
Overhead cost Cost formula Actual cost

Indirect Material $2.00 per machine hour 40,000
Indirect Labor $3.00 per machine hour 50,000
Supplies $18,000 per year 18,000
Rent $30,000 per year 30,000
Maintenance $10,000 plus $1.50 per machine hour 40,000
Fuel $1.50 per machine hour 25,000
Utility $1.00 per machine hours 20,000
Insurance $20,000 per year 20,000
Property Tax $12,000 per year 12,000
Supervisors Salary $15,000 plus $5.00 per machine hour 99,000
Depreciation $12,000 per year 12,000
Overtime Premium $8,000 plus $2.50 per machine hour 55,000
Unemployment tax $5,000 plus $1.50 per machine hour 35,000
Inspection cost $7,000 plus $2.00 per machine hour 40,000
Based on the above information, generate a report showing spending variance to supplement
the decision making process of management.
Solution:
Agility Machining
Normal Capacity: 20,000 Machine Hours; Actual Capacity: 18,000 Machine Hours
Actual Overhead Cost and Budgeted Cost at Actual Capacity
Actual Budgeted Spending

Overhead cost items Cost Formula
Cost Allowance Variance
Variable Overhead:
Indirect Material $2.00X 40,000 36,000 (4,000)
Indirect Labor $3.00X 50,000 54,000 4,000
Maintenance $1.50X 30,000 27,000 (3,000)
Fuel $1.50X 25,000 27,000 2,000
Utility $1.00X 20,000 18,000 (2,000)
Supervisors Salary $5.00X 84,000 90,000 6,000
Overtime Premium $2.50X 47,000 45,000 (2,000)
Unemployment tax $1.50X 30,000 27,000 (3,000)
Inspection cost $2.00X 33,000 36,000 3,000
Total $20.00X 359,000 360,000 1,000
Fixed Costs:
Supplies $18,000 per year 18,000 18,000 -
Rent $30,000 per year 30,000 30,000 -
Maintenance $10,000 per year 10,000 10,000 -
Insurance $20,000 per year 20,000 20,000 -
Property Tax $12,000 per year 12,000 12,000 -
Supervisors Salary $15,000 per year 15,000 15,000 -
Depreciation $12,000 per year 12,000 12,000 -
Overtime Premium $8,000 per year 8,000 8,000 -
Unemployment tax $5,000 per year 5,000 5,000 -
Inspection cost $7,000 per year 7,000 7,000 -
Total $137,000 per year 137,000 137,000 1,000 Fav.
Assumptions:
a) Fixed cost is assumed to be same as mentioned in cost formula. Any dispersion is considered
in variable part.
b) Actual cost minus budgeted allowance, if positive-favorable variance (Fav.) and if negative
unfavorable variance (Ufav.).
The budget figure in the Agility Machining example uses the concept of flexible budgeting where
the budget figure could be easily adjusted with any level of budgeted capacity. In this example,
cost formula for overhead cost is used as $137,000 + $20X (X = Machine Hours). For any level of
machine hours, the formula will result overhead cost as it is calculated in the example as
$497,000 [$137,000 + ($20.0018,000)]. The solution presented above will support
management to take special care on those costs where actual cost is higher than budgeted cost.
Idle Capacity Variance: Idle capacity variance results due to the under-utilization of capacity.
While the budget is set based on a capacity level which is different than actual capacity utilized,
it results idle capacity variance. In Agility Machining example, normal capacity was 20,000
machine hours whereas actual capacity utilized was only 18,000 machine hours. Thus, 2,000
machine hours were not utilized which will surely result unfavorable variance due to absorption
of budgeted fixed manufacturing overhead by 18,000 machine hours in lieu of 20,000 machine
hours. If budgeted level of activity (machine hours in this case) and actual level of activity
become same, there will be no idle capacity variance due to the fact that capacity was not idle
rather properly utilized.
Let us extend the example of Agility Machining. Predetermined overhead application rate as
used by Agility is $27.00 per machine hour. In that case, idle capacity variance would be:
Budgeted Allowance for actual capacity:

Variable Manufacturing Overhead - $20.00 18,000 $360,000
Fixed Manufacturing Overhead $137,000 $497,000
Applied Manufacturing Overhead - $27.50 18,000 $495,000
Idle Capacity Variance (Unfavorable) $ 2,000
Considering the example together, factory overhead was under-applied by $1,000 resulting
$1,000 favorable spending variance and $2,000 unfavorable idle capacity variance as shown
below.
Actual Factory Budgeted Allowance Based on Applied Factory
Overhead Actual Capacity Overhead
$359,000 + $137,000 $137,000 + [$20.00 18,000] = $27.50 18,000 =
= $496,000 $497,000 $495,000
$1,000 Favorable $2,000 Unfavorable
Under-applied by $1,000
Responsibility for the idle capacity variances rest with executive management, in as much as this
variance indicates the under- or over-utilization portion of plant and equipment. The cause of a
capacity variance, whether favorable or unfavorable, should always be determined and possible
reasons for the variance discovered. One cause may be a lack of proper balance between
production facilities and sales. On the other hand, it might be due to a favorable sales price that
recovers fixed overhead at an unusually low volume level.
6.11 Overhead Cost Allocation

Sometimes absorption of overhead costs by the ultimate cost objects follows a predefined
sequence. As the characteristic of overhead cost is indirect, they cannot be traced with the cost
object directly. They are primarily allocated and apportioned to cost centers. Then in next steps,
costs of service departments are reapportioned to production departments. Finally, cost is
absorbed by cost objects. This is the traditional way of overhead cost flows within the cost
accounting systems. The process is shown in Figure 6.5. However, this process allows some
errors in tracing the cost with the cost object properly. Activity Based Costing has been
proposed to ensure accuracy in tracing cost which is not the scope of this chapter.
Service Cost
apportionment
Step 1: Allocation and
Step 2: Re-
Apportionment Centers
Overhead Cost Centers
Production
Cost Centers
Absorption
Step 3:
Cost Objects
Figure 6.5: Overhead cost flow in a traditional costing system
Primary Distribution: Allocation & Apportionment

Primary distribution of overheads which is also called as Departmentalization of overheads
involves allocation & apportionment. Allocation of overheads is made when they are traceable
to cost centers. Overheads are apportioned when they are not traceable to cost centers.
Apportionment is made using the most suitable bases. Figure 6.6 below shows the allocation
and apportionment of overheads into cost centers.
Costs
Not
Traceable Traceable
Apportioned
Allocated
Service Service Service Production Production Production

Dept 1 Dept 2 Dept 3 Dept 1 Dept 2 Dept 3
Cost Objects
[Products, Services]
Figure 6.6: Single Stage Approach of Overhead Cost Absorption in Cost Objects
The above figure presents the allocation of support department costs over cost object under
single stage approach. In this approach, costs are first accumulated in both service and
production departments either through tracing them directly or apportioning them to
respective departments. Then cost accumulated in different departments (both service and
producing) is charged with the cost object directly. In this stage, no difference is made between
service departments and producing departments.
Secondary Distribution: Re-apportionment

Re-apportionment is a process where service centers costs are transferred to production centers
as shown in Figure 6.7 below. Cost centers are two types:
a) Production Cost Centers: They are cost centers where raw materials are converted to
finished goods through defined manufacturing process.
b) Service Cost Centers: They are the cost centers that support the production cost centers
in manufacturing process. Without the support of service cost centers, it remains very
difficult for the production centers to manufacture products.
Costs
Traceable Not
Traceable
Allocated Apportioned
Service Service Service Production Production Production

Dept 1 Dept 2 Dept 3 Dept 1 Dept 2 Dept 3
Cost Objects
[Products, Services]
Figure 6.7: Multiple Stage Approach of Overhead Cost Absorption in Cost Objects
The above figure presents multistage approach of service department cost allocation. Costs are
initially traced with the departments directly or apportioned based on some reasonable bases.
In the next step, all cost thus accumulated in service departments are reapportioned to
producing departments. After such reapportionment, service departments left no cost for being
absorbed by the cost objects that all cost is accumulated in production departments. And cost
objects are charged with the cost of the producing departments. Here cost of the production
departments have been increased due to absorbing the cost of service departments. Which
production department consumes how much of the cost of which service departments is a
question of analysis. If this is not properly analyzed, there is a possibility of distortion in cost
apportionment. There are different methods of cost apportionment all of which fall in any of
these three categories:
Scenario Method for Re-apportionment
a) No service between service cost centers Direct re-distribution method
b) Non reciprocal service between service cost centers Step ladder method
c) Reciprocal service between service cost centers 1. Repeated distribution method
2. Trial & Error method
3. Simultaneous Equation method
Direct Method
Direct method is named after the process of cost allocation where cost of support department is
directly transferred to production departments without considering the fact that one support
department may support other support departments. Thus, the allocation under direct method
is very much straightforward where the cost of one support department becomes zero after
allocation. If one support department doesnt provide any service to other support
department(s) in that case direct method is appropriate. At the same time, when support
departments do not vary that much in terms of their serviceability to other departments, direct
method may produce less distortion. However, as this method doesnt consider the reciprocity
of services at all, it is advised to avoid using this method for service department cost allocation.
Departments
SD 1 SD 2 PD 1 PD 2 PD 3
Departmental Costs $ $ $ $ $
Cost reapportioned - SD 1 0 $ $ $
Figure 6.8: Direct method of cost allocation
As per the example given in Figure 6.8 above there are two service departments (SD) and three
production departments (PD). Costs of both the service departments are apportioned among
three production departments (PD1, PD2 and PD3) only. However, cost of one service
department is not allocated over other service department.
Step down Method

