The area of overhead allocation falls within the field of management accounting, ie accounting internally focused to the running and decision making of a business. As apposed to financial reporting, which tends to be externally focused in 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; ie those costs that are incurred but not directly identifiable to the direct cost of that specific good or service.
For example in manufacturing: let’s say a business manufactures a range of “widgets” (if you haven’t come across this term before it is used where a generic good or service is being talked about – rather than going into the detail of a real world example) – widgets A, B and C. In this example the wages of the maintenance staff would be considered to be manufacturing overheads. Where as the wages of the accounting team would be classed as non-manufacturing overheads or administrative overheads.
We aren’t going to be getting into overhead cost allocation, that will certainly 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, while 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, are the debts a business may incur as a result of its normal day-to-day operations. This may be the electricity and gas accounts payable to the local power company, the rent owed to the landlord, materials bought that go into the manufacturing process, wages and salaries can also be accounts payable.
This account has a natural or normal credit balance and so to increase it a credit entry is made; while a debit entry would decrease 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 account. This machinery is used in contract work it carries out for its customers. The fuel is used in for their normal operations as it is an indirect cost for each contract job; ie it is no identifiable to any one particular contract, but rather to their normal contracting line of business. A more sophisticated system would be able to assign these fuel costs to specific contracts, 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. So at the end of January ABC was invoiced $5,545 by its local supplied for the fuel used for the month. 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 January fuel invoice and the following journal entry is made:
|Feb 15||Accounts Payable||5,545|||
The debit to Accounts Payable reduces this balance, this obligation has now been paid. While 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 these overheads can be allocated to the costs of work-in-progress and finished goods; so keep an eye for that. But in the mean time today we looked at a journal entry that debits manufacturing overhead and credits accounts payable; in particular how this increases the expenses of the business and increases its liabilities.