Blueprint Problem: Predetermined, overapplied, and underapplied overhead

The Nature of Overhead

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. Match the type of driver with its cause.

Driver	Cause
1. Volume:
2. Time:
3. Cost:

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.

APPLY THE CONCEPTS: 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.

Girard Inc. estimated that overhead costs will be $440,000 and will be driven by direct labor (DL) costs estimated at $880,000.

Girard Inc.

$	=	%
$

Doherty Co. estimated that overhead costs will be $220,000 and will be driven by machine hours estimated at 25,000 hours.

Doherty Co.

$	=	$

Ngumi Ltd. estimated that overhead costs will be $300,000 and will be driven by the units produced, estimated at 500 units.

Ngumi Ltd.

$	=	$

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

=

X

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.

APPLY THE CONCEPTS: Apply the overhead throughout the year

During the year, each company applied overhead, using the rates previously computed (in the calculate the predetermined overhead rate section). The totals for each cost driver are provided as follows. Calculate the total overhead applied during the year.

Girard's actual direct labor cost for the year was $924,000. How much overhead was applied for the year?

Girard Inc.
Rate		Driver
%	X	$	=	$

Doherty used 26,500 machine hours during the year. How much overhead was applied for the year?

Doherty
Rate		Driver
$	X	hrs	=	$

Ngumi produced 450 units during the year. How much overhead was applied for the year?

Ngumi
Rate		Driver
$	X	units	=	$

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