Under this method, the limitation of direct method is recovered partially at least for the first
service department. Under this method, service departments are ranked for allocation. This
ranking is done based on their importance of providing services. Costs of service departments
may be used as a proxy parameter to make the rank, the service department with the highest
cost should receive first rank and needs to be allocated first. Under the step down method, once
the cost of a department is allocated, the department will not receive any further allocation.
Thus the reciprocity is considered partially here. For example, in the following Figure 6.9, cost of
SD1 is allocated to all other departments including service department SD2 resulting the cost of
SD1 zero after allocation. In next step, cost of SD2 should be recomputed considering the
allocated cost of SD1 and then it should be allocated among the other departments. However,
SD1 receives no allocation of SD2 as the cost of SD1 is already zero. One department whose cost
has already been allocated should not receive any further allocation from other departments.
Departments
+
Cost reapportioned - SD 1 0 $ $ $ $
=
Figure 6.9: Step down method of cost allocation
Simultaneous Equation Method

Under this method, service reciprocity is considered to the fullest extent. For example, in the
Figure 6.10 below, a portion of cost of SD1 is allocated to SD2 and similarly a portion of SD2 is
allocated to SD1 making the allocation process holistic and more rational. This allocation is
supplemented by mathematical formulation that helps to revise the costs for service
departments. With two support departments, the mathematical formulation is easy which takes
the following form:
1 = + 2 and 2 = + 1
Departments
Cost reapportioned - SD $ $ $ $
1
Cost reapportioned - SD $ $ $ $
2
Figure 6.10: Simultaneous equation method of cost allocation
Here, a represents the standalone cost of respective departments and b represents the
percentage of services received from the other departments. A simple replacement method will
result revised costs for the service departments that will be allocated among all the
departments. However, if the service department becomes more than two, the mathematical
formulation will be difficult which calls for advance mathematics like matrix formulation.
However, repeated distribution or trial and error method may be an alternative where the
allocations need to be done repeatedly until the costs of service departments become zero.
Example 6.10
Assemble Machining has two service departments (administration and marketing) and two
production departments (molding and finishing). Overhead costs have been accumulated with
reference to the departments initially. The appropriate base for absorbing the cost of
administration department is number of employees and for marketing department, it is number
of number of major customers. You are required to re-apportion the cost of service
departments over the production departments under direct, step-down and simultaneous
equation methods based on the information given below:
Description Service Department Production Department Total
Admin Marketing Molding Finishing
Department Cost $600,000 $900,000 $3,700,000 $2,500,000 $7,700,000
Number of employees 20 10 5 15 50
Number of customers 10 10 30 10 60
Direct Method: Under direct method, costs of service department are directly allocated
between production departments. Here, cost of administration is allocated between molding
and finishing based on number of employees and cost of marketing is allocated between
molding and finishing based on number of major customers.
Direct Allocation of Service Department Costs

Administration Marketing Molding Finishing
Department Cost $600,000 $900,000 $3,700,000 $2,500,000 $7,700,000
Allocation:
Cost of Administration (600,000) - 150,000 450,000
Cost of Marketing - (900,000) 675,000 225,000
Cost after allocation - - $4,525,000 $3,175,000 $7,700,000
Number of employees n/a n/a 5 15
Number of customers n/a n/a 30 10
Allocation Calculations
Administration to Administration cost times ratio of molding employees to total
Molding productive department employees: $600,000 5/(5+15) = $150,000
Administration to Administration cost times ratio of finishing employees to total
Finishing productive department employees: $600,000 15/(5+15) = $450,000
Marketing to Molding Marketing cost times ratio of molding customers to total productive
department customers: $900,000 30/(30+10) = $675,000
Marketing to Finishing Marketing cost times ratio of finishing customers to total productive
department customers: $900,000 10/(30+10) = $225,000
Step-Down Method: Under step-down method, a ranking is made among the service
departments and allocation begins with the most important service department. Out of the two
service department, if administration is ranked first, allocation should begin with administration
and the cost should be absorbed by all the three other departments, e.g., marketing, molding
and finishing. With that allocation, cost of marketing department will be revised and then
allocated between molding and finishing. Administration will not absorb any cost of marketing
department.
Step Down Allocation of Service Department Costs

Department Cost $600,000 $900,000 $3,700,000 $2,500,000 $7,700,000
Allocation:
Cost of Administration (600,000) 200,000 100,000 300,000
1,100,000
Cost of Marketing - (1,100,000) 825,000 275,000
Number of employees n/a 10 5 15
Number of customers n/a n/a 30 10
Administration to Administration cost times ratio of marketing employees to total
Marketing department employees: $600,000 10/(10+5+15) = $200,000
Administration to Administration cost times ratio of molding employees to total
Molding department employees: $600,000 5/(10+5+15) = $100,000
Administration to Administration cost times ratio of finishing employees to total
Finishing department employees: $600,000 15/(10+5+15) = $300,000
Marketing to Molding Marketing cost times ratio of molding customers to total productive
department customers: $1,100,000 30/(30+10) = $825,000
Marketing to Finishing Marketing cost times ratio of finishing customers to total productive
department customers: $1,100,000 10/(30+10) = $275,000
Simultaneous Equation Method: Simultaneous equation method considers the full reciprocity
of services and produces the best allocation provided that the selected allocation bases are
perfect. Allocation under the method is based on the formulation of cost equation for each of
the service departments, solving the equation to have revise estimates of the service
departments and then allocating the revised costs among all the departments. The calculations
are shown below step by step:
Step 1: To form simultaneous equations for both the service departments, we need to compute
respective percentages to identify the services that one service department provides to another
service departments. In such computation, the very important assumption that we hold is that
one service department cannot serve itself rather serves others.
Department Cost $600,000 $900,000 $3,700,000 $2,500,000 $7,700,000
Number of employees 20 10 5 15 30
Percentages - 33.33% 16.67% 50% 100%
Number of customers 10 10 30 10 50
Percentages 20% - 60% 20% 100%
Lets assume that the department Administration is represented by X and the department
Marketing is represented by Y and thus the equations will be
X = $600,000 + 0.2Y .. (eq. 1)
Y = $900,000 + 0.3333X .. (eq. 2)
Step 2: Now both of the equation can be solved through replacement method to revise the cost
of administration and marketing after considering service reciprocity. If equation 2 is replaced in
equation 1, revised cost of administration (X) will come out.
X = $600,000 + 0.2 ($900,000 + 0.3333X)
= $600,000 + $180,000 + .06666X
X - .06666X = $780,000
.93334X = $780,000
X = $780,000 .93334
= $835,708
Now, if we put the value of X in equation 2, it will result the revised cost for marketing
department (Y).
Y = $900,000 + 0.3333 $835,708 = $900,000 + $278,542 = $1,178,542
Step 3: Now the apportionment can be done based on the revised cost of administration and
marketing as shown below:
Simultaneous Equation Method of Service Department Costs Allocation
Department Cost $600,000 $900,000 $3,700,000 $2,500,000 $7,700,000
Allocation:
Cost of Administration (835,708) 278,542 139,300 417,866
Cost of Marketing 235,708 (1,178,542) 707,126 235,708
Number of employees n/a 33.33% 16.67% 50%
Number of customers 20% n/a 60% 20%
Administration to Administration cost percentage of marketing employees to total
Marketing department employees: $835,708 33.33% = $278,542
Administration to Administration cost percentage of molding employees to total
Molding department employees: $835,708 16.67% = $139,300
Administration to Administration cost percentage of finishing employees to total
Finishing department employees: $835,708 50%% = $417,866
Marketing to Marketing cost percentage of administration customers to total
Administration department customers: $1,178,542 20% = $235,708
Marketing to Molding Marketing cost percentage of molding customers to total
department customers: $1,178,542 60% = $707,126
Marketing to Finishing Marketing cost percentage of finishing customers to total
department customers: $1,178,542 20% = $235,708
Absorption
The process of recovering overheads to cost of products is called absorption. In other words all
the overheads allocated & apportioned to a department are finally absorbed by the units
produced. Absorption of overheads can be made based on some suitable basis. The following
are some of widely used methods of absorption:
a) On the basis of Production units
b) As a % of Direct Labor Cost
c) As a % of Direct Material Cost
d) As a % of Prime Cost
e) On the basis of Direct Labor Hours i.e. Labor Hour Rate
f) On the basis of Machine Hours i.e. Machine Hour Rate
Overhead absorption rates are determined based on any one of the above methods. This rate is
applied to individual cost units (products, services etc) to derive the total overhead absorbed.
When actual overhead rate is applied on actual cost units, the actual and absorbed overheads
would be equal. However if a pre-determined rate is applied on the actual base, it would result
in a difference between actual and absorbed overheads. This would happen either because the
actual base deviated from the budgeted base or the actual expenses deviated from the budget.
If the absorbed overhead is more than the actual, it is called over absorption. On the other
hand if the actual overhead is more than the absorbed overhead then it is called under
absorption. These are already discussed as over or under applied overhead section.
Problems and Solutions
Problem 1
Murdock Goods Company set normal capacity at 70,000 machine hours. The expected operating
level for the period just ended was 50,000 machine hours. At this expected actual capacity,
variable expenses were estimated to be $75,000 and fixed expenses $25,000. Actual results
show that 47,000 machine hours were used and the actual factory overhead totaled $90,000
during the period.
Required
a) Compute predetermined factory overhead rate.
b) Compute applied factory overhead.
c) Compute the amount of over or under applied factory overhead
Solution:
a) Predetermined Factory Overhead
Fixed Overhead Rate = $25,000/50,000 MH = $0.50
Variable Overhead Rate = $75,000/50,000 MH = $1.50
Total = $2.00 per machine hour
b) Applied factory overhead: 47,000 machine hours @ $2.00 per MH = $94,000

c) Computing over or under applied factory overhead:
Actual Factory Overhead $90,000
Applied Factory Overhead $94,000
Over-applied Factory Overhead $ 4,000
Problem 2
Annual fixed overhead for Ample Manufacturer is budgeted to be $20,000 at an annual capacity
of 40,000 machine hour. But variable overhead at this capacity level is estimated to be
$120,000. During the first quarter of 2009, Ample worked for 8,000 machine hours. Actual
factory overhead for the quarter was $30,000. Compute the predetermined overhead rate and
over/under applied factory overhead.
Required
a) Compute predetermined factory overhead rate.
b) Compute applied factory overhead.
c) Compute the amount of over or under applied factory overhead
Solution:
a) Predetermined Factory Overhead
Fixed Overhead Rate = $20,000/40,000 MH = $0.50
Variable Overhead Rate = $120,000/40,000 MH = $3.00
Total = $3.50 per machine hour
b) Applied factory overhead: 8,000 machine hours @ $3.50 per MH = $28,000
c) Computing over or under applied factory overhead:
Actual Factory Overhead $30,000
Applied Factory Overhead $28,000
Under-applied Factory Overhead $ 2,000
Problem 3
Pass necessary journal entries in case of following independent scenarios:
a) Factory overhead was over-applied by $10,000 that should be closed in cost of goods sold
account.
Date Accounts Title and Explanation Ref Debit Credit
b) Actual factory overhead was $85,000. If factory overhead was under-applied by $15,000,
pass the journal entry to apply overhead.

