Accounting for Accounting for Overhead CostsOverhead Costs

Introduction to Management AccountingIntroduction to Management Accounting

Chapter Chapter 66

Manufacturing Costs

TheProduct

DirectLabor

Manufacturing Overhead

DirectMaterial

Direct Material

Example:Steel used tomanufacture

the automobile.

Example:Steel used tomanufacture

the automobile.

Cost of raw material that is used tomake, and can be convenientlytraced, to the finished product.

Cost of salaries, wages, and fringebenefits for personnel who work

directly on manufactured products.

Direct Labor

Example:Wages paid to an

automobile assemblyworker.

Example:Wages paid to an

automobile assemblyworker.

All other manufacturing costs

Manufacturing Overhead

Materials used to support the production process. Examples: lubricants and

cleaning supplies used in an automobile assembly plant.

IndirectLabor

IndirectMaterial

OtherCosts

All other manufacturing costs

Manufacturing Overhead

Cost of personnel who do not work directly on

the product. Examples: maintenance workers, janitors and security

guards.

IndirectLabor

IndirectMaterial

OtherCosts

All other manufacturing costs

Manufacturing Overhead

Examples: depreciation on plant and equipment,

property taxes, insurance, utilities,

overtime premium, and unavoidable idle time.

IndirectLabor

IndirectMaterial

OtherCosts

Accounting for Factory Overhead

Methods for assigning overhead costsMethods for assigning overhead coststo the products is an important part ofto the products is an important part ofaccurately measuring product costs.accurately measuring product costs.

LearningLearningObjective 1Objective 1

Budgeted Overhead Application Rates

1. Select one or more cost drivers.1. Select one or more cost drivers.2. Prepare a factory overhead budget.2. Prepare a factory overhead budget.3. Compute the factory overhead rate.3. Compute the factory overhead rate.4. Obtain actual cost-driver data.4. Obtain actual cost-driver data.5. Apply the budgeted overhead5. Apply the budgeted overhead to the products.to the products.6. Account for any differences between the6. Account for any differences between the amount of actual and applied overhead.amount of actual and applied overhead.

Budgeted overhead application rateBudgeted overhead application rate= Total budgeted factory overhead= Total budgeted factory overhead

÷ Total budgeted amount of cost driver÷ Total budgeted amount of cost driver

Budgeted Overhead Application Rates

Overhead rates are Overhead rates are budgeted; they are budgeted; they are estimates. The budgeted estimates. The budgeted rates are used to apply rates are used to apply overhead based on actual overhead based on actual events.events.

Illustration of Overhead Application

The company’s budgeted manufacturing overheadThe company’s budgeted manufacturing overheadfor the machining department is $277,800.for the machining department is $277,800.

Budgeted machine hours are 69,450.Budgeted machine hours are 69,450.

The budgeted overhead application rate is:The budgeted overhead application rate is:$277,800 ÷ 69,450 = $4 per machine hour$277,800 ÷ 69,450 = $4 per machine hour

Enriquez Machine Parts Company selects a Enriquez Machine Parts Company selects a single cost-allocation in each department for single cost-allocation in each department for applying overhead, machine hours in applying overhead, machine hours in machining and direct-labor in assembly.machining and direct-labor in assembly.

Machining Assembly

Budgeted manufacturing overhead $227,800 $103,200

Budgeted machine hours 69,450

Budgeted direct-labor cost $206,400

Budgeted overhead rate, per machine hour $4

Budgeted overhead rate, per direct-labor dollar 50%

Illustration of Overhead Application

Suppose that at the end of the year EnriquezSuppose that at the end of the year Enriquezhad used 70,000 hours in Machining and had used 70,000 hours in Machining and

incurred $190.000 of direct-labor cost in assemblyincurred $190.000 of direct-labor cost in assembly

How much overhead was applied the products produced?How much overhead was applied the products produced?

70,000 * 4+190,000 * 0.5 = $ 375,000

Choice of Cost-Allocation Bases

No one cost –allocation base is right for all situations.No one cost –allocation base is right for all situations.

The accountant’s goal is to find the cost-The accountant’s goal is to find the cost-allocation base that best links cause and effect.allocation base that best links cause and effect.

Choice of Cost-Allocation Bases

A separate cost pool should be A separate cost pool should be Identified for each cost-allocation base.Identified for each cost-allocation base.

