UNIT FIVE: ACCOUNTING FOR FACTORY OVER HEAD COSTS

Content
5.0 Introduction
5.1 Objectives
5.2 Meaning and Nature of Overhead
5.3 Departmentalizing Overhead Costs
5.4 Distributing Service Department Costs
5.4.1 Allocating Service Department Costs
5.5 Setting Overhead Rates
5.5.1 Factors Affecting Rate Setting
5.5.2 Departmental and Factory Rates
5.5.3 Types of Overhead Rate Bases
5.6 Applying Manufacturing Overhead
5.7 Overapplie3d or Under Applied Overhead
5.8 Summary
5.9 Answers for Check Your Progress

5.0. INTRODUCTION

In this unit you will learn what are the overhead costs in manufacturing activities, how they
are recorded and classified, summarized and at last distributed to units of production.

The first part of the unit discusses about departmentalization of overhead costs, distribution of
support department costs and some documents involved in such activities. The distribution of
overhead costs to each unit of production is discussed in the second part of the unit.

5.1 OBJECTIVE

After completing the unit you should be able to

Define overhead items
- Describe the over head items
- Describe possible methods of departmentalizing over head costs
- Distribute service department costs to production departments

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 - Define predetermined overhead rate
- Distinguish between actual and applied overhead
- Define under or over applied overhead
- Present appropriate journal entries to record overhead costs.

5.2 MEANING& NATURE OF OVER HEAD

Overhead refers to any cost which is not directly attributable to a particular unit. In other
words, overheads are real costs and represent spending on resources or services which benefit
all units of products and services. Overhead costs are costs common to more than one unit
cannot be linked to a particular unit.

5.3 DEPARTMENTALIZING OVERHEAD COSTS

Classification of overhead costs

a) Factory overhead

Factory overhead is the aggregate of indirect costs associated with manufacturing activities,
Factory overhead is also called factory burden, manufacturing overhead, manufacturing
expresses, or indirect manufacturing costs.
Factory overhead includes:
- Factory rent, lighting an heating
- Depreciation repairs and maintenance and insurance of factory building, plant and
machinery & other facilities.
- Power and fuel
- Salaries and related costs of production management
- Wages of indirect costs of production management
- Indirect materials
- Direct materials of small individual value that cannot be economically feasible to
allocate to individual unit
- Expenses connected with administration of factory
- Fringe benefits etc

In general, factory overhead costs are classified into three. There are:

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 1. Indirect labor
2. Indirect materials
3. Other factory overhead

b) Administration overhead

Administration overhead is the aggregate of the costs of formulating the policy, directing the
organization and controlling the operations of an undertaking which is not directly related to
production, selling and distribution. Administration is a distinct function of an organization
which supports the other main functions.

Examples of administration are:

1) Office rents
2) Office lighting, heating and cleaning
3) Depreciation, repairs and maintenance, and insurance of office buildings, office
equipment office furniture and other office machines.
4) Salaries of office staff
5) Director's remuneration
6) Office supplies and other expenses
7) Postage and telephone
8) Printing and stationery
9) Audit fees
10) Legal expense
11) Bank charges

Administration overhead costs are not product costs, rather directly recorded as expense when
incurred.

c) Selling overhead

Selling overhead costs refers to those indirect costs which are associated with marketing and
selling (excluding distribution) activities. Examples are:
1. Salaries commissions and traveling expenses of salesmen and technical
representatives.

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 2. Sales office expense
3. Bad -debits expense ( or uncollectible accounts)
4. Brokerage or third party commissions
5. Costs of marketing information system including market research
6. Advertisement and publicity expenses
7. Costs of catalogues and price -levels
8. Expenses incurred in maintenance of show rooms.

Selling overhead costs are not part of product costs. They are period costs

d) Distribution overhead

Distribution overhead costs are the aggregate of indirect costs associated with the distribution
of finished goods. Distribution includes such activities as moving articles to central or local
storage, moving articles to and from prospective customers. In gas, electricity, and water
industries “Distribution" means pipes, mains and services which may be regarded as
equivalent to packing and transportation. Some examples of distribution overhead are:

