Which amounts would you use to calculate the overhead rate, and why? What are th

Question

Which amounts would you use to calculate the overhead rate, and why?

What are the advantages of using the high or low estimates?

Are there any ethical issues in selecting the estimates?

What are the ramifications or under- or overestimating the overhead?

SkinFX Corporation Management Decisions SkinFX Corporation manufactures the special materials used to create face masks and realistic body parts for the movie industry. The company is preparing its projected financial statements for the upcoming year, and hopes to use them to secure a bank loan. The proceeds of the loan will be used to increase capacity at the plant. At current capacity, total overhead is about $1.2M, with about 170,000 total direct labors hours. If the company expands, the increased capacity will generate total overhead of $1.7M, with 195,000 direct labor hours.

Explanation / Answer

An overhead is cost that is not identified with any particular product.

Manufacturing overhead forms a major part of the cost of operations of a company and its allocation to all jobs during the period in which they are incurred is important to determine the profitability of a particular job.

Overheads costs vary a lot from month to month over an accounting period. For instance, a company might incur factory lease expense or insurance expense in a particular month, say April. The expense might be significantly large and therefore allocating the same only to the jobs done in April might not be ethical.

Such costs should be allocated to the jobs done throughout the accounting period. Also, many a times the company might not have actual cost details. In such situations a fair allocation of overhead costs to all jobs needs the use of estimates.

Businesses normally use estimated overhead and estimated activity to determine a rate for allocation of overheads to jobs. Such a rate is called predetermined overhead rate.

Predetermined Overhead Rate = Estimated overhead/estimated activity

The most commonly used activity is the direct labor hours or machine hours to accurately allocate overhead costs to jobs.

Suppose that the estimated overhead was estimated to be between $1.2M and 170,000 and estimated labor hours are 170,000 to 195,000.                                                                           

Determination of overhead rate depends on several factors. Few include nature of the product, organizational set-up, nature of the overhead and management policy.

So, with higher estimates, we arrive at a higher estimated overhead rate per hour, which may inflate the budget.

Again, when using lower estimates, the allocation rate would less and might not fairly reflect the overhead cost. Also, actual expenditure may be much higher and a major portion would remain unabsorbed in the cost.

When high and low estimates are provided it would be fair to use an average to arrive at an accurate value.

Considering the above estimates,

Estimated overhead costs can be arrived as follows: ($1.2M + $ 0.17M)/2 = $0.685M

Estimated labor hours can be arrived as follows (170,000+195000)/2 = 182,500 hours

The advantages of using the high and low estimates:

Simple and easy to calculate the overhead rate

Taking the average provides fairly stable and homogeneous estimate

The stress on the main production activity of the company is ideally considered

Since the method uses the average, major fluctuations in the labor hours or overhead estimates are properly accounted for.

Ethical issues

When an estimated labor hour rate is used to assign estimated overhead rate in a manufacturing concern, high-volume, labor intensive jobs received great proportion of the overhead burden than they actually used.

Ramifications of under or over absorption of overhead

When using a predetermined estimate based on an anticipated overhead base, the amount allocated may not be same as the actual expenses incurred. When the amount absorbed is less than the actual, the difference denotes under absorption. Likewise, when the amount absorbed is more than the actual expense it would result in over-absorption, which would increase the costs.

Causes and effects of such variations in estimated and actual overheads include:

Errors in estimating overhead expenditure

Errors in arriving at the a proper base for allocation

Major unanticipated changes in the production methods

Seasonal fluctuations in the overhead expenses

Write-off (under absorption) or write-back (over absorption) to the profit and loss account is a valid treatment to address the differences in estimated and actual overhead expenses.

Alternatively, the under absorbed or over-absorbed overhead can be carried forward to the next accounting period through a reserve account. However, this method is not considered to be in consistent with the Accounting Standards.

Use of supplementary rates is considered an ideal approach to adjust the effect on the costs. This method aims at splitting the overall effect between the cost of sales (that is charged to the current year income), and inventory (that is carried forward to the next accounting year).

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