Accounting for Factory Overhead

Learning Objectives

 Compute a factory overhead rate using the different bases

 Apply the concept of actual factory overhead and applied factory overhead department to
producing departments
 Compute the different factory overhead variances
 Apply the concept of activity-based costing

Introduction

All costs incurred in the factory that are not direct materials or direct labor are generally termed a
factory overhead. Factory overhead refers to the cost pool used to accumulate all indirect
manufacturing costs. Examples:

 Indirect materials and indirect labor

 Heat, light, and power for the factory
 Rent on factory building
 Depreciation on factory building and factory equipment
 Maintenance of factory building and factory equipment

Factory overhead is divided into three (3) categories:

1. Variable
2. Fixed
3. Mixed

Variable FO costs – these are factory overhead costs that vary in direct proportion to the level of
production, within the relevant range. Variable cost per unit remains constant as production either
increases or decreases. The greater the number of units produced, the higher the total variable costs.

Fixed FO costs – these are factory overhead cost that remain constant within the relevant range
regardless of the varying levels of production. The total remains constant but the fixed cost per unit
varies inversely with the production, that is, the greater the number of units produced, the lower the
fixed cost per unit.

Mixed FO costs – these factory overhead costs are neither wholly fixed nor wholly variable in nature but
have characteristics of both. Must be ultimately be separated into their fixed and variable components
for purposes of planning and control.
Budgeting Factory Overhead Costs

Budgets are management’s operating plans expressed in qualitative terms, such as units of production
and related costs. After factory overhead costs have been units of production and related costs. After
the factory overhead costs have been classified as either fixed, or variable, budgets can be prepared for
expected levels of production.

Factors to be considered in the computation of overhead

Base to used

a. Physical output
b. Direct materials cost
c. Direct labor cost
d. Direct labor hours
e. Machine hours

Activity level to use

a. Normal capacity
b. Expected actual capacity

Inclusion or exclusion of fixed factory overhead

a. Absorption costing – used for cost acctg

b. Direct costing – used for internal reporting (management services)

Use of single rate or several rates

a. Plant-wide or blanket rate – one rate for all producing dept

b. Departmentalized rate – one rate for each producing dept

Based to be used

The base to be used should be related to functions represented by the overhead cost being applied. If
factory overhead is labor – oriented, the most appropriate base to use is direct labor hours or direct
labor cost. If factory is investment-oriented, related to operation of machinery, then the most
appropriate base will be machine hours. On the other hand, if factory overhead is material-oriented,
then material cost might be considered as the most appropriate base. The simplest of all bases is
physical output or units of production.
1. Direct labor hours
This is the most commonly used base or denominator in the computation of the predetermined
factory overhead rate.

Factory overhead rate = Estimated factory overhead

Estimated direct labor hours

= Factory overhead rate/direct labor hour

2. Direct labor cost

This method is recommended if it can established that there is a direct relationship between
labor cost and factory overhead.

Factory overhead rate = Estimated factory overhead X 100

Estimated direct labor cost

= Percentage of direct labor cost

3. Machine hours
This is appropriate when a direct relationship exist between factory overhead cost and machine
hours.

Factory overhead rate = Estimated factory overhead

Estimated machine hours

= Factory overhead rate/machine hour

4. Direct material cost

This method is appropriate if it can be inferred that factory overhead costs are directly related
to direct material cost as in cases where direct materials are a very large part of total cost.

Factory overhead rate = Estimated factory overhead X 100

Estimated direct material cost

= Percentage of direct material cost

5. Units of production
This is most simple method to use because units produced are readily available. This method is
appropriate when a company or department manufactures only one product. The formula is:

Factory overhead rate = Estimated factory overhead

Estimated units of production

= Factory overhead rate/unit of production

ILLUSTRATIVE PROBLEM 1

The Round Table Company estimates factory overhead at P450,000 for the next fiscal year. It is
estimated that 90,000 units will be produced at a material cost of P600,000. Conversion will require an
estimated 100,000 direct labor hours at a cost of P3.00 per hour, with 45,000 machine hours.

