The company uses machine hours to assign manufacturing overhead costs to products. Calculate the predetermined overhead rate of GHJ Ltd if the required machine hours for next year’s production is estimated to be 10,000 hours. As you’ve learned, understanding the cost needed to manufacture a product is critical to making many management decisions (Figure 6.2).
It is important to include indirect costs that are based on this overhead rate in order to price a product or service appropriately. If a company prices its products so low that revenues do not cover its overhead costs, the business will be unprofitable. So, if you wanted to determine the indirect costs for a week, you would total up your weekly indirect or overhead costs. You would then take the measurement of what goes into production for the same period. So, if you were to measure the total direct labor cost for the week, the denominator would be the total weekly cost of direct labor for production that week.
- A large company with a corporate office, a benefits department, and a human resources division will have a higher overhead rate than a company that’s far smaller and with less indirect costs.
- Of course, management also has to price the product to cover the direct costs involved in the production, including direct labor, electricity, and raw materials.
- The overhead rate allocates indirect costs to the direct costs tied to production by spreading or allocating the overhead costs based on the dollar amount for direct costs, total labor hours, or even machine hours.
- The use of historical information to derive the amount of manufacturing overhead may not apply if there is a sudden spike or decline in these costs.
Its production department comes up with the details of how much the overheads will be and what other costs will be incurred. Departmental overhead rates are needed because different processes are involved in production that take place in different departments. However, one major disadvantage of the method is that both in transit what the term means and how it relates to accounting the numerator and the denominator are estimates and as such, it is possible that the actual result may vary significantly from the predetermined overhead rate. The predetermined overhead rate calculation shown in the example above is known as the single predetermined overhead rate or plant-wide overhead rate.
Common Types of Manufacturing Costs
The estimate is made at the beginning of an accounting period, before the commencement of any projects or specific jobs for which the rate is needed. The production hasn’t taken place and is completely based on forecasts or previous accounting records, and the actual overheads incurred could turn out to be way different than the estimate. Different businesses have different ways of costing; some use the single rate, others use multiple rates, and the rest use activity-based costing. Therefore, the predetermined overhead rate of GHJ Ltd for next year is expected to be $5,000 per machine hour.
- All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
- For example, the recipe for shea butter has easily identifiable quantities of shea nuts and other ingredients.
- Also, it’s important to compare the overhead rate to companies within the same industry.
If your company manufactures several products at different locations in your plant, each product has its own overhead expenses. Instead of figuring overhead costs for each product, you can calculate plant-wide expenses. This averages the costs for all products, and gives you an overview of expenses for your entire manufacturing operation. Sometimes called the “predetermined overhead rate,” your plant-wide figure helps you understand your company profitability. Another approach to calculating a single or plantwide overhead rate uses direct cost as a basis, rather than direct labor hours.
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Your indirect costs are those that continue no matter how much or how little you manufacture. These include things like rent or mortgage payments, insurance, equipment leases, and plant maintenance. This figure is your plant-wide indirect cost that you must pay just to be in business. All of your manufacturing activities depend on the services you are paying for throughout your plant.
Predetermined Overhead Rate
For example, the total direct labor hours estimated for the solo product is 350,000 direct labor hours. With $2.00 of overhead per direct hour, the Solo product is estimated to have $700,000 of overhead applied. When the $700,000 of overhead applied is divided by the estimated production of 140,000 units of the Solo product, the estimated overhead per product for the Solo product is $5.00 per unit. The computation of the overhead cost per unit for all of the products is shown in Figure 6.4. A predetermined overhead rate is defined as the ratio of manufacturing overhead costs to the total units of allocation. Enter the total manufacturing overhead cost and the estimated units of the allocation base for the period to determine the overhead rate.
Direct costs are costs directly tied to a product or service that a company produces. Direct costs include direct labor, direct materials, manufacturing supplies, and wages tied to production. The overhead rate is a cost added on to the direct costs of production in order to more accurately assess the profitability of each product. In more complicated cases, a combination of several cost drivers may be used to approximate overhead costs. For example, the recipe for shea butter has easily identifiable quantities of shea nuts and other ingredients.
Calculating the Plantwide Overhead Rate
Direct labor standard rate, machine hours standard rate, and direct labor hours standard rate are some methods of factory overhead absorption. Small companies tend to use activity-based costing, whereas in larger companies, each department in which different processes of production take place typically computes its own predetermined overhead rate. Hence, the overhead incurred in the actual production process will differ from this estimate. A single overhead rate for assigning all of the manufacturing production and service department costs to products. This rate is less accurate than departmental rates if a company manufactures a diverse group of products.
A predetermined overhead rate is an allocation rate that is used to apply the estimated cost of manufacturing overhead to cost objects for a specific reporting period. This rate is frequently used to assist in closing the books more quickly, since it avoids the compilation of actual manufacturing overhead costs as part of the period-end closing process. However, the difference between the actual and estimated amounts of overhead must be reconciled at least at the end of each fiscal year.
The sales price, cost of each product, and resulting gross profit are shown in Figure 6.6. You have to pay for personnel to do this checking, and in some cases you have to pay production personnel to fix the problem. In other cases, you may have to throw out defective products and write off the cost of making them. Add up all your quality control expenses into one grand total, even if most of the quality problems are with one or two products. Some small products may require large quantities, while complex projects may take longer to produce and therefore result in fewer units during any given period. Add up the total number of units you produce in a month regardless of which product it is.
Plantwide Overhead Rate Method
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. In these situations, a direct cost (labor) has been replaced by an overhead cost (e.g., depreciation on equipment). Because of this decrease in reliance on labor and/or changes in the types of production complexity and methods, the traditional method of overhead allocation becomes less effective in certain production environments. To account for these changes in technology and production, many organizations today have adopted an overhead allocation method known as activity-based costing (ABC). This chapter will explain the transition to ABC and provide a foundation in its mechanics.
Using the Solo product as an example, 150,000 units are sold at a price of $20 per unit resulting in sales of $3,000,000. The cost of goods sold consists of direct materials of $3.50 per unit, direct labor of $10 per unit, and manufacturing overhead of $5.00 per unit. With 150,000 units, the direct material cost is $525,000; the direct labor cost is $1,500,000; and the manufacturing overhead applied is $750,000 for a total Cost of Goods Sold of $2,775,000. The common allocation bases are direct labor hours, direct labor cost, machine hours, and direct materials. The overhead rate has limitations when applying it to companies that have few overhead costs or when their costs are mostly tied to production.
