Section C Process Costing Spoilage in Process Costing Spoilage is the term used for defective units that are not transferred to the next process. When there is spoilage, some of the costs of production will be allocated to the spoiled units. These spoiled units become an additional step in the calculation of EUP because they did have some work done on them prior to becoming spoiled. This is similar to treating spoilage as another form of ending WIP - the units were started, but never finished. It is also possible that they were finished but were designated as spoiled when inspection took place at the end of the process. But fundamentally, the spoiled units are more like EWIP because they are not transferred to the next department. The spoiled units will also receive the cost per EUP. We will look at this treatment of the costs later. As covered earlier, all of the costs that are in the department (either as Beginning WIP or incurred during the period) must be moved out of the department at the end of the period to either finished goods (FG) or Ending WIP. However, now that we add spoilage to the situation, there is another possible treatment for costs that are incurred in the process during the period. If there are spoiled units in the process, we must allocate the material costs and conversion costs to these spoiled units. The amount that will be allocated is done through the EUP and will depend on when the unit is identified as spoiled. EUP for Spoilage for Conversion Costs If the units are inspected at the end of the process, each spoiled unit will represent one complete EUP and will receive the same costs as a good unit produced during the period. If, however, the inspection is made at the halfway point (or any other point) in the process, then the spoiled units will have only one half (or the applicable % based on when the inspection takes place) of an EUP for conversion costs. EUP for Spoilage for Materials The EUP for materials will depend on when the materials are added to the process. Allocation of Costs to the Spoiled Units After the cost per EUP of materials and conversion costs are calculated as discussed above, the company will allocate costs to each unit, including the spoiled units. This is done in the same manner as the allocation to EWIP - the number of EUP for spoiled units is multiplied by the cost per EUP. Again, this will probably be done separately for materials and conversion costs. Transferring the Costs of Spoiled Units After determining the costs of the spoiled units, they must be transferred somewhere at the end of the period. (These costs will be some amount of materials and conversion costs.) It is obvious that these units are neither finished goods nor work-in-process, but the costs have been incurred in the department and must be moved out of the department. The treatment of spoilage costs will depend on the type of spoilage. Spoilage is classified as either normal spoilage or abnormal spoilage. Normal spoilage is the level and amount of spoilage that normally occurs during the process, and abnormal spoilage is any spoilage in excess of this normal expected amount of spoilage. I Note: The amount of spoilage that is considered normal will be given to you in the question. 221 Process Costing CMAPart 1 Normal Spoilage If the spoilage is normal spoilage, the costs that have been allocated to the normally spoiled units are added to the costs of the good units that are transferred to finished goods (or the next department). This will cause the cost per unit transferred in to the next department to be higher than the cost of producing a good unit in the current department. Abnormal Spoilage Abnormal spoilage is all spoilage in excess of the normal level of spoilage. The costs that have been allocated to the abnormal spoiled units will be expensed on the income statement in that period as a loss from abnormal spoilage. It is generally considered that production management can control abnormal spoilage because normal spoilage is expected to occur and generally cannot be prevented. However, abnormal spoilage, by definition, should not occur and should therefore be preventable. Note: When there is more than one point at which inspection of goods is made, the costs of normal spoilage should be charged to the good units that pass through that inspection pOint. This means that the costs of normal spoilage will continue through the process and not go to cost of goods sold. It is only the final inspection that will transfer costs to cost of goods sold for spoiled units. Additional Classifications of Spoilage Below are some additional terms that are similar to spoilage. Shrinkage Shrinkage is when a product simply evaporates or losses some of its quantity through time. We account for it in the same manner as spoilage - if it is normal it is charged to good units produced and if it is abnormal it is charged to the income statement. Rework When spoiled goods are fixed and prepared for sale, this is called rework. The costs incurred in rework of normally spoiled goods should be charged to the factory overhead account and allocated to all good units as part of factory overhead. Costs incurred in rework of abnormally spoiled units should be expensed. Waste Waste is the material that is left over after production is complete. It is simply unused and is now unusable materials. Question 127: A company that manufactures baseballs begins operations on January 1. Finished baseballs are inspected and defective ones are pulled out. Defective baseballs cannot be economically salvaged and are destroyed. Normal spoilage is 3% of the number of baseballs that pass inspection. Cost and produc tion reports for the first week of operations are: Raw materials cost - $840 and Conversion cost - $315. During the week 2,100 baseballs were completed and 2,000 passed inspection. There was no ending WIP. Calculate abnormal spoilage. a) $33 b) $20.35 c) $22 d) $1,100 (CIA