1. Packing charges
2. Warehousing expenses
3. Insurance of finished goods
4. Wastages of finished goods
5. Deprecation, repairs and maintenance, insurance, and cost of operating the distribution
vehicles.
Behavioral classification of factory overhead
Factory overhead costs are also classified in to three behavioral classifications (categories)
1. Fixed overheads
2. Variable overheads
3. Semi variable overheads
Fixed overheads are indirect costs which conform to the definition of fixed costs . If there are
many different types of overhead costs, factory overhead analysis sheets are used as a
subsidiary ledger. The controlling account of the analysis sheet is manufacturing overhead
control account. This summarizes the data in the analysis sheets. The format of the factory
overhead analysis sheet is shown below:

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 Departmental overhead Analysis Sheet
Department _________________ Month of ________ 19________
Date Ref Total Indirect Indirect Payroll Depreciation Utilities Others
Materials labor taxes
Sep. R42 2500.00 2500.00

Usually large businesses divide factory operations into departments so that costs can be
effectively controlled. There are two methods of achieving cost departmentalization.
1. Maintain separate control accounts
Under this method, a control account is maintained for each different manufacturing overhead
cost. An analysis sheets are used to show the amount chargeable to each department in a
subsidiary ledge. For example, a control account for indirect materials through the factory
may be set up in the following manner.
Indirect materials No_______________________
Departmental Analysis
Dep 1 Dept 2 Dept 3 Dept 4
Date Explanation Post Ref Total

2. Maintain single control accounts

Under this method a single control accounts is maintained for all manufacturing overhead
costs. The subsidiary ledger may organize costs two ways.

a) Subsidiary ledger by type of cost

For each manufacturing overhead cost a subsidiary ledger account is maintained (or kept) for
example, a separate account 'is established for indirect labor. Another account is maintained
for utilities. This method enables to accumulate costs by type.

b) Subsidiary ledger by department

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Under this method, the departmental overhead analysis sheet is used as a subsidiary ledger
account (refer the format presented in this chapter)
Recording overhead costs

You recall that manufacturing overhead costs are classified into indirect materials; indirect,
manufacturing overhead control account is debited. The credit may be cash vouchers payable
or other appropriate account. Certain factory overhead costs, such as electricity, fuel, and
water are paid at end of month. Thus, these costs are recorded when paid or bills are received.
Other manufacturing overhead costs, such as insurance vacations, and holidays, is accrued
and arises from adjusting entries made at the end of the relevant period.

The source documents for recording manufacturing overhead are generated internally and/or
extremely/ outside the company. For example, source documents for indirect materials and
indirect labor are materials requisitions and time tickets respectively. They are internally
generated documents. The source documents for fire insurance property taxes and utilities are
vendor invoices, which originate form external sources.
Once we obtain the necessary source documents, the necessary entries are made in the
voucher register. In order to record in a voucher register, a voucher must be prepared first
using the following steps.

1. Compare the invoice with purchase order and receiving report and all computations
are checked.
2. Prepare a voucher, including a notation of the department to be changed
3. Record the voucher in the voucher register. The entry is:
Manufacturing overhead control -----------------------------xxx
Vouchers payable -----------------------------------------------xxx
4. The cost clerk will post the cost to the appropriate departmental overhead analysis
sheet.

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 The format of the voucher register is shown below:
Voucher Register for Month of ___________________
Paid Vouchers MOH control
Date Voucher Payable to Payable Cr Dr
Date Check
No
No

Note that the above four steps do not apply to the manner of recording indirect materials and
indirect labor. Indirect materials are directly entered into departmental overhead analysis
sheet from materials requisition. Indirect labor is directly transferred from the time ticket
analysis to departmental overhead analysis sheet.

Manufacturing overhead costs that occur at the end of the period are recorded by means of
adjusting entries. These costs usually do not vary from month. Examples are depreciation,
taxes, and property insurance. These costs are recorded in the general journal voucher and
then posted to departmental overhead analysis sheet.
Illustration

1. Indirect materials costing Br 75,000 were issued to different departments. Prepare the
entry to record the issuance.
Entry
MOH control - Indirect materials ------------------------------75,000
Raw materials ---------------------------------------------------------------75,000

2. Analysis of time ticket indicates that indirect labor costs amounted to Br. 160,000
prepare the entry to record the costs.

