Question

How FOH are estimated, applied and compared. What is the result of the comparison of actual and applied FOH?

Answer 1

By definition, overhead cannot be traced directly to jobs. Most company use a predetermined overhead rate (or estimated rate) instead of actual overhead for the following reasons:

A company usually does not incur overhead costs uniformly throughout the year. For example, heating costs in a Steel Plant are greater during winter months. However, allocating more overhead costs to a job produced in the winter compared to one produced in the summer may serve no useful purpose.

Some overhead costs, like factory building depreciation, are fixed costs. If the volume of goods produced varies from month to month, the actual rate varies from month to month, even though the total cost is constant from month to month. The predetermined rate, on the other hand, is constant from month to month.

Predetermined rates make it possible for companies to estimate job costs sooner. Using a predetermined rate, companies can assign overhead costs to production when they assign direct materials and direct labor costs. Without a predetermined rate, companies do not know the costs of production until the end of the month or even later when bills arrive. For example, the electric bill for July will probably not arrive until August. If Steel Plant had used actual overhead, the company would not have determined the costs of its July work until August. It is better to have a good estimate of costs when doing the work instead of waiting a long time for only a slightly more accurate number.

Predetermined overhead rates

Predetermined overhead rates are used to apply overhead to jobs until we have all the actual costs available. To create the rate, we use cost drivers to assign overhead to jobs. A cost driver is a measure of activities, such as machine-hours, that is the cause of costs. To assign overhead to jobs, the cost driver should be the cause of the overhead costs, or at least be reasonably associated with the overhead costs. Just as automobile mileage is a good cost driver for measuring the cause of petrol consumption, machine-hours is a measure of what causes energy costs. By assigning energy costs to jobs based on the number of machine-minutes or hours the job uses, we have a pretty good idea of the energy costs required to produce the job.

Most manufacturing and service organizations use predetermined rates.

To calculate a predetermined overhead rate, a company divides the estimated total overhead costs for a period by an estimated base (or expected level of activity). This activity could be total expected machine-hours, total expected direct labor-hours, or total expected direct labor cost for the period. Companies set predetermined overhead rates at the beginning of the year in which they will use them. This formula computes a predetermined rate:

Predetermined Overhead Rate (POHR) =	Estimated Overhead
Estimated Base

Notice how the predetermined rate is based on ESTIMATED overhead and the ESTIMATED base or level of activity. To apply overhead, we will use the actual amount of the base or level of activity x the predetermined overhead rate. Again, to apply overhead use this formula:

Applied Overhead

= Actual amount of base x POHR

To demonstrate, assume the accountants at Steel Plant estimated overhead related to machine usage to be $ 100,000 for the year and estimated the machine usage for the year to be 8,000 machine-hours. Thus, the predetermined overhead rate would be calculated as follows:

Predetermined Overhead Rate (POHR) =	Estimated Overhead =	$100,000	= $12.5 per machine hour
	Estimated Base	8,000 machine hours

If we want to apply overhead to jobs. Job 1 had 800 machine hours and Job 2  had 4,00 machine hours. The calculation for actual overhead for each job would be:

Job	ACTUAL machine hours	POHR	Overhead applied
1	800	x $12.5	$ 100000
2	400	x $12.5	$ 50000
Total Overhead applied	$ 150000

Actual Overhead

Actual Overhead costs are the true costs incurred and typically include things like indirect materials, indirect labor, factory supplies used, factory insurance, factory depreciation, factory maintenance and repairs, factory taxes, etc. Actual overhead costs are any indirect costs related to completing the job or making a product.

We know overhead is applied using estimated or budgeted overhead and a base. Actual overhead costs may be different and we will not have all of those costs until late in the year. Estimated may be close but is rarely accurate with what really happens, so the result is Over-applied or Under-applied Overhead. At the end of the year, we will compare the applied overhead to the actual overhead and if applied overhead is GREATER than actual overhead, overhead is over-applied. If applied overhead is less than actual overhead, overhead is under-applied. But how do we correct it? Let us take the same example of Steel Plant mentioned above to get clear idea --

As we have seen above, that the Steel Plant had applied overhead to Jobs 1and 2 for a total amount of $150000 Actual overhead was $148000 in total. If we compare applied overhead $150000 and actual overhead $148000, we see a difference of $2000 over-applied since the applied amount is greater than the actual overhead.   Companies generally transfer the balance of the Overhead account to Cost of Goods Sold at the end of the accounting period. Some companies do this monthly; others do it quarterly or annually. The journal entry to transfer Steel Plant’ overhead balance to Cost of Goods Sold for the month of Aug  is as follows:

	Debit	Credit
Overhead	2000
Cost of goods sold		2000
To record over-applied overhead.

Why does the previous entry reduce the Cost of Goods Sold by $2000? The overhead cost applied to the jobs was too high—it was overapplied. Thus, the cost of jobs was overstated or we charged to much cost to jobs. Although those jobs are still in Work in Process or Finished Goods Inventory, companies usually adjust the Cost of Goods Sold account instead of each inventory account. Adjusting each inventory account for a small overhead adjustment is usually not a good use of managerial and accounting time and effort. All jobs appear in Cost of Goods Sold sooner or later, so companies simply adjust Cost of Goods Sold instead of the inventory accounts.

If applied overhead ($150000)was less than actual overhead(152000), we have under-applied overhead or not charged enough cost. The entry to correct under-applied overhead, using cost of goods sold, would be

	Debit	Credit
Cost of goods sold	2000
Overhead		2000
To record under-applied overhead.