 Hello, and welcome to this session. This is Professor Farhad and this session we're going to look at overhead allocation and compute a predetermined overhead rate. So let's talk about the overall. What is the issue here? Why do we have to deal with, or why do we have to have a separate recording for overhead? Well, three things goes into a product. We have direct material, direct labor, and manufacturing overhead. Those are the product costs. Here's the thing about direct material and direct labor. They can be easily traced to a product. So you can see it. Literally, you can see the people working on the product. Literally, you can see the material that went into a specific product. So it's easy to allocate and trace those two items. However, when it comes to manufacturing overhead, and what's manufacturing overhead? Manufacturing overhead are indirect labor, such as supervisor, indirect labor, indirect material that cannot be easily traced to the product, utilities at the manufacturing plant, maintenance cost, so on and so forth, taxes. There are many things, a list of items. And those items, we cannot easily trace. We cannot easily see when they are allocated to the product. Think about it this way. If I ask you, we are manufacturing a product, how much electricity does this product consume? Could you know how much electricity? You really don't know how much electricity. But you would know how much material it consumed. You would know how much labor. But electricity, you know it consumes some electricity, but you don't know how much electricity. So this is the problem with the manufacturing overhead. So how should we allocate the overhead? Well, one way to do it, if you really think about it, is to allocate the actual overhead. That looks very appealing. Well, but not practical. Why? Actual overhead is the most accurate. You wait until see how much you actually consume, then you allocate. But here's the problem with working with actual overhead. Let's take a look. We said indirect labor, a supervisor salary. Let's assume we're paying a supervisor 120,000 a year, which is, we can say, $10,000 a month. So that's easy. So every month, we allocate $10,000 of the salary of that supervisor to the product. That's fine, because we're allocating everything equally. Let's assume we're talking about utilities. What do we know about utilities? In the wintertime, it's going to be very cold. The wintertime will be very cold. And as a result, we're going to consume a high amount of utilities. What does that mean? It means when we produce our product during the wintertime, our product costs more, as well as the summer. In the summertime, also, we have to cool down the place. Our electricity goes up substantially. While in the fall and the spring, it may not be that much. What does that mean? Well, does it mean in the summer it's costing us more, in the winter it's costing us more, and spring and fall it's costing us less? No, just the overhead is not being spent equally. Another example will be maintenance. For example, let's assume in January, February, and March, we had routine maintenance. That's fine. Then somehow in April, there was a breakdown in the manufacturing facilities, and we had a big bill. So what does that mean? Does it mean that what we produce in January, February, and March should be a lower cost than April? Well, if that's the case, it's our cost keep on fluctuating up and down. So what we do, rather than having the actual cost applied to the product, what we can do, we're gonna estimate, estimate an overhead and apply the overhead to the cost. And this is what we're gonna need to learn about, but hopefully you saw the big picture. So the big picture is to do what? Is to take the factory overhead or the manufacturing overhead and apply it to the product through some method, through some activity. And we're gonna talk about this in a moment, but this is the overall picture. So what we're gonna do, we're gonna be using an allocation base. So what is an allocation base? An allocation base is something that's drives, drive the cost, drive the activity at the manufacturing facility. So the more we do of that thing, whatever that thing is, the more we consume of overhead. Traditionally, traditionally back in the old days, direct labor hours or direct labor dollar, either has something to do with labor, was the driver. And the reason is simple. Well, guess what? We pay our labor. Therefore, we have record of how much labor we consume, how many hours, how many dollar amount we consume. So it was very easy for manufacturing companies and manufacturing companies used to be labor intensive. So it was very easy to use direct labor hour and direct labor cost as the cost driver, the allocation base for our overhead, what drives our overhead. Then now it's more and more, we are using machine hours. Now, in this example, we're gonna be using one cost driver just to illustrate the point. But what we're trying to say is, you need to find something that's gonna drive your manufacturing overhead. That's the case, you need a driver. So what's the allocation base? We're gonna choose one for the purpose of this example and live with it, okay? So why use the allocation base once again? Let's recap what we just said. It's impossible or difficult to trace overhead to a particular job, because you cannot see the overhead. Manufacturing overhead consists of many different items ranging from grease used in the machine to production managers. So we spent them unevenly. And many types of manufacturing overhead are fixed, even though the output fluctuate during the period. And some of them are fixed, but the output fluctuate. For example, the salaries of the supervisor is fixed, but we produce more items in certain months than other items. So when we produce more items, our fixed cost per unit goes down. Well, does it mean it's costing us less? Not necessary, okay? So that's why we cannot use the actual we need the overhead. So what we do is this. We determine a predetermined. We compute a predetermined, pre, it's mean before. Predetermined overhead rate, P-O-H-R, to apply overhead to jobs to determine before the period begins. So before we begin production, what we do is