Question

• Explain how manufacturing overhead is allocated to jobs. Why is manufacturing overhead applied to products when product costs are used in making pricing decisions. Discuss the benefits of using a predetermined overhead rate instead of an actual overhead rate. Discuss one advantage and one disadvantage of prorating over-applied or under-applied overhead.

Answer 1

Manufacturing overheads is allocated to job based on pre-determined overhead absorption rate at the beginning of the year. The predetermined overhead rate is calculated based on estimated manufacturing overheads and estimated cost driver. The estimated cost driver can be direct labor cost, direct labor hours or machine hours. Based on actual consumption of cost driver the predetermined overhead rate is applied to the job.

Direct material and direct labor cost are directly traceable to a product. Manufacturing overheads facilitate the production activities and not directly traceable to a product. Hence it becomes imperative to apply manufacturing overhead to products. Manufacturing overheads are part of product cost but they are indirect cost. Allocation of manufacturing overheads reflects the full cost of product and helps in reliable product pricing.

Benefits of using pre-determined overhead rate

· It saves time and effort of management by not requiring to calculate overhead rate often when actual overheads are incurred

· It helps in product costing with uniform overheads application and eliminates fluctuations in cost

· It helps in reliable product pricing based on product cost

· It helps in decision making. For example: Continue or drop product lines, submitting bids, serving export orders, etc

Advantage of pro-rating over-applied or under-applied overhead

· The entire cost is not charged to cost of goods sold and pro-rating is rational since it is allocated to both work in process and finished goods inventory and cost of goods sold

Disadvantage of pro-rating over-applied or under-applied overhead

· Since all overheads are ultimately charged to income statement this is often considered as additional activity at the month end