Systems Design Question Solutions Essay Example

production costs such as a factory manager’s salary cannot be traced to a particular product or job, but rather are incurred as a result of overall production activities. In addition, some production costs such as indirect materials cannot be easily traced to jobs.

If these costs are to be assigned to products, they must be allocated to the products. If actual manufacturing overhead costs are applied to jobs, then the company must wait until the end of the accounting period to apply overhead and to cost jobs. A company may try to compute its actual overhead rate more frequently to get around this problem. However, overhead cost tends to be incurred somewhat uniformly from month to month (due to the presence of fixed costs), whereas production activity often fluctuates.

The result would be high overhead rates in periods with low activity and low overhead rates in periods with high activity. For these reasons, most companies use predetermined overhead rates to apply manufacturing overhead costs to jobs. The measure of activity used as the allocation base should drive the overhead cost; that is, the base should cause the overhead cost. If the allocation base does not cause the overhead, then costs will be incorrectly attributed to products and jobs and product costs will be distorted. Assigning manufacturing overhead costs to jobs does not ensure a profit. The units produced may not be sold and if they are sold, they may not be sold at prices sufficient to cover all costs. It is a myth that assigning costs to products or jobs ensures that those costs will be recovered. Costs are recovered only by selling to customers—not by allocating

costs. Generally, the amount of overhead applied will not be the same as the amount of actual cost incurred, since the predetermined overhead rate is based on estimates. Underapplied overhead occurs when the actual overhead cost exceeds the amount of overhead cost applied to jobs during the period. Overapplied overhead occurs when the actual overhead cost is less than the amount of overhead cost applied to jobs during the period. Underapplied or overapplied overhead is disposed of by either closing out the amount to Cost of Goods Sold or by allocating the amount among Cost of Goods Sold and ending inventories in proportion to the applied overhead in each account.