c) Factory overhead was under-applied by $15,000 and it has been decided to close in
inventories and cost of goods sold. The yearend balance in Work-in-Process, Finished Goods
and Cost of Goods Sold was $20,000; $40,000 and $240,000 respectively.
Finished Goods 2,000
d) Predetermined factory overhead rate is 200% of direct material costs. Cost of direct material
at the end of the production process amounted to $60,000. Pass the journal entry to apply
overhead into production.
Problem 4
Overhead Cost data for Multiplex Manufacturer is presented below:
Standard
Budgeted Fixed factory overhead $ 250,000
Variable factory overhead $ 150,000
Total Factory Overhead $ 400,000
Capacity Level
Normal Capacity 50,000 units
Expected Actual Capacity 30,000 units
Actual:
Capacity Utilization 35,000 units
Overhead Costs $ 330,000
Inventory:
Work in Finished Cost of
Inventories
Process Goods Goods Sold
Year End Balance $ 20,000 $ 80,000 $ 300,000
Requirement:
1. Compute predetermined overhead application rate. Assume that fixed portion of overhead
is based on normal capacity whereas variable portion is budgeted based on expected actual
capacity.
2. Compute the amount of factory overhead applied and pass necessary journal entry for
applying overhead in to production process.
3. Draw Factory Overhead Control ledger and show whether factory overhead is over-applied
or under-applied? Give the journal entry to shift applied factory overhead into factory
overhead control account.
4. Give disposal entry for over or under applied factory overhead as computed in requirement
3 under each of the following situations;
(a) If treated as period costs and floor management is hold responsible.
(b) If treated as period costs and general administration is hold responsible.
(c) If treated as product cost and allocated between inventories and cost of goods sold on
the ratio of yearend balance.
Solution:
1. Predetermined Factory Overhead
Fixed Overhead Rate = $ 250,000/50,000 units = $ 5.00
Variable Overhead Rate = $ 150,000/30,000 units = $ 5.00
Total = $ 10.00 units
2. Applied factory overhead: 35,000 units @ TK 10.00 per unit = TK 350,000
3. Factory Overhead Control Ledger

Debit Amount Credit Amount
Actual Factory Overhead 330,000 Factory Overhead Applied 350,000
Over-applied 20,000
350,000 350,000

4. Disposal Journal Entries

(a) Factory Overhead Control 20,000
(b) Factory Overhead Control 20,000
Income Summary 20,000
(c) Factory Overhead Control 20,000
Finished Goods 4,000
Problem 5
Granite Company uses a job order cost system. The company applies manufacturing overhead
to jobs using a predetermined overhead rate based on direct labor-hours. Last year,
manufacturing overhead and direct labor-hours were estimated at $80,000 and 16,000 hours
respectively, for the year. In June, job #315 was completed. Materials costs on the job total
$1,500 and labor costs totaled $2,400 at $6 per hour. At the end of the year, it was determined
that the company worked 15,000 direct labor-hours for the year, and incurred $78,000 in actual
manufacturing overhead costs.
Required:
a) Determine the predetermined overhead rate for the year.
b) Determine the amount of overhead charged to jobs during the year.
c) Determine the amount of under or over applied overhead of the year.
d) Assuming that 100 units were completed, determine the unit product cost that would
appear on the job cost sheet for Job #315.
Solution:
a. Predetermined overhead rate = $80,000/16,000 LH = $5 per LH
b. Applied overhead = 15,000 LH X $5 = $75,000
c. Over or under applied overhead:
Actual overhead costs $ 78,000
Applied overhead costs 75,000
Under-applied overhead $ 3,000
d. Cost per unit:
Direct labor 2,400
Overhead applied (400 LH * X $5 per LH) 2,000
Total cost $5,900
Unit product cost $ 59
*2,400 / $6 per LH = 400 LHs
Problem 6
The total overhead expenses of a factory are $446,380. Taking into account the normal working
of the factory, overhead was recovered in production at $1.25 per hour. The actual hours
worked were 293,104. How would you proceed to close the books of accounts, assuming that
besides 7,800 units produced of which 7,000 were sold, there were 200 equivalent units in work
in progress?
On investigation, it was found that 50% of the unabsorbed overhead was on account of increase
in the cost of indirect materials and indirect labor and the remaining 50% was due to factory
inefficiency. Also give the profit implication of the method suggested. (CA adapted)
Solution
Overhead Recovered from production (293,104 $1.25) $ 3,66,380
Actual overhead expenses incurred 4,46,380
Amount of under-recovered overhead $ 80,000
50% of the above amount is due to increase in the cost of indirect material and indirect labor
and should be charged to units produced by means of a supplementary rate.
Number of total units produced = 7,800 + 200 = 8,000 units

Supplementary rate = (50% of $80,000)/8,000 = $5 per unit
The amount of $40,000 should be apportioned among cost of sales, finished goods and work in
progress at the rate of $5 per unit.
Cost of sales = 7,000 x $5 = $35,000
Finished goods = 800 x $5 = $ 4,000
Work in progress = 200 x $5= $1,000
By using this method, the profit for the period will be reduced by $35,000 and the value of stock
will increase by $5,000.
The balance amount of $ 40,000 due to factory inefficiency should be charged to Costing Profit
and Loss Account as this is abnormal cost for which the production should not be penalized.
Problem 7
Mitta Companys normal operating capacity is rated at 47,500 machine hours per month. At this
operating level, fixed factory overhead is estimated to be $17,100 and variable factory overhead
is estimated to be $20,900. During November, the company operated 50,000 machine hours.
Actual factory overhead for the month totaled $39,300.
Required: Compute
(i) The over or under-applied factory overhead and
(ii) The spending and idle capacity variances
Solution:
Predetermined Overhead Rate:
Fixed - $17,100 47,500 =$0.36
Variable - $20,900 47,500 =$0.44
Total = $0.80
a. Actual Factory Overhead $39,300

b. Budgeted Allowance at Actual
Capacity
Variable - $0.44 50,000 $22,000
Fixed 17,100 $39,100
c. Spending Variance (a-b) $200 (unfavorable)
d. Applied Overhead ($0.80 50,000) $40,000
e. Idle capacity variance (b-d) $900 (favorable)
f. Over-applied overhead (d-a) $700 $700 (favorable)
Problem 8
Astana Ltd. is a small manufacturing organization that contains 10 partners and 12 support
persons. The company uses costing system in which predetermined overhead rates are used to
apply manufacturing overhead cost to jobs. The predetermined overhead rate in the Molding
Department is based on direct labor hours and the rate in the Painting Department is based on
direct labor cost. At the beginning of the year the companys management made the following
estimates:
Department
Molding Painting
Direct labor-hours 60,000 -
Machine-hours 8,000 70,000
Direct materials cost $6,20,000 $4,50,000
Direct labor cost 2,25,000 4,20,000
Manufacturing overhead cost 7,20,000 8,31,600
Job A1 was started on April 1 and completed on April 15. The companys cost records show the
following information concerning the job:
Department
Molding Painting
Direct labor-hours 55 25
Machine-hours 30 110
Direct materials cost $500 $440
Direct labor cost 340 750
Required:
1. Compute the predetermined overhead rate used during the year in the Molding Department
and in Painting Department.
2. Compute the total overhead cost applied to Job A1.
3. At the end of the year, the records revealed the following actual cost and operating data for
all jobs worked on during the year:
Department
Molding Painting
Direct labor-hours 55,000 10,000
Machine-hours 7,500 67,000
Direct materials cost $5,85,000 $4,10,000
Direct labor cost 2,10,000 3,80,000
Manufacturing overhead cost 6,42,000 7,65,500
a) What was the amount of under or over applied overhead in each department at the end
of the year?
b) Assume that the company closes any under or over applied overhead directly to Cost of
Goods sold. Prepare the appropriate entry.
Solution:
1. Predetermined Overhead Rate Calculation:
Department Predetermined Overhead Rate
Molding Estimated M. O/H cost / Direct labor hours
= $720,000 / 60,000
= $12 per Direct labor hour
Painting (Estimated M. O/H cost / Direct labor cost) 100
= ($831,600 / 420,000) 100
= 198% of Direct Labor Cost
2. Total overhead cost applied to JobA1:

Amount
Overhead cost applied to Molding Department
(55 Direct labor hour @ $12) $660
Overhead cost applied to Painting Department
($750 198%) $1,485
Total overhead cost applied to JobA1 $2,145
3. (a)
Department
Molding Painting
Actual manufacturing overhead costs $642,000 $765,500
Manufacturing overhead cost applied to work in process during
the year:
55,000 actual DL hours $12 per machine hour 660,000
$380,000 actual direct labor cost 198% of direct labor cost 752,400
Under-applied (over-applied) overhead $(18,000) $13,100
(b)
Molding Over-applied F. Overhead A/C Dr. $18,000

