2.4 Actual Vs. Applied Factory Overhead

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 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 Creative Printers 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 gasoline 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 Creative Printers estimated overhead related to machine usage to be $ 120,000 for the year and estimated the machine usage for the year to be 60,000 machine-hours. Thus, the predetermined overhead rate would be calculated as follows:

Predetermined Overhead Rate (POHR) = Estimated Overhead = $120,000 = $2 per machine hour
Estimated Base 60,000 machine hours

If we want to apply overhead to jobs.  Job 106 had 875 machine hours and Job 107 had 4,050 machine hours.  The calculation for actual overhead for each job would be:

Job ACTUAL machine hours   POHR Overhead applied
106 875 x $2 $ 1,750
107 4050 x $2  8,100
Total Overhead applied $ 9,850

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.  Next, we look at how we correct our records when the actual and our applied (or estimated) overhead do not match (which they almost never match!).

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