Entry

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 MOH control - Indirect labor ---------------------160,000
Factory payroll clearing ------------------------------------160,000
3. Assume that depreciation for the period amounts to Br. 120,000 on the factory
building and to Br. 95, 000 on the factory equipment. Prepare the entry to record
depreciation.
Entry
MOH control - Depreciation --------------------------215,000
Accumulated depreciation -Factory Building ---------------120,000
Accumulated depreciation - Factory Equipment---------- 95,000
4. Insurance of factory building amounting Br. 5000 has been expired during the period.
Prepayment for insurance was initially debited to asset account. Prepare the entry to
record the expired insurance.
Entry
MOH control property taxes -------------5000
Property taxes payable ---------------------------5000
5. Property taxes on factory facilities are estimated to be Br. 49000. Prepare the entry to
record property taxes.
Entry
MOH control property taxes ----------------------49000
Property taxes payable -----------------------------------49000
6. Factory utilities have been paid in cash of Br. 140,000
Entry
MOH control - Utilities ----------------------140,000
Cash -------------------------------------------------------140,000

5.4 DISTRIBUTING SERVICE DEPARTMENT COSTS

By the end of the period, the Production departments and other service departments are
expected to operate efficiently. Bur service departments do not produce goods themselves.
The manufacturing overhead costs charged to service departments operations must be
redistributed to where goods are produced.

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5.4.1 Allocating Service Department Costs

Service departments help producing departments and other service departments to operate
efficiently. But service departments do not produce goods themselves. The manufacturing
overhead costs charged to service departments operations must be redistributed to where
goods are produced.

It must be noted that relationships exist not only between service departments and production
departments but also among individual service departments. One service department receives
service from other service departments, or gives service to other service departments. Costs
are primarily accumulated at each department for planning and controlling purposes. For
inventory costing purposes, however, the factory service department costs must be allocated
to the production departments.

5.4.1.1 Basis of allocation

Allocation of service department costs require a proper assessment of the benefits received
provide the most equitable basis of allocation. The following are some of common bases
usually adopted for measurement of benefits.

Basis Cost Item

1. Floor Area Rent, depreciation, maintenance of building
lighting heating ,fire precaution service..
2. Number of workers employee Any expense associated with workers such as
recreation costs, time keeping supervision costs etc.
3. Value of materials passing Costs associated with material such as
through the department materials handling expenses
4. Capital value Depreciation, insurance and maintenance of
production facilities
5. Direct labor hours and/or Majority of general overhead items.
Machine hours

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 6. Technical estimates, or watts a) Lighting: capacity of lighting or number of Used
lights
b) Electric power, Horse power of machines
coupled with operating time
c) Steam
d) Water

5.4.1.2 Methods of Allocation

There are three methods of allocating the costs of service departments to production
departments. These are:
1. Direct allocation method
2. Step down allocating method
3. Reciprocal allocation method

1) Direct Allocation Method

This method ignores any service rendered by one service department to another. It allocates
each service department costs directly to the production departments in the ratio of the
benefits received by them. The direct allocation method is also called method. This method is
simple to use but inaccurate method. Under this method, there is no need to predict (or
budget) the usage of service department resources by other services departments.

Example

Consider a company with two service departments (plant maintenance and information
system) and two production departments (machining and assembly). The budgeted factory
overhead costs before any interdepartmental costs allocations are shown below:

Plant maintenance ------------------------------- Br. 100,000

Information systems---------------------------- 70,000
Machining -------------------------------------- 180, 000
Assembly --------------------------------------- 160,000

Budgeted labor hours by plant maintenance to:

Information systems ----------------------------- 2000 hours

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Machining ----------------------------------------- 5000
Assembly ----------------------------------------- 3000

Budgeted computer time by information systems to:

Plant maintenance ------------------------------- 1000 hours
Machining ---------------------------------------- 5000
Assembly ---------------------------------------- 4000

Plant maintenance costs are allocated on the basis of labor hours and that of information
systems are allocated on the basis of computer time.

Based on the above data, the costs of service departments are allocated to the two production
departments under direct method as follow:

2) Step -down allocation method

Step down allocation method for partial recognition of service rendered by service
departments to other service departments. A popular step -down sequence begins with the
departments that render the highest percentage of its total service to other service
departments. The sequence continues with the department that gives the next highest
percentage of its total services to other service departments, and so on, ending with the service
department that renders the lowest percentage of service to other service departments. An
alternative approach to selecting the sequence of allocations is to begin with the department
that renders the highest dollar (birr) amount of services to other service departments. In the
example under consideration, plant maintenance renders the highest service
(20%=2000/10,000) to information systems department. Thus allocation starts with plant
maintenance department. Using the preceding example, the costs of the two service
departments are allocated to production departments as follow:

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Step -down allocation method

Factory service depts.. Factory production depts.

