that at the beginning of 200 I, Conquest’s management makes the following estimates relating to bicycle manufacturing
activity for the upcoming year Using the above estimations, we will illustrate the use of an overhead application rate under two independent assumptions. Assumption
1: Conquest Uses Direct Labor Hours as Its Activity Base If Conquest uses direct labor hours to apply overhead costs, the application rate will be $12 per direct labor’ hour ($360,000 of estimated overhead costs, divided by 30,000 estimated direct labor
hours). Throughout the year, manufacturing overhead costs will be assigned in direct proportion to the actual direct labor hours required to manufacture the bicycles produced. For example, if a production run of a particular bicycle model uses 200 direct labor,hours, $2,400 of manufacturing overhead will be assigned to those units (200 , direct labor hours used, multiplied by the $12 application rate).
The assignment will be made by debiting theWork in Process Inventory account and crediting the Manufacturing Overhead account for $2,400. Assumption 2: Conquest Uses Machine Hours as Its Activity Base If Conquest chooses to use machine hours to apply overhead costs, its application rate will be $36 per machine hour ($360,000 of estimated overhead costs, divided by 10,000 estimated machine hours). Using this approach, manufacturing overhead costs will be assigned to bicycles
Errors in estimating’ the amount of total overhead costs for the coming period or the number of units in the, activity base will cause differences between the actual overhead incurred and the amounts assigned to units manufactured. These differences ‘usually are small -and are eliminated by an adjusting entry at the end of the
We will address this issue in based on the number of machine hours required to produce them. If 10 machine hours are required for a particular production run, the bicycles in that run will be assigned $360 of overhead costs (10 hours times $36 per hour), Again, the assignment will be made by debiting the Work in Process Inventory account and crediting the Manufacturing
Overhead account for $360.
What “Drives” Overhead Costs?
For overhead application rates to provide reliable results, ail activity base must be a significant “driver” of overhead costs. To be a cost driver, an activity base must be a causal factor in the incurrence of overhead costs. In other words, an increase in the number of activity base units (for example, direct labor hours worked) must cause a proportional increase in the actual overhead costs incurred.
Historically, direct labor hours (or direct labor costs) were viewed as the primary driver of overhead costs-s-and for good reason. Products that required ‘more direct labor otten required more indirect labor (supervision), resulted in more wear and tear on machinery (maintenance costs), and consumed a greater amount of factory supplies. Therefore. many manufacturing companies followed the practice of applying all manufacturing overhead costs in proportion to direct labor hours or direct labor costs. As factories became more highly automated, direct labor became much less of a causal factor in driving many overhead costs. Today, many manufacturing companies find that activity bases such as machine hours, computer time, or the time required to set up a production run result in a better matching of overhead costs and activities.
The Use of Multiple Overhead Application
Rates In an attempt to gain abetter understanding of what it costs to manufacture different. types of products, many companies have begun to implement techniques that rely on the use of multiple allocation bases. One such approach, activity-based costing, is illustrated in Chapters 17 and 18. In essence, activity-based costing uses multiple allocation bases that represent different types of manufacturing overhead costs. For instance, machine maintenance costs. may be allocated using machine hours as an activity base, whereas supervision costs may be allocated using direct labor hours.
Different application rates may also be used in each production department and in applying overhead costs to different types of products. The key point is that each manufactured product should be charged with the overhead costs generated by the manufacture of that product. If the activity base used to. apply overhead costs is not a primary cost driver, the relative production cost of different products may become significantly distorted. Consider, for example,a plant that makes two products; one product is highly labor intensive and the other product is made on a highly automated assembly line. Due to the extremely high maintenance and electricity costs associated with the automation process, . the automated assembly line is responsible for 80% of the plant’s total overhead cost. . If manufacturing overhead is allocated in proportion to direct labor hours, the labor intensive products will be assigned too much of the total cost. The automated product, responsible for most of these high overhead costs, will be charged with a relatively small share of the total allocation. This, in turn, may lead to many faulty decisions on the part of management