23 Compute a Predetermined Overhead Rate and Apply Overhead to Production

Fundamental Characteristics of the Overhead Determination Environment

Added to these issues is the nature of establishing an overhead rate, which is often completed months before being applied to specific jobs. 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. Therefore, in order to estimate manufacturing overhead, management must estimate the future purchase prices of dozens, or sometimes hundreds, of individual components, such as utilities, raw materials, contract labor, or diesel fuel. 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. You can envision the potential problems in creating an overhead allocation rate within these circumstances.

Before demonstrating the calculation of a predetermined overhead allocation rate, let’s review the basic principles of revenue recognition and expense. In accounting, there are three ways to recognize expenses:

1. Direct relationship between the expense and the associated revenue. This method is used for many costs, and the expense is recognized when a direct relationship exists. For example, sales commission expenses can be directly traced to product sales, and a commission expense is recorded when a sale is made.
   
2. Systematic and rational allocation of expenses. This approach is used when costs exist and there is an expected benefit, even though the costs cannot be directly traced to the benefit. The assigning of expenses to a product or time period must be done in an objective and consistent manner. Examples of such expenses would include equipment rental for a factory or property insurance for the factory.
   Both of these expenses (direct relationship and systematic and rational) are also examples of the types of expenses that compose manufacturing overhead. An example of the current revenue recognition principle is a company paying $4,800 a year for property insurance. Since production rates can vary month to month, most producers would allocate $400 each month for property insurance, and this cost would be incorporated into the total overhead costs anticipated when estimating a manufacturing overhead allocation rate.
   The direct benefit is that the product will be sold and the revenue recognized. The overhead is associated but cannot be directly traced to an individual product, so the overhead expenses need to be assigned in a systematic and rational manner.
   
3. Immediate recognition. This method is used when expenses exist but there is no direct expected benefit. In this case, the expense is recognized immediately. For example, research and development costs are necessary expenses but cannot be traced to a specific product, so they are expensed as incurred.

The allocation of overhead to the cost of the product is also recognized in a systematic and rational manner. The expected overhead is estimated, and an allocation system is determined. The actual costs are accumulated in a manufacturing overhead account. The overhead is then applied to the cost of the product from the manufacturing overhead account. The overhead used in the allocation is an estimate due to the timing considerations already discussed.

The application rate that will be used in a coming period, such as the next year, is often estimated months before the actual overhead costs are experienced. Often, the actual overhead costs experienced in the coming period are higher or lower than those budgeted when the estimated overhead rate or rates were determined. At this point, do not be concerned about the accuracy of the future financial statements that will be created using these estimated overhead allocation rates. You will learn in Determine and Disposed of Underapplied or Overapplied Overhead how to adjust for the difference between the allocated amount and the actual amount.

Despite improvements in technology and information flow, using the actual overhead to calculate the application rate is usually not possible because the actual overhead information is available too late for management to make decisions. Also, as you will learn, the results of the actual overhead costs, if they were available, could be misleading. Therefore, most manufacturing companies use predetermined overhead rates for these reasons:

• Overhead costs are not uniform throughout the year. An example is electricity costs that vary by weather and time of day.
• Some overhead costs are fixed, and the cost per unit varies with production. For example, rent may be $1,000 per month. If 500 units were made during one month, and 2,000 units were made the next month, the cost per unit would vary from $2 per unit to $0.50 per unit.
• The total number of units produced varies and is often known sooner than the cost of overhead. For example, a company may know it will have a contract to produce 100 custom units long before it knows the utility costs for the next year.

As previously described, a predetermined overhead rate is established prior to the beginning of the fiscal year and typically is not changed during the year. The predetermined rate is calculated as shown and is used to apply overhead costs to work in process:

Determining Estimated Overhead Cost

The estimated or budgeted overhead is the amount of overhead determined during the budgeting process and consists of manufacturing costs but, as you have learned, excludes direct materials and direct labor. Examples of manufacturing overhead costs include indirect materials, indirect labor, manufacturing utilities, and manufacturing equipment depreciation. Another way to view it is overhead costs are those production costs that are not categorized as direct materials or direct labor.