Application of Manufacturing Overhead Cost in Job Order Costing:

Learning objective of the article:

1. Define and explain predetermined manufacturing overhead rate, how is it calculated?
2. How manufacturing overhead is recorded on a job cost sheet and is applied to work in process? Explain the procedure with an example.

Predetermined Overhead Rate:

Manufacturing overhead must be included with direct labor on the job cost sheet since manufacturing overhead is also a product cost. However, assigning manufacturing overhead to units of product can be a difficult task. There are three reasons for this:

1. Manufacturing overhead is an indirect cost. This means that it is either impossible or difficult to trace these costs to a particular product or job.

2. Manufacturing overhead consists of many different items ranging from the grease used in machines to the annual salary of production manager.

3. Even though output may fluctuate due to seasonal or other factors, manufacturing overhead costs tend to remain relatively constant due to the presence of fixed costs.

Given these problems, about the only way to assign overhead costs to production is to use an allocation process. This allocation of overhead cost is accomplished by selecting an allocation base that is common to all of the company's products and services. An allocation base is a measure such as direct labor hours or machine hours that is used to assign overhead costs to products and services. The most widely used allocation bases are direct labor hours, and direct labor cost, with machine hours and even units of product (where a company has only a single product) also used to some extent. The allocation base is used to compute "predetermined overhead rate" in the following formula or equation.

Formula and Calculation of Predetermined Overhead Rate:

[Predetermined Overhead Rate = Estimated total manufacturing overhead cost / Estimated total units in the allocation base]

Example:

If a company has estimated that its total manufacturing overhead cost will be $320,000 for the year and its total direct labor hour will be 40,000. Its predetermined overhead rate for the year will be $8 per direct labor hour, as calculated below:

$320,000 / 40,000
= $8 per direct labor hour

predetermined overhead rate is based on estimates rather than actual results. This is because the predetermined overhead rate is computed before the period begins and is used to apply overhead cost throughout the period. The process of assigning overhead cost to jobs is called overhead application. The formula for determining the amount of overhead cost to apply to a particular job is:

[Overhead applied to a particular job = Predetermined overhead rate × Amount of allocation incurred by the job]

Note that the job cost sheet in the example below indicates that 27 labor hours have been worked. Therefore a total of $216 of manufacturing overhead cost would be applied to the job. See the following calculation:

Overhead applied to job 2B47 = Predetermined overhead rate × Actual direct labor hours charged to job 2B47

= $8 per DLH × 27 DLHs

= $216 of overhead applied to job 2B47

Example of Job Cost Sheet

The amount of overhead has been entered on the job cost sheet above. Note that this is not the actual amount of overhead caused by the job. There is no attempt to trace actual overhead costs to jobs--if that could be done, the costs would be direct costs, not overhead costs. Overhead assigned to the job is simply a share of the total overhead that was estimated at the beginning of the year. When a company applies overhead cost to jobs as we have done--it is called normal cost system. The overhead may be applied as direct labor-hours are charged to jobs, or all of the overhead can be applied at once when the job is completed. The choice is up to the company. If a job is not completed at the year-end, however, overhead should be applied to value the work in process inventory.

The Need for Predetermined Overhead Rate:

Instead of using a predetermined overhead rate, a company could wait until the end of the accounting period to compute an actual over head rate based on actual total manufacturing costs and the actual total units in the allocation base for the period. However, managers cite several reasons for using predetermined over head rates instead of actual overhead rates:

1. Managers would like to know the accounting system's valuation of completed jobs before the end of the accounting period. Suppose, for example a company waits until the end of the year to compute its overhead rate. Then there would be no way for managers to know the cost of goods sold for a job until the close of the year. The job may be completed and shipped before the end of the year. The seriousness of this problem can be reduced to some extent by computing the actual overhead more frequently, but that immediately leads to another problem as discussed below.

2. If actual overhead rates are computed frequently, seasonal factors in overhead costs or in the allocation base can produce fluctuations in the overhead rates. For example, the cost of heating and cooling a production facility will be highest in the winter and summer months and lowest in the spring and fall. If an overhead rate were computed each month or each quarter, the predetermined overhead rate would go up in the winter and summer and down in the spring and fall. Tow identical jobs, one completed in winter and one completed in spring, would be assigned different costs if the overhead rate were computed on a monthly or quarterly basis. Managers generally feel that such fluctuations in overhead rates and costs serve no useful purpose and are misleading.

3. The use of predetermined overhead rate simplifies the record keeping. To determine the overhead cost to apply t a job, the accounting staff simply multiplies the direct labor hours recorded for the job by the predetermined overhead rate.

The Flow of Documents in a Job Order Costing System
 

	A sales order is prepared as a basis for issuing a.....			A production order initiates work on a job, whereby costs are charged through...	→	Materials requisition form	These production costs are accumulated on a form, prepared by the accounting department known as...			The job cost sheet is used to compute unit product costs that in turn are used to value ending inventories and to determine cost of goods sold
Sales Order		→	Production Order			Direct labor time ticket		→	Job cost sheet
						Predetermined overhead rates

You may also be interested in other relevant articles:

1. Measuring Direct Materials Cost in Job Order Costing System
2. Measuring Direct Labor Cost in Job Order Costing System
3. Application of Manufacturing Overhead
4. Job Order Costing System--The Flow of Costs
5. Multiple Predetermined Overhead Rates
6. Under-applied overhead and over-applied overhead calculation.
7. Disposition of any balance remaining in the manufacturing overhead account at the end of a period
8. Predetermined Overhead Rate and Capacity
9. Recording Non-manufacturing Costs
10. Recording Cost of Goods Manufactured and Sold
11. Job Order Costing in Services Companies
12. Use of Information Technology in Job Order Costing
13. Advantages and Disadvantages of Job Order Costing System
14. Job Order Costing Discussion Questions and Answers
15. Job Order Costing Exercises
16. Case Studies

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