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A Job Costing System Accumulates Economics Essay

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Chapter 14

A job-costing system accumulates and analyzes costs separately for each product or small batches of products. Examples of firms that use job-costing systems include law firms and firms that build custom houses.

A process-costing system accumulates and analyzes costs by each process (or a department) rather than by each job. Examples of firms that use process-costing systems include steel mills and paper companies.

Direct materials and direct labor are traced, and overhead is allocated.

Work in process inventory is the inventory of unfinished products at the start of a period. Cost of goods manufactured is the cost of items finished and transferred from work in process inventory to finished goods inventory. Cost of goods sold is the cost of products sold in a period. It is the cost of items transferred from finished goods inventory to the income statement.

A predetermined overhead rate equals expected overhead costs for the period divided by the expected activity level.

Firms use predetermined overhead rates because actual overhead costs and activity volumes frequently fluctuate.

A normal-costing system is a job-costing system that uses a predetermined overhead rate.

Underapplied overhead means that the overhead applied to jobs is smaller than the amount actually spent on overhead. Overapplied overhead means that the overhead applied to jobs exceeds the amount spent on overhead.

False - if a firm has underapplied overhead, the actual rate must have exceeded the predetermined rate.

(1) correct rates are year end, (2) write off to cost of goods sold, and (3) prorate among inventory accounts and cost of goods sold.

The adjustment will increase cost of goods sold and, in turn, decrease net income.

The proration method allocates the under- or overapplied overhead to WIP inventory, FG inventory, and cost of goods sold in proportion to their unadjusted ending balances.

Three accounts will be affected: (1) WIP, (2) FG, and (3) COGS.

Income will be higher under the proration method because some of the adjustment will be to the inventory account.

Discussion Questions

Job shops and process shops differ considerably in the extent to which we can trace costs to individual units and jobs. A pure job shop makes custom products. Each unit is a separate job and is unique. It is therefore possible to trace many costs directly to each job. However, in process shops, it is not possible to trace most costs to individual units. Rather, we can trace the costs, even for direct materials and direct labor, only at the process or departmental level.

Yes. Each patient's care may be viewed as a job. Many of the costs, including the costs of nurse care, attending physician's time, medicines and drugs, room occupancy can be directly traced to the patient. Some indirect costs may still have to be allocated. However, such a system also has elements of process costing in that we might use pre-determined rates (e.g., $40 per hour of nursing or $100 per visit by a doctor) to determine costs rather than use actual costs.

Business consulting firms are likely to have job-costing like systems. Fast food restaurants like McDonald's have more of process costing-type environment.

True. Batch size is one of the main differences that distinguish job shops from process shops. Job shops can be viewed as having a production batch size of one with each batch being unique, while the batch size in process shops is typically large, with each batch consisting of a large number of identical units.

A firm's actual overhead cost and actual activity volume likely change from month to month. Firms compute a predetermined overhead rate using expected overhead costs and expected activity levels at the start of a plan period (usually a year), which provides a basis for computing overhead variances as the difference between actual overhead and applied overhead. These overhead variances can be potentially used for control purposes.

Using a higher predetermined overhead (for instance, using a smaller denominator volume to calculate the rate) tends to result in the overhead being overapplied. In this case, the year-end adjustment would be income-increasing.

Assume that the budgeted overhead is $100,000 and the normal volume is 10,000 units. Then the predetermined overhead rate is $10 per unit. Let us say that the actual volume is 9,500 units, and the actual overhead is also $100,000. Overhead would be underapplied by $5,000 (9,500 Ã- 10 - $100,000). The actual overhead rate is $100,000/9,500. The error in the predetermined rate is $10 - ($100,000/9,500). Multiplying this by the actual production units we get 9,500 Ã- [$10 - ($100,000/9,500)] = -$5,000, or $5,000 underapplied.

Yes, it will.. Adjusting the income for the entire amount of the underapplied or overapplied, means that the entire amount is charged to COGS. With actual rates, the adjustment will differ because some of the amount will go toward WIP and FG inventories. Indeed, the amounts will not agree even with proration because we use unadjusted balances as the allocation basis.

Yes it would. If the overhead is underapplied, the income would be higher when it is prorated among work-in-process inventory, finished goods inventory, and cost of goods sold rather than written off. If overhead is overapplied, the income would be lower when it is prorated among work-in-process inventory, finished goods inventory, and cost of goods sold.

We would generally agree with this statement. We view the method for disposing of overhead as an accounting exercise to balance the books and to zero out control accounts. The specific method used does not affect the estimate of future capacity costs and thus is not likely to be very useful from a decision making perspective.

Exercises

We can use the inventory equation for the WIP account to answer the question.

Beginning WIP + (materials + labor + applied overhead) = COGM + Ending WIP.

We know the items on the left hand side. But, we need to calculate Ending WIP, which will be the costs charged to job 232.

Direct materials $4,250

Direct labor $2,500

Mfg. overhead $3,750 $2,500 Ã- $1.50 per labor $

Ending WIP $10,500

(We use the total amounts charged to WIP to calculate the overhead rate as $36,000 applied overhead /$24,000 labor $ = $1.50 per labor dollar.)

Thus, we have:

COGM = $22,500 + (25,000+24,000 + 36,000) - $10,500 = $97,000.

The expected fixed overhead is $500,000 out of a total overhead amount of $1,200,000. Thus, the remaining $700,000 constitutes variable overhead. Given the expected activity of 10,000 machine hours, we have:

Variable overhead rate =

Fixed overhead rate =

Total overhead rate =

We compute the inventoriable cost of the job as:

Job cost = Cost of direct materials + cost of direct labor + allocated overhead.

Referring to the solution from part [a], we calculated the total overhead rate to be $120 per machine hour. Therefore, the cost of this job under the job-costing system is:

Job cost = $5,000 + $8,000 + ($120 per hour Ã- 40 hours) = $17,800.

Price = $22,250 = $17,800 Ã- 1.25 (for the 25% mark up).

Overhead application rate = Budgeted overhead / Budgeted DL costs.

Thus, the pre-determined rate is $525,000 / $150,000 = $3.50 per labor dollar.

Applied overhead = predetermined overhead rate Ã- Actual DL costs.

Thus, Applied overhead = $140,000 labor $ Ã- $3.50 per labor $ = $490,000.

Under/Overapplied overhead = Actual overhead - Applied overhead.

Thus, $530,000 - $490,000 = $40,000 underapplied.

Since overhead was overapplied, then the products' cost for the period should decrease.

Because Ace uses the proration method, we should allocate the overapplied overhead among the WIP, FG and COGS accounts.

The WIP account will decrease by

$10,000 Ã- [$25,000 / ($25,000 + $75,000 + $100,000)]

= $10,000 Ã- 0.125 = $1,250.

Thus, the adjusted balance is $25,000 - $1,250 = $23,750.

