Overhead accounting involves recording and allocating indirect costs associated with the operation of the business. These indirect costs, known as production overheads, are essential for running the business but cannot be directly linked to a specific product. Overhead accounting aims to systematically identify, classify, calculate, and allocate these costs, providing a comprehensive understanding of the true cost of production. It plays a crucial role in determining accurate production costs, facilitating price setting, and evaluating production efficiency and performance.
Overhead Accounting
Overhead accounting encompasses the systematic recording and allocation of indirect costs associated with the business operation. These production overheads are crucial for the business operation but aren’t directly attributable to a specific product. These include expenses like rent, utilities, and equipment depreciation, which are essential but not directly tied to a specific product. Overhead accounting ensures these costs are accurately distributed across the produced units, enabling a comprehensive understanding of the true cost of manufacturing.
- Identification of Overheads: Overheads can be fixed or variable. Fixed overheads, like rent, remain constant irrespective of production levels, while variable overheads, such as utilities, fluctuate with production volume. Identifying and categorizing these costs is the initial step.
- Collection and Allocation: Once identified, overhead costs are collected and allocated to the relevant cost centers or production units. This allocation is often based on specific allocation bases, such as machine hours or direct labor hours.
- Calculation of Overhead Rates: Overhead rates are then calculated by dividing the total overhead costs by the chosen allocation base. These rates provide a basis for distributing overhead costs to individual units of production.
- Application to Production Activity: Actual production activity levels, measured by the chosen allocation base, serve as the foundation for applying overhead rates. This step helps in determining the overhead cost associated with each unit produced.
- Journal Entries: Journal entries are recorded in the accounting system, debiting the Work in Process account (reflecting the direct production costs) and crediting the Manufacturing Overhead account.
- Reconciliation and Financial Reporting: At the end of the accounting period, reconciliation ensures that all overhead costs are accounted for. This process is crucial for accurate financial reporting, aiding in decisions related to production costs, pricing strategies, and overall operational efficiency.
Example
Assume a company, XYZ Manufacturing, has the following information:
- Total actual overhead costs incurred during the month: $50,000
- Allocation base: Machine hours
- Total machine hours worked during the month: 5,000
- The predetermined overhead rate (overhead rate calculated based on machine hours): $10 per machine hour
Now, let’s calculate the applied overhead costs and record the journal entry.
1 – Calculation of Applied Overhead Costs
Applied Overhead=Overhead Rate * Actual Machine Hours Applied Overhead = $10 * 5,000 = $50,000
2 – Recording Journal Entry
- Debit the Work in Process (WIP) account to recognize the overhead cost applied to the products being manufactured.
- Credit the Manufacturing Overhead account to reduce the balance in the overhead account.
| Date | Account | Debit ($) | Credit ($) |
|---|---|---|---|
| MM/DD/YYYY | Work in Process | 50,000 | |
| MM/DD/YYYY | Manufacturing Overhead | 50,000 |
This journal entry reflects the application of $50,000 of overhead costs to the Work in Process account. The Manufacturing Overhead account is credited to reduce its balance.
3 – Adjustments and Reconciliation
At the end of the accounting period, the company will compare the applied overhead costs ($50,000 in this case) with the actual overhead costs incurred. If there is any difference, an adjustment may be required to bring the accounts in line.
For example, if the actual overhead costs were $52,000, there would be an underapplied overhead of $2,000. In this case, an adjusting debit entry would be made to increase the Cost of Goods Sold, and the credit goes to the Manufacturing Overhead account.
| Date | Account | Debit ($) | Credit ($) |
|---|---|---|---|
| MM/DD/YYYY | Cost of Goods Sold | 2,000 | |
| MM/DD/YYYY | Manufacturing Overhead | 2,000 |
This adjustment ensures that the actual overhead costs are accurately reflected in the financial statements.
Keep in mind that the specific accounts used and the amounts involved will vary based on the company’s accounting policies and practices. The example provided is a simplified illustration.
In summary, overhead accounting is a crucial process for maintaining up-to-date financial records in businesses. By accurately capturing and distributing indirect costs, businesses can make informed decisions, ensuring profitability and sustainability in a competitive market.
Key takeaways
- Overhead accounting is the systematic process of recording and allocating indirect costs in businesses, ensuring a comprehensive understanding of the true production costs beyond direct expenses.
- Overheads, essential but not directly tied to products, can be fixed (e.g., rent) or variable (e.g., utilities). Moreover, they are collected and allocated based on chosen bases, like machine hours. Overhead rates are then calculated, forming the basis for distribution to individual units.
- Actual production activity levels determine the application of overhead rates, enabling a precise calculation of overhead costs associated with each unit produced.
- Overhead accounting is not just a financial formality; it’s a strategic tool. It empowers businesses to set competitive prices, evaluate production efficiency, and make informed decisions crucial for long-term sustainability.
Further Reading:
Overhead Allocation
Overhead (Indirect Expenses)
Absorption Costing
Overhead Absorption Methods
Overhead Budget
Fixed and Variable Overheads