Department Cost of Goods Sold A/CCr. $18,000
Painting Under-applied Cost of Goods Sold A/CDr. $13,100
Department F. Overhead A/C..Cr. $13,100
Problem 9
Bangladesh Lamps Co. applies overhead cost to jobs on the basis of direct material cost. In
computing an overhead rate for the year, the companys estimates were: manufacturing
overhead cost, $189,200; direct material cost $110,000 and direct labor cost $126,000. The
company has provided the following data for consideration:
Beginning Ending
Raw materials $31,500 $24,000
Work in Process 66,000 60,000
Finished Goods 102,000 90,000
The following actual costs were incurred during the year:
Amount ($)
Purchase of raw materials (all direct) 100,500
Direct labor cost 120,000
Manufacturing overhead costs:
Insurance, factory 10,500
Depreciation of equipment 27,000
Indirect labor 63,000
Property taxes 13,500
Maintenance 16,460
Rent of factory building 54,000
Required:
1. a. Compute the predetermined overhead rate for the year.
b. Compute the amount of under or over applied overhead for the year.
2. Assume that the company allocates any under or over applied overhead to Work in process,
Finished Goods and Cost of Goods Sold on the basis of the amount of overhead applied
during the year that remains in each account at the end of the year. These amounts are
$76,300 for Work in Process, $250,700 for Finished Goods, and $763,000 for Cost of Goods
Sold. Prepare the journal entry to show the allocation.
Solution:
1. (a) Predetermined Overhead Rate Calculation:
Predetermined O/H Rate = (Estimated M. O/H cost / Direct labor cost) 100
= ($189,200 / 110,000) 100
= 172% of Direct Labor Cost
(b) Over / Under-applied O/H:
Actual manufacturing overhead costs $184,460

Manufacturing overhead cost applied to work in process during the year:
DM cost* 172% of DM cost $185,760
Under-applied (over-applied) overhead $ (1,300)
*DM used in production = Beginning Inventory + Purchase Ending Inventory
= $31,500 + $100,500 - $24,000
= $108,000
2. Disposition of Over-applied Overhead:

F. Overhead A/C Dr. $1,300
Work-In-Process A/C Cr. $91
Finished Goods A/C Cr. $299
Cost of Goods Sold A/C Cr. $910
Note: Allocated in the ratio of 76,300: 250,700: 763,000
Problem 10
The Armstrong Enterprise Limited has three production department A, B and C and two service
departments D and E. The following figures are extracted from the records of the company:
Amount ($)
Rent and rates 5,000
General lighting 600
Indirect wages 1,500
Power 1,500
Depreciation of Machinery 10,000
Sundries 10,000
The following further details are available:

Total A B C D E
Floor space (sq. ft.) 10,000 2,000 2,500 3,000 2,000 500
Light points 60 10 15 20 10 5
Direct wages 10,000 3,000 2,000 3,000 1,500 500
H.P. of Machines 150 60 30 50 10 -
Value of Machinery ($) 2,50,000 60,000 80,000 1,00,000 5,000 5,000
Working hours 1,591 4,465 4,041
The expenses of D and E are allocated as follows:

A B C D E
D 20% 25% 35% - 20%
E 40% 20% 30% 10% -
Requirements:
1. Prepare the primary distribution summary of overhead costs.
2. What amount of service department costs (D & E) will be allocated to A, B and C using
(a) Direct method
(b) Step down method
(c) Reciprocal method using linear equation?
3. What is the total cost of an article if its raw material cost is $80, labor cost is $50 and it
passes through departments A, B and C for 4, 5 and 3 hours respectively? To derive your
result, consider secondary allocation of overhead cost is based on reciprocal method using
linear equation.
Solution:
Requirement 1: Primary Allocation
Basis of
Total A B C D E
allocation
Rent and rates Floor Space 5,000 1000 1250 1500 1000 250
General lighting Light Points 600 100 150 200 100 50
Indirect wages Direct Wages 1,500 450 300 450 225 75
Power H.P. of Machines 1,500 600 300 500 100 0
Depreciation of Value of
10,000 2400 3200 4000 200 200
Machinery Machineries
Sundries Direct Wages 10,000 3000 2000 3000 1500 500
Direct wages 2,000 - - - 1,500 500
Total 30,600 7,550 7,200 9,650 4,625 1,575
Requirement 1: Secondary Allocation

Direct Method
Total A B C D E
Cost as per primary allocation 30,600 7,550 7,200 9,650 4,625 1,575
Secondary Distribution:
D - 1,156 1,445 2,023 (4,625)
E - 700 350 525 (1,575)
30,600 9,406 8,995 12,198 - -
Step Down Method

Total A B C D E
D - 925 1,156 1,619 (4,625) 925
E - 1,111 556 833 - (2,500)
30,600 9,586 9,652 12,102 - -
Reciprocal Method Using Linear Equation
Total cost for D = 4,625 + 10% of E.(i)

Total cost for E = 1,575 + 20% of D.(ii)
Now, putting the value of D in equation (ii), we get,

E= 1,575 + 20% of (4,625 + .1 of E)
E= 1,575 + 925 + .02E
E - .02E = 2,500
E = 2,551
Now, putting the value of E in equation (i), we get,

D = 4,625 + 10% of 2,551
D = 4,625 + 255
D = 4,880
Total A B C D E
D - 976 1,220 1,708 (4,880) 976
E - 1,020 510 765 255 (2,551)
30,600 9,546 8,930 12,123 - -
Requirement 3: Cost Sheet

Amount
Material $80
Labor $50
Overhead*:
A 4 hours @ $6.00 = 24
B 5 hours @ $2.00 = 10
C 3 hours @ $3.00 = 9
$43
Total Cost $173
*Rate of Overhead:
A B C
Overhead Costs 9,546 8,930 12,123
Working Hours 1,591 4,465 4,041
Rate Per Hour ($) 6.00 2.00 3.00
Problem 11
Cost information
Department
Detail Total
Molding Shaping Packing
Overhead Cost 3 600 000 5 400 4 200 13 200 000
Labor Hours 60 000 60 000 100 000 220 000
Overhead rate per hour 60 90 42 60
Product A labor usage 100 0 90 190
Required
1. Determine the overhead cost of product A using a plant wide overhead allocation rate.
2. Determine the overhead cost of product A using a departmental overhead allocation rate.
Solution:
Requirement 1:
Overhead rate per hour 60
Product A labor usage 190
Allocated cost 11 400
Total 11 400
Requirement 2:
Molding Shaping Packing
Overhead rate per hour 60 90 42
Product A labor usage 100 0 90
Allocated cost 6 000 0 3 780
Total 9 780
The two different overhead cost allocations highlight the problem inherent with a single cost
driver in absorption costing. Activity based costing is the extreme opposite as multiple drivers
(rates) are used in an attempt to more accurately absorb overhead costs.
Problem 12
Based on the information below, solve the requirements followed by,
Production Departments Service Departments
Detail
A B C D E
Overhead Cost 3 600 000 5 400 000 3 300 000 750 000 1 200 000
Labor Hours 60 000 60 000 100 000
Use: Service Dept D 10% 5% 75% - 10%

Use: Service Dept E 50% 15% 10% 25% -
Product A labor usage 100 0 90 0 0
Required:
Determine the overhead costs to assign to product A if:
1. Service department costs are allocated to production departments directly.
2. Service department costs are allocated to production departments on a step down basis.
Solution:
Requirement 1: Direct Method
Production Departments
A B C
Production Overheads 3 600 000 5 400 000 3 300 000
Allocated Service Department D 83 333 41 667 62 500
(10 / 90) (5 / 90) (75 / 90)
Allocated Service Department E 800 000 240 000 160 000
(50 / 75) (15 / 75) (10 / 75)
Total overheads allocated 4 483 333 5 681 667 3 522 500

Total labor hours 60 000 60 000 100 000
Allocation rate 74.72 94.69 35.23
Product A labor usage 100 0 90

7 472 0 3 171
Total costs allocated: Product A 10 643
Requirement 2: Step Down Method
Production Departments Service Departments
A B C D E
Overhead Cost 3 600 000 5 400 000 3 300 000 750 000 1 200 000
Allocate Service Department E 600 000 180 000 120 000 300 000 (1 200 000)
(Highest first 25% vs. 10%) (50 / 100) (15 / 100) (10 / 100) (25 / 100)
Allocate Service Department D 116 667 58 333 875 000 (1 050 000)
(10 / 90) (5 / 90) (75 / 90)
Total overheads allocated 4 316 667 5 638 333 4 295 000

Total labor hours 60 000 60 000 100 000
Allocation rate 71.94 93.97 42.95
Product A labor usages 100 0 90

