The area of overhead allocation falls within management accounting, i.e. accounting focused on the running and decision making of a business instead of financial reporting. Financial reporting tends to be externally focused on the accounting information it produces. So in today’s accounting tutorial, we put the management accounting hat on and look at a journal entry that debits manufacturing overhead and credits accounts payable.
What is a Manufacturing Overhead?
We refer to overhead costs, including those within manufacturing, as indirect costs, i.e. those incurred but not directly identifiable to the direct cost of that specific good or service.
For example, in manufacturing, a business manufactures a range of “widgets” – widgets A, B and C. In this example, the wages of the maintenance staff are manufacturing overheads. In comparison, the wages of the accounting team would are non-manufacturing overheads or administrative overheads.
We will not be getting into overhead cost allocation; that will undoubtedly be for another accounting tutorial one day. But for this article, all we need to have is an understanding of what this cost is.
When we are dealing with overheads, we are, of course, dealing with expenses, which in the accounting equation have a natural debit balance. A debit to the account increases the balance, say when we pay for office rent, a credit decreases the balance.
What are Accounts Payable?
Probably better known to most readers, accounts payable, or often referred to as creditors or trade creditors. A business incurs debts in its normal day-to-day operations. For example, these debts could be electricity and gas, rent, materials, wages, and salaries.
This account has a natural or normal credit balance, and so to increase it, you make a credit entry, while a debit entry decreases the balance. And we’ll look at this in the example below.
Example Journal Entry
In this example, our trusty example company, ABC Ltd, buys fuel for its machinery on the account. ABC uses the machinery for contract work it carries out for its customers. The fuel is used for their normal operations as it is an indirect cost for each contract job; i.e. it is not identifiable to any particular contract, but rather to their regular contracting line of business. A more sophisticated system would assign these fuel costs to specific agreements, but ABC doesn’t operate this, and so allocates this cost across all contracts on a flat daily rate.
ABC pays its fuel bill on the 15th of the month following. At the end of January, ABC was invoiced $5,545 by its local fuel supplier. The accounts team would prepare the following entry:
|Jan 31||Machinery Fuel||5,545|||
The debit to the Machinery Fuel expense account increases this balance, while the credit increases the Accounts Payable (or creditors) account – thus keeping the accounting equation in balance.
Come February 15, ABC pays for the January fuel invoice and makes the following journal entry:
|Feb 15||Accounts Payable||5,545|||
The debit to Accounts Payable reduces this balance; the entry settles the obligation. At the same time, the credit part of the entry reduces the asset’s balance by the same amount of $5,545.
We will be producing material that looks at how overhead allocation to work-in-progress and finished goods. But today, we looked at a journal entry that debits manufacturing overhead and credits accounts payable; in particular, how this increases the business’s expenses and increases its liabilities.