Alternatively, you could construct a table as follows:

Item

Amount

Percent

Allocated

Amount of $10,000

Adjusted

Amount

Cost of Goods Sold

$100,000

50.0%

$5,000

$95,000

Finished Goods Inventory

$75,000

37.5%

$3,750

$71,250

Work-in-process inventory

$25,000

12.5%

$1,250

$23,750

Total

200,000

100.0%

10,000

190,000

We know that

Overhead rate = budgeted overhead / budgeted activity volume

$5 per machine hour = $25,000 / budgeted hours

Budgeted hours = 5,000.

Next, we know that

Applied overhead - actual overhead = under/(overapplied overhead)

In this case, applied overhead is smaller than actual overhead because overhead is under applied. Thus,

Applied overhead = $26,000 -$6,000 = $20,000.

Furthermore,

Applied overhead = actual # of machine hours Ã- rate per machine hour

Plugging in the relevant values, we have:

Actual number of machine hours = $20,000 / $5 per machine hour = 4,000 hours.

We need to use the inventory equation in the WIP account for this item.

Beginning WIP + (materials + labor + applied overhead) = COGM + Ending WIP.

Plugging in relevant data, we have:

Beginning WIP + ($90,000 +$107,000 + $113,000) = $313,000 + 0.4 Ã- Beginning WIP.

Solving, we calculate Beginning WIP as $5,000.

We then calculate Ending WIP = 40% Ã- Beginning WIP = 0.4 Ã- $5,000 = $2,000.

We know that

Applied overhead - actual overhead = under/(overapplied) overhead.

In this case, overhead is overapplied, meaning that applied overhead is larger than actual overhead. Thus,

Applied overhead = $500,000 + $50,000 = $550,000.

Furthermore,

Applied overhead = actual # of labor hours Ã- rate per labor hour

Plugging in the relevant values, we have:

Actual number of labor hours = $550,000 / $50 per labor hour = 11,000 hours.

We have to calculate this number indirectly as an input into the WIP account.

Beginning balance + (materials+ labor +applied overhead) - COGM =Ending balance.

We know the beginning and ending balances in this account. The inflows into this account are materials, labor (the answer), and applied overhead. We calculate the cost of materials by applying the inventory equation to the raw materials inventory account.

Materials added to WIP account = $30,000 + $200,000 - $40,000= $190,000

We know applied overhead to be $150,000. The final item to calculate is COGM, which we can do by applying the inventory equation to the finished goods account.

Beginning FG balance + COGM - COGS = Ending FG balance

$65,000 + COGM - $530,000 = $50,000, or COGM = $515,000.

Thus, $10,000 + ($190,000 + labor cost + $150,000) - $515,000 = $20,000

Labor cost = $185,000

We know that adjusted COGS is larger than the unadjusted amount. Hence, overhead is underapplied. Further, the adjustment is $757,500 - $720,000 = $37,500.

However, this is not the entire amount of the underapplied overhead. This is only the portion allocated to COGS. Under proration, COGS would have received $720,000 / ($720,000 + $54,000 + $90,000) = 83.33% of the total underapplied overhead.

Thus, the total underapplied overhead is $37,500/0.83333 = $45,000 underapplied.

a.

We have

Actual overhead $260,000

Applied overhead $280,000

Overapplied overhead ($20,000)

Closing the amount to the COGS give us an adjusted COGS of $200,000 - $20,000 = $180,000.

Notice that we reduce the COGS because overhead is overapplied.

b.

The percentage of overapplied OH that should be prorated to COGS is

$200,000 / ($50,000 + $150,000 + $200,000) = 50%.

Thus, the adjustment amount that should be applied to COGS is $10,000.

The adjusted COGS is therefore $200,000 - $10,000 = $190,000

Alternatively, you could construct a table as follows:

Item

Amount

Percent

Allocated

amount

Adjusted

Amount

Cost of Goods Sold

$200,000

50.0%

$10,000

$190,000

Finished Goods Inventory

$150,000

37.5%

$7,500

$142,500

Work-in-process inventory

$50,000

12.5%

$2,500

$47,500

Total

$400,000

100.0%

20,000

380,000

a.

We can do this problem in two ways. The first way is to calculate the flow through the WIP account. However, this method is tedious.

A shorter way, however, is to recognize that neither jobs J5-59 nor X9-60 are in the WIP account. Only job T10-61 is left in WIP. This job has costs of:

Direct materials $37,000

Direct labor 35,000

Mfg. overhead 43,200 1,200 hours Ã- $36 per machine hour

Total $115,200

b.

The only job remaining in Finished Goods is X9-60. Using the same logic as in part (a), the cost in the FG inventory is:

Beginning value $39,500

Direct materials 0 none were added

Direct labor $20,000

Mfg. overhead $ 7,200 200 hours Ã- $36 per machine hour

Total $66,700

The budgeted overhead rates for the most recent year are:

Variable overhead rate = $62 per rug,

Fixed overhead rate = $25 per rug,

Total overhead rate = $87 per rug.

Calculating applied overhead using the actual number of rugs produced, we find:

Variable overhead applied = $62 Ã- 9,750 = $604,500

Fixed overhead applied = $25 Ã- 9,750 = $243,750

Total overhead applied = $87 Ã- 9,750 = $848,250

Total overhead under- or overapplied

= Actual total overhead - Applied total overhead

= $848,250 - $848,250 = $0.

Thus, total overhead was neither under- nor overapplied.

Fixed overhead under- or overapplied

= Actual fixed overhead - Applied fixed overhead

= $603,250 - $604,500 = ($1,250) or $1,250 overapplied.

Fixed overhead under- or overapplied

= Actual variable overhead - Applied variable overhead

= $245,000 - $243,750 = $1,250 or $1,250 underapplied.

Notice that the amounts by which fixed and variable overhead are under- or overapplied exactly offset each other. Such an exact offset is generally unlikely.

The total overhead rate at the beginning of the year is:

Total overhead rate = Fixed overhead rate + Variable overhead rate

= = $152 per labor hour.

The applied overhead for the year = Actual direct labor hours Ã- overhead rate.

= 120,000 hours Ã- $152/hour = $18,240,000.

The actual overhead incurred was $18,000,000.

Thus, under- or overapplied overhead

= Actual overhead incurred - Applied overhead

= $18,000,000 - $18,240,000

= ($240,000), or $240,000 overapplied.

Because the overhead is overapplied by $240,000, cost of goods sold is overstated. Therefore, writing off the amount of cost of goods sold will decrease cost of good sold and, in turn, increase income by $240,000.

a.

Manufacturing overhead rate = Budgeted overhead / Budgeted activity volume

= $275,000 / 20,000 Machine hours

= $13.75 per machine hour

b.

The ending balance of Finished Goods is Job no. 401:

Prior period's production costs

$211,250

Current period's production costs:

Direct materials

$33,000

Direct labor

$15,200

Applied overhead

$34,375

Total

$293,825

Applied overhead = 2,500 machine hours Ã- $13.75 per machine hour

c.

