Understanding Manufacturing Overhead, Predetermined Overhead Rate, And Activity-Based Costing

What is Manufacturing Overhead?

• Define “manufacturing overhead,” and:

Cite three examples of typical costs that would be included in manufacturing overhead.

Explain why companies develop predetermined overhead rates.

• Explain why the increase in the overhead rate should not have a negative financial impact on Borealis Manufacturing.

Explain how Borealis Manufacturing could change its overhead application system to eliminate confusion over product costs.

• Describe how an activity-based costing system might benefit Borealis Manufacturing.?

Borealis Manufacturing was previously using QC inspectors for quality control process. The QC inspectors were appointed at each major process and there were a total of 10 inspectors. The salary being paid to the inspectors was charged to the operation as direct labour. However, in order to increase efficiency and quality, the company introduced a computerized video QC system at a cost of $250000. There were 2 QC engineer appointed to operate the cameras. The operating costs of the new QC system and the salary of the two QC engineers is included in the factory overhead in order to calculate the company’s manufacturing overhead rate which is based on direct labour. The Vice President of production is worried as the overhead rate has increased after the execution of new QC system. The manufacturing overhead and the overhead rate before and after are as below:

	Before	After
Budgeted Manufacturing Overhead	1900000	2100000
Budgeted Direct  Labour Cost	1000000	700000
Budgeted Overhead rate	190%	300%

Manufacturing Overhead also known as Factory Overhead can be defined as the indirect costs which are incurred in the production of a product along with direct material and direct labour. The manufacturing overhead costs should be assigned to each unit produced so that the cost of goods sold and the inventory can be valued and reported as per the generally accepted principles (GAAP).

There are also non – manufacturing costs like selling and administrative expenses which are incurred during the course of the business, but these costs are presented in the Income Statement as expenses represent a part of the total cost. They are not assigned to the product for inventory and COGS purposes.

There are many costs which form a part of the manufacturing overhead, however three types of costs that will typically be included in production include:

Salaries and wages of people involved in inspection of the product, maintenance of the equipment, cleanliness of the manufacturing area, material handling, setting up the manufacturing equipment and the factory management team.

Depreciation on the plants and equipments and the facilities used in production

Examples of Manufacturing Overhead Costs

Electricity, water, natural gas costs incurred in the production facilities and equipment.

A pre- determined overhead rate is the allocation rate which is used by the company to allocate the estimated manufacturing overhead costs to each unit of product for a specified reporting period. The rate is used so that the accounting books can be closed quickly since a lot of time will be wasted in compiling the actual manufacturing overhead and allocating the same. The predetermined rate can be computed as follows:

Estimated allocation base for the period

There are two bases which can be used for determining the pre – determined overhead rate which are Machine Hours and Labour Hours. Machine and labours are directly involved in production of goods and hence it can be identified as to how many hours are required by the machine to produce a part or the time taken by the labour to assemble a part of the machinery. The pre – determined overhead rate can be used to allocate the resources available to a company and therefore help in setting of the prices of the product.

The overhead rate helps in allocating manufacturing overheads to a particular product. The total manufacturing overhead will be allocated to all the products on basis of overhead rate. No matter how much cost is allocated to which product, the total manufacturing overhead will remain the same and will be reported as the inventory and the cost of goods sold in the financial statements. These amounts will be reasonably correct. Moreover, as long as the factory overhead appears in the financial statements as the cost of goods sold, the financial statements will be accurate and will receive a clean audit report. E.g. in the above case, the total manufacturing costs before the installation of the new system is $1900000 allocated to the products produced by Borealis on the basis of direct labour cost.  Even when the manufacturing overhead has increased to $2100000, the same will be allocated on the basis of labour cost. Since the overhead rate is higher in the new system, a product requiring more labour will be allocated higher manufacturing overhead. However, the total manufacturing overhead as reported in the financial statements in the form of cost of goods sold will remain $2100000, thereby not affecting the financial statements.

