We have to write a very detailed analysis of why predetermined overhead rate sho
ID: 2377873 • Letter: W
Question
We have to write a very detailed analysis of why predetermined overhead rate should be accurate. The professor went on and explained the important parts that we should discuss. I do not exactly understand everything he said but I will type it down here. First let me explain what the question is:It is dealing with this company that uses direct labor hours as their allocation base of manufacturing overhead. The under-applied or over-applied overhead is closed out to cost of goods sold at the end of the year. What they are doing is that they use less labor hours for the estimate of their predetermined overhead rate than what they think the actual number of hours should be. This way they end up in a high increase in net operating income at the end of the year.
OK .. here we should start the analysis:
so from what I understand, decreasing the estimated total amount of allocation base (labor hours) would increase predetermined overhead rate. OK.. from here I get confused.. Here are my notes from what the professor was saying, if someone could put it in a paragraph form and explain it to me I would really really appreciate it, it is 10% of my grade. so here are my notes:
explain what likely to take place in the company? if the application rate is too high, what happens to product cost? overstated? so inventory overstated?
lets say we only record at the end of the year, and we have no beginning inventory, whatever we produce we sell, and we expense everything (we sold everything).
inventory cost all high, but all is expended, so now adjust to COGS and bring it back to what it should have been.. COGS would be exactly the same. so other stuff going on?
we have inventories, now year end, interim reports showing overstated (something), inventories overstated .. what happens?
Thank you so much!
Explanation / Answer
OVERHEAD AND COST DRIVERS: The application of overhead to specific jobs is mostly an exercise in algebra. Jack applied overhead at the rate of $20 for each hour of direct labor. A similar mathematical exercise is used to apply overhead in the highly automated factory environment. Some predetermined scheme is used to apply the overhead to production. However, in a highly mechanized environment, one must give careful thought to the "cost driver." The cost driver is the factor that is viewed as causing costs to be incurred within an organization; it is best viewed only in an abstract context, as there are too many individual variables for any single factor to fully explain all cost incurrence. For Jack Castle's business, direct labor hours were viewed as the primary cost driver and the basis for assigning overhead. Labor hours may not be the most significant cost driver in a mechanized setting. Machine hours, number of direct material bar code scans, fuel consumption, spot-welds, or number of assembly steps could each provide a potentially logical base for allocating overhead. This choice must be logical, as it will govern the allocation of total overhead costs to individual products. It is a bit frightening to consider that product pricing, CVP analysis, inventory values, decisions to discontinue a product, and so forth are dependent upon costing information that is driven by arbitrary overhead allocation choices. This underscores the importance of careful methodology in correctly identifying cost drivers. To do otherwise could result in costing some products too high and others too low. This might lead to overproduction of unprofitable products and discontinuance of profitable lines. How is this possible? Suppose a computer manufacturer allocated overhead based on the installation of RAM memory chips. As a result, a machine with 2 GB of memory would absorb twice as much overhead as a machine with 1 GB. This is probably not a good idea; there is little difference in the production process needed to manufacture the two machines (save and except the difference in direct material cost for memory chips). The faulty overhead allocation could cause management to conclude that the 2 GB machines were too costly to produce, while the 1 GB machines seem a relative bargain. In short, the amount of memory is probably not the leading cost driver. Management accountants have long fretted about the overhead allocation problem. With so much at stake, quite a lot of thought has been put into ways to improve this effort. In the next chapter, you will discover "activity-based costing." ABC seeks to overcome some of the issues just described by dividing production into its component processes ("activities") and more closely associating overhead with each unique process. But, ABC has its own limitations, so do not be too quick to dismiss the merits of the overhead allocation approach introduced in this chapter. OVERVIEW Numerous cost accounting concepts can benefit management in decision-making, both for manufacturing and service companies. While many of the concepts discussed below are applicable to both types of companies, the basis for ease of discussion will be that of a manufacturing company. Therefore, some of the concepts to be discussed include understanding the distinction between manufacturing and non-manufacturing costs (and how these are disclosed in the financial statements), computing the cost of manufacturing a product (or providing a service), identifying cost behavior in order to utilize cost-volume-profit relationships, setting prices, budgeting and budgetary controls, and capital budgeting. These topics will be briefly discussed below. MANUFACTURING VS. NON-MANUFACTURING COSTS Manufacturing costs are those costs incurred by a producer of goods that are needed to transform raw materials into finished products, ready to sell. These costs consist of the cost of basic materials and components, plus the