7 194 0 3 866
Total costs allocated: Product A 11 060
Problem 13
A company has two service and two producing departments. The two service departments serve
not only to producing departments but also to each other. The departmental estimates for the
next year are as follows.
Producing Departments: A $ 50,000; B $ 40,000
Service Department : X $10,000; Y $ 8,800
The Service Departments costs are to be distributed as under:
Cost of X : 50% to A, 40% to B, and 10% to Y
Cost of Y : 40% to A, 40% to B, and 20% to X
Required:
Transfer the service departments costs to each other and to producing departments using the
simultaneous equation method.
Solution:
Now we solve the given illustration first using the simultaneous equation method as follows:
Original costs of service departments: X = $10,000 and Y = $8,800
After getting the share from distribution of service departments, two equations are:
X = $10,000 + 20% Y and Y = $8,800 + 10% X
By putting the value of Y in equation for X, we get -
X = $10,000 + 20% ($8,800 + 10%X)
X = $10,000 + 1760 + 0.2X
X 0.02X = $10,000 + $1,760
0.98X = $11,760
X = 11760 / 0.98
X = $12,000
By putting the value of X in equation for Y, we get -
Y = $ 8,800 + 10% ($12000)
Y = $ 8,800 + $ 1,200
Y = $10,000
Chapter Summary
1. Manufacturing overhead refers to all indirect cost incurred in production floor in the process
of manufacturing products
2. The materials that become part of and can be readily identified with a certain
manufacturing products can be classified as direct materials.
3. The employees who are required for the manufacturing process but who do not work
directly on the units being manufactured are considered indirect labor.
4. In order to determine the absorption of overhead in costs of jobs, products or process, a
rate is calculated and it is called as "Overhead Absorption Rate" or "Overhead Rate."
5. Predetermined overhead rate is determined in advance of actual production and the rate is
computed by dividing the budgeted overhead for the accounting period by the budgeted
base for the period.
6. Allocation bases mean the driver which causes the cost.
7. Expected actual capacity is the estimated volume of production for a given period of time in
the immediate future.
8. Normal capacity is the average expected production level for a budget year considering the
production facilities and the seasonal variation in the demand for the product.
9. The actual overhead refers to the indirect manufacturing costs actually occurring and
recorded.
10. Factory overhead applied is based on predetermined overhead rate and actual activity
recorded in line with the selected bases for a certain period.
11. To compute the amount of over or under applied overhead amount, it is important to
transfer Factory Overhead Applied account to Factory Overhead Control account.
12. If the amount of under-applied or over-applied overhead is significant, it should be allocated
among the accounts containing applied overhead: Work in Process Inventory, Finished
Goods Inventory, and Cost of Goods Sold.
13. Analysis of over or under applied overhead results two different types of variances, e. g.,
spending variance and idle capacity variance.
14. Spending variance is the difference between actual overhead costs incurred and budgeted
overhead costs for actual activity level.
15. Idle capacity variance results due to the under-utilization of capacity.
16. Primary distribution of overheads, which is also called as Departmentalization of
overheads, involves allocation & apportionment.
17. Allocation of overheads is made when they are traceable to cost centers. Overheads are
apportioned when they are not traceable to cost centers.
18. Re-apportionment is a process where service centers costs are transferred to production
centers.
19. Direct method is named after the process of cost allocation where cost of support
department is directly transferred to production departments without considering the fact
that one support department may support other support departments.
20. Under simultaneous equation method, service reciprocity is considered to the fullest extent.
21. The process of recovering overheads to cost of products is called absorption.
Multiple Choice Questions
1) At the end of the year, manufacturing overhead is found over-applied. How did this happen?
a) The company incurred more total job costs than the amount budgeted for the job.
b) The actual manufacturing overhead costs were less than the manufacturing overhead
assigned to jobs.
c) Estimated manufacturing overhead was less than actual manufacturing overhead costs.
d) The company incurred more manufacturing overhead costs than the manufacturing
overhead assigned to jobs.
2) Luca Company over-applied manufacturing overhead during 2013. Which one of the
following is part of the year end entry to dispose of the over-applied amount assuming the
amount is material?
a) An increase to finished goods
b) An increase to cost of goods sold
c) A decrease to applied overhead
d) A decrease to work in process inventory
3) Why is factory overhead applied to products and jobs by manufacturing companies?

a) Total actual overhead costs can never be accurately determined for production.
b) It provides a more accurate cost of the job or products being processed.
c) Because indirect costs are easy to trace to products and jobs.
d) It allows managers more timely determination of product costs during the
manufacturing process.
4) Which of the following represents the correct order in which inventories are reported on a
manufacturers balance sheet?
a) Raw materials, work in process, finished goods
b) Finished goods, work in process, raw materials
c) Work in process, finished goods raw materials
d) Work in process, raw materials, finished goods
5) Which one of the following is indirect labor considered?

a) Product cost
b) Period cost
c) Nonmanufacturing cost
d) Raw material cost
6) Which of the following is an element of manufacturing overhead?

a) Factory workers wages
b) Plant managers salary
c) Components used in calculators during production
d) Flour used in manufactured cake mixes
7) Poodle Company manufactures two products, Mini A and Maxi B. Poodle's overhead costs
consist of setting up machines, $800,000; machining, $1,800,000; and inspecting, $600,000.
Information on the two products is:
Mini A Maxi B
Direct labor hours 15,000 25,000
Machine setups 600 400
Machine hours 24,000 26,000
Overhead applied to Maxi B using traditional costing using direct labor hours is
a) $2,000,000
b) $1,670,000
c) $1,280,000
d) $1,536,000
8) Over-applied factory overhead always will result when a predetermined factory overhead rate
is employed and:
a) Production is greater than defined capacity
b) Actual overhead costs are more than expected
c) Defined capacity is less than normal capacity
d) Overhead incurred is less than applied overhead
9) Forbes Company uses a predetermined overhead rate based on direct labor-hours to apply
manufacturing overhead to jobs. At the beginning of the period, the company estimated
manufacturing overhead would be $18,000 and direct labor-hours would be 15,000. The
actual figures were $19,500 for manufacturing overhead and 16,000 direct labor-hours. The
cost records for the period will show -
a) overapplied overhead of $300
b) overapplied overhead of $1,500
c) underapplied overhead of $1,500
d) underapplied overhead of $300
10) Avery Co. uses a predetermined overhead rate based on direct labor-hours to apply
manufacturing overhead to jobs. For the month of October, Avery's estimated
manufacturing overhead cost was $300,000 based on an estimated activity level of 100,000
direct labor-hours. Actual overhead amounted to $325,000 with actual direct labor-hours
totaling 110,000 for the month. How much was the overapplied or underapplied overhead?
a) $25,000 overapplied
b) $25,000 underapplied
c) $5,000 overapplied
d) $5,000 underapplied
11) Heller Cannery, Inc. uses a predetermined overhead rate based on machine-hours to apply
manufacturing overhead to jobs. The company estimated that it would incur $510,000 in
manufacturing overhead during the year and that it would work 100,000 machine-hours.
The company actually worked 105,000 machine-hours and incurred $540,000 in
manufacturing overhead costs. By how much was manufacturing overhead underapplied or
overapplied for the year?
a) $4,500 overapplied
b) $4,500 underapplied
c) $30,000 overapplied
d) $30,000 underapplied
12) Linh Corporation applies manufacturing overhead to jobs on the basis of pounds of direct
material used. Linh estimated 160,000 pounds of material usage and $200,000 of
manufacturing overhead cost for the year. During the year, Linh actually used 150,000
pounds of material and incurred $171,000 of manufacturing overhead cost. What was Linh's
underapplied or overapplied overhead for the year?
a) $12,500 underapplied
b) $16,500 overapplied
c) $17,600 underapplied
d) $29,000 overapplied
13) Factory overhead should be allocated on the basis of:

a) An activity basis that relates to cost incurrence
b) Direct labor hours
c) Direct labor cost
d) Machine hours
14) When a large manufacturing company has a highly automated manufacturing environment,
the most appropriate base for applying factory overhead to work in process is:
a) Direct labor hours
b) Machine hours
c) Direct labor dollars
d) Cost of materials used
15) The overhead application method that considers non-volume-related activities that create
overhead costs as well as volume-related activities is:
a) Direct labor hours
b) Machine hours
c) Direct labor dollars
d) Activity-based costing
16) The most reasonable base for allocating the cost of a human resources department is:
a) Number of employees
b) Square footage
c) Materials used
d) Building depreciation
17) Which of the following departments would be classified as a support department?

a) Fabricating
b) Assembly
c) Engineering
d) Finishing
18) Which of the following departments would be classified as a producing department?

a) Engineering
b) Machining
c) Final Inspection
d) Maintenance
[Answer questions 19 and 20 based on the information given here] XYZ Company has two
support departments (Power and Maintenance) and two producing departments (Assembly and
Finishing). The direct allocation method is used to assign support department costs to the
producing departments. The causal factor for the power costs is kilowatt hours; the causal factor
for the maintenance costs is repair hours. Assume the following information:
Power Maintenance Assembly Finishing