we compute our, we estimate our dollar amount of the manufacturing overhead for the coming period. Now, how do we do so? There are many ways we do it. We could look at last year. We could look at last year and at 5%. We could look at last year and subtract 5% depending on what we know about our production. But we're gonna estimate this dollar amount. Then we divide this dollar amount by a driver. And this is what I was talking about earlier. That driver could be the labor hours, labor dollar, machine hours could be anything, anything that we believe it drives our cost. Okay? It drives our cost. So what are we making the assumption? Here's the assumption. The denominator making the following assumption. The denominator is consuming the overhead. Okay? So that's what we're assuming. Whatever we put in the denominator, it's consuming the overhead. And in this example, we are assuming, we did not assume anything. We're gonna see what we assume here. So we did not choose anything yet. We'll choose something. So there's a direct relationship between the denominator and the consumption of whatever we are consuming. Okay? A predetermined overhead rate that rely upon estimated data are often used. Of course, we have to rely on estimated because we cannot wait because actual overhead for the period is not known until the end of the period. So we have to make a decision before the end of the period. If somebody asks us to do some work, we cannot tell them. We don't know how much we're gonna charge you until we build it. They're not gonna be happy with that. They want to know now because they want to know how much they're gonna be paying. Thus, inhibiting the ability to estimate job costs during the period. So actual, it's not practical. We cannot wait till the end of the period. We have to know how much something's gonna cost us now. Actual overhead can fluctuate seasonally, thus leading us to misleading decision. Therefore, what we do actual overhead, sometimes it's gonna be high, sometimes it's gonna be low. So it's gonna give us bad data. So just to kind of illustrate the example, let's go back up here and just kind of work some numbers here. And let's assume just for the sake of illustration, for the sake of illustration, let's assume our total manufacturing overhead is $160,000, okay? Just for the sake of illustration, that's our total manufacturing overhead. And now we're gonna have to determine, we're gonna have to determine a driver. And for the purpose of the driver, for the purpose of the driver, let's assume we are going to go with direct labor hours, direct labor hours. So for direct labor hours, let's assume for direct labor hours, let me just kind of make up a number real quick here. And let's assume we have 40,000, that's the driver, and let's make it as, yes, 40,000 direct labor hours is the driver. So if we take 160,000, which is the overhead, divided by 40,000 hours, that's gonna give us $4 per hour. Now, how do we use this data? Let's assume we are completing, let's assume we are completing job number A143. And for that job, we consume material of 116, that's easy to trace, direct material of 116, direct labor of eight hours. Now from the direct labor, it's easy. If we consume eight hours of direct labor for this job, we're gonna multiply this by $4 based on the predetermined overhead rate that I computed up here, $4, then we know the overhead that needs to be allocated is $32 to this job. So therefore we know the manufacturing overhead is $32. So this is applied. Applied in a sense that we estimated this amount based on the direct labor hours, okay? What we just saw is something called normal costing. Normal costing means we're gonna be using actual direct material, actual direct labor and estimated manufacturing overhead. This is what we called normal costing system. Now, since we are using, we are estimating overhead at the end of the period, we're gonna know what was our actual overhead. So what's gonna happen when we know our actual overhead? Let me, the best way to illustrate this is to work with this through a T account. Let's assume this is our manufacturing overhead account. Some companies, they might have two, some company might have one, but the debit side of it will be for the actual overhead. That's when we keep track of our actual overhead. And the credit side will be for the applied overhead. So for this job, just to kind of illustrate the point, we applied $32. We applied $32. Let's assume we find out later after we received all the bills, all the bills, the actual overhead for this job, the actual overhead, just keep it simple, was $30, okay? Let's look at our balance. We have a $2 credit. What does that mean we have a $2 credit? The actual was $30 and we applied $32. It means we over applied by $2. Or we over estimated by $2. Now, how do we close this? If we want to close this, we usually close it to cost of goods sold. So what we do, manufacturing overhead need to be closed at the end of the period. Therefore, we debit manufacturing overhead for $2 and we cost of goods sold, we debit manufacturing overhead and we credit cost of goods sold, reducing our cost of goods sold by $2. So this is what happened. Now let's change the scenario a little bit, okay? Let's assume the manufacturing, the actual was $35, the actual was $35. Therefore, we end up with a $3 debit balance. This means we underestimated or under applied by $3, we underestimated. We applied $32, but we actually, it cost us the overhead was $35. Now to close this, we need to credit manufacturing overhead to make it go down to zero and we debit, we increase cost of goods sold by $3. So this is what happened. And oftentimes actual and applied don't equal to each other, but hopefully the difference is very small. So this is basically, hopefully a good session about how do we apply manufacturing overhead? And here we are making some simplification. We are assuming that one driver, which is direct labor hours, drives our overhead. You could have more than one driver for the sake of illustration, we're only using one. If you have any questions, any comments, by all means email me or see me in class. If you're studying for your CPA or your CMA, study hard, it's worth it.