Plant Information Machining Assembl
Total
maintenance systems y
Budgeted MOH 100,000 70,000 180,000 160,000 510,00
costs 0
Allocation plant
Maintenance ( 100,000) 20,000 50,000 30,000
( 210/5/10)
Allocation of (90,000) ( 50,000) (40,000)
information
systems ( 5/9, 4/9)
Total budgeted
MOH costs of 280,000 230,000 510,00
production 0
departments
a)
a) 2000 5000 3000
10,000 10,000 10,000

b) 5000 4000
9000 9000

Alternative term for step -down allocation method is sequential allocation method.
3) Reciprocal allocation method

The reciprocal allocation method allocates costs explicitly including the mutual services
rendered among all service departments. This method enables us to incorporate fully inter
departmental relationship in to the service cost allocations the reciprocal allocation method is
also called allocation method m matrix allocation method, and double distribution allocation
method.

Allocation of service department costs under reciprocal allocation method requires three
steps.

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Step. 1 Express service department costs and service department reciprocal relationship in
linear equation form.
Let:
PM: the complete reciprocated costs of plant maintenance department
IS: the complete reciprocated costs of information systems department
PM: 100,000 + 0.10 IS
IS: 70,000 + 0.20 PM

Step 2

Solve the above equations using simultaneous equation to obtain the complete reciprocated
cost of each service department

PM= 100,000 + 0.10 ( 70,000 + 0.20 PM)

PM = 100,000 + 7000 + 0.02 PM
PM = 107,000 _ 0.02 PM
PM = 0.02 PM = 107,000

0.98 PM = 107,000
PM = 107,000.98 = Br 109,183.67

The Br. 109,183.67 represents the total reciprocated ( artificial)cost of plant maintenance
department.

IS= 70,000 + 0.20 PM

= 70,000 + 0.20 (109,183.67)
= Br. 9,836.67 - Total reciprocated cost (artificial) cost of information systems department

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 Step 3.
Allocate the complete reciprocated cost of each service department to all other departments
(both production and service departments) using the usage proportions:

Factory service Production departments

departments Total
Plant Information Machining Assembly
maintenan system
ce
Budgeted MOH costs 100,000 70,000 180,000 160,00 510,000.00
Allocation of plant
maintenance 109,183.6 21,836.73 54591.84 32.755.10
( 2/10,5/10,3/10) 7
Allocation of
information system 9183.67 91,836.73 36.734.69 36,734.69
( 1/10, 5/10, 4/10)
Total budgeted MOH
costs of production 0 0 280,489.79 510,000.00
departments

5.5. SETTING OVERHEAD RATES

Manufacturing overhead costs are not directly traceable to a unit of output. Instead, these
costs are accumulated during the year and charged to jobs or products at the end of the year.
However, management cannot wait until the end of the year, or month to find out how much
particular job costs. Cost date are most useful when they are immediately available then they
can be used to evaluate efficiency, to suggest changes in procedures, and to help setting
profitable selling prices. The cost accountant is usually expected to report the total setting
profitable selling prices. The cost accountant is usually expected to report the total cost of a
job as soon as it s finished. At this time the actual total overhead costs are available, as they
would be t the end of a fiscal period. Thus, the accountant has to devise a method of
estimating overhead costs applicable of the completed jobs. This is achieve by establishing a
predetermined overhead rates, or predetermined overhead application rate.

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Predetermined overhead application rate refers to the rate determined before the
commencement of the period during which the same would be used.

5.5.1 Factors Affecting Rate Setting

Several factors affect the setting overhead rate. Among these are:
1. Length of the Period
This refers to the length of the period over which the rate is to be used. Selection of the length
of the period determines the questions as to how frequently the rate should be revised. The
period varies from organization to organization. Rate may be revised every year, six months,
quarter, or even every month.

The general principle governing the selection of the period is that the period should be long
enough to normalize the rate. A shorter period for averaging costs is not satisfactory because
wide variation can occur from to period. These variations are due to changes is seasons,
calendar, and volume. Fluctuating costs also complicate any attempt to use shorter period
such as a month.

5.5.2. Departmental and factory rates

The second factor is whether a single factory wide rate is used for all factory overhead or
whether separate rates are used for each producing departments. If the company is small, has a
few manufacturing departments, produces very few types of goods, it may successfully use a
single overhead application rate. However, a single overhead rate is not appropriate if
different types of products are manufactured, of if all products do not go through all
departments. If one department uses largely machine operations, and another department uses
primarily hand labor, a single rate is not suitable. Note that when a single rate is used for the
entire, it is called blanket rate.

