Recall that unit costs include direct materials, direct labor, and overhead. The costs for direct materials and direct labor are incurred throughout the period. However, overhead costs may not necessarily fluctuate with production or sales, and some overhead costs are unknown until the end of the period or early in the next period (such as income taxes, bonuses, and so on). As you can see, this causes a problem when a company tries to determine unit costs, because overhead costs are not always directly related to units produced. Therefore, normal costing is used, rather than actual costing. Under normal costing, overhead is estimated, typically at the beginning of the year, and applied to production throughout the year. This requires three steps:
1. Calculate the predetermined overhead rate.
2. Apply the overhead throughout the year.
3. Reconcile the applied and actual overhead at the end of the year.
Predetermined Overhead Rate
The overhead costs are allocated to jobs using a common measure related to each job. This measure is called an activity base, allocation base, or activity driver. The activity base or driver used to allocate overhead should reflect the consumption or use of the overhead costs. There are basically three types of drivers (or activity bases) used to compute a predetermined overhead rate: volume, cost, and time.
To calculate the predetermined overhead rate, you must first estimate the overhead costs for the year, as well as the associated level of activity that will drive these costs.
1. Match the type of driver with its cause.
Driver............................Cause
1. Volume:
Select Cash or cash equivalent given up in order to conduct an activity, such as cash paid for direct labor cost How long it takes to complete an activity, such as direct labor hours Units of work completed, such as manufactured units, orders processed, machine setups Correct 1 of Item 1
2. Time:
Select Cash or cash equivalent given up in order to conduct an activity, such as cash paid for direct labor cost How long it takes to complete an activity, such as direct labor hours Units of work completed, such as manufactured units, orders processed, machine setups Correct 2 of Item 1
3. Cost:
Select Cash or cash equivalent given up in order to conduct an activity, such as cash paid for direct labor cost How long it takes to complete an activity, such as direct labor hours Units of work completed, such as manufactured units, orders processed, machine setups Correct 3 of Item 1
The formula for calculating the predetermined overhead rate is the following:
Predetermined Overhead Rate = Estimated Annual Overhead / Estimated Cost Driver
Notice that the predetermined overhead rate is computed using estimated amounts at the beginning of the period. This is because managers need timely information on the product costs of each job.
2. Calculate the predetermined overhead rate
The following three companies made their overhead estimates at the beginning of the year. Complete the formula to compute the annual predetermined overhead rate for each company.
Murphy Inc. estimated that overhead costs will be $380,000 and will be driven by direct labor (DL) costs estimated at $826,087.
Murphy Inc.
$ = % Select% of direct labor cost per machine hour per unit produced Correct 3 of Item 2
Azinian Co. estimated that overhead costs will be $260,000 and will be driven by machine hours estimated at 40,625 hours.
Azinian Co.
$ = $ Select% of direct labor cost per machine hour per unit produced Correct 7 of Item 2
Garcia Ltd. estimated that overhead costs will be $350,000 and will be driven by the units produced, estimated at 500 units.
Garcia Ltd.
$ = $ Select% of direct labor cost per machine hour per unit produced Correct 11 of Item 2
Application of Overhead
Now that the overhead rate has been determined, overhead can be allocated, or applied, during the year. Overhead is applied by multiplying the predetermined overhead rate by the actual units of the cost driver (time, volume, or cost). Complete the formula:
Applied Overhead = (Select Cost Driver Estimated Annual Overhead Predetermined Overhead Rate Correct 1 of Item 3) X (Select Actual Units of the Cost Driver Cost Driver per Unit Units Sold Correct 2 of Item 3)
After overhead has been applied, total product costs for the period can be calculated by adding actual direct material costs and actual direct labor costs to the applied overhead. As units are sold, Cost of Goods Sold is debited for the units' product cost.
3. Apply the overhead throughout the year
During the year, each company applied overhead, using the rates previously computed (in calculate the predetermined overhead rate section). The totals for each cost driver are provided as follows. Calculate the total overhead applied during the year.
Murphy's actual direct labor cost for the year was $908,695.7. How much overhead was applied for the year?
Azinian used 37,375 machine hours during the year. How much overhead was applied for the year?
Garcia produced 475 units during the year. How much overhead was applied for the year?
Reconcile the Applied and Actual Overhead
The goal is to estimate overhead as closely as possible to actual overhead costs. At the end of the year, however, it is unlikely that the two will be equal. The difference is sometimes referred to as the "overhead variance," which can be caused by estimating either the overhead cost or the cost driver at the beginning of the year. A variance occurs when overhead is either under-applied or over-applied. (See animated illustration)
Select Over-applied Under-applied Correct 10 of Item 4 overhead occurs when actual overhead is greater than applied overhead and must be added to Cost of Goods Sold.
Select Over-applied Under-applied Correct 11 of Item 4 overhead occurs when applied overhead is greater than actual overhead and must be subtracted from Cost of Goods Sold.
To properly report Cost of Goods Sold, both actual and applied overhead must be accounted for. During the year, actual overhead costs are recorded in an account typically called Overhead. The account acts as a clearing account for actual and applied overhead costs. Actual amounts are debited to this account as they occur. As overhead is applied, this account is credited. The balance is generally transferred to Cost of Goods Sold, which makes it part of the product cost. A debit balance in this account at the end of the period would indicate Select Over-applied Under-applied Correct 12 of Item 4overhead. A credit balance in this account at the end of the period would indicate Select Over-applied Under-applied Correct 13 of Item 4overhead. The balance is closed to Cost of Goods Sold in an adjusting entry, which will either increase or decrease Cost of Goods Sold reported on the income statement.
Overhead T account
The T account illustrates how the costs flow through the account.
In a manufacturing environment, this account may be called Manufacturing Overhead, but keep in mind that overhead occurs in merchandising and service environments as well as manufacturing.
4. Reconcile the applied and actual overhead at the end of the year
Illustrate how the applied and actual overhead is reconciled for each company by entering the cost flows in the first row of the T accounts. Calculate the overhead variance and enter it in the second row of the T accounts. Recall that this amount is closed to Cost of Goods Sold in an adjusting entry. Determine the adjusted balance of Cost of Goods Sold for each company.Use the minus sign to indicate over-applied overhead.
The actual overhead costs for Murphy Inc. were $418,600.022 for the year. The unadjusted Cost of Goods Sold balance is $1,045,000.055 at the end of the year.
The actual overhead costs for Azinian Co. were $238,995 for the year. The unadjusted Cost of Goods Sold balance is $598,000 at the end of the year.
The actual overhead costs for Garcia Ltd. were $332,310 for the year. The unadjusted Cost of Goods Sold balance is $831,250 at the end of the year.