Question

I am trying to understand how to determine and adjust overhead costs at year end.

Answer 1

Overhead costs are those product costs which cannot be
directly traced to units of output. Hence, they are to be
assigned to the units of output on a reasonable basis.
As costs are to be ascertained as and when production
takes place it is necessary to have a predetermined
overhead rate for assignment of overhead.
The predetermined overhead rate is calculated as:
Estimated overhead for the period/Estimated base for
assignement of overhead.
The basis for assignment may be direct labor hours,
direct labor cost, machine hours etc, as may be deemed
appropriate.
Once the OH predetermined rate is calculated, it is
applied to the WIP as and when production takes place.
But, the OH rate is applied to the actual base. It is
OG rate*Actual base. At the end of the period there will
be a difference between the actual overhead and the
overhead assigned. This is due to two reasons:
1] Change in amount spent with respect to the amount
of estimated overhead for the period.
2] Change in the actual units of the base chosen, when
compared with the estimated actual units at the
beginning of the period.
This difference is called underapplied overhead or
overapplied overhead, accordingly as the actual OH is
more than or less than the overhead applied.
The underapplied or overapplied overhead is closed to
COGS if it is not material.
If it is material it is prorated to the FG, WIP and COGS on
the basis of the overhead amounts already applied.
Let us consider an example:
The actual overhead may be taken as:
Indirect material used in production	$            5,000
Factory supplies used	$            5,000
Depreciation on the factory	$         50,000
Factory security guard cost	$         10,000
Factory supervision	$         80,000
Depreciation on production equipment	$      1,00,000
Actual overhead	$      2,50,000
Let us further suppose that the predetermined OH at
the beginning of the period was ascertained as $250000/50000 DLH =	$              5.00	per DLH
Again let us suppose that the actual DLH
is 49000 or 51000.
If it is 49000 the OH assigned = 49000*5 =	245000
The underapplied overhead would be	5000
If the actual DLH is 51000 the OH applied is	255000
The overhead overapplied is	5000
The underapplied overhead or over applied overhead
is transferred to COGS.

If it is underapplied OH, it would be to the debit of COGS and if it is overapplied

overhead it would be to the credit of COGS. This is the final adjustment of OH

expenses. This is done when the difference is not material.

If the difference is material, the under or overapplied OH amount is transferred to

WIP, FG and COGS in proportion of the overhead assigned to each.

The adjustment is to reflect the actual costs in the cost of production and income

statement.