Adapted) 222 Section C Process Costing Question 128: Nance Co. began operations in January 2005 and uses the FIFO Process Costing method in its accounting system. After reviewing the first quarter results, Nance is interested in how the equivalent units produced would have been different if the weighted average method had been used instead. Assume that the number of units in ending work-in-progress were the same at the end of January, February and March and that at the end of each month they were the same percentage complete. If Nance had used the weighted average method, the EUP for conversion costs for each of the first two months would have compared to the FIFO method in what way? Januarv Februarv a) Same Same b) Greater number Greater number c) Greater number Same d) Same Greater number (HOCK) Question 129: Atthe end of the first month of operations, Larkin had 2,000 units in ending WIP that were 25% complete as to conversion costs. All materials are added at the end of the process. The number of equivalent units of conversion costs would be: a) Equal to the number of units completed during the period. b) Less than the number of equivalent units of materials. c) Less than the number of units completed during the period. d) Less than the number of units placed into the process during the period. (HOCK) Question 130: A company employs a process cost system using the FIFO method. The product passes through both Department 1 and Department 2 in order to be completed. Units enter Department 2 upon completion in Department 1. Additional direct materials are added in Department 2 when the units have reached the 25% stage of completion with respect to conversion costs. Conversion costs are added proportionally in Department 2. The production activity in Department 2 for the current month was: Beginning work-in-process inventory (40% complete with respect to conversion costs) Units transferred in from Department 1 Units to account for Units completed and transferred to finished goods Ending work-in-process inventory (20% complete with respect to conversion costs) Units accounted for How many equivalent units for direct materials were added in Department 2 for the current month? a) 70,000 units. b) 80,000 units. c) 85,000 units. d) 90,000 units. 15,000 80.000 95.000 85,000 10.000 95.000 (CMA Adapted) 223 Process Costing CMAPart 1 Question 131: The following data pertain to a companys cracking-department operations in December. Work-in-process, December 1 Units started Units completed and transferred to the distilling department Work-in-process, December 31 Materials are added at the beginning of the process and conversion costs are incurred uniformly through out the process. Assuming use of the FIFO method of process costing, the equivalent units of conversion performed during December were: a) 170,000 equivalent units. b) 175,000 equivalent units. c) 180,000 equivalent units. d) 185,000 equivalent units. Units 20,000 170,000 180,000 10,000 Completion 50% 50% (CIA Adapted) Question 132: A manufacturing firm has a normal spoilage rate of 4% of the units inspected; anything over this rate is considered abnormal spoilage. Final inspection occurs at the end of the manufacturing process. The firm employs the first-in, first-out (FIFO) method of inventory flow. The processing for the current month was as follows: Beginning work-in-process inventory Units entered into production Units completed and passing inspection Units failing final inspection Ending work-in-process inventory The equivalent units assigned to normal and abnormal spoilage for the month would be: Normal Siloilage Abnormal Siloilage a) 904 units 21,696 units b) 18,432 units 4,168 units c) 18,816 units 3,784 units d) 19,336 units 3,264 units 24,600 units 470,400 units (460,800) units ( 22.600) units 11 600 units (CIA Adapted) 224 Section C Process Costing Question 133: Assume 5,500 units were worked on during a period when a total of 5,000 good units were completed. Normal spoilage consisted of 300 units; abnormal spoilage, 200 units. Total production costs were $2,200. The company accounts for abnormal spoilage separately on the income statement as loss due to abnormal spoilage. Normal spoilage is not accounted for separately. What is the cost of the good units produced? a) $2,080 b) $2,120 c) $2,200 d) $2,332 (CIA Adapted) Question 134: During May 2005, Mercer Company completed 50,000 units costing $600,000, exclusive of spoilage allocation. Of these completed units, 25,000 were sold during the month. An additional 10,000 units, costing $80,000, were 50% complete at May 31. All units are inspected between the completion of manufacturing and transfer to finished goods inventory. Normal spoilage for the month was $20,000, and abnormal spoilage of $50,000 was also incurred during the month. The portion of total spoilage that should be charged against revenue in May is a) $50,000 b) $20,000 c) $70,000 d) $60,000 (CMA Adapted) 225 Overhead Allocation CMAPart 1 Overhead Allocation Introductory Note on Overheads There are actually two main types of overheads - manufacturing (or factory) overheads and nonmanufactur ing overheads. In general, overheads are costs that cant be traced directly to a specific product or unit. Manufacturing overheads are overheads that are related to the production process (factory rent and electricity, for example), whereas nonmanufacturing overheads are not related to the production process. Examples of nonmanufacturing overheads are accounting, advertising, cafeteria and general corporate administration. In these materials, we will first look at the allocation of manufacturing overheads. This is covered in a variety of methods that include standard allocation, activity-based costing, process costing, job-order costing, and life-cycle costing. The allocation of nonmanufacturing overheads is covered in the section on service cost allocation. However, some of the concepts and ideas