Actual overhead

= $50,000 + $53,000 + $26,250 + $168,000

= $297,250.

Applied overhead = Total machine hours Ã- $13.75 per machine hour

= (2,500 + 6,800 + 6,500 + 12,000) Ã- $13.75 per machine hour

= $382,250.

Thus, overhead is under- or overapplied by

= 297,250 - $382,250 = ($85,000) or $85,000 overapplied.

Lone Star Glassworks would apply factory overhead as:

Factory overhead applied =

Overhead rate per direct labor hour Ã- actual direct labor hours.

Thus,

Factory overhead applied = $8 Ã- 50,000 = $400,000.

We calculate underapplied (overapplied) overhead as:

Underapplied (overapplied) overhead = Actual overhead incurred - Applied overhead

From part (a), we know factory overhead applied = $400,000.

Actual factory overhead for the year = $415,000

= $160,000 indirect labor + $75,000 depreciation on manufacturing equipment + $60,000 factory fuel + $120,000 factory rent.

Note: We do not include sales commissions because, under GAAP, sales commissions are a period cost and not an inventoriable product cost.

For Lone Star, overhead was underapplied by $15,000 = $415,000 - $400,000 for the year.

a.

Dept A overhead rate =Dept Budgeted OH / materials cost in department

= $ 9,000,000 / [($6,000 per unit Ã- 4,000 units) + ($6,000 per unit Ã- 2,000 units)]

=$9,000,000 / $36,000,000

= $ 0.25 per materials dollar

Dept B overhead rate = Dept Budgeted OH / (Machine hours in Dept)

= $3,000,000 / [(4,000 units Ã- 40 hours per unit) + )2,000 units Ã- 20 hours per unit)]

= $3,000,000 / 200,000 hours

= $15 per machine hour

b.

Inventoriable cost consists of materials, labor, and applied overhead.

Materials $6,000

Labor in department A 1,000

Labor in department B 750

Overhead in department A 1,500 $6,000Ã- 0.25/material $

Overhead in department B 300 20 machine hours Ã- $15 per machine hour

Total cost $9,550

For the previous year, Serene has total overhead of ($500,000 + $600,000) = $1,100,000, and 10,000 budgeted machine hours. Thus, its total overhead rate is $110 per machine hour.

Repeating the exercise for the current year, we calculate the total overhead rate as $100 per machine hour.

The manufacturing cost for a product comprises the cost of materials, labor, and overhead. Using the overhead rates from part (a), we calculate the allocated overhead per unit as ($110 Ã- .25 per unit) = $27.50, and ($100 Ã- .25 per unit) = $25.00 for the previous and current years, respectively. Adding these costs to the cost of materials and labor yields:

Previous Year Current Year

Materials + DL cost per unit $45.00 $45.00

Allocated overhead per unit $27.50 $25.00

Cost per unit $72.50 $70.00

The unit cost has come down by $2.50 per unit from the previous year to the current year. However, this fact does not necessarily mean that the firm has reduced costs or increased efficiency. In particular, each unit actually consumed 0.25 machine hours both last year and this year. Thus, there is no gain in efficiency.

The decline in reported cost arises because the fixed overhead rate and, in turn, the total overhead rate has changed.

The variable overhead rate has stayed the same because the total variable overhead has increased in direct proportion to machine hours. In the prior year, Serene budgeted 10,000 machine hours and, in the current year, Serene budgeted 12,500 machine hours. At a variable overhead rate of $60 per machine hour (=$750,000/12,500 hours), this increase of 2,500 machine hours corresponds exactly to an increase in variable overhead of $150,000.

On the other hand, the budgeted fixed overhead has stayed the same at $500,000. However, because budgeted machine hours have increased from 10,000 to 12,500, the fixed overhead rate has declined from $50 per machine hour to $40 per machine hour.

This decline in fixed overhead rates is the only reason for the apparent decline in costs. Stated differently, the firm was able to utilize its capacity better, resulting in less money lost to idle capacity. We are not comfortable, however, terming this higher utilization as reducing costs.

Note: In general, as the volume of activity increases but the fixed overhead stays the same, the fixed overhead rate declines. However, the variable overhead rate stays the same as long as the variable overhead increases in the same proportion. Thus, one way of distinguishing fixed and variable overhead items is to look at the trend in the respective rates over time as the volume of the allocation base fluctuates. Variable overhead rates would remain relative stable, whereas fixed overhead rates would vary inversely with volume.

Let us begin by first calculating the amount of under- or overapplied overhead.

Underapplied (overapplied) overhead = Actual overhead incurred - Applied overhead.

For the labor-related pool, we have:

Underapplied overhead = $1,445,400 - ($0.80 Ã- 1,800,000) = $5,400.

For the machine-related pool, we have:

Overapplied overhead = $1,816,550 - ($22 Ã- 84,000) = ($31,450).

Thus, the total under- or overapplied overhead is ($31,450) + $5,400 = $26,050 overapplied.

When we write off under- or overapplied overhead to COGS, net income decreases or increases by a like amount. Overapplied overhead reduces COGS and increases net income. Thus, the year-end adjustment increases Malcolm's net income to $471,330 = $445,280 + $26,050.

In part (a), the adjustment resulted in net income increasing by the entire amount of the overapplied overhead. However, by definition, when we prorate (or allocate) overapplied overhead among COGS and the inventory accounts, we allocate less than $26,050 to COGS. Thus, the amount of decrease in COGS, and the corresponding increase in net income, would be lower than that in Part (a). Thus, Malcolm's income would be lower than the answer computed in part [a].

Problems

Underapplied (Overapplied) overhead = Actual overhead - Applied overhead.

We know that actual overhead is $692,415. Further, applied overhead = $679,815, the sum of the applied overhead amounts in WIP, FG, and COGS (=$61,183.35+$95,174.10+$523,457.55, respectively). Thus,

$692,415 - $679,815 = $12,600 underapplied overhead.

Closing out the underapplied overhead to COGS would increase COGS, thereby reducing income. Thus, the adjustment for underapplied overhead would reduce Skoll's net income by $12,600, from $122,342 to $109,742.

Under pro-ration, the underapplied overhead would be allocated among the WIP, FG, and COGS accounts. No adjustment would be made to the Raw Materials account because no overhead has been charged to this account in the first place. The adjustment in each account is proportional to the ending balances as shown below:

Work in process

Finished Goods

Cost of Goods Sold

Total

Unadjusted year-end value

$143,516.50

$215,274.75

$1,076,373.75

$1,435,165

% of value in account

10%

15%

75%

100%

Allocation for underapplied overhead

$1,260.00

$1,890.00

$9,450.00

12,600

Adjusted balance

$144,776.50

$217,164.75

$1,085,823.75

$1,447,765

We find that COGS increases by $9,450, meaning that net income decreases by a like amount. We compute adjusted net income as $122,342 - $9,450 = $112,892.