In order to avoid confusion over the apportionment of indirect costs to the products, Borealis Manufacturing can look at changing its costing system to make it more efficient and appropriate. Currently, the direct labour cost is the allocation base for manufacturing overhead allocation. After installation of the new system, the direct labour cost has gone down from $1000000 to $700000, and the manufacturing overhead as increased from $190000 to $2100000, thus increasing the overhead absorption rate to 300% from 190%. Hence, a product/process requiring more labour will be allocated higher manufacturing overhead even if the product/process does not form a major part of the total production or process of the company. Thus, the allocation might be inappropriate.

Predetermined Overhead Rate and Its Significance

In order, to remove the inefficiency in resource allocation, Borealis should adopt a costing method which allocates the overhead costs in a more logical manner and not purely on the basis of direct labour cost. Currently there may be products which require higher machine hours and the machine hour rate may be more than the direct labour cost rate. So the products with more machine hours and less labour hours will be allocated lower overhead cost since the overhead rate is based on direct labour cost. Whereas, in terms of costs, more costs are being incurred for the said product. Hence, in order to eliminate this flaw of assigning manufacturing overhead costs on the basis of only one particular basis like machine hours or labour hours/cost is incorrect, a better way of cost apportionment would be through  Activity Based Costing (ABC) which takes into consideration the reason for the incurring of the manufacturing overhead i.e. which activity is causing the overhead to incur and then it assigns the costs to the products which demand the most of those activities, thus making the allocation more logical.

Activity Based Costing is a two process system where the overhead costs are assigned to the activities in the first stage and then the costs are allocated from these activities to the products in the second stage. The basic assumption in ABC costing is that the overhead costs are incurred due to a number of activities and the different products use these activities in a non- homogenous manner. Thus there may be some activities which are more expensive than the other. A product which uses most of the expensive activity will be assigned higher overhead costs. The various steps involved in Activity Based Costing are as follows:

Identification of all activities involved in the process of production

Classification of the activity on the basis of cost hierarchy

Identification of the total costs for every activity identified

Identification of the cost drivers for each activity

Estimation of the total units of the cost drivers relevant for each activity

Calculation of the activity usage rate by dividing the activity cost per unit by the relevant cost driver

Apportionment of the cost of each activity to the product based on the activity rate.

In the above case of Borealis, the various activities and the relevant cost drivers to that activity could include:

Activity	Relevant Cost Driver
Production of parts	Number of machine hours
Assembly of parts	Number of labour hours
Set up costs	Number of set ups
Product testing	Number of testing hours
Designing	Number of designer hours
Differences in the units	Number of differences
Packaging	Number of units
Shipping	Number of units
Rent	Labour cost

Many organisations have adopted the ABC costing method of resource allocation as it is more appropriate and logical; however, the system has its own limitations which may hold the company from implementing the system:

Expensive implementation – the implementation of ABC costing is very expensive and time consuming as it involves breaking down the process into various activities. It can lead to using of company resources as data is collected and entered in the system. Use of software for ABC, appointment of a specialised consultant and training of the employees are other costs of introducing ABC costing.

Misinterpretation of Data – the accounting standards accept the traditional costing and not the activity based costing. Hence, interpreting the ABC cost allocation with the regular accounting information can lead to misleading and bad decision making.

However, the benefits of ABC costing are more as compared to the limitations and a company should use software to integrate its information with the regular cost accounting information.

References

Mahal, I., Hossain, A., (2015), Activity Based Costing (ABC) – An Effective Tool for Better Management, Research Journal of Finance and Accounting, Vol. 6, No.4

Anderson, R., Steven, and Kalpan, (2003), ‘Time Driven Activity – Based Costing’

Joan, M., (2009), Traditional Versus Activity-Based Product Costing Methods: a field study in a Defense Electronics Manufacturing Company, Proceedings from ASBBS Annual Conference

Roztocki, N., Schultz, S.M., (2003), Adoption and Implementation of Activtiy- Based Costing: A Web – Based Survey, State University of New York at New Paltz School of business