Question

Aomi, a new Japanese automotive parts manufacturer, will be implementing job-order costing and would like to use a predetermined overhead rate to apply its manufacturing overhead to jobs. However, the company's controller, Hiroshi Itoma, would like your input on his contemplation of which denominator-level driver would be more appropriate for the company to use: machine hours or direct labor hours.

The facts he has provided to you are:

Within the manufacturing process, the employees work in small groups of three to five employees. Based on trial production runs, the company believes there will be more direct labor hours than machine hours in the manufacturing process.

Using your understanding of how to apply manufacturing overhead in a job-order costing environment, what do you think would be the more appropriate basis of overhead application: machine hours or direct labor hours? Why do you believe that is the best answer? Given the choice of driver, are there any implications to consider for underapplied or overapplied overhead?

Answer 1

Even though the company believes that there will be more direct labour than machine hours in the manufacturing process, it is expected that the factory overheads may mainly consist of maintenance and repairs of machinery,depreciation,power consumption due to operation of machines and other indirect expenses. These over heads are expected to be more than the direct labour cost. It is also mentioned in the problem that the employees work in small groups of 3 to 5 within the manufacturing process.

Therefore it is suggested that the allocation of manufacturibng overheads on the basis of machine hours will be more appropriate.

Since the overheads are absorbed based on pre determined over head rate, the actual overheads normally vary resulting in under-absorption or over-absorption . For arriving at profitability, the actual overheads are to be considered. If the overheads are under absorbed , the difference has to be added to the absorbed overheads to arrive at actual cost. Otherwise the same has to be deducted from over absorbed overheads to arrive at the actual cost.

If the variation between actual overheads and absorbed overheads are considerable, the pre-determined rate may be recalculated considering the actual overheads.