covered in manufacturing overhead are also applicable in the allocation of nonmanufacturing overheads. Note: In order to help these study materials flow more easily, we will use the term overhead in the majority of Situations, even when the term manufacturing overhead would be more technically accurate. If we use the term manufacturing overhead in every Situation, the language becomes very cumbersome and more difficult to read. Also, the term factory overhead can be used in place of manufacturing overhead because the two are interchangeable terms. Manufacturing Overhead Allocation We have already covered the three main classifications of production costs. These are: 1) Direct materials, 2) Direct labor, and 3) Manufacturing (or Factory) Overhead. Direct materials (DM) and direct labor (DL) are usually simple to trace to individual units or products because these costs are directly and obviously part of the production process. As such, there is little emphasis put on the determination of DM and DL on the CMA Exam. Rather, the emphasis is on the allocation of overhead. Overheads are production and operation costs that a company cannot trace to any specific product or unit of a product. Because these costs are incurred and paid for by the company and are necessary for the production process, it is essential that the company know what these costs are and allocate them to the different products that are produced. This must occur so that the full costs of production and operation are known in order to set the selling prices for the different products. If a company does not take overheads into account when it determines the selling price for a product, there is significant risk that it will price the product so that it is actually selling at a loss. The price that a company charges may cover the direct costs of production, but it may not cover all of the indirect costs of production. In this section we will talk about the allocation of manufacturing overheads in much greater detail. In later sections we will examine the allocation of nonmanufacturing overheads. The categories of costs included in factory overhead (OH) are: 1) Indirect materials - materials not identifiable with a specific product or job, such as cleaning supplies, small or disposable tools, machine lubricant and other supplies; 2) Indirect labor - salaries and wages not directly attributable to a specific product or job, such as plant superintendent, janitorial services and quality control; and 3) General manufacturing overheads, such as facilities costs (factory rent, electricity and utilities) and eqUipment costs. 226 Section C Overhead Allocation Note: Remember that factory overhead and manufacturing overhead are interchangeable terms that mean the same thing. Either may be used in a question. Overheads may be either fixed or variable (or mixed). A fixed overhead, like a fixed cost, is one that does not change over the relevant range of activity or production. An example of a fixed manufacturing overhead is factory rent. Variable overheads are costs that change as the level of production changes. Examples are plant electricity, equipment maintenance, utilities, etc. The number of ways a company can allocate overhead are numerous and limited only by the imagination of the accountant, and now, the computer programmer. However, for the CMA Exam, there are only a few methods of allocation with which you need to be familiar. But, no matter the manner of allocation, it is simply a mathematical exercise of distributing the overhead costs to the products that were produced using some sort of basis and formula. Standard (Traditional) Allocation Method Traditionally, manufacturing overhead costs have been allocated to the individual products based on either the direct labor hours, machine hours, materials cost, units of production, weight of production or some similar measure that is easy to measure and calculate. The measure used is called the activity base. If a company allocated factory overhead based on direct labor hours, this meant that for every hour of direct labor that went into a specific unit, a certain amount of factory overhead (the determination of how much is covered below) would be allocated (or applied) to that product. By adding together the direct materials, direct labor and allocated manufacturing overhead, a company can determine the total cost of production. Determining the Basis of Allocation When choosing the basis of allocation (for example, direct labor hours or machine hours), it is important that the basis used for the allocation closely reflects the reality of the way in which the costs are actually incurred. For example, in a company that is highly automated, direct labor would most likely not be a good allocation basis for factory overhead because labor would not be a large part of the production process. In a company that produces very large, heavy items (such as an appliance manufacturer), the best basis to allocate overhead may be the weight of each product. To best reflect the way that manufacturing overhead is incurred, it is preferable to use different methods of allocation in different departments. This is necessary because different departments incur these manufacturing overhead expenses differently. A department that paints needs to allocate costs based on square footage or meterage of the painted products, while a department that assembles products may allocate costs based on the number of parts in a product. The more manufacturing overhead allocation rates used, the more accurate the allocation process will be. However, this increase in the accuracy of the number will be offset by additional costs in the allocation process. The more bases used to allocate overhead, the more costs will be incurred to obtain the needed information for the allocation. Therefore, a company needs to find a balance between the usefulness of having more than one overhead allocation basis against the cost of making the needed calculations for the additional bases. Note: The only time that it may be applicable to use only one rate for the factory is when production is limited to a single product or to different, but very similar products. 