This requirement is similar to requirement [c] except that the allocation basis is different. We now allocate based on the current period overhead, rather than the end of year balances, as shown below.

Work in process

Finished Goods

Cost of Goods Sold

Total

Current period overhead

61,183.35

95,174.10

523,457.55

679,815

% of value in account

9%

14%

77%

100%

Unadjusted value at year end

$143,516.50

$215,274.75

$1,076,373.75

$1,435,165

Allocation for underapplied overhead

$1,134.00

$1,764.00

$9,702.00

12,600

Adjusted balance

$144,650.50

$217,038.75

$1,086,075.75

$1,447,765

Thus, we find that COGS increases by $9,702, meaning that net income decreases by a like amount. We have the adjusted net income as: $122,342 - $9,702 = $112,640.

The results differ because of the different allocations of the underapplied overhead of $12,600. The methods in (b) - (d) use differing allocation basis: all to COGS, proportional to ending balances, proportional to overhead applied during the year.

Intuitively, we might expect the answers for parts (c) and (d) to be the same as we are prorating overhead in both instances to the same accounts. However, the amounts allocated differ the ratio of overhead to the ending balance would vary across the accounts. For instance, for Skoll, WIP comprises 10% of the total value but only 9% of the overhead. Such a discrepancy might arise because we still have to perform some work on the units in WIP (meaning that we would allocate more overhead to these units).

a.

Manufacturing OH rate = $1,728,000 / (24 persons * 2,000 artisan hours per person)

= $36 per artisan hour

b.

The unadjusted balance of Cost of Goods Sold is the cost of Job no. 101:

Prior period's production costs

$200,000

Current period's production costs:

Direct materials

$160,000

Direct labor (1,000 DLHs Ã- $50)

$ 50,000

Overhead (1,000 DLHs Ã- $36)

$36,000

Total

$446,000

c.

First, let us calculate the under- or overapplied overhead. We have:

Actual overhead = $187,500 + $50,000 + $30,000 + $108,500 = $376,000.

Applied overhead = $36 per artisan hour * (1,000 + 6,500 + 3,000) hours = $378,000.

Overapplied overhead = $378,000 - $376,000 = $2,000.

The adjusted cost of goods sold is therefore $446,000 - $2,000 = $444,000.

a.

Let us begin by calculating the overhead rate as

Total overhead / total machine hour

= $4,000,000 / 200,000 = $20 per machine hour.

Thus, the job's total cost is:

Materials given $5,000

Labor 250 hours Ã- $16 $4,000

Overhead 1,000 hours Ã-$20 $20,000

Total $29,000

Notice that we apply overhead based on the total machine hours, across both departments. Thus, 250 hours = 100 + 150 hours; 1,000 hours = 400 + 600 hours.

b.

Let us begin by calculating the overhead rates

Materials handling $1,500,000 / 150,000 = $10 per labor hour

Assembly $2,500,000 / 100,000 = $25 per machine hour

Thus, the job's total cost is:

Materials given $5,000

Labor 250 hours Ã- $16 $4,000

Overhead 100 labor hours Ã-$10 $1,000

Overhead 600 machine hrs Ã- $25 /hr 15,000

` Total $25,000

Notice that we apply materials handling overhead only on the labor hours in that department (100 hours), and the assembly department overhead only on the machining costs in that department.

The accounting equation for the raw materials account is:

Ending balance = Beginning balance + raw materials purchased - raw materials issued to production. Thus,

$80,000 = $60,000 + raw materials purchased - $225,000.

Therefore, raw materials purchased = $245,000.

Total costs charged to production = raw materials issued to production consumed + direct labor cost + (120% Ã- direct labor cost) = $885,000.

$225,000 + direct labor cost + (1.2 Ã- direct labor cost) = $885,000.

2.2 Ã- direct labor cost = $885,000 - $225,000 = $660,000.

Therefore,

Direct labor cost charged to production = $300,000.

The accounting equation for the work-in-process account is:

Ending balance = Beginning balance + costs charged to operations - cost of goods manufactured.

$105,000 = $80,000 + $885,000 - Cost of goods manufactured.

Cost of goods manufactured = $860,000.

Overhead applied during the period = 120% Ã- direct labor cost

= 1.2 Ã- $300,000 = $360,000.

Actual overhead incurred is $400,000.

Underapplied (overapplied) overhead = Actual overhead incurred - Applied overhead

= $400,000 - $360,000 = $40,000,

= $40,000 underapplied.

We can express cost flows through the finished goods account using the following accounting equation:

Ending balance = Beginning balance + Cost of goods manufactured - Cost of goods sold.

$320,000 = $300,000 + $860,000 - Cost of goods sold.

Cost of goods sold = $840,000

[Alternatively, we can calculate cost of goods sold as cost of goods available for sale less ending balance in finished goods, or $1,160,000 less $320,000, to get $840,000.]

Therefore, the balance in cost of goods sold after writing off the underapplied amount of $40,000 is $840,000 + $40,000 = $880,000.

Given the unit data, we know total overhead = (4,800 Ã- $48) + (3,200 Ã- $72) = $460,800.

Variable overhead = 40% of direct labor $ = .40 Ã- [(4,800 Ã- $24) + (3,200 Ã- $36)] = $92,160.

Thus, fixed overhead = $460,800 - $92,160 = $368,640.

We can calculate the total assembly hours required to make 4,800 units of Cavalier and 3,200 units of Classic as (4,800 Ã- 0.80) + (3,200 Ã- 2.40) = 11,520 assembly hours.

Total budgeted overhead = Budgeted fixed overhead + Budgeted variable overhead

= $368,640 + (0.40 Ã- 230,400) = $460,800.

Therefore, the new overhead rate = per assembly hour.

With this rate, each unit of Cavalier will be charged ($40 Ã- 0.80) = $32 of overhead, and each unit of Classic will be charged ($40 per assembly hours Ã- 2.40 assembly hours) = $96 per unit. Therefore,

Unit manufacturing cost of Cavalier = $20 + $24 + $32 = $76.

Unit manufacturing cost of Classic = $30 + $36 + $96 = $162.

Note: With this new allocation scheme, the Classic appears even more expensive. It takes 3 times as long to assemble each Classic compared to each Cavalier. In contrast, with labor dollars as the allocation basis, the Classic attracted only 1.5 times the overhead as the Cavalier because the labor content of the Classic was 1.5 times that of the Cavalier. The question of which of these two allocation bases is more appropriate depends on which of these bases better captures the consumption of overhead resources. We addressed these issues in detail in Chapter 10, Activity Based Costing.

We can calculate the budgeted total overhead rate as:

Budgeted overhead rate = $0.80 per labor hour.

With this overhead rate, we can calculate applied overhead.

