5.3 More about Manufacturing Overhead

Overhead is the hardest part of determining how much a project costs.  In the previous section, we learned about predetermined overhead.  In this section, we will learn how activity-based costing might be a better solution for overhead.

Activity-Based Costing

Activity-based costing (ABC) is an accounting method that recognizes the relationship between product costs and a production activity, such as the number of hours of engineering or design activity, the costs of the set up or preparation for the production of different products, or the costs of packaging different products after the production process is completed. 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.

ABC is a five-stage process that allocates overhead more precisely than traditional allocation does by applying it to the products that use those activities. ABC works best in complex processes where the expenses are not driven by a single cost driver. Instead, several cost drivers are used as the overhead costs are analyzed and grouped into activities, and each activity is allocated based on each group’s cost driver. The five stages of the ABC process are:

1. Identify the activities performed in the organization
2. Determine activity cost pools
3. Calculate activity rates for each cost pool
4. Allocate activity rates to products (or services)
5. Calculate unit product costs

Step 1

The first step is to identify activities needed for production. An activity is an action or process involved in the production of inventory. There can be many activities that consume resources, and management will need to narrow down the activities to those that have the biggest impact on overhead costs. Examples of these activities include:

• Taking orders
• Setting up machines
• Purchasing material
• Assembling products
• Inspecting products
• Providing customer service

Step 2

The second step is assigning overhead costs to the identified activities. In this step, overhead costs are assigned to each of the activities to become a cost pool. A cost pool is a list of costs incurred when related activities are performed. For example, the production cost pool consists of costs such as indirect labor for those accepting the order, verifying the customer has credit to pay for the order, maintenance and depreciation on the machines used to produce the orders, and utilities and rent for operating the machines.  A list of cost pools and potential activities are as follows:

Step 3

Once the costs are grouped into similar cost pools, the activities in each pool are analyzed to determine which activity “drives” the costs in that pool, leading to the third step of ABC: identify the cost driver for each cost pool and estimate an annual level of activity for each cost driver. As you’ve learned, the cost driver is the specific activity that drives the costs in the cost pools.

The fourth step is to compute the predetermined overhead rate for each of the cost drivers. This portion of the process is similar to finding the traditional predetermined overhead rate, where the overhead rate is divided by direct labor dollars, direct labor hours, or machine hours. Each cost driver will have its own overhead rate, which is why ABC is a more accurate method of allocating overhead.

Step 5

Finally, step five is to allocate the overhead costs to each product. The predetermined overhead rate found in step four is applied to the actual level of the cost driver used by each product. As with the traditional overhead allocation method, the actual overhead costs are accumulated in an account called manufacturing overhead and then applied to each of the products in this step.

Notice that steps one through three represent the process of allocating overhead costs to activities, and steps four and five represent the process of allocating the overhead costs that have been assigned to activities to the products to which they pertain. Thus, the five steps of ABC involve two major processes: first, allocating overhead costs to the various activities to get a cost per activity, and then allocating the cost per activity to each product based on that product’s usage of the activities.

Let’s look at Musicality, a company that produces music books. Musicality is making a positive gross profit each year but is considering switching to an activity-based costing approach for determining overhead and has collected data to help them decide which overhead allocation method they should use.

Step 1: Identify cost pools necessary to complete the product. Musicality determined its cost pools are:

• • Setting up machines
  • Purchasing material
  • Inspecting products
  • Assembling products
  • Technological production

Step 2: Assign overhead cost to the cost pools. Based on historical information, Musicality has estimated the overhead for each cost pool to be:

Step 3: Identify the cost driver for each activity, and estimate an annual activity for each driver. Musicality determined the driver and estimated activity for each product to be the following:

Step 4: Compute the predetermined overhead for each cost driver. Musicality determined this predetermined overhead rate for each driver by using the formula:

Estimated Overhead Costs / Total Activity = ABC Rate per Activity

Step 5: Allocate overhead costs to products. Assuming Musicality’s activities were as estimated, the amount allocated to each product is calculated by using the formula:

Cost Driver * ABC Rate per Activity = Allocated Overhead

Notice that the total overhead for machine setups of $200,000 has now been allocated fairly across the solo, band, and orchestra division.  Now that Musicality has applied overhead to each product, they can calculate the cost per unit. Management can review its sales price and make necessary decisions regarding its products.  During the year, the following information was gathered from musicality’s records.

With this information we can now determine how much overhead should be assigned to each product, determine our gross profit for each product, and verify if our products are being sold for the correct amount.

Total Allocated Product Overhead / Est. # of Units to be Produced = Overhead Cost per Unit

Solo: $1,260,000 / 140,000 = $9.00

Band: $815,000 / 100,000 = $8.15

Orchestra: $ 425,000 / 250,000 = $1.70

The calculations Musicality did in order to switch to ABC revealed that the Solo product was generating a loss for every unit sold. Knowing this information will allow Musicality to consider whether they should make changes to generate a profit from the Solo product, such as increase the selling price or carefully analyze the costs to identify potential cost reductions. Musicality could also decide to continue selling Solo at a loss, because the other products are generating enough profit for the company to absorb the Solo product loss and still be profitable.

Why would a company continue to sell a product that is generating a loss? Sometimes these products are ones for which the company is well known or that draw customers into the store. For example, companies will sometimes offer extreme sales, such as on Black Friday, to attract customers in the hope that the customers will purchase other products. This information shows how valuable ABC can be in many situations for providing a more accurate picture than traditional allocation.

Actual versus Applied Overhead

No matter how you allocate overhead, the actual overhead incurred during the year is rarely equal to the amount that was applied to the individual jobs. Thus, at year-end, the manufacturing overhead account often has a balance, indicating overhead was either overapplied or underapplied.

If, at the end of the term, there is a positive balance in manufacturing overhead, the overhead is considered underapplied overhead. A positive balance in manufacturing overhead shows either that not enough overhead was applied to the individual jobs or overhead was underapplied. If, at the end of the term, there is a negative balance in manufacturing overhead, more overhead was applied to jobs than was actually incurred. This shows the actual amount was overapplied overhead.

Since the overhead is first recorded in the manufacturing overhead account, then applied to the individual jobs, traced through finished goods inventory, and eventually transferred to cost of goods sold, the year-end balance is eliminated through an adjusting entry, offsetting the cost of goods sold. If manufacturing overhead has a positive balance, the overhead is underapplied, and the resulting amount in cost of goods sold is understated. The adjusting entry is:

If manufacturing overhead has a negative balance, the overhead is overapplied, and the resulting amount in cost of goods sold is overstated. The adjusting entry is:

Licensing and Attribution:

Content on this page is adapted from the following openly licensed resource(s):

Principles of Accounting, Volume 2: Managerial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License