227 Overhead Allocation CMAPart 1 Calculating the Manufacturing Overhead Allocation Rate Once the method, or basis, of manufacturing overhead allocation is determined, it is necessary to calculate the predetermined manufacturing overhead allocation rate. This is the amount of manufacturing overhead that will be charged (allocated) to each unit of a product for each unit of the allocation basis (direct labor hours, machine hours, and so on) used by that product (direct labor hour, machine hour, and so on) during production. The rate that is used to allocate overhead is calculated at the beginning of the year and it will be used to allocate manufacturing overheads throughout the year. It is important to remember that this manufacturing overhead allocation rate is calculated at the beginning of the year and then used throughout the year. Because it is done at the beginning of the year, it must use budgeted, or expected, amounts. This rate is called the predetermined rate because it is calculated at the start of the period. This predetermined rate, used throughout the period, is calculated as follows: Budgeted Dollar Amount of Manufacturing Overhead Budgeted Activity Level It is critical that you use the budgeted (expected) amounts in this calculation. These are the costs and units of the allocation method that the company expects to incur or use during the upcoming year. Again, the company determines the allocation rate at the start of the year and uses it for the entire year for the application of the manufacturing overhead costs. Clearly, the rate that is calculated at the beginning of the year is not going to be the actual rate that occurs during the year. However, in order to determine the cost of goods produced throughout the year, an estimated rate must be used. A company cannot wait until the end of the year to determine what the cost of production was. Note: The calculation of the allocation rate that we will look at can also be done on a weekly or monthly basis. In such a situation, the process would be exactly the same except that the budgeted numbers would be for the upcoming week or month (or whatever time period is used). U This is the number of expected direct labor hours, direct labor cost, material cost, or machine hours for use during the period used as allocation basis. This is discussed in greater detail on the following page. 228 Section C Overhead Allocation Determining the Level of Activity In relation to the allocation rate, the company must decide what level of activity to use for its budgeted amount of the activity level. This is the decision regarding how many machine hours, or direct labor hours, the company plans to use during the year. As this is one of the two figures used in the determination of the manufacturing overhead rate, it will greatly impact the allocation rate. In Section A of this book, we discussed the four choices for the activity level to use in calculating a standard cost for overhead. The same four options are also available when determining the activity level to use for manufacturing overhead allocation, even if standard costing is not being used. The four options are: • Theoretical, or ideal, capacity - the level of activity that will occur if the company produces at its absolute most efficient level at all times. This is not a good basis to use because a company will not be able to achieve this level in the long run, and manufacturing overhead will be underapplied. (We will take a more detailed look at under- and overapplied manufacturing overhead later.) • Practical (or currently attainable) capacity - the theoretical level reduced by allowances for idle time and downtime, but not for a decrease in sales demand. Though this basis is more realistic than theoretical capacity, it is still too optimistic and will also result in an underapplication of manufac turing overhead. This is because the amount that will be allocated for each machine hour (or direct labor hour) will be less than the amount that is actually used as a result of dividing the expected manufacturing overhead amount over more expected units. This leads to a smaller amount being ap plied per machine hour (or whatever the allocation base is). • Expected actual capacity utilization (or master budget capacity utilization) - the amount of output actually expected during the next budget period based on expected demand. This level will result in a different overhead rate for each budget period because of increases or decreases in planned production due to expected increases or decreases in demand. • Normal capacity utilization - the level of activity that will be achieved in the long run, taking into account seasonal changes in the business and cyclical changes. Seasonal changes in business result from the seasons during the year and cyclical changes are connected to the larger business cycle. Normal capacity utilization is the level of activity that will satisfy average customer demand over a long-term period such as 2-3 years. The method that a company should use depends on the given situation and upon the companys purpose in using the activity level. If the capacity utilization is being used in pricing decisions, the use of normal capacity can result in fixed overhead costs being spread over a small number of output units, causing high per-unit costs. This can result in high, noncompetitive selling prices and lead to a downward demand spiral. A downward demand spiral is a continuing reduction in demand that occurs when costs are too high. As demand drops, the cost per unit gets higher and higher, leading to more price increases, which lead to more reduction in demand, and so forth. For example, a