Direct costs $100,000 $150,000 $75,000 $50,000
Kilowatt hours 10,000 90,000 100,000
Repair hours 500 2,500 2,000
19) What would be the Power Department allocation to the Assembly Department?
a) $45,000
b) $47,368
c) $50,000
d) $54,474
20) What would be the Maintenance Department allocation to the Finishing Department?
a) $20,000
b) $22,222
c) $60,000
d) $66,667
True or False (Indicate your answer in the Answers column by writing a T for True or an F for
False).
1. Factory overhead includes indirect materials, indirect labor, and all other indirect
manufacturing expenses.
2. Examples of fixed factory overhead costs include property taxes and insurance on factory
equipment.
3. A flexible budget shows the expected factory overhead at any level of production.
4. A department-type analysis sheet system provides a separate sheet for each type of factory
overhead expense incurred.
5. Predetermined factory overhead rates are not very popular in practice because it is not
important to know the cost of a job or process until the end of the period.
6. Varying wage rates within the factory are more of a problem in arriving at good allocations
when using the direct labor cost method of applying overhead than the direct labor hour
method.
7. A credit balance in Factory Overhead, after Applied Factory Overhead has been closed to it,
indicates that more overhead was applied than actually was incurred.
8. When the year-end balance in Under and Over-applied Factory Overhead is large, it should be
closed to Work in Process, Finished Goods, and Cost of Goods Sold so as not to distort net
income for the period.
9. The entry to close Applied Factory Overhead to Factory Overhead is a debit to Factory
Overhead and a credit to Applied Factory Overhead.
10. The activity-based costing method can be used by service businesses as well as
manufacturing businesses.
Discussion Questions
1. What is the importance of overheads in product costing?
2. What are the different elements of manufacturing costs?
3. Classify overheads and briefly explain each of them.
4. What do you mean by overhead rates? Mention different types of overhead rates.
5. Critically explain the necessity of predetermined overhead rates.
6. What do you mean by allocation bases? Give examples with explanation.
7. What is the use of capacity levels in overhead rate calculation?
8. What are the different types of capacity levels? Explain with a hypothetical example.
9. Differentiate between excess and idle capacity.
10. How to account for actual overheads? And what the relationship is of applied overhead with
that.
11. Explain factory overhead control account with a hypothetical example.
12. What do you mean by over and under applied overhead? What are the situations of such
over or under application of overheads?
13. Critically explain the impact of over or under applied overhead on product cost.
14. What are the different methods of disposing over or under applied overhead?
15. Give a choice between immediate write off and proration while disposing over or under
applied overheads.
16. Differentiate between spending and idle capacity variance.
17. What do you mean by overhead cost allocation? What are the different steps in such
allocation?
18. Differentiate between primary and secondary distribution of overhead?
19. What are the different methods of secondary distribution? Which method produces more
accurate overhead cost allocation among direct, step-down and simultaneous equation
method?
20. How is overhead cost absorbed in cost objects? Why it is important?
Exercises
1. Classify each of the following departments in a factory as a producing department or a
support department by placing a check mark in the appropriate column.
Departments Producing Department Support Department
a) Fabricating
b) Accounting
c) Machining
d) Finishing
e) Rework
f) Cafeteria
g) Maintenance
h) Grinding
i) Heat treat
j) Cutting
k) Materials storeroom
l) Purchasing
m) Assembly
n) Engineering
o) Welding
2. At the beginning of the year, ABC Company estimated overhead cost of $450,000 and direct
labor cost of $600,000. ABC uses normal costing and applies overhead on the basis of direct
labor cost. For the month of December, direct labor cost was $38,900.
Required:
a) Calculate the predetermined overhead rate for the year.
b) Calculate the overhead applied to production in December.
3. At the end of the year, ABC Company provided the following actual information:
Overhead $ 456,500
Direct labor cost 607,200
ABC uses normal costing and applies overhead at the rate of 75 percent of direct labor cost.
At the end of the year, Cost of Goods Sold (before adjusting for any overhead variance) was
$890,000.
Required:
a) Calculate the overhead variance for the year.
b) Dispose of the overhead variance by adjusting Cost of Goods Sold.
4. At the beginning of June, ABC Company had two jobs in process, Job A1 and Job A2, with the
following accumulated cost information:
Job A1 Job A2
Direct materials $4,600 $ 500
Direct labor 1,200 1,000
Applied overhead 750 1,300
Balance, June 1 $6,550 $2,800
During June, two more jobs (B1 and B2) were started. The following direct materials and
direct labor costs were added to the four jobs during the month of June:
Job A1 Job A2 Job B1 Job B2
Direct materials $1,500 $6,110 $800 $700
Direct Labor 1,000 2,400 2,000 600
At the end of June, Jobs A1, A2, and B2 were completed. Only Job A1 was sold. On June 1,
the balance in Finished Goods was zero.
Required:
a) Calculate the overhead rate based on direct labor cost.
b) Prepare a brief job-order cost sheet for the four jobs. Show the balance as of June 1 as
well as direct materials and direct labor added in June. Apply overhead to the four jobs
for the month of June, and show the ending balances.
c) Calculate the ending balances of Work in Process and Finished Goods as of June 30.
d) Calculate the Cost of Goods Sold for June.
5. At the beginning of the year, XYZ Company estimated the following:

Assembly Department Testing Department Total
Overhead $620,000 $180,000 $800,000
Direct labor hours 155,000 20,000 175,000
Machine hours 80,000 120,000 200,000
XYZ uses departmental overhead rates. In the assembly department, overhead is applied on
the basis of direct labor hours. In the testing department, overhead is applied on the basis
of machine hours. Actual data for the month of March are as follows:
Assembly Department Testing Department Total
Overhead $53,000 $15,500 $68,500
Machine hours 6,800 13,050 19,850
Required:
a) Calculate the predetermined overhead rates for the assembly and testing departments.
b) Calculate the overhead applied to production in each department for the month of
March.
c) By how much has each departments overhead been over-applied? Under-applied?
6. XYZ Company builds internal conveyor equipment to client specifications. On October 1, Job
877 was in process with a cost of $20,520 to date. During October, Jobs 878, 879, and 880
were started. Data on costs added during October for all jobs are as follows:
Job 877 Job 878 Job 879 Job 880
Direct materials $13,960 $ 7,000 $ 350 $4,800
Direct labor 13,800 10,000 1,500 4,000
Overhead is applied to production at the rate of 85 percent of direct labor cost. Job 878 was
completed on October 28, and the client was billed at cost plus 50 percent. All other jobs
remained in process.
Required:
a) Prepare a brief job-order cost sheet showing the October 1 balances of all four jobs, plus
the direct materials and direct labor costs during October. (There is no need to calculate
applied overhead at this point or to total the costs.)
b) Calculate the overhead applied during October.
c) Calculate the balance in Work in Process on October 31.
d) What is the price of Job 878?
7. Watson Products Inc. uses a normal job-order costing system. Currently, a plant-wide
overhead rate based on machine hours is used. Marlon Burke, the plant manager, has heard
that departmental overhead rates can offer significantly better cost assignments than a
plant-wide rate can offer. Watson has the following data for its two departments for the
coming year:
Department A Department B
Overhead costs (expected) $50,000 $22,000
Normal activity (machine hours) 20,000 16,000
Required
a) Compute a predetermined overhead rate for the plant as a whole based on machine
hours.
b) Compute predetermined overhead rates for each department using machine hours.
(Carry your calculations out to three decimal places.)
c) Job 73 used 20 machine hours from Department A and 50 machine hours from
Department B. Job 74 used 50 machine hours from Department A and 20 machine hours
from Department B. Compute the overhead cost assigned to each job using the plant-
wide rate computed in Requirement a. Repeat the computation using the departmental
rates found in Requirement b. Which of the two approaches gives the fairer
assignment? Why?
d) Repeat Requirement c, assuming the expected overhead cost for Department B is
$40,000 (not $22,000). For this company, would you recommend departmental rates
over a plant-wide rate?
8. Suppose that back in the 1970s, Steve was asked to build speakers for two friends. The first
friend, Jan, needed a speaker for her band. The second friend, Ed, needed a speaker built
into the back of his hatchback automobile. Steve figured the following costs for each:
Jans Job Eds Job

Materials $50 $75
Labor hours 10 20
Steve knew that Jans job would be easier, since he had experience in building the type of
speaker she needed. Her job would not require any special equipment or specialized fitting.
Eds job, on the other hand, required specialized design and precise fitting. Steve thought he
might need to build a mock-up of the speaker first, to fit it into the space. In addition, he
might have to add to his tool collection to complete the job. Normally, Steve figured a wage
rate of $6 per hour and charged 20 percent of prime costs as an overhead rate.
Required:
a) Prepare job-order cost sheets for the two jobs, showing total cost.
b) Which cost do you think is more likely to be accurate? How might Steve build in some of
the uncertainty of Eds job into a budgeted cost?
9. During August, Pamell Inc. worked on two jobs. Data relating to these two jobs follow:
Job 64 Job 65
Units in each order 50 100
Units sold 50
Materials requisitioned $1,240 $985
Direct labor hours 410 583
Direct labor cost $6,150 $8,745
Overhead is assigned on the basis of direct labor hours at a rate of $12. During August, Job
64 was completed and transferred to Finished Goods. Job 65 was the only unfinished job at
the end of the month.
Required:
a) Calculate the per-unit cost of Job 64.
b) Compute the ending balance in the work-in-process account.
c) Prepare the journal entries reflecting the completion and sale on account of Job 64. The
selling price is 160 percent of cost.
10. Triad Company has two support departments (Janitorial and Payroll) and two producing
departments (Assembly and Finishing). The sequential allocation method is used to assign
support department costs to the producing departments. Payroll costs are allocated first. A
proxy for janitorial services is square footage; a proxy for payroll is number of employees.
Assume the following information:
Janitorial Payroll Assembly Finishing

Direct costs $250,000 $275,000
Square feet 500 3,500 1,500
Number of employees 5 8 125 100
Required:
a) What would be the Payroll Department allocation to the Assembly Department?
b) What would be the Janitorial Department allocation to the Finishing Department?
Problems
1. Turnip Company applies manufacturing overhead based on direct labor hours. Information
concerning manufacturing overhead and labor for May are as follows:
Estimated manufacturing overhead $ 84,000