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5.5.3 Types of overhead rate bases

The overhead rate is calculated with reference to the amount of overhead provided in the
budget and a predetermined volume of production in terms of the base which will be used as
denominator. The base should be the best available of the cause and effect relationships
between overhead costs and cost drivers.

Overhead rate = Estimated manufacturing overhead

Estimated activity base

Activity base may be any one of the six bases mentioned below:

A number of bases may be used in computing overhead application rate. The most common
bases are:
1. Units of production
2. Direct material cost
3. Direct labor cost
4. Prime cost
5. Direct labor hours
6. Machine hours

Illustration
A summary of the budget data for Abdi manufacturer for the year ended December 31, 1998
is given below:

Budgeted Manufacturing overhead costs = $ 600,000

" Units of production = 30,000 units
" Direct labor costs = $400,000
" Direct labor hours = 240,000 hours
" Direct material costs = $ 360,000
" Machine hours = 350,000 hours

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Required: Determine overhead application rate under each of the following bases:
a) Units of production
b) Direct material cost
c) Direct labor cost
d) Prime cost
e) Direct labor hours
f) Machine hours

a) Units of production
Units of production result in a meaningful rate only if the manufacturing process is simple
and only if one type or a few very similar types of goods are produced.

Rate = Estimated Manufacturing Overhead

Estimated units of production
= 600,000 = $ 20 unit
30,000
The rate implies that if one units is produced, the overhead applied ( charged) to this unit is
$20. If a job of 100 units is produced, the overhead applied to the job would be $2000 (i.e.
$20 x 100 units= $2000)

b) Direct Material cost

Under this method, the overhead application rate is expressed as a percentage of direct
material costs.

Rate = Estimated Manufacturing Overhead

Estimated Direct material costs
= 600,000
360,000
= 1.67 or 167% of direct maternal costs
If direct materials consumed of job No. 15 totaled $22,000, the overhead applied to this job
would be $36,740 (i.e 167%22000: 36,740)

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Direct material cost is more appropriate when each article manufactured must require
approximately the same amount of materials, or usage must distributed uniformly thought
out the manufacturing process.

However, in practice, most overhead costs have little relationship to materials used. As a
result, it is likely to give totally inaccurate results.

C) Direct labor cost

Rate = estimated manufacturing overhead
Estimated direct labor costs

= 600,000
400,000
The rate implies that the amount of overhead applied to a job or product is 150% of actual
direct labor cost incurred on that job. For instance, if actual direct labor costs incurred on
job No. 15 totaled $ 20,000, the overhead applied to this job would be $ 30,000 (i.e 150%
x20, 000 = 30,000)

This method is the most widely used overhead application basis because it is simple and
easy to use. However, the direct labor costs basis is not generally used in all cases where a
large proportion of overhead costs relate to the use of machinery. Also if hourly wage rates
vary widely between different workers on the same job or in the same department, the direct
labor cost is not appropriate.

d) Prime cost under this method overhead rate is expressed as a percentage of prime costs
(i.e. direct materials plus direct labor)

Rate = Estimated Manufacturing Overhead

Estimated prime cost

= 600,000 = 0.79 or 79% of prime cost

400,000 + 360,000
This method takes in to account both direct materials and direct labor. However, it would
produce inaccurate results due to the following reasons:

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1. If material cost is predominant in prime cost, the method would completely ignore the
time element.
2. If ignores the fact that use of expensive machinery gives rise to additional overheads
( i.e. higher depreciation higher insurance, higher repair and maintenance etc)
3. It combines the disadvantages associated with the rates based on the direct material
costs and those based on the direct labor costs.
e) Direct labor hours:
This method assumes that overhead costs tend to vary with the number of hours of direct
labor used:
Rate=
Rate= Estimated Manufacturing Overhead
Estimated Direct labor hours
= 600,000
240,000
= 250% of direct labor hours, or
= $2.50 direct labor hour.
If a job required 100 direct labor hours is completed, the overhead applied to job would be
$25000 (i.e $2.50 x 100 hours = $2500)

The direct labor hour basis is more appropriate if labor operations are the major part of the
production process.

f) Machine Hours

This method is used when machine operations are the major part of the production process.
When work is performed primarily by machines, a large part of factory overhead consists of
depreciation, power repairs and other costs associated with machinery. Thus, a logical
relationship exists between the use of the machinery and the amount of overhead costs
incurred.
Rate = Estimated Manufacturing Overhead
Estimated Machine Hours
= 600,000
350,000

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 = $1.71 per machine hour

If job 15 used hours basis is not accurate if different kinds of machines are used for various
products. In such a case, variations in original cost, operating costs, machine speed, and
labor costs would make this rate in appropriate as an overall formula.