Required: Compute the predetermined factory rate base on:

a. Material cost
b. Units of production
c. Machine hours
d. Direct labor cost
e. Direct labor hours

SOLUTION TO ILLUSTRATIVE PROBLEM 1

a. Factory overhead rate = Est. factory overhead

Est. direct mat. Cost

= P450,000 X 100
P600,000

= 75% of direct mat. Cost

b. Factory overhead rate = Est. factory overhead

Est. units of production

= P450,000
90,000 direct labor hours

= P5.00/unit

c. Factory overhead rate = Est. factory overhead

Est. machine hours

= P450,000
45,000 machine hours

= P10.00/machine hour
 d. Factory overhead rate = Est. factory overhead
Est. direct labor cost

= P450,000 X 100
P300,000
= P150% of direct labor cost

e. Factory overhead rate = Est. factory overhead

Est. direct labor hours

= P450,000
100,000 direct labor hours

= P4.50/direct labor hour

The rates computed above are known as the plant-wide or blanket rate. All departments in the company
will use the same application rate for factory overhead and also the same base. A single plant wide
factory application rate can be used when either a single product is being manufactured or when the
different products being manufactured pass through the same series of productive departments and are
charged similar amounts of applied factory overhead. Multiple departmental factory overhead
application rates are preferable when the different products being manufactured either do not pass
through the same series of productive departments or, if they do, they should be charged dissimilar
amounts of applied factory overhead because of the differing amounts of attention each product
receives.

STEPS IN COMPUTATION OF DEPARTMENTALIZED OVERHEAD RATE

1. Divide the company into segments, called departments, cost centers, to which expenses are
charged.
2. Estimate the factory overhead for each department (direct departmental charges + indirect
departmental charges).
3. Select and estimate the base to be used by each department.
4. Allocate the service department costs to the producing departments.
5. Compute the factory overhead rate (similar to computation using blanket rate).

TYPICAL ALLOCATION BASES FOR COMMON COSTS

Most common costs can be grouped into four:

1. Labor-related common costs

2. Machine-related common costs
3. Space-related common costs
4. Service-related common costs
 Common costs should be analyzed carefully to determine the most appropriate allocation base. The
typical allocation bases for common costs are shown below

COMMON COST TYPICAL ALLOCATION BASE

Labor-related
1. Supervision No. of employees, payroll amount of DLHrs
2. Personnel services Number of employees

Machine-related
3. Insurance on equipment Value of equipment
4. Taxes on equipment Value of equipment
5. Equipment depreciation Machine-hours, equipment value
6. Equipment maintenance Number of machines, machine hours

Space-related
7. Building rental Space occupied
8. Building insurance Space occupied
9. Heat and air-conditioning Space occupied, volume occupied
10. Concession rental Space occupied and desirability of location
11. Interior bldg. maintenance Space occupied

Service-related
12. Material handling Quantity or value of materials
13. Billing and accounting Number of documents
14. Indirect materials Value of direct materials

METHODS OF ALLOCATING SERVICE DEPARTMENT COST TO PRODUCING DEPARTMENTS

1. Direct method – the most widely method. This method ignores any service rendered by one
service department to another, it allocates each service department’s total cost directly to the
producing departments.

2. Step method – sometimes called sequential method of allocation. This method recognizes
services rendered by service departments to other service departments and is more
complicated because it requires a sequence of allocation. The sequence typically starts with the
department that renders service to the greatest number of other service departments and ends
with the department that renders service to the least number of other departments. Once a
service department’s costs are allocated, no subsequent service department costs are allocated
to it.

3. Algebraic method – sometimes called reciprocal method. This method allocates costs by
explicitly including the mutual services rendered among all departments.
 ILLUSTRATIVE PROBLEM 2
Kappa Gamma Company’s factory is divided into four departments – producing departments;
Molding and Decorating, serviced by the Buildings and Grounds and the Factory Admiration
departments. Building and Grounds cost will be allocated using square feet (floor area) and
Factory Administration cost will be allocated using direct labor hours. In computing
predetermined overhead rates, machine hours are used as the base in Molding and direct labor
hours as the base in Decorating.