total cost per unit when fixed cost per unit is based on a low production level may cause a bid to be higher than it would be if it were based on fixed costs with a higher production level. This can cause the company to lose the business, which would cause the production level to be used in the next bid to be even lower and the price even higher. In this case, the use of theoretical capacity or practical capacity would avoid increasing unit costs if expected demand levels decrease. Normal capacity is often used as a basis for long-term (multi-year) plans. For long-term planning purposes, the cost to produce one unit should not be higher in one accounting period than in another simply because demand and thereby production levels are expected to be lower and the fixed costs are spread over fewer units. Since normal capacity is a long-run average, it has no particular meaning for judging current performance. Using normal capacity to evaluate current performance is misusing a long-run measure for a short-run purpose. The master budget capacity utilization is more meaningful for current period planning and control. 229 Overhead Allocation CMAPart 1 The company will have an under-application of manufacturing overhead any time the actual overhead incurred is greater than the amount of manufacturing overhead applied to production (the level of production achieved). This means that the manufacturing overhead charged to the products was actually less than the actual incurred manufacturing overhead. On the other hand, if the amount of manufacturing overhead applied is greater than the amount actually incurred, the manufacturing overhead will be over-applied, meaning that more manufacturing overhead was charged to the products than was incurred by the company. At the end of the accounting period, variances that result from differences between the actual overhead incurred and the overhead applied must be resolved as part of the closing activities. These variances may be prorated among ending work-in-process, ending finished goods, and cost of goods sold for the period. Or, they may be 100% closed out to cost of goods sold. A third approach (though not often used) is to restate all amounts using actual cost allocation rates rather than the budgeted cost application rates. If 100% of the variances are closed out to cost of goods sold, the use of master budget capacity or normal capacity will lead to the highest net income of these choices. This will be true whether actual overhead incurred is greater than overhead applied (i.e., overhead is under-applied) or whether overhead incurred is less than overhead applied (i.e., overhead is over-applied). When master budget or normal capacity is used, the denominator level used will be the lowest of all the methods. (In some years, master budget capacity may be lower than normal capacity; and in other years, normal capacity may be lower than master budget capacity.) That means the resulting application rate will be the highest. Therefore, more manufacturing overhead will be allocated to the products throughout the period than it will be if theoretical or practical capacity is used. So, more manufacturing overhead will be included in the finished goods and work-in-process inventories on the balance sheet at the end of the period than would be the case with usage of the other denominator levels. When the variances are 100% closed out to cost of goods sold, no adjustment is made to inventories as part of the closing entries. So inventories under normal capacity will remain higher than under the other methods. Since inventories are higher, cost of goods sold will be lower. That is the reason why net income will be higher when normal capacity is used and 100% of the variances are written off to COGS. However, if variances caused by differences between the actual manufacturing overhead incurred and the overhead applied are prorated among inventories and cost of goods sold or if the amounts are restated using actual rates, the choice of the denominator level for allocating manufacturing costs during the period will have no effect on the end-of-period financial statements. Net income will be the same no matter which capacity level is used to set the overhead allocation rate for the period. We will look at both over- and under-applied manufacturing overhead in more detail later. Note: In some sources only the capacity concepts of theoretical (ideal) and practical (currently attainable) are given. Allocating Manufacturing Overhead to the Units Once the overhead allocation rate is determined, the company can allocate overhead to the individual units that are produced. This is done by multiplying the predetermined rate by a given number of units of the allocation basis that were either actually used or that were supposed to be used in the production of each unit. This is a very simple mathematical operation, but it becomes a little more involved because the company must make a decision about which cost allocation method to use. 230 Section C Overhead Allocation Costing System Methods The amount of manufacturing overhead allocated to each unit of product depends upon the costing system that the company uses. There are three systems that you need to be aware of, and you must know how manufacturing overhead is allocated to a unit under each method. The three methods are standard, normal and actual costing systems. • In a standard costing system, the company will multiply the predetermined manufacturing over head rate (calculated earlier) by the standard number of the allocation base that should be used in producing one unit of product. • In a normal (or extended normal) costing system, the predetermined manufacturing overhead rate (calculated earlier) is multiplied by the actual number of the allocation base that was used in producing the product. • In an actual costing system, actual direct labor and materials costs are charged to the units, and the actual manufacturing overhead costs are allocated to the units. Because actual costing does not use a predetermined rate to allocate manufacturing overhead (it is done when the actual costs are known), you need to focus on standard and normal costing and understand how manufacturing overheads are charged to the individual products under these two methods. This is shown in the following table: Application Rate Allocation Base Standard Costing Standard (or Predetermined) Rate Normal Costing Predetermined Rate Standard Usage of Allocation Base Actual Usage of Allocation Base The following pOints should be noted when comparing the three costing systems: 1) All three costing systems record the cost of inventory based on actual output. 