Setting Departmental overhead rates

As described earlier, if a single factory -wide overhead rate is not appropriate , multiple
overhead rates are calculated for each production departments. Note that the rate is now
computed for service departments. In order to compute departmental overhead rates, the
following may be used:

Step 1. Allocate service department costs to production departments using the methods
introduced earlier (i.e. direct allocation method, step -down allocation method, or reciprocal
allocation method)

Step 2. Determine the overhead application rate using any one of the appropriate base
described earlier in this chapter. It is determined in the same way as single overhead
application rate.

5.6 APPLYING MANUFACTURING OVERHEAD

In the preceding discussion, the methods of determining overhead application rate were
introduced. However, accounting for applied overhead was not introduced. Thus, this topic is
intended to introduce how manufacturing overhead is applied to jobs or products, how to
record in the accounting records, and how to treat the difference between actual
manufacturing overhead and applied manufacturing overhead.

In general the following procedures are used to apply manufacturing overhead to jobs or
products.

Step 1. Select the application base (bases described earlier)

Step 2. Prepare a factory overhead budget for the planning period. The two key Items
are
(a) Budgeted total overhead and

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 (b) Budgeted total volume of the application base.
Step 3 Compute the overhead application rate by dividing the budgeted total overhead by the
budgeted total volume of the application base.

Step 4 Obtain the actual application base date (such as machine hours) for the period.

Step5 Apply the overhead to the jobs by multiplying the overhead application
rate by the actual application base data.

Step 6 prepare the necessary entry to the applied factory overhead by the
following entry
Work in process---------------------------xxx
Manufacturing -----------------------------xxx

Step 7 At the end of the period, account for any difference between the amount of
overhead actually incurred and overhead applied to products.

Example

Suppose that a company budgeted its factory overhead for the fourth coming year as
$900,000. Assume that manufacturing overhead is applied to products on the basis of
machine hours of 600,000 hours. Assume further that a job cost sheet for job 243 included
the following information:

Actual direct materials cost ----------------------------$ 2500

Actual direct labor cost --------------------------------- 3000
Actual machine hours ----------------------------------- 2000 hours

Required
A.Determine the overhead application rate
A. Compute the applied overhead to job 243
B. Prepare the entry to record applied overhead to job 243
C. Determine the total manufacturing costs of job 243.

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Solution

a. Overhead application rate = Estimated Manufacturing Overhead

Budgeted machine hours
= 900,000
600,000

= $ 1.51 machine hour

b. Applied overhead = overhead rate x Actual activity base
= 1.50 x 2000
= $ 3000
c. Entry
Work in process -----------------------------------------3000
Manufacturing --------------------------------------------------------3000

d. Actual direct material cost ……………….. $ 2500

Actual direct labor cost …………………… 3000
Applied manufacturing overhead ………… 3000
Total manufacturing costs (Job 243) …….. $ 7500

Note that the applied manufacturing overhead is posted to job cost sheet.
Some accountants prefer to credit special departmental overhead applied account, instead of
directly crediting manufacturing overhead control account. i.e.
Work in process ………………………. 3000
Manufacturing overhead applied ………………. 3000
Then manufacturing overhead applied account is closed to manufacturing overhead control
account as follows:
Manufacturing overhead applied ………… 3000
Manufacturing overhead control ……………………. 3000

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5.7 OVER APPLIED OR UNDER APPLIED OVERHEAD

Actual manufacturing overhead costs have been debited to MOH control account, and the
same account has been credited fro the manufacturing overhead applied to jobs or products.
At the end of the period, MOH control account may have debit or credit balance. A credit
balance in the account implies over applied manufacturing overhead. In other words, over
applied overhead occurs when applied overhead is greater than actual manufacturing
overhead. If actual manufacturing overhead, on the other hand, exceeds applied overhead, the
difference is called under applied overhead. In other words, under applied overhead is said to
exist if MOH control account has debit balance.