Applied overhead = $0.80 Ã- Actual labor cost incurred.

= $0.80 Ã- $900,000 = $720,000.

Therefore,

Underapplied (overapplied) overhead = Actual overhead - Applied overhead

= $640,000 - $720,000 = ($80,000), or

$80,000 overapplied.

There are three jobs in work-in-process at the end of the year - Jobs 126, 130, and 137. At the rate of $0.80 for every labor dollar, the overhead applied to these jobs would be:

Overhead applied to Job 126 = $25,000 Ã- 0.80 = $20,000.

Overhead applied to Job 130 = $15,000 Ã- 0.80 = $12,000.

Overhead applied to Job 137 = $40,000 Ã- 0.80 = $32,000.

Therefore,

The cost of Job 126 = $10,000 + 25,000 + $20,000 = $55,000.

The cost of Job 130 = $8,000 + $15,000 + $12,000 = $35,000.

The cost of Job 130 = $38,000 + $40,000 + $32,000 = $110,000.

The ending balance in work-in-process (before year-end adjustments) is ($55,000 + $35,000 + $110,000) = $200,000.

The following table prorates the overapplied overhead of $80,000 to work-in-process, finished goods, and cost of goods sold.

Account

Unadjusted balance

Proportion

Allocation of $80,000

Adjusted balance

Work-in-process

$200,000

20%

$16,000

$184,000

Finished Goods

$300,000

30%

$24,000

$276,000

Cost of Goods Sold

$500,000

50%

$40,000

$460,000

Total

$1,000,000

100%

$80,000

$920,000

If the company had chosen to write off the entire $80,000 of overapplied overhead to cost of goods sold, then income would have increased by $80,000. Because of proration, the income only increases by $40,000. Therefore, income would be higher under the write off approach by $40,000 (= $80,000 - $40,000).

Overhead rate for machine operations = = $80 per machine hour.

Overhead rate for assembly = = $15 per labor hour.

Applied overhead in Machine operations = $80 Ã- 12,000 = $960,000.

Actual overhead in Machine operations = $650,000.

Therefore, overhead was overapplied in machine operations by $310,000.

Applied overhead in Assembly = $15 Ã- 22,000 = $330,000.

Actual overhead in Assembly = $275,000.

Therefore, overhead was overapplied in assembly by $55,000.

Cost of Job #C252 in work-in-process = $2,000 + $6,000 + ($80 Ã- 40) + ($15 Ã- 250)

= $14,950.

The following table pro-rates the total overapplied overhead of $365,000 ($310,000 + $55,000) to work-in-process, finished goods, and cost of goods sold accounts.

Account

Unadjusted balance

Proportion

Allocation of $365,000

Adjusted balance

Work-in-process

$14,950

1.63%

$5,950

$9,000

Finished Goods

$150,000

16.39%

$59,824

$90,176

Cost of Goods Sold

$750,000

81.98%

$299,226

$450,774

Total

$914,950

100%

$365,000

$549,950

With pro-rating, income will rise by $299,226 for the year.

Clearly, in this case, McMaster has significantly over-estimated its overhead rate. In particular, the actual volume of operations is much higher (12,000 versus 7,500). Although the overhead costs also increased, the actual overhead rate of $650,000/12,000 = $54.16 for machining is significantly lower than the budgeted rate of $80 per machine hour. This error is the reason for the large overapplied overhead.

We can add up the listed amounts for overhead to calculate the overhead as $350,000 for production and $250,000 for assembly. We then have:

Overhead rate for Production = = $14 per machine hour.

Overhead rate for Assembly = = $0.50 per labor dollar.

We know that the applied overhead in the production department is $322,000. Thus,

$322,000 = $14 Ã- Actual machine hours worked, or

Actual machine hours worked = 23,000.

Applied overhead in Assembly = $0.50 Ã- actual direct labor cost

= $0.50 Ã- $550,000 = $275,000.

We first compute the amount by which overhead is under- or overapplied.

In Production, overhead is underapplied by $38,000 (= actual of $360,000 - applied overhead of $322,000). In Assembly, overhead is overapplied by $50,000 (= actual of $225,000 - applied overhead of $275,000). Combining the two departments, overhead is overapplied by $12,000.

Since this overapplied amount is written off as an adjustment to cost of goods sold, its balance decreases by $12,000 from $1,650,000 to $1,638,000.

The gross margin after adjustment would be $1,612,000 (= sales of $3,250,000 - cost of goods sold of $1,638,000).

Using normal volume, the total overhead rate for the year is:

Total overhead rate = Fixed overhead rate + Variable overhead rate

= = $128 per labor hour.

Using the rate from part (a), applied overhead for the year = Actual direct labor hours Ã- overhead rate = 110,000 Ã- $128 = $14,080,000.

The actual overhead incurred was $16,000,000. Thus,

Underapplied (overapplied) overhead = Actual overhead incurred - Applied overhead

= $16,000,000 - $14,080,000 = $1,920,000, or $1,920,000 underapplied.

Because the overhead was underapplied by $1,920,000, cost of goods sold is understated. Therefore, writing off the amount of cost of goods sold will increase cost of good sold, and decrease income.

Using budgeted direct labor hours, we compute the total overhead rate as:

Total overhead rate = Fixed overhead rate + Variable overhead rate

= = $152 per labor hour.

The applied overhead for the year = Actual direct labor hours Ã- overhead rate

= 110,000 Ã- $152 = $16,720,000.

The actual overhead incurred was $16,000,000. Thus,

Underapplied (overapplied) overhead = Actual overhead incurred - Applied overhead

= $16,000,000 - $16,720,000 = $720,000, or $720,000 overapplied.

If Hansen writes off this amount to cost of goods sold, the resulting adjustment will decrease cost of goods sold and increase net income.

By allocating fixed costs using budgeted volume, Hansen charges all costs to the volume budgeted for the year. Thus, last year, only 100,000 hours of direct labor were budgeted, much below the normal volume of 150,000 labor hours, which indicates that the company did not expect to utilize its capacity fully. Consequently, the fixed costs (including the costs of projected idle capacity of 50,000 labor hours) are spread over a smaller volume, resulting in a higher fixed overhead rate ($24 per hour higher = $152 - $128).

In contrast, by allocating fixed costs using normal volume, Hansen does not charge all costs to the volume budgeted for the year. This leads to stable product costs and can facilitate pricing and product emphasis decisions. On the downside, using normal volume can lead to large underapplied overhead amounts, and income decreasing adjustments at year end, when actual volume is consistently less than normal volume.

Most firms employ some variant of budgeted volumes to compute predetermined overhead rates. Chapter 10 discussed in detail the merits of alternative volume basis.

Note: The accounting for unused capacity is an item that is under debate both in the professional and practitioner communities.

There could be legitimate disagreement about Jason's profit. The item under dispute is whether the profit computation should include the overhead charge. In other words, should Jason take a short- or long-term view in computing the operating profit from the job?