Base 1 Base 1 Pool 1Pool 1

Base 2 Base 2 PoolPool 22

Choice of Cost-Allocation Bases

80-20 rule 80-20 rule

20% of the bases 20% of the bases 80% of the overheads80% of the overheads

Normalized Overhead Rates

““Normal” product costs includeNormal” product costs includean average or normalizedan average or normalized

chunk of overhead.chunk of overhead.

Actual direct materialActual direct material+ Actual direct labor+ Actual direct labor

+ Normal applied overhead+ Normal applied overhead= Cost of manufactured product= Cost of manufactured product

•Cost ofGoodsMfd.

Finished Goods

•Cost ofGoodsSold

•Cost ofGoodsMfd.

Cost of Goods Sold

•Cost ofGoodsSold

•Direct Material

•Direct Labor•Overhead Applied

Work in Process

Cost Flows

Disposing of Under-applied or Over-applied Overhead

Suppose that Enriquez appliedSuppose that Enriquez applied$375,000 to its products.$375,000 to its products.

Also, suppose that Enriquez actually incurred $392,000 Also, suppose that Enriquez actually incurred $392,000 of actual manufacturing overhead during the year.of actual manufacturing overhead during the year.

$392,000 actual $392,000 actual ––375,000375,000 applied applied $ 17,000 Under-applied$ 17,000 Under-applied

The $375,000 becomes part of Cost of The $375,000 becomes part of Cost of Goods Sold when the product is sold. The Goods Sold when the product is sold. The $17,000 must also become an expense.$17,000 must also become an expense.

Disposing of Under-applied or Over-applied Overhead

The applied overhead is The applied overhead is $17,000 less than the $17,000 less than the amount incurred. It is:amount incurred. It is:

Over-applied overhead occurs when Over-applied overhead occurs when the amount applied exceeds the the amount applied exceeds the amount incurredamount incurred..

Immediate Write-Off

Manufacturing OverheadManufacturing Overhead

392,000392,000 375,000375,000 17,00017,000

00

Cost of Goods SoldCost of Goods Sold

17,00017,000Incurred Incurred Overhead Overhead (Actual)(Actual)

Applied Applied Overhead Overhead

(Budgeted)(Budgeted)

This method regards the $17,000 as a This method regards the $17,000 as a reduction in current income and adds it reduction in current income and adds it to Cost of Goods Sold.to Cost of Goods Sold.

Prorating Among Inventories

This method prorates the $17,000 of This method prorates the $17,000 of Under-applied overhead to Work-In Process (WIP),Under-applied overhead to Work-In Process (WIP),Finished Goods, and Cost of Goods Sold accountsFinished Goods, and Cost of Goods Sold accountsassuming the following ending account balances:assuming the following ending account balances:

Work-in-Process InventoryWork-in-Process Inventory $ 155,000$ 155,000Finished Goods InventoryFinished Goods Inventory 32,000 32,000Cost of Goods SoldCost of Goods Sold 2,480,000 2,480,000

TotalTotal $2,667,000$2,667,000

Account balance Allocating $17000 (under-applied)

Work-in-Process Work-in-Process InventoryInventory

$ 155,000$ 155,000 $17,000 × 155/2,667$17,000 × 155/2,667= 988 = 988

Finished Goods Finished Goods InventoryInventory

32,00032,000

$17,000 × 32/2,667$17,000 × 32/2,667= $204= $204

Cost of Goods Cost of Goods SoldSold

2,480,0002,480,000

$17,000 × 2,480/2,667$17,000 × 2,480/2,667= $15,808 = $15,808

Total $2,667,000$2,667,000

Variable and Fixed Application Rates

The presence of fixed costs is aThe presence of fixed costs is amajor reason of costing difficulties.major reason of costing difficulties.

Some companies distinguish betweenSome companies distinguish betweenvariable overhead and fixedvariable overhead and fixed

overhead for product costing.overhead for product costing.

Variable Versus Absorption Costing

Variable costing excludes fixed manufacturing Variable costing excludes fixed manufacturing overhead from the cost of products.overhead from the cost of products.

Absorption costing includes fixed manufacturing Absorption costing includes fixed manufacturing overhead in the cost of products.overhead in the cost of products.