The next question is how to treat under applied or over applied overhead. The treatment
depends on whether the objective is to prepare interim or annual financial statements. The
manner of treating under applied or over applied overhead varies, depending on whether the
intention is for interim or annual report

1. Monthly procedures (Interim Reporting)

The balance of MOH control account is closed to over “applied or under applied
manufacturing overhead” account at the end of the month. Under applied overhead is closed
as follows:

Under applied manufacturing overhead ……………….. Xxx

Manufacturing overhead control ……………………….. Xxx
Over applied overhead is closed as follows:
Manufacturing overhead control ………………… xxx
Over applied manufacturing overhead …………………… xxx

The under applied or over applied manufacturing overhead is not closed monthly. The
amount of under applied is considered a deferred charge and is shown under prepaid expenses
on the interim balance sheet as a deferred credits.

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Note that the amount of under applied or over applied overhead does not appear in the interim
income statement. The statement of cost of goods manufactured shows direct materials used,
direct labor, and manufacturing overhead applied.

2. End-of-year procedures
The balance of under applied or over applied manufacturing overhead represents a difference
between overhead costs applied to goods worked on during the year and the actual overhead
costs that were incurred in producing these goods. There are two ways of treating under
applied or over applied overhead at the end of the year.

a) Immediate write off method

If the amount of under applied or over applied overhead is small, it is regarded as an
adjustment to Cost of Goods sold (i.e. written-off against cost of goods sold account).

Example
Assume that factory overhead incurred is $800.000 and that factory overhead applied is
$750.000. The difference is under applied of $50.000. The closing entry is:
Cost of Goods sold ……………………. 50.000
Manufacturing overhead control ……………………50.000
If the difference were over applied, the closing entry would be:
Manufacturing overhead control ………………… 50.000
Cost of Goods sold …………………………………………50.000

b) Perorations Method
If the amount of under applied or over applied overhead is considered to be material, it is
divided among Cost of Goods Sold. Work in Process, and Finished Goods Inventory.

Example
Assume that factory overhead incurred is $900.000 and that factory overhead applied is
$1,200,000. The difference is considered to the material. Assume further that the ending
balances (before prorating) were as follows:

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 Cost of goods sold ………………….. $1,000,000
Work in Process …………………….. 400,000
Finished goods ……………………… 600,000
Required
1. Compute under applied or over applied overhead at year end.
2. Prorate under applied or over applied overhead among the three balances.
3. Prepare the closing entry to record the prorated amount assuming that applied
overhead was recorded in manufacturing overhead control account.
4. Compute the new balances of the account after proration.
Solution
1. Over applied overhead:
Factory overhead applied …………………………….. $1,200,000
Less Factory overhead incurred ………………………. 900.000
Over applied overhead ………………………………… $ 300.000
2. Proration of over applied overhead is shown below:
1,000.000
Cost of Goods Sold = x300.000 = $ 150.000
2.000.000
400.000
Work in Process = x300.000 = 60,000
2,000.000
600,000
Finished Goods = 2,000,000 x300,000 = 90,000

3. Manufacturing overhead control ……………… 300,000

Cost of Goods sold ……………………………… 150,000
Work in Process ………………………………… 60,000
Finished Goods …………………………………. 90,000
4. The balance of the three accounts after proration are computed below.
Cost of Goods sold = 1,000,000 - $150,000 = $850,000
Work in Process = 400,000 - 60,000 = 340,000
Finished Goods = 600,000 - 90,000 = 510,000

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Cheek Your Progress Questions
EXERCISES

I .A company manufactures four products A, B, C and D products are assigned 5,10,8 and 4
points respectively, to compensate the basic difference in the products. The normal capacity
is as follows:

A-------------------------------2000 units
B-------------------------------5000 units
C-------------------------------3000 units
D-------------------------------4000 units

Total factory overhead costs for the budget year are estimated at $700,000.
Required: Determine overhead application rate if units of production basis is used.

II. The UNITED Company uses a budgeted overhead rate for applying overhead to job orders
on a machine hour basis for the machining department and on a direct labor cost basis for the
finishing department. The company budgeted the following for 1999
Machining Finishing
Factory overhead …………………. $10,000,000 $8,000,000
Machine hours ……………………. 200,000 33,000
Direct labor hours ………………… 30,000 160,000
Direct labor cost …………………... $ 900,000 $4,000,000

Required
1. What is the budgeted overhead rate that should be used in the machining department? In
the finishing department?
2. During the month of January, the cost record for job No. 431 shows the following:
Machining Finishing
Direct materials requisitioned …………….. $ 14,000 $ 3,000
Direct labor cost …………………………... 600 1,250
Direct labor hours ………………………… 30 50
Machine hours ……………………………. 130 10
What is the total overhead applied to job 431?

