Question

Luzadis Company makes furniture using the latest automated technology. The company uses a job-order costing system and applies manufacturing overhead cost to products based on machine-hours. The predetermined overhead rate was based on a cost formula that estimates $900,000 of total manufacturing overhead for an estimated activity level of 75,000 machine-hours.

During the year, a large quantity of furniture on the market caused Luzadis to cut production and build inventories. The company provided the following data for the year:

Machine-hours 60,000
Manufacturing overhead cost $ 850,000
Inventories at year-end:
Raw materials $ 30,000
Work in process (includes overhead applied of $36,000) $ 100,000
Finished goods (includes overhead applied of $180,000) $ 500,000
Cost of goods sold (includes overhead applied of $504,000) $ 1,400,000
Required:
Compute the underapplied or overapplied overhead.
Assume the company closes underapplied or overapplied overhead to Cost of Goods Sold. Prepare the appropriate journal entry.
Assume the company allocates underapplied or overapplied overhead proportionally to Work in Process, Finished Goods, and Cost of Goods Sold. Prepare the appropriate journal entry.
How much higher or lower will net operating income be if the underapplied or overapplied overhead is allocated to Work in Process, Finished Goods, and Cost of Goods Sold rather than being closed to Cost of Goods Sold?

Answer 1

To determine the underapplied or overapplied overhead, we first need to calculate the applied overhead and then compare it to the actual overhead costs.

### Step 1: Determine the Predetermined Overhead Rate (POHR)

The predetermined overhead rate (POHR) is calculated as follows:

\[
\text{POHR} = \frac{\text{Estimated Total Manufacturing Overhead}}{\text{Estimated Total Machine-hours}} = \frac{900,000}{75,000} = 12 \text{ per machine-hour}
\]

### Step 2: Calculate Applied Overhead

The applied manufacturing overhead can be calculated using the following formula:

\[
\text{Applied Overhead} = \text{POHR} \times \text{Machine-hours used}
\]

Using the actual machine-hours of 60,000:

\[
\text{Applied Overhead} = 12 \times 60,000 = 720,000
\]

### Step 3: Determine Underapplied or Overapplied Overhead

Now we can calculate whether the overhead is underapplied or overapplied by comparing applied overhead to actual overhead.

\[
\text{Underapplied or Overapplied Overhead} = \text{Actual Overhead} - \text{Applied Overhead}
\]
\[
\text{Underapplied or Overapplied Overhead} = 850,000 - 720,000 = 130,000 \text{ (underapplied)}
\]

### Step 4: Prepare Journal Entry Closing to Cost of Goods Sold

If the underapplied overhead is closed to Cost of Goods Sold, the journal entry would be:

**Journal Entry:**
```
Date Account Debit Credit
[Date] Cost of Goods Sold 130,000
Manufacturing Overhead 130,000
```

### Step 5: Prepare Journal Entry Allocating to WIP, FG, and COGS

The next step is to allocate the underapplied overhead proportionately to Work in Process, Finished Goods, and Cost of Goods Sold.

To do this, we first need to find the total costs to allocate the underapplied overhead:

- Work in Process: $100,000 (includes $36,000 applied overhead)
- Finished Goods: $500,000 (includes $180,000 applied overhead)
- Cost of Goods Sold: $1,400,000 (includes $504,000 applied overhead)

Calculating total manufacturing costs:
\[
\text{Total Costs} = 100,000 + 500,000 + 1,400,000 = 2,000,000
\]

Now, we calculate the allocation for each component based on their proportion of total costs:

#### Proportions:
- WIP: \( \frac{100,000}{2,000,000} = 0.05 \)
- FG: \( \frac{500,000}{2,000,000} = 0.25 \)
- COGS: \( \frac{1,400,000}{2,000,000} = 0.7 \)

Now, apply the underapplied overhead:

- Proportion to WIP: \( 130,000 \times 0.05 = 6,500 \)
- Proportion to FG: \( 130,000 \times 0.25 = 32,500 \)
- Proportion to COGS: \( 130,000 \times 0.7 = 91,000 \)

**Journal Entry for Allocation:**
```
Date Account Debit Credit
[Date] Work in Process 6,500
Finished Goods 32,500
Cost of Goods Sold 91,000
Manufacturing Overhead 130,000
```

### Step 6: Effect on Net Operating Income

If the underapplied overhead is closed directly to Cost of Goods Sold, the Cost of Goods Sold would increase by $130,000. Therefore, Net Operating Income (NOI) would be lower by $130,000.

On the other hand, if the underapplied overhead is allocated proportionally, the impact on Cost of Goods Sold would be only $91,000.

Thus, the difference in impact on Net Operating Income is:

\[
\text{Difference in NOI} = 130,000 - 91,000 = 39,000
\]

**Conclusion**: Net Operating Income would be $39,000 higher if the underapplied overhead is allocated to Work in Process, Finished Goods, and Cost of Goods Sold rather than being closed directly to Cost of Goods Sold.