These journal entries are pretty common. Hopefully, you recall them from your Financial Accounting background. Here I've shown the journal entries to record depreciation expense, utilities expense, and expired prepaid insurance.
Let's combine them into one journal entry to help in this visual aid. If this company were a service firm or a merchandiser, this journal entry is perfectly correct.
The expenses are recorded and end up on the income statement as operating expenses in the period incurred. Operating expenses are period costs.
But let's assume this company is a manufacturer and all of these costs come from the production activity of the value chain. These costs are product costs and need to be moved to balance sheet inventory accounts rather than expense accounts. So we actually record manufacturing overhead costs to the manufacturing overhead account
rather than the various expense accounts used by service or merchandising firms. The credits still go to the related balance sheet accounts.
So actual manufacturing overhead costs are debited to the account manufacturing overhead . This account is an expense account but it is where all overhead is accumulated before it is moved to WIP.
So let's learn how to do that.
Manufacturing overhead cannot be traced to specific jobs based on actual cost incurred. This is because manufacturing overhead are costs that cannot easily be traced to products. They include indirect materials, indirect labor, and other costs often related to production operations as a whole.
Additionally, the actual costs are not known, usually, before the job is closed. Because of this, companies assign manufacturing overhead to work in process using an estimated basis known as the predetermined overhead rate. The predetermined overhead rate, sometimes referred to as a plant wide rate, is based on the relationship between estimated annual overhead costs and expected annual operating activity.
So the predetermined overhead rate calculates an estimated amount of manufacturing overhead assigned to jobs based on activity like; direct labor costs, or direct labor hours, or machine hours.
The formula for computing predetermined overhead rate is budgeted annual manufacturing overhead dollars, divided by the estimated amount of the allocation base.
Then the rate is used to apply overhead to jobs.
So the WIP account is debited for direct materials, direct labor and applied or estimated manufacturing overhead. It is not debited for actual overhead. It is very important that you remember that.
Let's look at example of how to calculate and use the predetermined overhead rate.
Here a company estimates that its total manufacturing overhead for the upcoming year will be 2.5 million dollars. It estimates that it will use 100,000 direct labor hours to complete all the jobs.
So the predetermined overhead rate is 2.5 million dollars, divided by 100,000 direct labor hours, which equals $25.00 of manufacturing overhead per direct labor hour.
That's the predetermined overhead rate.
Let's assume that Job 10 uses 1000 hours of direct labor to complete, so we would apply 25,000 dollars of manufacturing overhead to that job. So $25,000 would be moved
from the manufacturing overhead account to WIP.
On the job cost record, manufacturing overhead would be applied for the total of $25,000.
A completed job cost record might look something like this: $50,000 for direct materials; $10,000 for direct labor; and $25,000 for manufacturing overhead - making the total job cost $85,000.
Finally, let's look at the journal entries related to manufacturing overhead. The journal entry to record actual manufacturing overhead is a debit to manufacturing overhead and a credit to the various balance sheet accounts. The journal entry to apply overhead to jobs is a debit to WIP and a credit to manufacturing overhead. Remember the amount of this journal entry is determined by using the predetermined overhead rate, not actual manufacturing overhead costs.
And that concludes this short video and how to allocate overhead to jobs.