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3. Assuming that job 431 consists of 200 units of product, what is the total costs and unit
cost of job 431?

4. Balances at the end of 1999:

Machining Finishing
‘Factory overhead Incurred ………… $11,200,000 $7,900,000
Direct labor cost …………………… 950,000 4,100,000
Machine hours ……………………… 220,000 32,000
Compute the under applied or over applied overhead for each department and for the factory
as a whole.

III. GH manufacturing company applies overhead to jobs on the basis of machine hours. The
following data is extracted from the record or the company for 1996.
Budgeted factory overhead costs ………………….. $ 7,000,000
Budgeted machine hours …………………………… 200,000 hours
Actual factory overhead costs ………………………$ 6,800,000
Actual machine hours ………………………………. 195,000

Required
a) Compute the factory overhead application rate.
b) Journalize the application of factory overhead.
c) Compute the amount of under applied or over applied factory overhead. Journalize the
disposition of the ending balance in manufacturing overhead control account to Cost of
Goods Sold.

IV. For the current year, 1999, the estimated manufacturing overhead for the cutting
department is $256,000. The estimated number of units of production is 204-800.
The company uses the units of production base for overhead rates. How much
overhead should be applied to:
a) job 15 for 1200 units
b) job 22 for 980 units

V. The D and L Company use the direct labor cost base in establishing overhead rates for its
production departments. Fro the year 1999,the company estimates the following overhead
budgets:

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 Building services ………………………… $ 42,000
Department 1 ……………………………. 60,000
Department 2 ……………………………. 80,000
Department 3 ……………………………. 70,000
Building services is a service department that assists the production departments on the basis
of floor space occupied. The floor space occupied is given below:

Floor space
Department 1 ………………………….. 2,000 sq.ft.
Department 2 ………………………….. 3,000 sq.ft.
Department 3 ………………………….. 5,000 sq.ft.
Required: Determine the factory overhead application rates for each department, assuming
that the estimated direct labor costs for each department are $136,800, $ 236,500, and
$910,000 respectively.

5.9 ANSWER KEY FOR CHECK YOUR PROGRESS QUESTIONS

I. Product Normal capacity (units) Points Assigned Total points

A 2000 5 10,000
B 5000 10 50,000
C 3000 8 24,000
D 4000 4 16,000
100,000
Overhead application rate/point = 700,000
100,000 = $7

Converting this rate of $7 per point in to rate per unit we get:

Product Rate per point Points Assigned Rate per unit

A 7 5 $35
B 7 10 70
C 7 8 56
D 7 4 28

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 If 2000 units of A, 1500 units of B 800 units of C, and 3000 units of D were produced in the
first month, determine the overhead costs applied to each product.
Product overhead rate/unit units Applied overhead
A $ 35 2000 $ 70,000
B 70 1500 105,000
C 56 800 44,800
D 28 3000 84,000
$303,
$303, 800
II. A) Budgeted overhead rate:
BudgetedFactoryOverhead
Machining = BudgetedMachineHours

10,000,000
= 200,000

= $ 50 per machine hour

BudgetedFactoryOverhead
Finishing = BudgetedDirectlabor cos t

8,000,000
= 4,000,000

= 200% direct labor cost

B. Overhead applied to job 431 in

Machining department (50x130) ………………….. $ 6500
Finishing department (2x1250) ……………………. 2500
Total overhead applied to job 431 ………………… $ 9000
C. Total cost of job No 431:
Machining Finishing Total
Materials ………… $ 14000 $3000 $ 17000
Direct labor ……… 600 1250 1850
Overhead Applied … 6500 2500 9000
Total costs ……….. $ 21,100 $ 6750 $ 27850

Total cos tofajob

Unit cost =
TotalUnits

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 27850
=
200
= $ 139.25

D. Applied Manufacturing overhead in:

Machining (50x 220,000) ………………………. $ 11,000,000
Finishing (2x 4,100,000) ………………………... 8,200,000
Total Manufacturing overhead applied …………. $ 19,200,000
Total Factory overhead Incurred.. $ 19,100,000
Total manufacturing overhead applied …… 19,200,000
Over applied overhead ………………… $ 100,000

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