Allocated Overhead

Learning Outcomes

  • Allocate manufacturing overhead to jobs

Before we allocate Factory Overhead to the projects, let’s assume that Jackie received payment on Job 1 from Dhanila Parboteeah in the amount of $2,000 on July 28, and she delivered the completed skateboard to the customer. Normally this would trigger a transfer on the books of the cost of the product from Work in Process to Finished Goods Inventory.

Two horizontal flowcharts are shown. The first flow chart is labeled “Physical flow of inventory”. It shows four boxes, from left to right, Materials storeroom, Production departments, Finished goods storeroom, and Delivered to customers. The second flowchart is labeled “Job costing”. It shows four boxes, from left to right, Raw Materials inventory, Work in Process inventory, Finished Goods inventory, and Cost of Goods Sold. Below Work in Process inventory, there are two additional boxes pointing to it, Direct labor and Manufacturing overhead. The Manufacturing overhead box is highlighted.

However, in our example, we are going to assume Jackie will make that journal entry at the end of the month so that we can see more clearly how this all ties together. When she received the cash from the customer, she only records the sale of the item:

Date Account/Explanation Debit Credit
Jul 28 Checking Account         2,000
      Sales Revenue           2,000
Payment on Job 1.

 

For now, we’ll omit showing the results of posting this transaction.

Now, Jackie wants to allocate Factory Overhead to the jobs to see if she is making or losing money on these discrete projects. With the help of her managerial accounting friends, she has come up with an initial allocation rate of $3 per direct labor dollar. So, for every dollar in direct labor she pays to the college students, she will allocate $3 in Factory Overhead.

Person skateboardingThe Factory Overhead account is used to record all factory expenses except direct materials and direct labor. Rather than Supplies Expense, Maintenance Expense, Depreciation Expense, Insurance Expense, Wages Expense (indirect), etc., the Factory Overhead account is used to substitute for any expense incurred in the factory. Factory overhead costs are indirect because they cannot be specifically traced to particular jobs but are instead incurred in the factory as a whole. Factory Overhead is debited (increased) for any actual overhead cost incurred. While these expenses are in the Factory Overhead account, they are not yet part of any of the manufactured items.

Materials, such as wood, may be requisitioned for general factory use. These materials are considered an indirect cost since they do not become part of a manufactured item. Materials is credited just like it was for the requisition of direct materials. In this case, Factory Overhead is debited for the indirect materials rather than Work in Process.

If the same production employees also perform some general factory work, such as hanging the wood shelves, the labor is considered indirect since the time is not spent working on an actual manufactured item. Wages Payable is credited just like it was for the direct labor. In this case, Factory Overhead is debited for the indirect labor rather than Work in Process.

Wages Expense is not used because the indirect expense occurs in the factory, where all expenses are accounted for as Factory Overhead.

Factory expenses accumulate in the Factory Overhead account. Notice the Work in Process is not used at all in these transactions, so at this point, the third cost of manufacturing has not been added to the cost of any job yet.

For MaBoards, we have only included one expenditure item in Factory Overhead in order to keep the example as simple as possible. The ledger at the end of the month appears as follows:

Factory Overhead
Debit Credit
2,500
Double line2,500 Double line

 

This third cost of production, factory overhead, must be added (or “applied”) to Work in Process to arrive at the total cost of the job(s). This final debit to Work in Process allocates an estimated amount of the factory expenses from the Factory Overhead account to the cost of each unit manufactured.

In reality, since all expenses associated with the period may not yet be determined and all bills not yet received, actual factory overhead is not yet known. The running balance of $2,500 shown may be incomplete since more bills may be outstanding. However, since the company needs timely information about the cost of each job, factory overhead is estimated at the time it is applied to Work in Process. That is why companies use standard rates and will apply Factory Overhead throughout the month as jobs are completed.

Also, since factory overhead cannot be specifically traced to a particular job, it is instead allocated to jobs using an activity base that estimates its consumption. Each company uses a method of estimating that makes sense for them, so the process can vary among companies.

Three common plant-wide activity bases used to allocate factory overhead costs are (1) a percentage of direct labor cost, (2) number of direct labor hours, or (3) number of machine-hours. When units such as hours are used, a predetermined factory overhead rate is multiplied by the number of hours. The predetermined factory overhead rate equals estimated total factory overhead costs divided by the estimated number of hours in the activity base.

In this example, assume total estimated factory overhead is $3,000. It will be allocated, or applied to jobs, using a predetermined factory overhead rate that uses an activity base of an estimated $1,000 direct labor costs. Therefore, Jackie is using a standard rate of $3/DL$.

She makes this calculation on the job cards or job sheet:

Job 1 Job 2 Job 3 Total WIP
Subcategory, Direct Materials
      Wood 100 100 100 300
      Wheels/trucks 50 100 150
Direct Labor 400 600 1000
Overhead allocation 1200 1800 0 3000
Total Job Cost Single Line1750Double line Single Line2600Double line Single Line100Double line Single Line4450Double line

 

The Factory Overhead account is reduced by crediting it, and that expense amount is moved into the Work in Process (asset) account by debiting it.

Date Account/Explanation Debit Credit
Jul 31 Work In Process         3,000
      Factory Overhead           3,000
To allocate factory overhead to jobs.

 

This journal entry represents the third of the three debits to the Work in Process account. As shown in the ledger accounts, the third cost of production, factory overhead, has been added (or “applied”) to Work in Process to arrive at the total estimated cost of the job(s).

A journal entry dated July 31 shows a debit of $3,000 to Work in Process and a credit of $3,000 to Factory Overhead with the note “To allocate factory overhead to jobs”. Each line item in the journal entry points to the corresponding debit or credit on its respective t-account.

This also indicates that based on information posted to the ledgers so far, Factory Overhead has been over-allocated by $500. However, as noted earlier, not all transactions may have been posted. Remember that managerial accounting uses estimates to come up with real-time information for decision making. Jackie is using a reasonable estimate for applying Factory Overhead to jobs, instead of waiting until mid-August for the financial accountants to finish their work.

However, Jackie does notice that indirect materials have not been applied to Factory Overhead yet. She counts the quantity of paint and lacquer and other non-direct material in inventory, assigns a cost, and determines that the cost of ending Raw Materials – indirect is $700. This means her workers used $300 in building the products. This has already been assigned to the jobs since indirect materials are part of Factory Overhead, but the cost of those materials needs to be moved from inventory (on-hand) to overhead (used up).

Date Account/Explanation Debit Credit
Jul 31 Factory Overhead           300
      Raw Materials – Indirect               300
To adjust indirect materials to actual on hand.
A journal entry dated July 31 shows a debit of $300 to Factory Overhead and a credit of $300 to Raw Materials - indirect with the note “To adjust indirect materials to actual on hand”. Each line item in the journal entry points to the corresponding debit or credit on its respective t-account.

Before we move on to finish the month-end reporting and reconciliations, check your understanding of the process of allocation overhead to jobs.

Practice Question