VariableVariablecostingcosting

AbsorptionAbsorptioncostingcosting

LearningLearningObjective 2Objective 2

Variable costing

Direct material

Direct labor

Variable manufacturing overhead

costs to account for inventoried costs expense on income on balance sheet statement

Initially applied to inventory as product costs

Become expenses when the inventory is sold

Fixed manufacturing overhead

Become expenses immediately

absorption costing

Direct material

Direct labor

Variable manufacturing overhead

Fixed manufacturing overhead

costs to account for inventoried costs expense on income on balance sheet statement

Initially applied to inventory as product costs

Become expenses when the inventory is sold

Facts and Illustration

Basic Production Data at Standard CostBasic Production Data at Standard Cost

Direct materialDirect material $205$205Direct laborDirect labor 75 75

Variable manufacturing overheadVariable manufacturing overhead 20 20Standard variable costs per unitStandard variable costs per unit $300$300

Facts and Illustration

The annual budget for fixed The annual budget for fixed manufacturing overhead is $1,500,000manufacturing overhead is $1,500,000

Budgeted production is 15,000 computers.Budgeted production is 15,000 computers.

Sales price = $500 per unitSales price = $500 per unit

$20 per computer is variable overhead.$20 per computer is variable overhead.

Sales commissions = 5% of dollar salesSales commissions = 5% of dollar sales

Fixed S&A expenses = $650,000Fixed S&A expenses = $650,000

Facts and Illustration

UnitsUnits 20X7 20X7 20X8 20X8

Opening inventoryOpening inventory –– 3,000 3,000ProductionProduction 17,00017,000 14,00014,000SalesSales 14,00014,000 16,00016,000Ending inventoryEnding inventory 3,000 3,000 1,000 1,000

There are no variances from the There are no variances from the standard variable manufacturing costs, standard variable manufacturing costs, and the actual fixed manufacturing and the actual fixed manufacturing overhead incurred is exactly overhead incurred is exactly $1,500,000. $1,500,000.

Variable- Costing Method Cost of Goods Sold

Variable expenses:Variable expenses:Variable manufacturing costVariable manufacturing cost of goods soldof goods sold Opening inventory, atOpening inventory, at – – $ 900$ 900

standard costs of $300standard costs of $300Add: variable cost of goodsAdd: variable cost of goods manufactured at standard,manufactured at standard, 17,000 and 14,000 units 17,000 and 14,000 units 5100 5100 4200 4200

Available for sale, 17,000 units Available for sale, 17,000 units 5100 5100 5100 5100Ending inventory, at $300Ending inventory, at $300 900 900¹¹ 300 300²²Variable manufacturingVariable manufacturing cost of goods soldcost of goods sold $4200$4200 $4800$4800

(thousands of dollars)(thousands of dollars) 20X7 20X7 20X8 20X8

¹3,000 units × $300 = $900,000 ²1,000 units × $300 = $300,000

Variable-Costing Method Comparative Income Statement

Sales, 14,000 and 16,000 unitsSales, 14,000 and 16,000 units $7,000$7,000 $8,000$8,000Variable expenses:Variable expenses:

Variable manufacturingVariable manufacturing cost of goods soldcost of goods sold 420042001 480048001

Variable selling expenses,Variable selling expenses, at 5% of dollar salesat 5% of dollar sales 350 350 400 400

Contribution marginContribution margin $2,450$2,450 $2,800$2,800Fixed expenses:Fixed expenses:

Fixed factory overheadFixed factory overhead $1,500$1,500 $1,500$1,500Fixed selling and admin. expensesFixed selling and admin. expenses 650 650 650 650

Operating income, variable costingOperating income, variable costing $ 300$ 300 $ 650$ 650

(thousands of dollars) 20X7 20X8

1 from Cost of Goods Sold previous calculation from Cost of Goods Sold previous calculation

Fixed-Overhead Rate

The fixed-overhead rateThe fixed-overhead rate is theis theamount of fixed manufacturingamount of fixed manufacturing

overhead applied to eachoverhead applied to eachunit of production.unit of production.

$1,500,000 ÷ 15,000 = $100$1,500,000 ÷ 15,000 = $100

budgeted fixed manufacturing budgeted fixed manufacturing overheadoverhead expected volume of production expected volume of production

Fixed overhead rate = Fixed overhead rate =

Beginning inventoryBeginning inventory $ –$ – $1,200$1,200Add: Cost of goods manufacturedAdd: Cost of goods manufactured

at standard, of $400at standard, of $400** 6,800 6,800 5,600 5,600Available for saleAvailable for sale $6,800$6,800 $6,800$6,800Deduct: Ending inventoryDeduct: Ending inventory 1,200 1,200 400 400Cost of goods sold, at standardCost of goods sold, at standard $5,600$5,600 $6,400$6,400

(thousands of dollars) 20X7 20X8

Absorption-Costing Method Cost of Goods Sold

*Variable cost*Variable cost $300 $300 Fixed costFixed cost 100 100 Standard absorption costStandard absorption cost $400 $400

