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Identify two reasons why overhead might be under-applied in a given year and how this might be prevented. Explain what a predetermined overhead rate is and how it is computed. Discuss the most appropriate allocation base for the denominator in the predetermined overhead rate calculation and justify your choice. Consider the factors involved in selecting this allocation base, including efficiency and relevance. Include citations within the text and references from credible sources to support your discussion.

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Overhead under-application occurs when the actual manufacturing overhead costs incurred during a period exceed the overhead costs applied to products or jobs based on the predetermined overhead rate. This discrepancy often arises due to estimation inaccuracies or allocation errors. One primary reason for under-application is inaccurate estimation of overhead costs at the beginning of the period. Companies typically use historical data or forecasts to estimate overhead; if these estimates are too low, it results in under-applied overhead at the end of the period (Garrison, Noreen, & Brewer, 2018). Another reason is the misestimation of activity levels, such as direct labor hours or machine hours, used as the basis for applying overhead. When actual activity levels are higher than estimated, the applied overhead does not match the actual expenses, leading to under-application. Prevention strategies include adjusting estimates regularly based on actual data, improving the accuracy of cost estimations, and reviewing overhead rates periodically to reflect current operational conditions (Hilton & Platt, 2018).

A predetermined overhead rate is a rate used to apply manufacturing overhead costs to jobs or products throughout a fiscal period. It is calculated before the period begins and is based on estimated overhead and an activity base such as direct labor hours or machine hours. The rate is computed by dividing the estimated total manufacturing overhead by the estimated total activity base. For example, if estimated overhead is $180,000 and estimated direct labor hours are 15,000, the predetermined overhead rate would be $12 per direct labor hour ($180,000 / 15,000). This rate enables companies to assign overhead costs consistently and in a timely manner (Weygandt, Kimmel, & Kieso, 2019).

Choosing an appropriate allocation base is crucial for accurately assigning manufacturing overhead costs. The best base is typically a measure that has a strong causal relationship with overhead costs, such as direct labor hours, machine hours, or material costs. The decision depends on the nature of the production process. For instance, if overhead costs are primarily driven by machine usage, machine hours are preferred. If labor effort is more influential, direct labor hours are more suitable (Drury, 2013). Factors to consider include the ease of measurement, the relevance to overhead incurrence, and the consistency of the base's relationship with costs. An optimal allocation base reduces the risk of over- or under-applied overhead and enhances cost accuracy (Kaplan & Anderson, 2004).

In practical application, the choice of an allocation base influences the precision of cost control and decision-making. For example, using direct labor hours might be appropriate in labor-intensive industries, whereas machine hours are better for automated processes. The focus should be on selecting a base that accurately reflects the consumption of resources used to incur overhead costs, thereby ensuring acceptable levels of accuracy and simplicity in calculations (Innes & Mitchell, 2018). Consequently, understanding the production environment and cost behavior is fundamental when selecting an allocation base, ultimately leading to better financial management and strategic planning (Horvath & Schindler, 2020).

References:

Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial Accounting (16th ed.). McGraw-Hill Education.

Hilton, R., & Platt, D. (2018). Managerial Accounting: Creating Value in a Dynamic Business Environment (11th ed.). McGraw-Hill Education.

Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2019). Managerial Accounting (16th ed.). John Wiley & Sons.

Drury, C. (2013). Management and Cost Accounting (8th ed.). Cengage Learning.

Kaplan, R. S., & Anderson, S. R. (2004). Time-driven activity-based costing. Harvard Business Review, 82(11), 131-138.

Innes, J., & Mitchell, F. (2018). Activity-based costing: Making it work for manufacturing and services. Chartered Institute of Management Accountants.

Horvath, P., & Schindler, R. (2020). Cost Management Strategies for Competitive Advantage. International Journal of Business and Management, 15(2), 45-60.