Bookkeeping entries for absorption of production overheads

mge

I have recently been reading about the bookkeeping entries for the absorption of production overheads.

As I understand it, production overheads are transferred to WIP using an OAR based on the PREDICTED overhead costs, and the PREDICTED levels of production.

If the predicted levels are significantly different from the actual levels, this will surely give an inaccurate figure for cost of sales, and therefore gross profit?

I can understand how this system may be necessary for costing purposes. However, for bookkeeping purposes would it not be more accurate to absorb production overheads retrospectively based on the ACTUAL overhead costs incurred and the ACTUAL levels of production?

Any help would be very much appreciated.

Rinske

mge wrote: »

I have recently been reading about the bookkeeping entries for the absorption of production overheads.

As I understand it, production overheads are transferred to WIP using an OAR based on the PREDICTED overhead costs, and the PREDICTED levels of production.

If the predicted levels are significantly different from the actual levels, this will surely give an inaccurate figure for cost of sales, and therefore gross profit?

I can understand how this system may be necessary for costing purposes. However, for bookkeeping purposes would it not be more accurate to absorb production overheads retrospectively based on the ACTUAL overhead costs incurred and the ACTUAL levels of production?

Any help would be very much appreciated.

The whole point of using the budgetted overhead rates is to have a clear overview of the expected costs.

Realistically in a company you write the raw materials to the WIP account the moment they are issued. If that's at the start of the month, you won't know what the actual costs are. By writing the budgetted costs to the WIP account at that point, it gives an indication of the costs per product, rather than no indication at all.

The point of budgetting costs is to have an expectation/ indication of what the costs will be so you can calculate that in the costs, but you don't know the actual costs till after the period.

mge

Many thanks for your reply Rinske. I'm still trying to get my head around this.

I can understand that raw materials could be transferred to WIP at the moment they are issued. Are you saying that you would transfer production overheads to WIP at the same time? In the examples in the book, production overheads get transferred to WIP at the end of a four week period.

SandyHood

Try and imagine a business where overheads constitute a large proportion of the total costs. I often talk about car repairs in garages.
You take the car in, the mechanic looks at it and quotes £75 per hour plus parts.

You might think wow mechanics get paid £75 per hour until you think that £9.00 is nearer the mark. The remaining £66 is to "recover" overheads and profit. Let us guess £50 per hour to recover overhead.

You don't know the overheads when the year starts so you produce the best budget you can. You pick the best method of recovering them, in the case of car mechanics, labour time.

So every hour a mechanic works on a car £50 is debited to the work in progress control account, and credited to the production overhead account.
Your text book might say it happens at the end of the month, but it doesn't have to.

I don't know where you work, if you work at a garage you might take the hours daily as part of your routine and so you'd enter the transactions a day after the hours are worked. If you are independent and go to the garage once a month/once a week you would put them on the system when you are working for the firm.

mge

Many thanks Rinske and SandyHood once again. Your answers have been extremely helpful.

I'm very impressed by this forum - it's great how people are prepared to help others out. Many thanks!