2) Direct labor and direct materials are treated the same under normal and actual costing. 3) Normal and standard costing use the same overhead rate. 4) Standard costing is typically used with a flexible budget system. Standard costing is based on the inputs (i.e., direct materials, direct labor and factory overhead) that should have been used for the actual output produced. It is important in a question that you identify whether the company uses standard or normal costing. If the company uses standard costing, you are interested only in the standard number of machine, direct and labor hours allowed to produce the units. The actual amount is necessary only if the company uses normal costing. 231 Overhead Allocation CMAPart 1 Example: RedHawks Co. produces bookshelves for shipment to distributors. The manufacturing overheads of RedHawks in 2010 are expected to be $250,000. In a perfect situation, Red Hawks has the capacity to produce 40,000 bookshelves. Last year, Red Hawks produced 38,000 bookshelves, which was the most in company history. Management thinks that this was attributable to a performance bonus that was in place for management in 2009, but was not given in 2010. For the 7 years prior to last year, Red Hawks produced an average of 35,000 bookshelves, with production always between 33,500 and 36,500. The CFO of Red Hawks is trying to determine how much it will cost to produce each bookshelf. He knows to do this, the manufacturing overhead must be included in each of the units. Calculating the Predetermined Rate If Red Hawks uses the theoretical capacity, the allocation rate will be $6.25 per unit ($250,000 + 40,000 units). If the manufacturing overhead allocation rate is determined using last years performance (practical capacity), the allocation rate will be $6.58 per unit ($250,000 + 38,000 units). Finally, if they use what had been the normal capacity prior to 2009, it would be $7.14 ($250,000 + 35,000 units). Allocation of Manufacturing Overhead Under the Traditional Method Let us assume that Red Hawks actually produces 34,500 units in 2010. (Given the fact that there was no information about any other part of the process, overhead must be allocated per unit.) Under each of the three levels of capacity, there would be a different amount of manufacturing overhead allocated to the products. The allocation is made by multiplying the actual number of units by the predetermined rate. Under theoretical capacity, Red Hawks would have allocated $215,625 (6.25 x 34,500 units). Under last years capacity, it would have allocated $227,010 (6.58 x 34,500 units). Under the normal capacity, it would have allocated $246,330 (7.14 x 34,500 units). Summary Analysis As you can see, because the actual production was different from any of the bases used, the amount of overhead allocated was not correct. However, the amount of overhead allocated under normal capacity would be the closest to the expected amount of $250,000. If Red Hawks had used the theoretical base at the beginning of the year in its calculation of cost per unit, the company would have run the risk of underpricing the bookshelves. This is because the amount of overhead would have been allocated to too many bookshelves - overhead would have been allocated to bookshelves that would never be made. 232 Section C Overhead Allocation The Process of Accounting for Factory Overhead As factory overhead costs are actually incurred, they are placed in a factory overhead (OH) control account with the following journal entry: Dr Factory Overhead Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X This account collects all of the actual factory overhead costs that the company incurs during the year. It is from this account that overhead will be allocated to work-in-process and then to finished goods. As each unit is produced, some of this cost (using the predetermined rate calculated earlier) is transferred to the Work-in-Progress (WIP) account with this journal entry: Dr WIP Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X The Work-in-Progress account is one of the inventory accounts for the company (the others are finished goods and raw materials), and when the overheads are transferred into the WIP account, they become what we call applied. What is happening in the accounting process is that the Factory OH Control account is receiving the actual costs that the company incurs, and then the costs are allocated out from the Factory OH Control Account to the to the WIP account and applied to goods that are produced, using some sort of budgeted rate. Graphically it looks like this: Cr Cash or Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X Cr Factory Overhead Control ................................................. X Actual Costs Factory Overhead Account Work-in-Process Inventory Account @ Budgeted Manufacturing Overhead Rate x Allocation Basis The amount allocated out from the Factory OH Control Account will not be exactly the same amount as the actual costs that came into the Factory OH Control account when the actual costs were incurred. If the amounts that come out during a period are less than the incurred amounts, the overhead is under-applied. If the amounts that come out during a period are greater than the incurred amounts, overhead is over applied. The amount of the difference is a variance, and it remains in the Factory OH Control Account until the period is closed. This will be explained in more detail in the pages that follow. After the costs are moved into the WIP account, they will be in one of three places in the financial statements at the end of the year. Where they are on the financial statements depends on what happened to that unit by the end of the year. The three possible locations in the financial statements are: 1) Cost of Goods Sold on the income statement if the item has been sold, 2) Finished Goods Inventory on the balance sheet if the item has been completed, but not sold, or 3) Ending WIP on the balance sheet if the item has not been completed. 