While accounting for inventory, manufacturing overhead costs are included in the cost of inventory. Unlike the raw material cost or the direct labor costs, the manufacturing overhead costs are not direct. Therefore, manufacturing overhead is allocated to the inventory based on a pre-determined rate as it cannot be directly traced to one single product.
WHAT IS A MANUFACTURING OVERHEAD
Manufacturing overhead is a fixed cost which is incurred irrespective of the volume of the inventory produced. Both IFRS and ASPE requires us to use the absorption costing method to allocate the manufacturing overhead costs to the inventory.
EXAMPLES OF MANUFACTURING OVERHEAD
Manufacturing overhead costs are overhead costs which include cost to operate the manufacturing facility. This includes heat, electricity, depreciation of the facility, insurance of machinery or the factory. It also includes indirect factory labor (labor costs which are not directly related to the products being manufactured).
HOW IS A MANUFACTURING OVERHEAD ALLOCATED TO INVENTORY?
Manufacturing overhead is allocated to inventory using a pre-determined rate called as the pre-determined overhead rate (POHR). As the name indicates, the pre-determined overhead rate (POHR) is the rate arrived at based on a cost driver. This is done well before the manufacturing activity occurs.
WHAT ARE COST DRIVERS?
Cost drivers are those which drive the overhead expenses making them to increase or decrease. Examples of cost drivers for the manufacturing overhead include units produced or machine hours.
The pre-determined manufacturing overhead rate is computed at the very beginning of the period by estimating the overhead costs. The estimated manufacturing overhead costs are then divided by the normal volume of the cost driver (machine hours, production units) at normal capacity. (Example of a normal capacity is: 5 Lac units per month).If there is a low production or idle plant, the overhead allocated to the product should not be increased.
OVER / UNDER ALLOCATION OF MANUFACTURING OVERHEAD
Under this method, over allocation of the manufacturing overhead or under allocation of the manufacturing overhead can happen as the estimated manufacturing overhead costs would differ from the actual manufacturing overhead costs.
If there is an over allocation or under allocation of the manufacturing overhead, the differential amount called the variance will be adjusted in the cost of goods sold (COGS).
Example 1 :
Finger Foods Inc.manufactures potato chips. At the beginning of the period, it estimates that there will be a manufacturing overhead of $150,000. This includes rent of the factory, insurance, heat and electricity. The direct material cost per unit of the finished product is $0.07 and the direct labor cost per unit of the finished product is $0.12. During the period, Finger Foods estimates that it will manufacture 1,000,000 packets of potato chips and this will be the normal capacity.
Find out the direct cost per unit and overhead allocation per unit for the manufacturing cost.
Computation of direct cost per unit
Raw material cost and labor cost are the two costs which are directly related to the product. Hence the direct cost per unit is ($0.12 + $0.07) = $0.19 per unit.
Computation of manufacturing overhead allocation cost per unit How to compute overhead allocation
overhead allocation cost per unit = Total overhead cost = $150,000
Expected volume of production 1000,000 units
= $0.15/ unit
The total cost of each unit of the potato chips manufactured will be = $0.15+ $ 0.19 = $0.34
Assume Finger Foods Inc actually had an overhead of Case 1 $175,000 and Case 2 $140,000. Find out if the overhead costs have been over allocated or under allocated.
As per the estimated overhead costs, Finger Foods Inc has allocated manufacturing overhead amounting to $150,000 to the inventory, which is lower than the actual manufacturing overhead cost which is $175,000. Hence in case 1, the overhead is under allocated to the extent of $25,000. In case 2, the allocated overhead is $150,000, whereas the actual overhead is $140,000. The manufacturing overhead allocated is higher than the actual manufacturing overhead by $10,000.
In case 1, the cost of goods sold were made lower by under allocation. Hence, it has to be brought to the correct cost, by adding the remaining manufacturing overhead to the cost of goods sold.
The entry will be as follows:
Dr. Cost of goods sold (expense account) $25,000
Cr. Manufacturing overhead (temporary account) $25,000
In case 2, the cost of goods sold were made higher by over allocation. Hence, it has to be brought to the correct cost, by deducting the remaining manufacturing overhead to the cost of goods sold.
The entry will be as follows
Dr. Manufacturing overhead (temporary account) $10,000
Cr. Cost of goods sold (expense account) $10,000
The remaining manufacturing overhead costs are adjusted in the cost of goods sold when all of the inventory are sold. But it the accounting treatment for allocation of manufacturing overhead costs differs in case if all of the goods are not sold and few still remain in the inventory.
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