Applying Overhead to Jobs

Overview

• What you’ll learn: Why manufacturing overhead requires a predetermined rate, how to calculate the predetermined overhead rate, how to select an appropriate allocation base, and how to apply overhead to individual jobs throughout the period.
• Prerequisites: Lesson 1 — Job Costing Systems. Understanding of the three cost categories on a job cost sheet.
• Estimated reading time: 18 minutes

Introduction

The Grand Historian records: Direct materials and direct labor are the loyal soldiers of cost accounting — they march straight to the job that commands them, and their allegiance is never in doubt. But manufacturing overhead is the mercenary army — electricity that lights the entire factory, depreciation on machines used by many jobs, the salary of the supervisor who oversees all production. These costs serve many masters, and assigning them to any single job requires an act of allocation that is part science, part art, and part diplomatic negotiation.

The fundamental problem is this: manufacturing overhead costs are indirect. You cannot look at the electricity bill and say, “Exactly $47.23 of this went to Job #407.” You cannot watch the factory roof depreciate and assign a precise fraction to each job sitting on the production floor. Yet these costs are real, they are substantial (often exceeding direct labor in modern manufacturing), and they must be included in the cost of each job if we are to know the true cost of production.

The solution, elegant in its pragmatism, is the predetermined overhead rate — a rate calculated at the beginning of the period that allows overhead to be applied to jobs as work progresses, rather than waiting until year-end when actual overhead is finally known.

Why We Cannot Use Actual Overhead

A reasonable person might ask: Why not simply wait until all overhead costs are known and then divide them among the jobs? The answer reveals three fundamental problems:

The Timeliness Problem

Many overhead costs are not known until month-end or year-end. Property taxes might be billed annually. Utility bills arrive monthly. Insurance is often paid in advance. If we waited for actual overhead, we could not determine job costs until the period was over — far too late for pricing decisions, profitability analysis, or management action.

The Fluctuation Problem

Actual overhead per unit fluctuates wildly from month to month due to seasonal variations. A heating plant consumes enormous energy in winter and almost none in summer. If we used actual overhead, identical jobs completed in January and July would show dramatically different costs — not because the jobs were different, but because the calendar changed. This is misleading and useless for decision-making.

The Volume Problem

Fixed overhead costs (rent, depreciation, salaried supervisors) remain constant regardless of production volume. In a slow month with few jobs, each job would absorb a disproportionately large share of fixed overhead. In a busy month, each job would appear artificially cheap. Again, the variation reflects production volume, not the actual resources consumed by the job.

The Predetermined Overhead Rate

To escape these three traps, we calculate a predetermined overhead rate (POHR) at the beginning of the accounting period using budgeted (estimated) figures:

Predetermined Overhead Rate = Budgeted Manufacturing Overhead Costs
                              ÷ Budgeted Amount of the Allocation Base

A Worked Example

Suppose TopGiga Manufacturing estimates the following for the coming year:

• Budgeted manufacturing overhead: $600,000
• Budgeted direct labor hours: 40,000 hours

POHR = $600,000 ÷ 40,000 DLH = $15 per direct labor hour

This rate is established before the year begins and remains fixed for the entire period. Every job that passes through the factory will be charged $15 of overhead for each direct labor hour consumed. No surprises, no monthly fluctuations, no waiting until December to know costs.

Choosing the Allocation Base

The allocation base is the denominator of the POHR formula — the activity measure used to link overhead costs to individual jobs. The choice of allocation base is one of the most consequential decisions in cost accounting, for it determines how the burden of overhead is distributed among jobs.

Common Allocation Bases

The Causality Principle

The ideal allocation base has a causal relationship with overhead costs — the activity that drives overhead should be the base used to allocate it. In a factory dominated by automated equipment, machine hours drive most overhead costs (depreciation, maintenance, power), so machine hours should be the base. In a labor-intensive workshop, direct labor hours are the better choice.

Choosing the wrong allocation base distorts product costs. A labor-intensive job in a machine-dominated factory would be over-costed using machine hours (it uses few machines but occupies many workers), and under-costed using labor hours. This is why modern cost accounting increasingly favors activity-based costing (ABC) — a topic for advanced study — which uses multiple allocation bases tied to specific activities.

Applying Overhead to Jobs

Once the POHR is established, overhead is applied to each job as it progresses through production:

Overhead Applied to a Job = POHR × Actual Amount of the Allocation Base Used by the Job

Example: Applying Overhead to Three Jobs

Using our POHR of $15 per direct labor hour:

The journal entry to apply overhead:

Dr. Work-in-Process Inventory    6,000
    Cr. Manufacturing Overhead       6,000

Notice that the credit goes to the Manufacturing Overhead account, not to Cash or Accounts Payable. The Manufacturing Overhead account is a temporary clearing account: actual overhead costs are debited to it as they are incurred, and applied overhead is credited to it. The balance remaining at year-end reveals whether we applied too much or too little — a topic for Lesson 3.

The Manufacturing Overhead Account

The Manufacturing Overhead account operates as a bridge between actual costs and applied costs:

Throughout the year, actual overhead is debited as costs are incurred, and applied overhead is credited as jobs consume the allocation base. At year-end, we compare the two sides:

• If debits > credits: overhead is under-applied (we did not apply enough).
• If credits > debits: overhead is over-applied (we applied too much).

Departmental Overhead Rates

Many organizations use departmental overhead rates rather than a single plantwide rate. Each production department calculates its own POHR based on its own budgeted overhead and its own allocation base. This is more accurate because different departments may have very different cost structures:

• Machining Department: Capital-intensive, uses machine hours as the base.
• Assembly Department: Labor-intensive, uses direct labor hours as the base.
• Finishing Department: Materials-intensive, uses direct materials cost as the base.

A job passing through all three departments receives overhead from each at different rates, yielding a more accurate total cost than a single blended rate would provide.

Key Takeaways

• Manufacturing overhead cannot be traced directly to individual jobs — it must be allocated using a predetermined rate.
• Actual overhead cannot be used in real time due to timeliness, fluctuation, and volume problems.
• The predetermined overhead rate (POHR) = Budgeted Overhead ÷ Budgeted Allocation Base, calculated at the start of the period.
• The allocation base should have a causal relationship with overhead costs — common bases include direct labor hours, machine hours, and direct labor cost.
• Overhead is applied to each job using: POHR × Actual allocation base consumed by the job.
• The Manufacturing Overhead account accumulates actual costs (debits) and applied costs (credits); the year-end balance reveals over- or under-application.
• Departmental rates are more accurate than a single plantwide rate when departments have different cost structures.

What’s Next

In Lesson 3, we shall confront the inevitable reckoning: What happens when overhead applied does not equal overhead incurred? You will learn the concepts of over-applied and under-applied overhead, and the methods for disposing of the difference at year-end — proration versus the simpler COGS adjustment.

預定分攤率 = 預算製造費用 ÷ 預算分攤基礎數量

POHR = $600,000 ÷ 40,000 = 每直接人工小時 $15

批次分攤之費用 = 預定分攤率 × 該批次實際使用之分攤基礎數量

予定配賦率 = 予算製造間接費 ÷ 予算配賦基準量

POHR = $600,000 ÷ 40,000 = 直接作業時間あたり$15

ジョブ配賦額 = 予定配賦率 × そのジョブが実際に使用した配賦基準量