233 Overhead Allocation CMA Part 1 Over-Applied and Under-Applied Manufacturing Overhead Chances are very good that the actual costs incurred and/or the actual level of activity during the period will be different from the estimation at the start of the year. This is problematic because of the fact that the actual costs are being allocated using the budgeted costs and budgeted usage of the allocation basis. If the actual costs or usage are different from the budgeted, this allocation will be, in essence, incorrect. n As a result, the overhead control account will have a balance in it at the end of the year. This balance may be positive or negative, but in any case it needs to be eliminated from this account. If the balance is a debit balance (a balance still remains in the OH Control account), it means that we under applied factory overhead to the products. In other words, the amount of factory overhead that was applied during the period was less than the actual factory overhead incurred during the period. Alternatively, if the OH Control account has a credit balance (negative balance), it means we over-applied factory overhead to the products. In other words, the amount of factory overhead that was applied during the period was greater than the actual factory overhead costs incurred during the period. The amount of over- or under-applied factory overhead is calculated as follows: Actual Costs Incurred Factory Overhead Applied During the Period = Under (OYer) Appljed Factorv Overhead In either of these Situations, the company needs to correct this imbalance, because it is not reasonable to have a balance in this account at the end of the period. Therefore, this remaining balance (the amount over or under-applied) in the overhead control account must be removed from the account. The way we transfer out this remaining over- or under-applied balance depends on whether the balance is immaterial or material. Immaterial Amount If the under-applied amount is immaterial it will simply be charged to COGS in that period. This will increase the COGS amount and decrease the profit for the period. If the over-applied amount is immaterial, this will be taken out of COGS, reducing this amount and increasing the profit for the period. Material Amount If the amount that was over- or under-applied is material, it must be distributed to the WIP Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. This distribution will be made proportionally to each of these three accounts based upon the number of units in each of these categories. An under-applied amount will be added to these accounts while an over-applied amount will be taken out of these accounts. The process of the allocation of the material over- or under-applied overhead makes it as if the correct, actual rate of allocation had been used during the year. In the case of the under-application of overhead, this adjustment at the end adds to the value (or cost) of each of the goods produced during the year. In the situation of over-applied overhead, this allocation reduces the value (or cost) of each item produced during the period. 234 Section C Overhead Allocation Comprehensive Example of Accounting for Fixed Overhead and FOH Variances The following example should help to clarify the way manufacturing overhead is handled in a standard cost accounting environment. This example focuses on fixed overhead because fixed overhead is a little more difficult to see, conceptual ly, than the variable manufacturing costs. However, the basic principles are applicable to all manufacturing costs, because all manufacturing costs are applied to units as the units are produced. The difference between fixed overhead costs and variable costs (both variable overhead and direct costs) is that for fixed overhead, the predetermined overhead rate per unit of the allocation base is a calculated amount, calculated by dividing the fixed total by the anticipated volume. If production volume increases or decreases, the total fixed cost does not change as long as the volume stays within the relevant range. With variable costs, this per unit calculation is not necessary because the cost per unit is a given, known amount; and the total cost increases when volume increases and decreases when volume decreases. However, variable costs are applied to production as production progresses, just as fixed costs are. This example integrates the concepts from budgeting, performance management (variance reporting) and overhead allocation that we have studied so far in this book. 1) When the company makes up its budget for the coming year, it determines what its budgeted fixed manufacturing overhead will be. For this example, budgeted fixed manufacturing overhead for the coming year is $10,000,000. 