[Music] [ Silence ] >> So next we're going to talk a little bit more specifically about counting for overhead costs. That will be a theme that completes this module as well as takes us into the next one. But here are some basic considerations to kick things off. Let's envision a service setting, a consultant firm, and they face 2 issues, 1, accounting for costs, and 2, using those costs for a pricing decision. Now, to keep things very simple, we'll just consider 2 general types of costs that this consulting firm incurs. One is the labor, the consultants that are providing the service, and then two is everything else, the overhead; so facilities costs, support staff, et cetera. Let's turn to this example. [ Silence ] Now, one thing about overhead is the nature of its timing throughout the year. We can think about a year or any accounting period really, the beginning of the period and the end of the period. At the beginning of the period, we have an estimate, or a budgeted amount of overhead that we think we will spend. And it isn't until the end of the year that we actually know how much we actually spent. Also, the spending of overhead throughout the year is not as smooth as it is for other types of costs. For example, you might pay all of the rent for the facility at the beginning or the end of the period. Utilities costs might fluctuate throughout the period. Manager salaries might be lumpy as well. All of the costs that belong in overhead may not be as smooth throughout the period. The problem is, is that we're making decisions along the way. Again, we're focused on our pricing decision. So throughout the year, managers are trying to understand the cost of the service that they're providing, so that they can price these services appropriately. With the problem of overhead not knowing what the actual costs were until the end of the period, incorporating this information into that pricing decision can be difficult. So what we need is an estimate. And what we call that when we're talking about overhead, is an application, or an estimate of applied overhead. This allows us to inform what the cost of our services that we're providing during the year are so that we can make appropriate pricing and other decisions based on this information. So to apply overhead, we use a relatively simple formula. We refer to this as a predetermined overhead rate. In the numerator we have the total amount of overhead that we think will be spent for the accounting period. This is going to be in the form of dollars. In the denominator we have the total volume of some driver. Now, a driver, or a cost driver, is the measure of an activity that we think corresponds to the spending of overhead. Whatever the firm feels is the best driver, that's what will be used in the denominator of this equation. So that's some end, some volume of the cost driver that they've identified. We're using this rate to ultimately allocate overhead to the cost objects of interest. Now, there are 2 steps in applying overhead. The first is to calculate this predetermined overhead rate. And, again, it is some budgeted overhead in total, attributable to the accounting period ahead, divided by the total volume of the driver that we think best represents the spending of overhead. Suppose that the firm has identified that the total budgeted overhead for the year will be $1,500,000. And the driver that they've identified is labor hours. We think that as labor hour is used, that roughly corresponds to the spending of overhead; not perfectly, because these costs are not traceable directly to the actual consulting engagements, but it's a rough estimator. We've identified our capacity or the expected use of labor hours to be 30,000 labor hours in total; 1,500,000 divided by 30,000 labor hours is $50 per hour. That is our predetermined overhead rate. So step 2 in this process is actually to apply overhead. Suppose that a consulting engagement used 350 of these labor hours. Well, we can use our predetermined overhead rate, calculate it as $50 per hour, multiplied by the 350 labor hours that this consulting engagement used, its driver. That total is equal to $17,500. And it is this amount of overhead that gets applied to this particular engagement. This number, in conjunction with the amount spent on direct labor for the engagement, would provide a nice estimate cost incurred for this consulting engagement. In this case the pricing decision is more informed because we've incorporated more of the costs, including both direct labor, and overhead, or some representation of it so that the pricing decision can be more informed. So a few notes about applying overhead. First off, it's important to realize that the predetermined overhead rate is based on budgeted information. It's created at the beginning of the accounting period when actuals aren't available to us yet. However, estimates from the beginning of the year likely do that match actual overhead at the end of the year. Thus, an adjustment is usually made to reflect this difference in the costing system. When this difference is small, it's not as big of a deal. But large discrepancies can oftentimes throw managers off; the reason being if they have been relying on estimated overhead to make pricing decisions, but actual overhead ends up looking much differently, then their pricing decisions and other decisions may have been mislead. We'll talk in future modules about the importance of budgeting, and the role of these adjustments as we evaluate and compensate managers [ Silence ]
