What you will learn to do: allocate manufacturing overhead using a single rate and a single base
The simplest way to allocate manufacturing overhead is to base the computation on some reasonable base.
Let’s assume you have obtained the following more detailed income statement for Yore Company:
| Description | Amount | Amount | Total |
|---|---|---|---|
| Subcategory, Sales | $ 1,072,400.00 | ||
| Subcategory, Variable manufacturing costs | |||
| Direct Materials, basic | $ 320,000 | ||
| Direct Labor, basic | 264,000 | ||
| Total direct costs, basic | Single Line | $ 584,000.00 | |
| Direct Materials, deluxe | 117,600 | ||
| Direct Labor, deluxe | 112,000 | ||
| Total direct costs, deluxe | Single Line | 229,600.00 | |
| Fixed Manufacturing Costs | 188,000.00 | ||
| Cost of Goods Manufactured and Sold | Single Line | 1,001,600.00 | |
| Gross Profit | Single Line70,800.00 | ||
| Subcategory, Selling, General, and Administrative Costs | |||
| Variable Selling, General, and Administrative | 18,800.00 | ||
| Subcategory, Fixed Selling, General, and Administrative | 35,600.00 | ||
| Total Selling, General, and Administrative | 54,400.00 | ||
| Net income from operations | Single Line$ 16,400.00Double line | ||
Based on the sales data you received, you see that the company sold 3,760 purses in total, broken down like this:
| Units | $/unit | Total | |
|---|---|---|---|
| Sales | |||
| Basic | 3,200 | $ 245.00 | $ 784,000.00 |
| Deluxe | 560 | $ 515.00 | 288,400.00 |
| Total sales | 3,760 | $ 1,072,400.00 |
The sales manager calculated the cost of each purse by simply taking the total cost of goods manufactured and dividing it equally between all the purses:
$1,001,600 / 3,760 = 266.3829787234… which the sales manager rounded to $266.38 each.
However, it doesn’t take into account the variable costs per type of purse that appear to be quite different.
Let’s take a look at three important numbers which comprise the total cost of goods manufactured:
Total variable direct costs for the basic purse = $584,000
Total variable direct costs for the deluxe purse = $229,600
Total fixed manufacturing overhead (not allocated to either type) = $188,000
From the financial statements, you can figure out the variable cost per purse by dividing the total variable cost by the number of units for each type of purse:
- Variable costs per basic purse = $182.50 ($584,000 / 3,200 units)
- Variable cost per deluxe purse = $410.00 ($229,600 / 560).
One way to allocate the $188,000 in fixed manufacturing overhead would be to simply divide it by the number of units produced: $188,000 / 3,760 = $50 per unit. This would allocate an equal amount of factory overhead to each unit, making the total cost of each unit as follows:
| Basic | Deluxe | |
|---|---|---|
| Direct Variable Costs | 182.50 | $ 410.00 |
| Allocated Fixed Costs | 50.00 | $ 50.00 |
| Total manufacturing cost | Single Line$ 232.50Double line | Single Line$ 460.00Double line |
We can then determine a gross profit per unit that allocates direct variable costs to each product accurately and allocated the fixed overhead equally:
| Basic | Deluxe | |
|---|---|---|
| Sales Price | $ 245.00 | $ 515.00 |
| Less: Direct Variable Costs | 182.50 | $ 410.00 |
| Single Line62.50 | Single Line$ 105.00 | |
| Less: Allocated Fixed Costs | 50.00 | $ 50.00 |
| Gross profit per unit | Single Line$ 12.50Double line | Single Line$ 55.00Double line |
To check our work, let’s multiply the gross profit per unit times the number of units sold:
| Basic | Deluxe | ||
|---|---|---|---|
| Gross profit per unit | $ 12.50 | $ 55.00 | |
| Times number of units sold | 3,200 | 560 | |
| Total gross profit | Single Line $ 40,000Double line | Single Line $ 30,800Double line | |
| Total gross profit – basic | $ 40,000.00 | ||
| Total gross profit – deluxe | 30,800.00 | ||
| Total gross profit, all products | Single Line$ 70,800.00Double line |
That agrees with the gross profit per the financial statements.
Spreading fixed overhead over all the units equally is a fairly simple calculation. However, there may be a better way to allocate fixed manufacturing overhead. If the production manager is correct, and it takes more than twice as long to manufacture a single deluxe purse as it does to manufacture a single basic purse, perhaps the fixed manufacturing overhead allocation could be “weighted.” In other words, we could allocate more fixed overhead to the deluxe purse than to the basic purse. That would reflect the idea that if we shifted resources to produce more deluxe purses, our production capacity for basic purses would be reduced. In other words, if our total production capacity is 5,000 basic purses, it would only be 2,500 deluxe purses, or fewer, because they take longer to make (use more resources).
Therefore, it might be more accurate to allocate more fixed overhead to deluxe purses, but we need a rational, logical way to accomplish that.
Managerial accountants solve this issue by looking for a “base” that accurately reflects the amount of fixed manufacturing overhead being physically allocated to a certain product line. The term “base” is another word for the denominator of a fraction, the amount below the dividing line, that is considered the base of the division problem. For instance, in calculating a percentage, the base is 100 (thus the term “per cent” which means “per 100” or “divided by 100”).
Example: 45% = 45/100
But a base can be anything. Another example is the term “per capita” which means per person. In that case, the base would be the number of people. In 2018, China had a Gross Domestic Product (GDP) of almost $14 trillion (USD). Germany had a Gross Domestic Product of less than $4 trillion (USD). However, China had a population of 1.4 trillion versus Germany’s 83 million. Using population as a base, the per capita GDP for each is:
- Germany GDP/population = $48,000
- China GDP/population = $10,000
By using population as a base, we get GDP per person.
In this section of the module, we’ll explore a single-base system of allocating fixed manufacturing costs using common bases such as direct materials, direct labor hours, and direct labor dollars.
When you are done with this section, you will be able to:
- Calculate predetermined overhead allocation rate
- Allocate manufacturing overhead to cost objects
Learning Activities
The learning activities for this section include the following:
- Reading: Establishing a Fixed Overhead Rate
- Self Check: Establishing a Fixed Overhead Rate
- Reading: Allocating Overhead
- Self Check: Allocating Overhead
