How Do you Assign Overhead to the Costs of a Job?

The approach to assigning overhead costs to a job changes based upon whether the company is a manufacturer (makes products) or is a service based company. 

Let’s address assigning Manufacturing Overhead Costs first.
 

How do you Assign Manufacturing Overhead Costs to Jobs?

Manufacturing overhead consists of all costs related to the production process other than direct materials and direct labor (such as factory rent and factory utilities). 

Because manufacturing overhead costs are difficult to trace to specific jobs, the amount allocated to each job is based on an estimate (through application of a “Predetermined Overhead Rate” - Discussed below).

How do service organizations track Overhead using job costing?

Like manufacturing companies, service organizations often use a predetermined overhead rate to apply overhead. 

Because overhead is typically driven by direct labor hours in a service organization, direct labor hours or direct labor cost is the most common allocation base. 

Again, the process of recording this information in the journal and job cost sheet is exactly the same as for a manufacturing company 

What is a Predetermined Overhead Rate?

The process of creating an estimate of costs to allocate to a job requires the calculation of a predetermined rate.

We calculate the predetermined overhead rate as follows, using estimates for the coming year:

Predetermined overhead rate = Estimated overhead costs / Estimated activity in allocation base

The numerator requires an estimate of all overhead costs for the year, such as indirect materials, indirect labor, and other indirect costs associated with the factory. 

The denominator requires an estimate of activity in the allocation base for the year.

What is Normal Costing? 

The use of a predetermined overhead rate rather than actual data to apply overhead to jobs is called normal costing. 

Normal costing averages these costs out over the course of a year.

Most companies prefer normal costing over assigning actual overhead costs to jobs, as actual overhead costs can fluctuate from month to month, causing high amounts of overhead to be charged to jobs during high-cost periods. 

Actual overhead cost data are typically only available at the end of the month, quarter, or year. Managers prefer to know the cost of a job when it is completed—and in some cases during production—rather than waiting until the end of the period.

The price charged to customers is often negotiated based on cost.  A predetermined overhead rate is helpful when estimating costs.

Bookkeeping is simplified by using a predetermined overhead rate. One rate is used to record overhead costs rather than tabulating actual overhead costs at the end of the reporting period and going back to assign the costs to jobs.

Once the allocation base is selected, a predetermined overhead rate can be established. 

The predetermined overhead rate is calculated prior to the year in which it is used in allocating manufacturing overhead costs to jobs.

What is an Allocation Base?

The activity used to allocate manufacturing overhead costs to jobs is called an allocation base. 

The goal is to allocate manufacturing overhead costs to jobs based on some common activity, such as direct labor hours, machine hours, or direct labor costs. 

Organizations use various other types of allocation bases. 

The most common allocation bases are direct labor hours, direct labor costs, and machine hours. 

What factors do companies consider when deciding on an allocation base?

Companies typically look at the following two items when determining which allocation base to use:

• Link to overhead costs - The goal is to find an allocation base that drives overhead costs, often called a cost driver. 

Note: It may make more sense to use several allocation bases and several overhead rates to allocate overhead to jobs. This approach, is called activity-based costing, 

• Ease of measurement - An allocation base should not only be linked to overhead costs; it should also be measurable. 

The three most common allocation bases—direct labor hours, direct labor costs, and machine hours—are relatively easy to measure. 

Direct labor hours and direct labor costs can be measured by using a timesheet, as discussed earlier, so using either of these as a base for allocating overhead is quite simple. 

Machine hours can also be easily measured by placing an hour meter on each machine if one does not already exist.

Recording Overhead Applied in the General Journal?

The overhead costs applied to jobs using a predetermined overhead rate are recorded as credits in the manufacturing overhead account. 

When this journal entry is recorded, we also record overhead applied on the appropriate job cost sheet, just as we did with direct materials and direct labor. 

What is a Manufacturing Overhead Account?

The manufacturing overhead account is used to record transactions.

The manufacturing overhead account is classified as a clearing account. 

A clearing account is used to hold financial data temporarily and is closed out at the end of the period before preparing financial statements.

The manufacturing overhead account tracks the following two pieces of information:

• Actual overhead costs incurred.  (Recall that manufacturing overhead costs include all production costs other than direct labor and direct materials. Examples of actual manufacturing overhead costs include factory utilities, machine maintenance, and factory supervisor salaries.); and 
• Overhead costs applied to jobs

Related Topics

• Job Costing vs Process Costing
• Assign Direct Material and Direct Labor to Job
• Assign Manufacturing Overhead Costs to Job
• Assign Overhead Costs to Products
• Plantwide Cost Allocation
• Department Cost Allocation
• Activity-Based Costing
• Weighted-Average Cost of Products
• Production Cost Report
• Fixed, Variable, and Mixed Cost Estimations
• Contribution Margin Income Statement
• Cost-Volume-Profit Analysis
• Margin of Safety
• Contribution Margin per Unit of Constraint
• Absorption Costing vs Variable Costing
• Differential Analysis and Decisions
• Cost Decisions for Joint Products
• Capital Budgeting
• Life Cycle Costing
• The Master Budget
• Activity-Based Budgeting
• Standard Costs
• Imputed Value
• Variance Analysis for Product Costs
• Absorption Pricing
• Price Variance
• Absorption Variance 
• Responsibility Centers
• Comparing Segmented Income
• Using ROI to Evaluate Performance
• Using Residual Income to Evaluate Performance
• Use Economic Value Added to Evaluate Performance
• Transfer Pricing