There is little dispute about Jason's contribution margin from the job. It is $24,000 - $7,200 - $8,000 = $8,800. It is not clear whether Jason's expenditure on overhead would increase by $500 (=$8,000 applied based on actual labor - $7,500 budgeted) because of the increased labor cost. After all, the overhead represents an allocation of capacity costs, which are fixed in the short term. While Jason needs to include an allocation for overhead in pricing (he does need to take a long-term view in pricing), it is not clear that such an allocation is useful for assessing operational efficiency. Such a control role is a key driver for computing job-level profits. For that purpose, Jason should focus on contribution margin (as we detailed in Chapters 4-7).

The following table provides the required analysis.

Bid Actual Variance

Revenue $24,250 $24,000 $250 U

Direct materials $7,000 $7,200 $200 U

Labor $7,500 $8,000 $500 U

Contribution margin $9,750 $8,800 $950 U

As detailed in Chapter 8, we could further decompose the labor variance of $500U into a price and an efficiency portion. Using the columnar format, we have:

Budgeted As if budget Actual cost

500 Ã- $15 = $7,500 550 Ã- $15 = $8,250 $8,000

Thus, the labor efficiency variance = $750 U ($7,500 - $8,250) and the labor price variance is $250 F ($8,250 - $8,000).

Note: we do not have enough information to decompose the materials variance into price and efficiency components.

The variance analysis does not include a flexible budget because there is no change in output volume. That is, Jason budgeted costs for a certain amount of work (say a job that delivered 10,000 units). His actual costs would then be computed for the same amount of work (after all, the customer will demand 10,000 units before payment).

a.

The firm's total variable overhead is:

(10,000 Ã- $1 per hour) + (20,000 Ã- $5 per hour) = $110,000

The total fixed overhead is $400,000+ 630,000 = $1,030,000

Thus, total overhead is $1,140,000 = $110,000 + $1,030,000

The rate is $1,140,000/30,000 = $38 per labor hour.

b.

Machining OH Rate = [($1 Ã- 10,000) + $400,000] / 10,000 hours = $41.00 per hour

Assembly OH Rate = [($5 Ã- 20,000) + $630,000] / 20,000 hours = $36.50 per hour

c.

Ultimate

Deluxe

Direct material

$85.00

$60.00

Direct labor (1.5 hours at $25.00 per hour)

37.50

37.50

Mfg. overhead in machining

(@$41/ labor hour in machining)1

32.80

24.60

Manufacturing overhead in assembly (@$36.50 / labor hour in assembly)2

25.55

32.85

Total

$180.85

$154.95

1 $32.80 = $41 * 0.8 hours; $24.60 = $41 per hour *0.7 hours.

2 $25.55 = $36.50 * 0.6 hours; $32.85=$36.50 * 0.9 hours.

a.

The firm's total variable overhead is:

(30,000 hours Ã- $20 per hour) + (30,000 hours Ã- $6 per hour) = $780,000

The total fixed overhead is $115,000+ 230,000 = $345,000

Thus, the total overhead is $780,000 + $345,000 = $1,125,000

The rate is $1,125,000 / 60,000 hours = $18.75 per labor hour.

At this rate, each product gets an allocation of 12 hours Ã- $18.75 per hour = $225 toward its share of overhead costs.

b.

Dept. A OH rate = [(30,000 Ã- $20) + $115,000] / 30,000 = $23.83per DLH

Dept. B OH rate = [(30,000 Ã- $6) + $230,000] / 30,000 = $13.67 per DLH

c.

R1

R2

Direct material

$ 200.00

$ 300.00

Direct labor

$ 160.00

$ 160.00

Mfg overhead in dept A

(@$23.83 per hour)1

$ 214.47

$ 119.15

Mfg overhead in dept B

(@13.67 per hour)2

$ 41.01

$ 95.69

Total

$ 615.48

$ 674.84

1 $214.47 = $23.83 *9 hours; $119.15 = $23.83 per hour *5 hours.

2 $41.01 = $13.67 * 3 hours; $95.69 = $13.67 * 7 hours.

a.

The problem appears to be the way National is allocating overhead costs when developing bids. To see this, notice that the regular jobs (using data from Year 1) have an overhead rate of $100 per labor hour (= $20.5 million / 205,000 hours). The problem states that National has a long history with such jobs, meaning that this overhead rate would stay the same if National did not change its underlying characteristics.

However, the overhead rate has steadily increased over time. For Year 2, the rate was $107.317 ($22 million/205,000 hours) and was $116.279 for Year 3. It is likely that such dramatic increases in the overhead rate occur because of the addition of the new jobs, which seem to be resource intensive.

Indeed, the data support this conjecture. Suppose National had not added "new" jobs in Year 1. Then, for Year 2, we expect overhead of $19 million (190,000 hours Ã- $100 per hour) from the regular jobs. If we believe that the remaining overhead is because of the new jobs, we have the rate for new jobs as $200 per hour ($3 million/15,000 hours, where $3 million = $22 million - $19 million). Naturally, the average rate increased from year 1 to year 2. An analysis of the change in costs from Years 2 to 3 yields the same estimates for per hour rates for the two kinds of jobs.

This information clarifies why National's job mix is changing. Because it uses an average rate, and because it engages in cost based pricing, National is under-pricing the new jobs (charging overhead at $107 and $116 instead of $200 per labor hour) and over-pricing regular jobs (charging overhead at $107 and $116 instead of $100 per labor hour)!

b.

Much like the EZ-rest case that we discussed in Chapter 10, National might be able to improve its cost estimates if it moves to a two-pool system, with one pool for costs connected with regular jobs and another pool for costs associated with new jobs.

Total overhead rate = Fixed overhead rate + Variable overhead rate:

Total overhead rate for year 1 = = $1.65 per labor dollar.

Total overhead rate for year 2 = = $1.2333 per labor dollar.

We find that the overhead rate for year 2 is lower than for year 1 because the same fixed overhead of $1,000,000 is spread over a larger base of direct labor.

The total overhead rate computed using normal labor cost will be the same for each of the next two years. It is:

Total overhead rate = = $1.40 per labor dollar.

Projected application of overhead = Budgeted direct labor hours ´ overhead rate.

In year 1, the projected application of overhead = 800,000 ´ $1.65 = $1,320,000.

Projected total overhead = $1,000,000 + (800,000 ´ 0.4) = $1,320,000

In year 2, the projected application of overhead = 1,200,000 ´ 1.2333 = $1,480,000.

Project total overhead = $1,000,000 + (1,200,000 ´ 0.4) = $1,480,000

Therefore, Ricardo Windows does not expect to have any underapplied or overapplied overhead in either year.

Intuitively, this result makes sense. There is no "projected" underapplied or overapplied overhead because we are applying overhead using the same volume that we used to calculate the overhead rate in the first place.

