Why do companies allocate overhead to jobs instead of using actual overhead cost?

Overhead costs are ongoing expenses a business incurs to operate. Many expenses are considered overhead costs, including rent, utilities, depreciation and labor. An overhead rate, or predetermined overhead rate, is an equation that allocates a certain amount of manufacturing overhead to each direct labor or machine hour. This rate helps businesses allocate resources and set pricing.

Manufacturing Overhead

1. Bellevue College describes manufacturing overhead as costs that cannot be traced to specific units of production. These are costs, such as rent and utilities, indirect materials and indirect labor. Indirect materials are materials used in the support process, such as cleaning supplies and repair tools. Indirect labor encompasses wages paid to employees such as maintenance workers, who are not directly involved in the manufacturing process. Because the company cannot place a per-unit cost on these expenses, they are placed under total manufacturing overhead costs.

Direct Labor and Machine Hours

1. Direct labor and machine hours can be traced to specific production units. Workers and machines that are directly involved in the production process fall under this category. The company can calculate the time it takes a machine to produce a part or a worker to assemble a piece of machinery with a certain degree of accuracy.

Predetermined Overhead Rate

1. The predetermined overhead rate is the quotient of the estimated total manufacturing overhead cost for the coming period divided by the total labor hours or machine hours for the coming period.

   As an example, say Company XYZ expects total manufacturing costs to equal $400,000 in the coming period. Company XYZ expects the staff to work a total of 20,000 direct labor hours.

   The predetermined overhead rate for the coming period is $20 per hour.

Applying this Rate

1. Company XYZ determined that its overhead costs are $20 per labor hour. The organization is now aware that if a job takes 10 hours, the overhead cost for that job is $200. Say that Company XYZ is an auto repair shop. With a predetermined overhead rate, the company has a baseline cost-per-hour figure so that it may appropriately charge its customers for labor and earn a profit.

Special order manufacturers and construction companies often assign direct and indirect expenses using job-order costing. A main reason is that assigning expenses on a per-job basis makes production costs easier to manage and analyze. In job-order costing, indirect expenses -- such as the cost of supplies, wages for support staff and equipment depreciation -- directly affect the overall cost and profit margin for each manufacturing job. However, unlike direct materials and labor expenses, indirect costs can’t be traced directly to units within each job. Instead, overhead allocations most often use a predetermined rate.

GAAP Accounting Requirements

1. Generally accepted accounting principles require businesses that use accrual basis accounting to include both direct and overhead expenses in production cost allocations. Overhead allocations must occur during the manufacturing process so that overhead is a component in work-in-process and finished goods inventory balance sheet valuations as well as in the cost-of-goods-sold entry on the income statement. Predetermined overhead rates allow accounting employees to comply with the GAAP matching principal by allocating overhead while products are still in production.

Procedural Efficiencies

1. In job-order costing, each product manufactured must absorb an equal part of the total manufacturing overhead expenses for each job. For example, each product in a job must equally absorb the cost of utilities and accumulating depreciation expenses for each piece of production equipment. Calculating and tracking how much overhead each product consumes would not only be time-consuming and difficult, but also would decrease productivity. However, a predetermined overhead rate -- most often calculated annually -- allows production managers to allocate overhead costs as a single group, saving time and creating process efficiencies.

Improved Decision-Making

1. Actual overhead expenses can’t be calculated until the manufacturing process is complete. However, predetermined overhead rates allow production managers to allocate overhead expenses as soon as production begins. Having this information when production begins allows managers to make better cost-based business decisions. These include cost-control assessments as well as pricing and budgeting decisions. This also allows customer service personnel to inform customers more quickly in situations where production costs exceed the customer's expectations.

Simplifies Overhead Account Reconciliation

1. A predetermined overhead rate makes reconciling the overhead account much easier. Most often, the overhead account will reflect a credit balance or a debit balance. A credit balance indicates predetermined overhead was over-applied and a debit balance indicates predetermined overhead was under-applied. Regardless of which occurs, the balance in the manufacturing overhead account doesn’t have to equal zero until the end of the fiscal year. Most businesses simply reconcile overhead by transferring the balance in the manufacturing overhead account to the cost of goods sold.

Why estimated overhead costs rather than actual overhead costs are used in the costing process?

Why the company prefers the use of the predetermined overhead rate rather than the actual overhead rate?

Why should a company not use actual amounts of overhead cost and allocation base?

Can you allocate overhead to a job?

Are actual manufacturing overhead costs charged to jobs Why or why not?

Why an actual overhead rate is rarely used for product costing?