Solved Calculate the predetermined overhead rate Managerial Accounting and Professional Issues ACCT 2220

Based on the manufacturing process, it is also easy to determine the direct labor cost. But determining the exact overhead costs is not easy, as the cost of electricity needed to dry, crush, and roast the nuts changes depending on the moisture content of the nuts upon arrival. Recall from Chapter 2 «How Is Job Costing Used to Track Production Costs?» that the manufacturing overhead account is closed to cost of goods sold at the end of the period. If actual overhead costs are higher than applied overhead, the resulting underapplied overhead is closed with a debit to cost of goods sold and a credit to manufacturing overhead.

However, many industries have evolved, primarily due to changes in technology, and their production processes have become more complicated, with more steps or components. Many of these industries have significantly reduced their use of direct labor and replaced it with technology, such as robotics or other machinery. For example, a mobile phone production facility in China replaced 90 percent of its workforce with robots. The activity base is the measure of the level of activity that drives the manufacturing overhead costs. The activity base can be different for different companies, but some common examples include machine hours, direct labor hours, or units of production. Until now, you have learned to apply overhead to production based on a predetermined overhead rate typically using an activity base.

ABC in Action at SailRite Company

For example, if we choose the labor hours to be the basis then we will multiply the rate by the direct labor hours in each task during the manufacturing process. This is related to an activity https://www.bookstime.com/ rate which is a similar calculation used in Activity-based costing. A pre-determined overhead rate is normally the term when using a single, plant-wide base to calculate and apply overhead.

To ensure that the company is profitable, an additional cost is added and the price is modified as necessary. In this example, the guarantee offered by Discount Tire does not include the disposal fee in overhead and increases that fee as necessary. If sales and production decisions are being made based in part on the predetermined overhead rate, and the rate is inaccurate, then so too will be the decisions. For every dollar in direct labor wages and benefits paid, we allocate $0.50 in fixed overhead to that item.

Comparison of ABC to Plantwide Costing at SailRite

Overhead costs are then allocated to production according to the use of that activity, such as the number of machine setups needed. In contrast, the traditional allocation method commonly uses cost drivers, such as direct labor or machine hours, as the single activity. Further, the company uses direct labor hours to assign manufacturing overhead costs to products.

The base unit identification is critical for the accurate allocation, which ultimately helps identify the department-wise performance and any issues. Applying our formula, we get $188,000 in fixed overhead divided by the base of $376,000 total direct labor dollars for an allocation rate of $0.50 per machine hour. Activity-based costing (ABC) is a more specific and more accurate way of assigning factory overhead to manufactured goods versus using single factory or departmental rates. A cost object (in the case of manufacturing, the item produced) is the target of the activity. Cost objects include products, jobs, services, projects, clients, patients, customers, and contracts. For example, the recipe for shea butter has easily identifiable quantities of shea nuts and other ingredients.

Calculation of Predetermined Overhead and Total Cost under Traditional Allocation

As you’ve learned, understanding the cost needed to manufacture a product is critical to making many management decisions ((Figure)). Knowing the total and component costs of the product is necessary for price setting and for measuring the efficiency and effectiveness of the organization. Remember that product costs consist of direct materials, direct labor, and manufacturing overhead. A company’s manufacturing overhead costs are all costs other than direct material, direct labor, or selling and administrative costs. Once a company has determined the overhead, it must establish how to allocate the cost.

• Examples of manufacturing overhead costs include indirect materials, indirect labor, manufacturing utilities, and manufacturing equipment depreciation.
• An activity base is considered to be a primary driver of overhead costs, and traditionally, direct labor hours or machine hours were used for it.
• Estimating overhead costs is difficult because many costs fluctuate significantly from when the overhead allocation rate is established to when its actual application occurs during the production process.
• The person involved in preparing and finalizing overhead rates must have an eye for detail and an in-depth understanding of products and the manufacturing process within the organization.
• Notice that the three pie charts in the illustration are of equal size, representing the $8,000,000 total overhead costs incurred by SailRite.
• As you have learned, the overhead needs to be allocated to the manufactured product in a systematic and rational manner.

Establishing the overhead allocation rate first requires management to identify which expenses they consider manufacturing overhead and then to estimate the manufacturing overhead for the next year. Manufacturing overhead costs include all manufacturing costs except for direct materials and direct labor. Estimating predetermined overhead rate overhead costs is difficult because many costs fluctuate significantly from when the overhead allocation rate is established to when its actual application occurs during the production process. You can envision the potential problems in creating an overhead allocation rate within these circumstances.

An activity base is considered to be a primary driver of overhead costs, and traditionally, direct labor hours or machine hours were used for it. For example, a production facility that is fairly labor-intensive would likely determine that the more labor hours worked, the higher the overhead will be. A predetermined overhead rate is calculated at the start of the accounting period by dividing the estimated manufacturing overhead by the estimated activity base. The predetermined overhead rate is then applied to production to facilitate determining a standard cost for a product. A predetermined overhead rate is calculated at the start of the accounting period by dividing the estimated manufacturing overhead by the estimated activity base.

These rates help exactly track each department’s expense and resource utilization, which helps the higher management fix any issues quickly before it goes out of hand. After the actual numbers are out, comparing actual and budgeted numbers helps identify variances and the factors driving them. This analysis is one of the most important aspects of cost accounting in any organization, as it accurately identifies the reason for the change.

This chapter will explain the transition to ABC and provide a foundation in its mechanics. This means that for every machine hour used by a product or service, the company will allocate $10 of manufacturing overhead costs. To account for these changes in technology and production, many organizations today have adopted an overhead allocation method known as activity-based costing (ABC). Product costing involves allocating costs from activity centers to products and calculating a product cost per unit. The problem with this approach is that fixed costs are often a large part of the overhead costs being allocated (e.g., building and machinery depreciation and supervisor salaries).

In recent years increased automation in manufacturing operations has resulted in a trend towards machine hours as the activity base in the calculation. Applying our formula, we get $188,000 in fixed overhead divided by the base of 47,000 total direct machine hours for an allocation rate of $4 per machine hour. As you can see in Figure 3.6 «SailRite Company Product Costs Using Activity-Based Costing», overhead is a significant component of total product costs. This explains the need for a refined overhead allocation system such as activity-based costing.