Projected application of overhead = Budgeted direct labor hours ´ overhead rate.

In year 1, the projected application of overhead = 800,000 ´ $1.40 = $1,120,000.

Project total overhead = $1,000,000 + (800,000 ´ 0.4) = $1,320,000.

Therefore, there is underapplied overhead of $200,000 in year 1.

In year 2, the projected application of overhead = 1,200,000 ´ $1.40 = $1,680,000.

Projected total overhead = $1,000,000 + (1,200,000 ´ 0.4) = $1,480,000

Therefore, there is overapplied overhead of $200,000 in year 2.

Based on the overhead rate using the normal direct labor cost, the underapplied overhead in year 1 indicates that Ricardo expects unused capacity costs of $200,000. We know that in year 1, the budgeted volume is less than normal volume by $200,000. Therefore, we can calculate the projected cost of unused capacity as:

Cost of projected unused capacity = $200,000 ´ fixed overhead rate

= $200,000 ´ 1 = $200,000.

Notice that this matches the amount of the projected underapplied overhead exactly.

The overapplied overhead in year 2 indicates that the company expects to go beyond capacity by $200,000. We know that in year 2 the budgeted volume exceeds normal volume by $200,000. Therefore, we can calculate the fixed cost of additional capacity as:

Fixed cost of additional capacity = $200,000 ´ fixed overhead rate

= $200,000 ´ $1 = $200,000

Notice that this matches the amount of the projected overapplied overhead exactly.

In sum, if budgets accurate depict reality, then the use of budgeted volumes to compute predetermined overhead rates should lead applied overhead to mirror actual overhead. In contrast, the use of "normal" volumes frequently leads to under/overapplied overhead and, oftentimes, significant end-of-period adjustments. There are, of course, benefits to using long-run normal volumes - we discussed these benefits in Chapter 10, when we discussed ABC systems.

Mini-Cases

The total overhead rate is:

Total overhead rate =

Thus, total budgeted overhead for the previous year = $250,000 Ã- 2 = $500,000.

We can calculate the budgeted variable overhead as

Budgeted variable overhead = Budgeted total overhead - Budgeted fixed overhead.

= $500,000 - $375,000 = $125,000.

Variable overhead rate = = $0.50 per labor $.

We know that the total overhead rate is $2 per labor dollar. We can compute total overhead applied the previous year using this rate and actual labor cost:

Total overhead applied = Total overhead rate Ã- actual labor cost.

= 2 Ã- $300,000 = $600,000.

The actual overhead incurred was $ 630,000. Therefore,

Underapplied overhead = Actual overhead - Applied overhead.

= $630,000 - $600,000 = $30,000 underapplied.

We know that:

Budgeted fixed overhead rate = Budgeted total overhead rate

- Budgeted variable overhead rate

= $ 2 - $0.50 = $1.50 per labor $.

We therefore calculate applied fixed overhead as:

Applied fixed overhead = $1.50 Ã-$300,000 = $450,000.

Then,

Fixed overhead under- or overapplied

= Actual fixed overhead -Applied fixed overhead

= $475,000 - $450,000 = $25,000 or $25,000 underapplied.

We can calculate the actual variable overhead incurred as:

Actual variable overhead = Actual total overhead - Actual fixed overhead.

= $630,000 - $475,000 = $155,000.

Because the variable overhead rate is $0.50 per direct labor dollar,

Applied variable overhead = $300,000 Ã- 0.5 = $150,000.

Therefore,

Variable overhead under- or overapplied

= Actual variable overhead -Applied variable overhead

= $155,000 - $150,000 = $5,000, or $5,000 underapplied.

We know that the total overhead rate is $2 per labor dollar. Therefore,

Overhead that would have been applied to Job 125 = $20,000 Ã- 2 = $40,000.

Overhead that would have been applied to Job 178 = $13,000 Ã- 2 = $26,000.

Accordingly,

The cost of Job 125 in the work-in-process inventory = $16,000+$20,000+$40,000

= $76,000.

The cost of Job 178 in the work-in-process inventory = $18,000+$13,000+$26,000

= $57,000.

The total balance in the work-in-process account = $76,000 + $57,000 = $133,000.

If Superior Auto Body & Paint Shop were to write off the entire underapplied amount of $30,000 (=$25,000 underapplied fixed overhead + $5,000 underapplied variable overhead) to the cost of goods sold account, the balance in this amount would increase by $30,000 from $800,000 to $830,000, causing the income (before taxes) for the period to decrease by $30,000.

The following table computes the proportions and the allocation of the underapplied overhead of $30,000 (computed earlier) to the three accounts:

Account

Unadjusted Balance

Proportion

Allocation of $30,000

Adjusted balance

Work-in-process

$133,000

11.74%

$3,522

$136,522

Finished Goods

$200,000

17.65%

$5,295

$205,295

Cost of Goods Sold

$800,000

70.61%

$21,183

$821,183

Total

$1,133,000

100%

$30,000

$1,163,000

Referring to part (j), we see that the balance in the cost of goods sold account increases by $21,183 if the underapplied overhead is prorated to work-in-process, finished goods, and cost of goods sold. In contrast, we found in part (i) that cost of goods sold would increase by $30,000 if the entire amount is written off.

Consequently, the income would be higher by $8,817 ($30,000 - $21,813) if the underapplied were to be pro-rated instead of being written off fully to COGS.

a.

Let us begin by computing the ending balance in raw materials and supplies. We will use the inventory equation to determine all ending balances. For the raw materials and supplies inventory we have:

Beginning balance + purchases - issued out = ending balance.

Plugging in the numbers, we have:

Item

Amount

Beginning balance

$28,100

Purchases: RM

112,340

Purchases: Supplies

26,430

Issued out to WIP1

(115,450)

Issued out to overhead control

(22,000)

Ending Balance

$29,420

1$114,450= $22,000+$58,000+24,000+$11,450.

b.

We know that Divine uses a predetermined overhead rate, based on labor hours. From the budget, we know that:

Budgeted overhead for the year = $1,688,400

Budgeted labor hours for the year = 80,400

Thus, overhead rate per labor hour = $21 per labor hour.

c.

We know that the WIP has several jobs. Let us first calculate the cost of each of the jobs in WIP. Each job's cost consists of the beginning value plus materials issued plus labor costs plus overhead. We know the first three items for each job. We calculated the overhead rate to compute the overhead charged to a job. In part (b), we calculated the overhead rate. With this rate in hand, let us return to the valuation of individual jobs:

Job number

X

K

L

B

Total

Model

OO

OI

RO

RI

Description

Oval, OTC

Oval,

in sink

Round, OTC

Round,

in sink

Units

700

500

200

700

Labor hours

1,920

2,430

1,678

845

6,873

Beginning Balance

$124,320

$124,320

Raw materials

22,000

$58,000

$24,000

$11,450

115,450

Labor

34,560

43,740

29,365

15,210

122,875

Overhead1

40,320

51,030

35,238

17,745

144,333

Total

221,200

152,770

88,603

44,405

Cost per unit

$316

$305.54

$443.02

n/a

1Overhead rate of $21 per labor hour * number of labor hours.