Actual manufacturing overhead $ 85,200
Direct labor estimated 3,000 hours @ $14.00 = $42,000
Direct labor incurred 2,900 hours @ $14.50 = $42,050
Required:
a) How much is the predetermined overhead rate?
b) How much overhead should be applied in total during May?
c) Post all amounts to the account in which you will find any over or under-applied amount
are year end. Label the account with the correct name. Calculate the account balance
and label as over or under-applied.
d) Dispose of the balance in the MOH expense account.
2. The books of Peach Tree Products Company revealed that the following general journal
entry had been made at the end of the current accounting period:
Factory Overhead $2,000
Under- and Over-applied Factory Overhead $2,000
Closed credit balance in factory overhead control account.
The total direct materials cost for the period was $40,000. The total direct labor cost, at an
average rate of $10 per hour for direct labor, were one and one-half times the direct
materials cost. Factory overhead was applied on the basis of $4 per direct labor hour.
Required: What was the total actual factory overhead incurred for the period?
3. XYZ corporation will apply manufacturing overhead to its jobs using a predetermined
overhead rate based on direct labor-hours requires to complete a job. Last period, the
company's manufacturing overhead was $80,000. The direct labor hours were 16,000 hours.
Halfway through the year, job #10 was completed. Materials costs that the company spent
on job #10 were $1,500. The labor costs that it spent totaled $2,400 at exactly $6 per hour.
At the end of the accounting year, the in-house accountants determined that the company
worked 15,000 direct labor-hours for the year. During the same time, it incurred $78,000 in
actual manufacturing overhead costs for the entire manufacturing year.
Required:
a) Determine amount of overhead that will be charged to jobs during the year.
b) Calculate predetermined overhead rate for the year.
c) Calculate amount of under- or over-applied overhead for the year.
d) Assume that 100 units were completed, what is the unit product cost (UPC) that would
appear on the accounting job cost sheet for Job #10.
4. In a factory, the overheads of a production department are absorbed on the basis of $18 per
machine hour. During October 2012, factory overheads incurred was $1,650,000. This
amount includes $250,000 payable due to an award of labor court; $150,000 is due to prior
period expenses booked in the month of October 2012 and 6,500 are for actual machine
hours worked.
Actual production was 260,000 units; however, only 195,000 units were sold. On analyzing
the reasons, it was found that 40% of the under absorbed overheads was due to defective
planning and the rest was attributed to normal cost increase.
Required: How would you treat under absorbed overheads in Cost Accounts? (CA adapted)
5. XYZ Company, a job-order costing firm, worked on three jobs in July. Data are as follows:
Job 73 Job 74 Job 75
Balance, July 1 $8,450 $0 $0
Direct materials $7,450 $12,300 $16,150
Direct labor $12,000 $10,500 $23,000
Machine hours 400 350 1,000
Overhead is applied to jobs at the rate of $20 per machine hour. By July 31, Jobs 73 and 75
were completed. Jobs 70 and 73 were sold. Job 74 remained in process. On July 1, the
balance in Finished Goods was $49,000 (consisting of Job 70 for $19,000 and Job 72 for
$30,000).
XYZ prices its jobs at cost plus 30 percent. During July, variable marketing expenses were 10
percent of sales, and fixed marketing expenses were $2,000; administrative expenses were
$4,800.
Required:
a) Prepare job-order cost sheets for all jobs in process during July, showing all costs
through July 31.
b) Calculate the balance in Work in Process on July 31.
c) Calculate the balance in Finished Goods on July 31.
d) Calculate Cost of Goods Sold for July.
e) Prepare an income statement for Berne Company for the month of July.
6. Ionia Company uses a normal job-order costing system. The company has two departments
through which most jobs pass. Overhead is applied using a plant-wide overhead rate of $12
per direct labor hour. During the year, several jobs were completed. Data pertaining to one
such job, Job 9-601, follow:

Direct labor cost:
Department A (6,000 hours @ $6) $36,000
Department B (1,000 hours @ $6) $6,000
Machine hours used:
Department A 100
Department B 1,200
Units produced 10,000
Required:
a) Compute the total cost of Job 9-601.
b) Compute the per-unit manufacturing cost for Job 9-601.
[For Requirements 3 and 4, assume that Ionia uses departmental overhead rates. In
Department A, overhead is applied at the rate of $3 per direct labor hour. In Department B,
overhead is applied at the rate of $7 per machine hour.]
c) Compute the total cost of Job 9-601
d) Compute the per-unit manufacturing cost for job 9-601
7. Spade Millhone Detective Agency performs investigative work for a variety of clients.
Recently, Alban Insurance Company asked Spade Millhone to investigate a series of
suspicious claims for whiplash. In each case, the claimant was driving on a freeway and was
suddenly rear-ended by an Alban-insured client. The claimants were all driving old,
uninsured automobiles. The Alban clients reported that the claimants suddenly changed
lanes in front of them, and the accidents were unavoidable. Alban suspected that these
accidents were the result of insurance fraud. Basically, the claimants cruised the freeways
in virtually worthless cars, attempting to cut in front of expensive late-model cars that
would surely be insured. Alban believed that the injuries were faked.
Rex Spade spent 37 hours shadowing the claimants and taking pictures as necessary. His
surveillance methods located the office of a doctor used by all claimants. He also took
pictures of claimants performing tasks that they had sworn were now impossible to perform
due to whiplash injuries. Victoria Millhone spent 48 hours using the Internet to research
court records in surrounding states to locate the names of the claimants and their doctor.
She found a pattern of similar insurance claims for each of the claimants.
Spade Millhone Detective Agency bills clients for detective time at $120 per hour. Mileage is
charged at $0.50 per mile. The agency logged in 510 miles on the Alban job. The film and
developing amounted to $120.
Required:
a) Prepare a job-order cost sheet for the Alban job.
b) Why is overhead not specified in the charges? How does Spade Millhone charge clients
for the use of overhead (e.g., the ongoing costs of their officesupplies, paper for notes
and reports, telephone, utilities)?
c) The mileage is tallied from a source document. Design a source document for this use,
and make up data for it that would total the 510 miles driven on the Alban job.
8. Uehler Prosthetics Company produces artificial limbs for individuals. Each prosthetic is
unique. On January 1, three jobs, identified by the name of the person being fitted with the
prosthetic, were in process with the following costs:
Asher Styne Wollner
Direct materials $100 $340 $ 780
Direct labor 350 700 1,050
Applied overhead 280 560 840
Total $730 $1,600 $2,670
During the month of January, two more jobs were started, Johns and Burton. Materials and
labor costs incurred by each job in January are as follows:
Materials Direct
Labor
Asher $ 600 $ 300
Styne 550 200
Wollner 860 250
Johns 1,310 1,650
Burton 260 180
Wollner and Johns prosthetics were completed and sold by January 31.
Required:
a) If overhead is applied on the basis of direct labor dollars, what is the overhead rate?
b) Prepare simple job-order cost sheets for each of the five jobs in process during January.
c) What is the ending balance of Work in Process on January 31? What is the Cost of Goods
Sold in January?
d) Suppose that Uehler Prosthetics Company prices its jobs at cost plus 20 percent. In
addition, during January, marketing and administrative costs of $850 were incurred.
Prepare an income statement for the month of January.
9. Xanning Company manufactures specialty tools to customer order. There are three
producing departments. Departmental information on budgeted overhead and various
activity measures for the coming year is as follows:
Welding Assembly Finishing

Estimated overhead $200,000 $22,000 $250,000
Direct labor cost $90,000 $150,000 $120,000
Machine hours 5,000 1,000 2,000
Currently, overhead is applied on the basis of machine hours using a plant-wide rate.
However, Janine, the controller, has been wondering whether it might be worthwhile to use
departmental overhead rates. She has analyzed the overhead costs and drivers for the
various departments and decided that Welding and Finishing should base their overhead
rates on machine hours and that Assembly should base its overhead rate on direct labor
hours. Janine has been asked to prepare bids for two jobs with the following information:
Job 1 Job 2
Direct materials $4,500 $8,600
Direct labor cost $1,000 $2,000
Direct labor hours:
Welding 10 20
Assembly 60 20
Finishing 30 80
Number of machine hours:
Welding 50 30
Assembly 40 5
Finishing 110 165
The typical bid price includes a 30 percent markup over full manufacturing cost.
Required:
a) Calculate a plant-wide rate for Xanning Company based on machine hours. What is the
bid price of each job using this rate?
b) Calculate departmental overhead rates for the producing departments. What is the bid
price of each job using these rates? (Round all answers to the nearest dollar.)
10. At the beginning of the year, Paxton Company budgeted overhead of $180,000 as well as
15,000 direct labor hours. During the year, Job K456 was completed with the following
information: direct materials cost, $2,340; direct labor cost, $3,600. The average wage for
Paxton Company employees is $10 per hour. By the end of the year, 15,400 direct labor
hours had actually been worked, and Paxton Company incurred the following actual
overhead costs for the year:
Equipment lease $ 5,000

Depreciation on building 20,000
Indirect labor 100,000
Utilities 15,000
Other overhead 45,000
Total 185,000
Required:
a) Calculate the overhead rate for the year.
b) Calculate the total cost of Job K456.
c) Prepare the journal entries to record actual overhead and to apply overhead to
production for the year.
d) Is overhead over-applied or under-applied? By how much?
e) Assuming that the normal cost of goods sold for the year is $700,000, what is the
adjusted cost of goods sold?
11. Reynolds Printing Company specializes in wedding announcements. Reynolds uses an actual
job-order costing system. An actual overhead rate is calculated at the end of each month
using actual direct labor hours and overhead for the month. Once the actual cost of a job is
determined, the customer is billed at actual cost plus 50 percent.
During April, Mrs. Lucky, a good friend of owner Jane Reynolds, ordered three sets of
wedding announcements to be delivered on May 10, June 10, and July 10, respectively.
Reynolds scheduled production for each order on May 7, June 7, and July 7, respectively.
The orders were assigned job numbers 115, 116, and 117, respectively.
Reynolds assured Mrs. Lucky that she would attend each of her daughters weddings. Out of
sympathy and friendship, she also offered a lower price. Instead of cost plus 50 percent, she
gave her a special price of cost plus 25 percent. Additionally, she agreed to wait until the
final wedding to bill for the three jobs.
On August 15, Reynolds asked her accountant to bring her the completed job-order cost
sheets for Jobs 115, 116, and 117. She also gave instructions to lower the price as had been
agreed upon. The cost sheets revealed the following information:
Job 115 Job 116 Job 117
Cost of direct materials $ 250.00 $ 250.00 $ 250.00
Cost of direct labor (5 hours) 25.00 25.00 25.00
Cost of overhead 200.00 400.00 400.00
Total cost $ 475.00 $ 675.00 $ 675.00
Total price $ 593.75 $ 843.75 $ 843.75
Number of announcements 500 500 500
Reynolds could not understand why the overhead costs assigned to Jobs 116 and 117 were
so much higher than those for Job 115. She asked for an overhead cost summary sheet for
the months of May, June, and July, which showed that actual overhead costs were $20,000
each month. She also discovered that direct labor hours worked on all jobs were 500 hours
in May and 250 hours each in June and July.
Required:
a) How do you think Mrs. Lucky will feel when she receives the bill for the three sets of
wedding announcements?
b) Explain how the overhead costs were assigned to each job.
c) Assume that Reynoldss average activity is 500 hours per month and that the company
usually experiences overhead costs of $240,000 each year. Can you recommend a better
way to assign overhead costs to jobs? Re-compute the cost of each job and its price
given your method of overhead cost assignment. Which method do you think is best?
Why?
12. Walton Company is a manufacturing firm that uses job-order costing. The company's
inventory balances were as follows at the beginning and end of the year:
Beginning Balance Ending Balance