Absorption-Costing Method Comparative Income Statement

*Based on expected volume of production of 15,000 units:*Based on expected volume of production of 15,000 units: 20X7: (17,000 – 15,000) × $100 = $200,000 F20X7: (17,000 – 15,000) × $100 = $200,000 F 20X8: (14,000 – 15,000) × $100 = $100,000 U20X8: (14,000 – 15,000) × $100 = $100,000 U1From Cost of Goods Sold previous calculation1From Cost of Goods Sold previous calculation

SalesSales $7,000$7,000 $8,000$8,000Cost of goods sold, at standardCost of goods sold, at standard 5,6005,6001 6,4006,40011

Gross profit at standardGross profit at standard $1,400$1,400 $1,600$1,600Production-volume varianceProduction-volume variance** 200 200 F F 100 100 U UGross margin or gross profit “actual”Gross margin or gross profit “actual” $1,600$1,600 $1,500$1,500Selling and administrative expensesSelling and administrative expenses 1,000 1,000 1,050 1,050Operating income, variable costingOperating income, variable costing $ 600$ 600 $ 450$ 450

(thousands of dollars) 20X7 20X8

Variable Costing and Absorption Costing

The difference between income reportedThe difference between income reportedunder these two methods is entirely due tounder these two methods is entirely due tothe treatment of fixed manufacturing costs.the treatment of fixed manufacturing costs.

Variable Costing and Absorption Costing

On a variable-costing income statement, costs are On a variable-costing income statement, costs are separated into the major categories of fixed and variable.separated into the major categories of fixed and variable.

Revenue less all variable costs (both manufacturing Revenue less all variable costs (both manufacturing and non-manufacturing) is the contribution margin.and non-manufacturing) is the contribution margin.

On an absorption-costing income statement, costsOn an absorption-costing income statement, costsare separated into the major categories of are separated into the major categories of

manufacturing and non-manufacturing. Revenue manufacturing and non-manufacturing. Revenue less manufacturing costs (both fixed and variable)less manufacturing costs (both fixed and variable)

is gross profit or gross margin.is gross profit or gross margin.

Sales, 14,000 and 16,000 unitsSales, 14,000 and 16,000 units $7,000 $7,000 $8,000$8,000Variable expenses:Variable expenses:

Variable manufacturingVariable manufacturing cost of goods soldcost of goods sold 420042001 480048001

Variable selling expenses,Variable selling expenses, at 5% of dollar salesat 5% of dollar sales 350 350 400 400

Contribution marginContribution margin $2,450$2,450 $2,800$2,800Fixed expenses:Fixed expenses:

Fixed factory overheadFixed factory overhead $1,500$1,500 $1,500$1,500Fixed selling and admin. expensesFixed selling and admin. expenses 650 650 650 650

Operating income, variable costingOperating income, variable costing $ 300 $ 300 $ 650 $ 650

SalesSales $7,000 $7,000 $8,000 $8,000Cost of goods sold, at standardCost of goods sold, at standard 5,6005,600 6,4006,400Gross profit at standardGross profit at standard $1,400 $1,400 $1,600 $1,600Production-volume varianceProduction-volume variance** 200 200 F F 100 100 U UGross margin or gross profit “actual”Gross margin or gross profit “actual” $1,600 $1,600 $1,500 $1,500Selling and administrative expense Selling and administrative expense 1,000 1,000 1,0501,050Operating income, variable costingOperating income, variable costing $ 600 $ 600 $ 450 $ 450

(thousands of dollars) 20X7 20X8

Why Use Variable Costing?

Sales, (1000unites,$6 per unit)Sales, (1000unites,$6 per unit) $6,000$6,000 $6,000$6,000Costs of goods sold:Costs of goods sold:

direct costs & variable overheaddirect costs & variable overhead (1000unites,$2per unit) (1000unites,$2per unit) $2,000 $2,000 $2,000$2,000

fixed overheadfixed overhead $4,800$4,800 $1,600$1,600Gross profitGross profit $ (800)$ (800) $2,400$2,400Selling and admin. expensesSelling and admin. expenses 1000 1000 1,000 1,000Operating income, variable costingOperating income, variable costing $(1,800)$(1,800) $1,400$1,400

production 1000 units 3000 units

(thousands of dollars) 20X1 20X2

Why Use Variable Costing?

One reason is that absorption-costingOne reason is that absorption-costingincome is affected by productionincome is affected by production

volume while variable-costingvolume while variable-costingincome is not.income is not.

