Direct costs are assigned to products during the accounting period when they are identified by material requisitions and daily time records, and summarized in either daily or weekly reports. In order to determine the total cost of production, the indirect costs have to be assigned to products in a timely manner. Unfortunately, manufacturing overhead costs, including equipment maintenance, lighting in the factory, and property taxes on the factory, cannot be directly identified with particular products. The cost accountant needs to design and implement a system to figure and record the actual overhead costs as they are incurred, as well as a system to assign manufacturing overhead to the products as they are produced.
Overhead costs are incurred during the accounting period. This happens when indirect materials are used for production, indirect labor is used to support production work, utilities are used, and maintenance is done on the factory. Whenever a manufacturing overhead cost is incurred, an entry is made to debit the manufacturing overhead control account and to credit the appropriate account. When indirect material is used for production, the raw materials inventory control account is credited. The entry for indirect labor uses a credit to payroll expense.
Certain overhead costs, like property taxes on the factory and casualty insurance premiums, are normally paid in advance once a year or periodically, and are recorded when paid. Depreciation on the factory and production equipment is normally recorded at the end of the accounting period. These costs benefit production for the entire year, but they are usually recorded either before or after production occurs. For this reason, at most points in the accounting period, the manufacturing overhead control account will include either more or less of the overhead costs that need to be assigned to the products.
Because actual overhead cost is not known until year-end, and overhead costs cannot be identified directly with products, cost accountants apply overhead with the use of the manufacturing overhead rate. Normally, the accountant bases the manufacturing overhead rate on direct labor hours, direct labor cost, or machine hours, or some other basis that is a logical measure of activity. The manufacturing overhead rate needs to be determined before the total amount of overhead cost for the period is determined. For this reason, the accountant needs to estimate both the amount of overhead cost for the period and the amount of production for the period. The overhead rate is then calculated by dividing the estimated overhead cost by the estimated activity level.
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