Raw materials $11,000 $15,000
Work in process $32,000 $14,000
Finished goods $108,000 $123,000
The company applies overhead to jobs using a predetermined overhead rate based on
machine-hours. At the beginning of the year, the company estimated that it would work
17,000 machine-hours and incur $272,000 in manufacturing overhead cost. The following
transactions were recorded for the year:
a) Raw materials were purchased, $416,000.
b) Raw materials were requisitioned for use in production, $412,000 $(376,000 direct and
$36,000 indirect).
c) The following employee costs were incurred: direct labor, $330,000; indirect labor,
$69,000; administrative salaries, 157000; selling costs $113,000 and factory utility costs,
$29,000.
d) Depreciation for the year was $121,000 of which $114,000 is related to factory
operations and $7,000 is related to selling, general, and administrative activities.
e) Manufacturing overhead was applied to jobs. The actual level of activity for the year
was 15,000 machine-hours.
f) Sales for the year totaled $1,282,000.
Required:
a) Prepare a schedule of cost of goods manufacture in good form.
b) Was the overhead under-applied or over-applied? By how much?
c) Prepare an income statement for the year in good form. The company closes any under-
applied or over-applied manufacturing overhead to Cost of Goods Sold.
13. Following is the flexible budget of the Machining Department of Walton Manufacturing
Company.
Walton Manufacturing Company
Machining Department
Monthly Flexible Budget
Capacity 80% 90% 100%
Standard production 800 1,000 1,200
Variable factory overhead (per labor
hour):
Indirect labor $1,600 $2,000 $2,400 $0.50
Indirect materials 960 1,200 1,440 $0.30
Supplies 640 800 960 $0.20
Repairs 480 600 720 $0.15
Power and light 160 200 240 $0.05
Total variable factory overhead $3,840 $4,800 $5,760 $1.20
Fixed factory overhead (per Month):
Supervisor $1,200 $1,200 $1,200
Depreciation on machinery 700 700 700
Insurance 250 250 250
Property tax 250 250 250
Power and light 400 400 400
Maintenance 400 400 400
Total fixed factory overhead $3,200 $3,200 $3,200 $3,200
Total factory overhead ($3,200 per month $7,040 $8,000 $8,960
+ $1.20 per labor hour
Other Data:
Actual factory overhead is $7,384. Actual production is 850 units of finished product. Actual
hours used are 3,475 hours. 4 standard hours are allowed to complete a unit of finished
product.
Required: Calculate factory overhead idle capacity variance assuming standard production of
1,000 units as normal capacity.
14. QRS Company has two support departments (Administration and Janitorial) and three
producing departments (Fabricating, Assembly, and Finishing). Costs and activities are as
follows:
Administration Janitorial Fabricating Assembly Finishing
Direct costs $50,000 $30,000 $40,000 $50,000 $25,000
Number of employees 10 30 40 20
Square feet 2,000 10,000 28,000 15,000
Administrative services are allocated based on the number of employees; janitorial
services are allocated based on square footage. Overhead rates for the three producing
departments are based on direct labor hours.
Required:
Determine the overhead application rates for the producing departments using each of the
three allocation methods:
B. Direct allocation method for the support departments
C. Sequential allocation method for the support departments
D. Reciprocal allocation method for the support departments
15. Tonya Martin, CMA and controller of the Parts Division of Gunderson Inc., was meeting with
Doug Adams, manager of the division. The topic of discussion was the assignment of
overhead costs to jobs and their impact on the divisions pricing decisions. Their
conversation was as follows:
Tonya: Doug, as you know, about 25 percent of our business is based on government
contracts, with the other 75 percent based on jobs from private sources won through
bidding. During the last several years, our private business has declined. We have been
losing more bids than usual. After some careful investigation, I have concluded that we are
overpricing some jobs because of improper assignment of overhead costs. Some jobs are
also being underpriced. Unfortunately, the jobs being overpriced are coming from our
higher volume, labor-intensive products; thus, we are losing business.
Doug: I think I understand. Jobs associated with our high-volume products are being
assigned more overhead than they should be receiving. Then, when we add our standard 40
percent markup, we end up with a higher price than our competitors, who assign costs more
accurately.
Tonya: Exactly. We have two producing departments, one labor-intensive and the other
machine-intensive. The labor-intensive department generates much less overhead than the
machine-intensive department. Furthermore, virtually all of our high-volume jobs are labor-
intensive. We have been using a plant-wide rate based on direct labor hours to assign
overhead to all jobs. As a result, the high-volume, labor-intensive jobs receive a greater
share of the machine-intensive departments overhead than they deserve. This problem can
be greatly alleviated by switching to departmental overhead rates. For example, an average
high-volume job would be assigned $100,000 of overhead using a plant-wide rate and only
$70,000 using departmental rates. The change would lower our bidding price on high-
volume jobs by an average of $42,000 per job. By increasing the accuracy of our product
costing, we can make better pricing decisions and win back much of our private-sector
business.
Doug: Sounds good. When can you implement the change in overhead rates?
Tonya: It wont take long. I can have the new system working within four to six weeks
certainly by the start of the new fiscal year.
Doug: Hold it. I just thought of a possible complication. As I recall, most of our government
contract work is done in the labor-intensive department. This new overhead assignment
scheme will push down the cost on the government jobs, and we will lose revenues. They
pay us full cost plus our standard markup. This business is not threatened by our current
costing procedures, but we cant switch our rates for only the private business. Government
auditors would question the lack of consistency in our costing procedures.
Tonya: You do have a point. I thought of this issue also. According to my estimates, we will
gain more revenues from the private sector than we will lose from our government
contracts. Besides, the costs of our government jobs are distorted; in effect, we are
overcharging the government.
Doug: They dont know that and never will unless we switch our overhead assignment
procedures. I think I have the solution. Officially, lets keep our plant-wide overhead rate. All
of the official records will reflect this overhead costing approach for both our private and
government business. Unofficially, I want you to develop a separate set of books that can be
used to generate the information we need to prepare competitive bids for our private-
sector business.
Required:
a) Do you believe that the solution proposed by Doug is ethical? Explain.
b) Suppose that Tonya decides that Dougs solution is not right and objects strongly.
Further suppose that, despite Tonyas objections, Doug insists strongly on implementing
the action. What should Tonya do?

Accounting For Manufacturing Overhead

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Accounting For Manufacturing Overhead

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Overheads:

CHAPTER LEARNING OBJECTIVES (CLO)

1. Understand the importance of overhead on product costing

The Hidden Factory

Exhibit II shows how overhead as a percentage of value added increases as a representative

Introducing Estimation Accounting Disposition

Manufacturing Overheads: Manufacturing overhead has got numerous synonyms some of

6.2 Classification of Overheads

(1) On the Basis of Nature

Nature Behavior Function

1. Indirect Material 1. Variable Overhead 1. Manufacturing Overhead

Figure 6.1: Types of Overheads

(2) On the Basis of Function

(3) On the Basis of Behavior

In numerator, the formula captures manufacturing overhead expenses which is divided by

Actual Overhead Expenses for the Month

b) Predetermined Overhead Rate: Predetermined overhead rate is determined in advance of

Budgeted Overhead Expenses for the Period

Overhead expenses of the Entire Factory

Overhead Cost Allocated and Apportioned to Each Cost Center

e) Normal Overhead Rate: Normal overhead rate is a predetermined rate calculated

6.4 Predetermined Overhead Rates

Exhibit 6.1: In Business

6.5 Allocation Bases

Sl. Allocation Base Nature of the rates

1. Factory overhead expense for the period $ 25,000

Allocation Bases Formula Rate

Exhibit 6.2: Choose Appropriate Allocation Base

Predetermined Overhead Rates

Comparison of alternative bases

6.6 Production Capacity Levels

Factory Machine Units of

Music Corporation Data

Courtesy: Bradley James Bryant, http://www.ehow.com/how_5166514_calculate-overhead-

Idle Capacity vs. Excess Capacity

6.7 Factory Overhead: Actual and Applied

Exhibit 6.4: Actual Costing Versus Normal Costing

6.8 Overhead Accounting

Exhibit 6.5: Steps in Overhead Accounting

6.8.1 Factory Overhead Control Account

Overhead Expense Debit Credit

6.8.2 Factory Overhead Applied Account

6.8.3 Over and Under-applied Overhead

Actual Overhead Applied Overhead

Exhibit 6.6: Over or Under Applied Overhead

Factory Overhead Control

Factory Overhead Applied

Factory Overhead Applied Closed to Control Account

Figure 6.3: Flow of overhead expenses

6.8.4 Reasons of under applied or over applied overhead

6.9 Disposal of Under or Over Applied Overhead

6.9.1 Immediate Write-off

Under Applied Over Applied

Date Accounts Title Date Accounts Title

(1) Cost of Goods Sold (1) Factory Overhead Control

(2) Income Summary (2) Factory Overhead Control

Under Applied Over Applied

(1) Finished Goods Inventory (1) Factory Overhead Control

Schedule of Cost of Goods Sold

Finished Goods Inventory 2,000

If the amount of under-applied or over-applied overhead is significant, it should be allocated

6.10 Variance Analysis

Actual Factory Budgeted Allowance Based on Applied Factory