We can then summarize the information as in the following table:

Beginning Balance - WIP

$124,320

Raw materials

115,450

Labor

122,875

Overhead

144,333

Completed: X

(221,200)

Completed: K

(152,770)

Completed: L

(88,603)

Ending balance - WIP

$44,405

Notice that the value of the ending WIP is the value of job B, the only job that is incomplete at the end of September. The cost of goods manufactured is the total of the costs of the jobs transferred to FG, which is ($221,200 + $152,770 + $88,603) = $462,573.

d.

Just as we did the detail for the WIP account, we need to compute the detail for the FG account as well. We need this detail because the FG has several types of products. Let us begin with the product level detail:

Model

OO

RI

OI

RO

Total

Description

Oval, OTC

Round,

In sink

Oval,

in sink

Round,

OTC

Units

Beginning inventory

100

400

450

0

Added this period

700

0

500

200

Sold in September

750

200

400

150

Ending inventory

50

200

550

50

Beginning Balance

$32,000

$78,900

$134,100

0

$245,000

From WIP

221,200

0-

152,770

88,603

462,573

Sold (see detail)

237,400

39,450

119,200

66,452.25

462,502.25

Ending inventory

15,800

39,450

167,670

22,150.75

245,070.75

Notice two features of the above table. First, the detail in the FG inventory is by product and not by batch. This is because there might be several batches of the same product in store. Second, it is useful to keep track of the inventory both in units and in value, because we need to employ an inventory cost flow assumption to value the units, and different units of the same product might have different values because they are from different batches.

The following table computes the sales value of each of the products. Notice that we keep track of the layers of inventory. Notice that the total corresponds to the Cost of Goods Sold of $462,502.25 we computed earlier.

Model

OO

RI

OI

RO

Description

Oval, OTC

Round,

In sink

Oval,

In sink

Round,

OTC

Units

Beginning inventory

100

400

450

0

Cost per unit (beginning value / number of units)

$320.00

$197.25

$298

N/A

Sold from beginning inventory

100

200

400

0

Value of units sold

$32,000

$39,450

$119,200

0

Added this period

700

0

500

200

Cost per unit (job cost / # of units)1

$316.00

$305.54

$443.02

Sold from current production

650

0

0

150

Value of units sold

$205,400

$0

Total Sales

$237,400

$39,450

$119,200

$66,452.25

1 $316 = $221,200/700.

e.

Answer computed as a piece of the answer to part c.

f.

Answer computed as a piece of the answer to part d.

g.

The final item we need to compute is the amount of under- or overapplied overhead. We know:

Under/overapplied overhead = applied overhead - actual overhead.

Until September, we have

Actual overhead = $1,569,450

Applied overhead = $1,581,615 $21/labor hour Ã- 75,315 labor hours

Overapplied OH = $12,165

That is, Divine begins September with a credit balance of $12,165 in the overhead control account.

Now, let us add the transactions for September in the overhead control account.

Item

Amount

Beginning balance (September 1)

(12,165)

Supplies

$22,000

Indirect labor

32,000

Supervision

18,400

Depreciation

32,650

Utilities

8,900

Factory rent

15,400

Applied overhead

(see WIP detail)

(144,333)

Ending balance

($27,148)

That is, Divine would have overapplied overhead of $27,148 as of September 30. Another way of computing the same answer is to compute the under/over applied overhead for September.

Actual overhead for September $129,350

Applied overhead for September $144,333

Overapplied overhead ($14,983)

Added to the overapplied balance at the start of September, the total overapplied overhead is $27,148 = $12,165 + $14,983.

Total overhead rate for year 1 = = $0.756 per labor dollar (rounded).

Total overhead rate for year 2 = = $0.694 per labor dollar (rounded).

Total overhead rate for year 3 = = $0.815 per labor dollar (rounded).

Applied overhead = Overhead rate Ã- Actual labor cost.

Overhead applied in year 1 = $0.756 Ã- $725,000 = $548,100.

Actual overhead in year 1 = $565,000.

Thus, overhead was underapplied in year 1 by $16,900.

Overhead applied in year 2 = $0.694 Ã- $900,000 = $624,600.

Actual overhead in year 2 = $600,000.

Thus, overhead was overapplied in year 2 by $24,600.

The total cost of Phoebe's order in year 2 = $15,000 + $30,000 + ($30,000 Ã- 0.694).

= $65,820.

The markup charged for each order is 50% of the total cost. Therefore:

Price charged for year 2 order = $65,820 + ($65,820 Ã- 0.50).

= $98,730.

The total cost of Phoebe's order in year 3 = $15,500 + $32,000 + ($32,000 Ã- 0.815).

= $73,580.

Price quoted for year 3 order = $73,580 + ($73,580 Ã- 0.50).

= $110,370.

It is hard to disagree with Phoebe. From her point of view, both direct materials and direct labor costs have not gone up by much. However, the overhead allocation rate is much higher in year 3 than in year 2 (up from $0.694 to $0.815 per direct labor dollar). The reason is that in year 3, the company's fixed costs are the same as in year 2, but Vanessa expects lower demand during the year -- the budgeted direct labor cost is down from $810,000 in year 2 to $650,000 in year 3. One could argue that there is no reason why Phoebe, as a customer, should pay a higher price just because things don't look good for Vanessa's company.

In suggesting any other method, there are at least two key issues to consider:

Year 3 appears to be a "down" year for the company. In general, when demand conditions are not favorable, most firms offer price cuts and discounts to stimulate demand. The cost-plus pricing scheme that Noel Draperies has in place results in a price increase, which is contrary to this common business intuition.

It also does not seem intuitive that the cost of what is essentially the same job appears to be a function of outside demand conditions.

Using normal volume to calculate the overhead rate addresses these issues because it will not fluctuate as the volume of business fluctuates from period to period. Because Vanessa believes the average of the actual direct labor cost over the previous two years is a fair estimate of the normal volume of business, we have:

Normal volume of business in direct labor cost = = $812,500

Overhead rate in year 3 using normal volume = = $0.652 per direct labor dollar.

Using this rate, the corresponding price for year 3 is:

year 3

Direct materials

$15,500

Direct labor

32,000

Applied overhead ($32,000 * 0.652)

20,864

Total cost

$68,364

Markup (50%)

34,182

Order price

$102,546

As we can see from these calculations and the price charged in year 2, the difference in prices between the job in year 2 and year 3 is almost entirely due to the differences in materials and labor costs. Thus, the use of normal volume in the denominator to calculate the overhead rate results in costing and pricing schemes that are more consistent over time.


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