Manufacturing Overhead
Now let’s delve deeper into the concept of manufacturing overhead. There are three characteristics that make overhead difficult to grasp.
The first point is that we can’t directly trace overhead costs to our products. For instance, we can’t assign an exact cost of electricity, such as $0.50, to every product. We’ll use an electricity bill as an example throughout this section.
Secondly, we only learn the total of our manufacturing overhead costs at the end of the period. With electricity, for example, the final cost isn’t known until the bill arrives. However, waiting until the end of the period to start allocating costs isn’t feasible as cost allocation should be ongoing.
The third point is that we don’t know in advance how many products we will make during the period. Given these uncertainties about overhead costs and production volume, we need to allocate overhead.
Overhead Allocation Rate = Total Estimated Overhead Costs / Total Estimated Number of Cost Driver
To allocate overhead, we first select an allocation base. The two most common bases are direct labor hours and machine hours. CPA problems will specify which allocation base to use. In this example, we’ll use direct labor hours as our allocation base.
Once the allocation base is established, we need to make two estimates:
- The anticipated cost of our electricity bill
- The projected number of direct labor hours for the period
Assuming last month’s electricity bill was $10,000, we expect this month’s bill to be the same amount. To estimate the number of direct labor hours for the month, we presume we’ll make 500 laptops, with each requiring two direct labor hours. Thus, we project our total direct labor hours to be 1,000.
Overhead Allocation Rate = $10,000 / 1,000 = $10 allocation rate
What does this $10 per hour represent? It means for every direct labor hour used this month, we’re going to apply $10 of overhead expenses. “Applying” overhead means we’re attributing overhead costs to our work-in-process account.
Imagine we’re at the end of the month and our manager wants to know the total manufacturing overhead. Let’s assume we planned to make 500 units but only produced 400. Given that direct labor hours are our allocation base and we allocate $10 of overhead for every direct labor hour, we can now determine the cost. In this example, assume we had 760 direct labor hours. In this case, we would allocate $7,600 of manufacturing overhead ($10 allocation rate X 760 direct labor hours), which would be recorded in the work-in-process account.
We expected to spend $10,000 on electricity but what if we actually spent $11,000? We’ve allocated $7,600 of manufacturing overhead but actually spent $11,000. How do we account for this $3,400 difference? This indicates that we under-applied overhead by $3,400. In instances of under or over-application, the difference is directly expensed to the cost of goods sold. We would record a debit to the cost of goods sold for $3,400.
Study Tip 😀
Under-applied and over-applied overhead is directly recorded to cost of goods sold expense.
Summary of Manufacturing Overhead
Let’s summarize this complex process. At the start of a period, we don’t know our overhead costs or the number of units we’ll produce. Therefore, we select an allocation base, such as direct labor hours, and estimate our total overhead costs. We estimate the total number of direct labor hours we expect to utilize. We then divide our estimated overhead by the estimated number of direct labor hours, and this gives us the allocation rate.
By the end of the period, we’ll know how much we actually spent on overhead and how many direct labor hours we used. Two aspects may have changed throughout the month: our estimated overhead costs could differ significantly from our actual overhead costs, and we might have used more or fewer direct labor hours than expected. As a result, we could either under-apply or over-apply overhead, and we record that difference directly to cost of goods sold.