As you will recall from Unit 1, product costs include manufacturing overhead, as

Question

As you will recall from Unit 1, product costs include manufacturing overhead, as well as direct costs such as labor and materials. In Job-order Costing, manufacturing overhead needs to be computed and included in the cost of the “job”. However, there are some problems with computing how much of the overhead should be assigned.

Manufacturing overhead is an indirect cost, so it is almost impossible to figure out how much overhead each job uses up. Manufacturing overhead includes some fixed costs. Therefore, if a company has a seasonal production (producing a lot of units in one period, but not many in another), the individual product cost will vary widely. Conversely, if the company has a level-production schedule, but a widely fluctuating level of fixed costs (such as high utility bills in the summer or winter), then the per unit cost will also vary widely.

The way around these problems is to allocate manufacturing overhead by using a common base. An allocation base such as direct labor hours or direct machine hours allows managers to proportionately assign costs to a job. Typically, managers estimate the total amount of the allocation base that they believe they will need for the reporting period before the reporting period starts. In this way, they can assign costs to a job through-out the period. The estimate is called the predetermined overhead rate. It is computed using the following formula:

This means that for every labor hour (or fraction thereof) needed to produce one unit, the proportionate amount of $7.50 will be added to the per unit product cost. If it takes half an hour to make one unit then the per unit cost will increase by $3.75. As you can see, these estimates can play a very crucial role in the bottom line of a company’s financial statements. If the predetermined overhead rate is very high (overestimating product costs) then estimated net profit will be low. Conversely, if the predetermined rate is low, the profit estimates are better. Can you see how this may affect a manager’s decision on choosing an allocation base, or in making the estimates?

Questions

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

2) What are the advantages of using the high or low estimates? Are there any ethical issues in selecting the estimates?

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

Please answer all of the questions, if you can not answer all of the questions do not reply.

Predetermined OverheadTotal estimated Manufacturing Overhead Total estimated amount of allocation base For example: if a company estimates that its overhead will be $1,500,000 over the coming year, and they will need 200,000 labor hours to produce their product, the predetermined overhead would be: $1,500,000 200,000 labor hours $7.50 per labor hour

Explanation / Answer

In order to calculate the overhead cost you require the amount of raw materials required to manufacture the goods, the direct labour involved , indirect energy expenses, equipment repairs, depreciation, property taxes and the salaries of maintenance workers. In an automated factory it can be based on allocation of machine hours. But in general it is based on direct labour hours as a basis for computing. The advantage of using high or low estimate is that the results are estimates and not the exact number. These estimates can be obtained through monthly expenses and activity level also from which the difference between high and low values is calculated. The ethical issues in selecting the estimates are lack of transparency and considerations given to the decisions made wholly on the lowest price. Over or under-applied manufacturing overhead is actually the debit or credit balance of manufacturing overhead account. At the end of the year, the balance in manufacturing overhead account (over or under-applied manufacturing overhead) is disposed of by allocating it among work in process, finished goods and cost of goods sold .

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