2) The company projects how many units it will produce during the year. This is where the different capacity levels that a company may use come in. Those are covered in this textbook in the section on Budgeting, under the heading Determining the Level of Activity. Review those if you need to before reading further. The company must decide what capacity level it will base its forecast on for the num ber of units it will plan to produce. For simplicitys sake, we will assume this company has only one product. So we will say that the company projects it will produce 1,000,000 units, using whichever capacity level it chooses to use. 3) The company sets the standard for the quantity of the application base to be used for each unit to be produced. This company is allocating fixed overhead on the basis of machine hours, and each unit is expected to require 5 machine hours. Therefore, 5,000,000 machine hours will be required to produce 1,000,000 units. 4) The company takes its total budgeted fixed manufacturing overhead for the coming year ($10,000,000) and divides it by the 5,000,000 machine hours it plans to use in the coming year. This gives it the budgeted, or standard, fixed overhead cost per unit of the cost allocation base used. This per unit amount is also called the predetermined rate. The standard (predetermined) fixed overhead rate for the coming year is $2 per machine hour and, since 5 machine hours are required per unit, it is $10 per unit. 5) The next year begins. Fixed overhead costs (like rent, plant supervisor and janitorial salaries, etc.) are paid, and manufacturing production progresses. As each fixed cost is incurred, the accounting department debits an account called Factory Overhead Control for the cost and credits Accounts Pay able or whatever other account is appropriate (i.e., accrued compensation costs for salaries). The actual costs will almost certainly not be exactly equal to the budgeted cost of $10,000,000. In this case, the actual total fixed overhead costs for the year turn out to be $11,000,000 when the year is over. 235 Overhead Allocation CMAPart 1 6) At the same time as the actual costs are being paid, the cost accountants are getting reports from the factory floor about the number of units being manufactured. For each unit that is manufactured, the cost accountants apply 5 machine hours x $2 per machine hour, or $10 of fixed overhead to that unit. They do not worry about what the actual costs are at this pOint. When the accountants apply the fixed overhead, they debit Work-In-Process Inventory and credit Factory Overhead Control for $10 of fixed overhead for each unit manufactured. (The same thing is done for variable costs, as welL) This is done because as the year progresses, no one knows what the actual fixed costs incurred will be at the end of the year. But by applying this predetermined rate to production, the company can have a close estimate of what its total production costs are as the year goes on. During the year, 1,200,000 units are manufactured. Therefore, 1,200,000 x $10, or $12,000,000 of fixed overhead will be ap plied to the units produced. This applied overhead flows first to Work-In-Process inventory, then to Finished Goods Inventory as the units are completed, and finally, when the units are sold, to Cost of Goods Sold. 7) By the end of the year, the company has three amounts: Budgeted fixed overhead of $10,000,000; Actual fixed overhead of $11,000,000; and Applied fixed overhead of $12,000,000. The Total Fixed Overhead Variance is the Actual Fixed Overhead of $11,000,000 minus the Applied Fixed Overhead of $12,000,000, or $(1,000,000). Because $1,000,000 more overhead was applied than was actually incurred, the fixed overhead is over-applied by $1,000,000. 8) The company must make the year-end account balances reflect only the Actual fixed overhead incurred, because both the budgeted and the applied fixed overhead are just estimates. This Total Fixed Overhead Variance of $(1,000,000) right now is in the Factory Overhead Control account. Remember we said that as actual costs are paid, they are debited to the Factory OH Control account, and as the overhead is applied to production, the amount applied is credited to the Factory OH Con trol account. Therefore, the Factory OH Control account has been debited for $11,000,000 and credited for $12,000,000. It has a credit balance of $(1,000,000), which is also the Total Fixed Over head Variance. That variance will be moved out of the Factory OH Control account by the accountants in the year-end adjusting entries they will make. 9) The Total Fixed Overhead Variance can be split into two different variances, to permit management to better analyze it and understand what caused it. Those two variances are: 10) Fixed Overhead Budget (or Fixed Overhead Spending) Variance, which is Actual Fixed Overhead Incurred minus Budgeted Fixed Overhead. Here, that is $11,000,000 - $10,000,000, whi � is $1,000,000. This is a positive number, because Actual Fixed Overhead Incurred was greater than Budgeted Fixed Overhead. This might be considered an Unfavorable variance, because actual costs were higher than planned. However, remember that actual production was 1,200,000 units, which was 200,000 greater than the 1,000,000 units that were planned. So actually, the fixed overhead cost per unit was less than planned, because the fixed overhead cost per unit actually produced was $11,000,000 .;. 1,200,000 units, or $9.16 per unit. 11) Fixed Overhead Production-Volume Variance. This variance is Budgeted Fixed Overhead minus Applied Fixed Overhead. Here, that will be $10,000,000- $12,000,000, which is $(2,000,000), a negative number. This variance tells management that more fixed overhead was applied than had been budgeted for. The reason more fixed overhead was applied than was budgeted for is, of course, because production was higher than planned. And that is a good thing. So a negative Fixed Over head Production-Volume Variance is a Favorable variance. 12) These two variances - $1,000,000 Fixed Overhead Budget Variance plus $(2,000,000) Fixed Overhead Production-Volume Variance - total to $1,000,000, which is the Total Fixed Overhead Va riance.
Posted on: Sun, 17 Nov 2013 05:53:37 +0000
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