Question

In a service industry or manufacturing company, how likely is it that POHR is applied correctly? What happens when POHR is under applied or over applied? What would be the affect on what management would do?

Answer 1

Predetermined overhead rate (POHR) is used to apply manufacturing overhead to products or job orders and is usually computed at the beginning of each period by dividing the estimated manufacturing overhead cost by an allocation base or activity base. Commonly used allocation bases are direct labor hours, direct labor dollars, machine hours, and direct materials.

formula  of predetermined overhead rate is ;

  predetermined overhead rate = estimated manufacturing overhead cost

   estimated total units in the allocation base

A cost driver is a measure of activities, such as machine-hours, that is the cause of costs. To assign overhead to jobs, the cost driver should be the cause of the overhead costs, or at least be reasonably associated with the overhead costs. Just as automobile mileage is a good cost driver for measuring the cause of fuel consumption, machine-hours is a measure of what causes energy costs. By assigning energy costs to jobs based on the number of machine-minutes or hours the job uses, we have a pretty good idea of the energy costs required to produce the job.

The predetermined overhead rate computed above is known as single predetermined overhead rate or plant-wide overhead rate. It is mostly used by small companies. In large companies, each production department computes its own predetermined overhead rate. The use of multiple predetermined overhead rates may be complex and time consuming but is considered more accurate than a single plant-wide overhead rate.

According to a survey 34% of the manufacturing businesses use a single plant wide overhead rate, 44% use multiple predetermined overhead rates and rest of the companies use activity based costing (ABC) system.

The over or under-applied manufacturing overhead is defined as the difference between manufacturing overhead cost applied to work in process and manufacturing overhead cost actually incurred during a period.

If the manufacturing overhead cost applied to work in process is more than the manufacturing overhead cost actually incurred during a period, the difference is known as over-applied manufacturing overhead. On the other hand; if the manufacturing overhead cost applied to work in process is less than the manufacturing overhead cost actually incurred during a period, the difference is known as under-applied manufacturing overhead.

simply,,

over applied manufacturing overhead == applied overhead >>> actual overhead

under applied manufacturing overhead == applied overhead <<< actual overhead

Over or under-applied manufacturing overhead is actually the debit or credit balance of manufacturing overhead account.

At the end of a period, if manufacturing overhead account shows a debit balance, it means the overhead is under-applied. On the other hand; if it shows a credit balance, it means the overhead is over-applied.

The management will take enough steps to maitain an accurate measurement on predetermined overhead rate and it will encounter difficult if there is huge difference between actual cost and predetermined cost.