costs of labor and factory overhead needed to convert the materials into finished products. Materials and labor can be classified as either direct or indirect in relation to the final product. Direct materials are those major components that can be easily traced to the finished good and are accounted for carefully due to their significance to the product. In the case of manufacturing a lawn mower, for example, these types of materials would include the engine, housing, wheels, and handle. Indirect materials would include those minor items that are essential but which cannot be easily traced to the finished product. Examples of these would be screws, nuts, bolts, washers, and lubricants. One might say that the cost of keeping an account of each of these indirect items exceeds the benefit derived from having the information. Consequently, the costs of these items are accumulated as part of factory overhead and prorated to products on some.Direct labor refers to the efforts of factory workers that can be directly associated with transforming the materials into the finished product, such as laborers who assemble the product. Indirect laborers are those whose efforts cannot be traced directly or practically to the finished product. The indirect laborers would include maintenance personnel and supervisors. COMPUTING THE COSTS OF PRODUCING A PRODUCT OR SERVICE Manufacturing companies use a variety of production processes in creating goods. These processes include job shops, batch flows, machine-paced line flows, worker-paced line flow, continuous flows, and hybrids that consist of more than one of the previous separate flow process. The type of production process to a certain extent determines the type of product costing system that a company utilizes. Job shops, such as machine shops, receive orders for products that are manufactured to the unique blue-print specifications of the requesting customer. As such, it would be rare for these products to meet the needs of any other customer. Thus each "job" must be accounted for separately as the goods are produced and no goods would be produced on a speculative basis. An appropriate method to determine the cost of each unique item produced is activity-based costing (ABC). This method is discussed in detail elsewhere in this publication; please see Activity-Based Costing. The essence of ABC costing is that the exact costs of materials and labor, and a highly accurate estimate of factory overhead costs based on the specific activities (cost drivers) incurred to produce the goods, are determined for each unique product. COST BEHAVIOR One of the critical steps in decision-making is the estimation of costs to be incurred for the particular decision to be made. To be able to do this, management must have a good idea as to how costs "behave" at different levels of operations; i.e., will the cost increase if production increases or will the cost remain the same? A common use of cost behavior information is the attempt by management to predict the total production costs for units to be manufactured in the upcoming month. There are several methods used to estimate total product costs: the high-low method, a scatter-graph, and least-squares regression. Each of these methods attempts to separate costs into components that remain constant (fixed) in total regardless of the number of units produced and those that vary in total in proportion to changes in the number of units produced. Once the behavior of costs is known, predictive ability is greatly enhanced. Use of the high-low method requires the use of only two past data observations: the highest level of activity (such as the number of units produced during a time period) and the associated total production cost incurred at that level, and the lowest level of activity and its associated cost. All other data points are ignored and even the two observations used must represent operations that have taken place under normal conditions. The loss of input from the unused data is a theoretical limitation of this method. SETTING PRICES Setting the price for goods and services involves an interesting interaction of several factors. The price must be sufficient to exceed the product and period costs and earn a desirable profit. For normal sales to external customers, most companies are unable to unilaterally set prices. Prices are typically set in these competitive markets by the laws of supply and demand. However, if a company manufactures a product unique to customer specifications, or if the company has a patent to its product, then the company can set its own price. One approach to accomplish this is cost-plus pricing. As discussed above, the company must have knowledge of the costs that it will incur. Then the company can apply the proper markup, given the competitive market conditions and other factors, to set its target-selling price. BUDGETING AND BUDGETARY CONTROLS Managers use budgets to aid in planning and controlling their companies. A budget is a formal written expression of the plans for a specific future period stated in financial terms. Jerry Weygandt, Donald Kieso and Paul Kimmel's book, Managerial Accounting: Tools for Business Decision Making lists the following benefits of budgeting: CAPITAL BUDGETING Companies with excess funds must make decisions as to how to invest these funds in order to maximize their potential. The choices that involve long-term projects require the use the technique of capital budgeting, that is, choosing among many capital projects to find those that will maximize the return on the invested capital. Several methods of capital budgeting are available to management; among these are the payback period method, the net present value method, and the internal rate of return method. All of these methods require the use of estimated cash flow amounts.
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