Another reason is based on whichAnother reason is based on whichsystem the company believessystem the company believes

gives a better signal aboutgives a better signal aboutperformance.performance.

Effects of Sales and Productionon Reported Income

Production > Sales Production > Sales

Variable costing income is lowerVariable costing income is lowerthan absorption income.than absorption income.

Production < Sales Production < Sales

Variable costing income is higherVariable costing income is higherthan absorption income.than absorption income.

Used for production of large, unique, high-cost items.

Built to order rather than mass produced.

Many costs can be directly traced to each job.

TWO TYPES:

Job-shop operations

Products manufactured in very low volumes or one at a time.

Batch-production operations

Multiple products in batches of relatively small quantity.

ProcessCosting

Job-OrderCosting

Types of Product-Costing Systems

Job-Order Costing and Process Costing

Job-order costing allocates costsJob-order costing allocates coststo products that are identified byto products that are identified by

individual units or batches. individual units or batches.

Job-order costing allocates costsJob-order costing allocates coststo products that are identified byto products that are identified by

individual units or batches. individual units or batches.

Process costing averages costsProcess costing averages costsover large numbers of nearlyover large numbers of nearly

identical products.identical products.

Process costing averages costsProcess costing averages costsover large numbers of nearlyover large numbers of nearly

identical products.identical products.

LeaningLeaningObjective 3Objective 3

Typical job-order cost applications: Special-order printing Building construction

Also used in service industry Hospitals Law firms

ProcessCosting

Job-OrderCosting

Types of Product-Costing SystemsTypes of Product-Costing Systems

ProcessCosting

Job-OrderCosting

Used for production of small, identical, low cost items.

Mass produced in automated continuous production process.

Costs cannot be directly traced to each unit of product.

Typical process cost applications:Petrochemical refinery

Paint manufacturer

Paper mill

Types of Product-Costing SystemsTypes of Product-Costing Systems

Date Started: Date Started: 1/7/20X71/7/20X7 Job Number: Job Number: 963 963Date Completed: Date Completed: 1/14/20X71/14/20X7 Units completed: Units completed: 12 12CostCost DateDate Ref.Ref. QuantityQuantity AmountAmount SummarySummary

Direct Materials:Direct Materials:6” Bars6” Bars 1/71/7 N41N41 2424 120.00120.00CasingsCasings 1/91/9 K56K56 1212 340.00340.00 460.00460.00Direct Labor:Direct Labor:DrillDrill 1/81/8 7Z47Z4 7.07.0 105.00105.00

1/91/9 7Z57Z5 5.55.5 82.50 82.50GrindGrind 1/131/13 9Z29Z2 4.04.0 80.00 80.00 267.50267.50Overhead:Overhead:AppliedApplied 1/141/14 9.0 mach. hrs.9.0 mach. hrs. 180.00180.00 180.00180.00Total costTotal cost 907.50907.50Unit costUnit cost 75.62575.625

Date Started: Date Started: 1/7/20X71/7/20X7 Job Number: Job Number: 963 963Date Completed: Date Completed: 1/14/20X71/14/20X7 Units completed: Units completed: 12 12CostCost DateDate Ref.Ref. QuantityQuantity AmountAmount SummarySummary

Direct Materials:Direct Materials:6” Bars6” Bars 1/71/7 N41N41 2424 120.00120.00CasingsCasings 1/91/9 K56K56 1212 340.00340.00 460.00460.00Direct Labor:Direct Labor:DrillDrill 1/81/8 7Z47Z4 7.07.0 105.00105.00

1/91/9 7Z57Z5 5.55.5 82.50 82.50GrindGrind 1/131/13 9Z29Z2 4.04.0 80.00 80.00 267.50267.50Overhead:Overhead:AppliedApplied 1/141/14 9.0 mach. hrs.9.0 mach. hrs. 180.00180.00 180.00180.00Total costTotal cost 907.50907.50Unit costUnit cost 75.62575.625

Job-Cost Record

Contracts

Missions

Programs

Cases

THE JOB

Job-Order Costing in Job-Order Costing in Nonmanufacturing OrganizationsNonmanufacturing Organizations

Process Cost Flows

Direct materialDirect laborApplied manufacturing transferred to and transferred tooverhead department B finished goods

Direct materialDirect laborApplied manufacturing

overhead

during current period

Two Sequential Production DepartmentsWork-in-Process Inventory Work-in-Process InventoryProduction Department A Production Department B

Cost of goods sold

Cost of goods completedin department A and Cost of goods completed

Finished Goods Inventory Cost of Goods Sold