 CAPACITY PRODUCTION In the estimation of manufacturing overhead, as well as the estimation of the
base to be used for allocation, it is important to determine what capacity of production should be
adopted. a. Theoretical, maximum or ideal capacity - a capacity to produce at full speed without
interruptions. It gives no allowance for human capacity to achieve the maximum nor due allowance for
any circumstances that might result to a stoppage of production within or not within the control of
management. At this capacity level, the plant is assumed to function 24 hours a day, 7 days a week, and
52 weeks a year without any interruptions in order to yield the highest physical output possible.

c. Practical capacity - a capacity of production that provides allowance for circumstances that
might result to stoppage of production. c. Expected actual capacity - a capacity concept based
on a short range outlook which is feasible only for firms whose products are seasonal or where
the market and style changes allow price adjustments according to competitive conditions and
customer demands. d. Normal capacity - a capacity of production taking into consideration the
utilization of the plant facilities to meet commercial demands served over a period long enough
to level out the peaks and valleys which come with seasonal and cyclical variations. This capacity
is commonly used in the computations of overhead rates.
Actual overhead costs are usually incurred daily and recorded periodically in the general and subsidiary
ledgers. Subsidiary ledgers permit a greater degree of control overhead factory overhead costs as
related accounts can be grouped together and the various expenses incurred by different departments
can be described in detail. COMPUTATION OF OVERHEAD CHARGEABLE TO INDIVIDUAL COST SHEETS -
(FACTORY OVERHEAD APPLIED) After the factory overhead application rate has been determined, it is
used to apply (or match) estimated factory overhead costs to production. The estimated factory
overhead costs are applied to production on an on-going basis as goods are manufactured, according to
the base used (i,e., as a percentage of direct material costs or direct labor cost or on the basis of direct
labor hours, machine hours, or units produced). Applied factory overhead can be computed by
multiplying the actual factor incurred per cost sheet x predetermined overhead rate.

Factory overhead variance - the difference between the actual factory overhead as shown by factory
overhead control account and the overhead charged to production as shown by the factory overhead
applied account. Classification of manutacturing overhead variance a. Underapplied overhead - the
difference between actual overhead and applied overhead when the actual is more than the applied. b.
Overapplied overhead - the difference between actual overhead and applied overhead when the actual
is less than the applied. Causes of the manufacturing overhead variance: a. Spending variance - the
variance due to expense factors. b. ldle capacity or volume variance - the variance due to difference in
volume and activity factors.

ACCOUNTING FOR OVERHEAD VARIANCE a. During the period prior to the closing of the books, the
overhead variance is not recognized in the account and the actual factory overhead account as well as
the applied factory overhead accounts are kept open. When interim financial statements are prepared
and the variance is expected to be absorbed prior to year-end, such variance should be deferred rather
than disposed of immediately. b. At the end of the accounting period 1. If the amount of the overhead
variance is immaterial or it is established to be the result of inefficiency, it is closed to cost of goods sold.
2. If the amount of the overhead variance is material and found to be the result of an erroneous
computation of the predetermined overhead rate, such variance is distributed to the cost of goods sold,
finished goods inventory, and the work in process inventory.

ACTIVITY BASED COSTING The growth in the automation of manufacturing has brought many
challenges to product costing. Increased use of robotics, specialized machinery, and other computer-
driven processes has changed the nature of manufacturing and the composition of total product cost.
In many highly-automated manufacturing businesses the significance of direct labor cost has
diminished and overhead costs have increased. The cost of acquiring installing, maintaining, and
operating state-of-art manufacturing technologies has greatly increased overhead costs. In addition,
costs that used to be classified as indirect such as quality control, computer programming, trouble
shooting, and middle level management costs have become major components of total production
cost. In highly automated manufacturing environments, overhead application rates based on direct
labor may not provide accurate overhead charges because they no longer represent cause and effect
relationship between output and overhead costs. The need for more representative overhead
application bases has led to activity-based costing (ABC) which is also known as transaction costing.
Those activities (transactions) that consume overhead resources are identified and related to the costs
incurred. The basic premise in activity-based costing is that overhead costs that are caused by
activities are traced to individual product units on the basis of frequency of consumption of overhead
resources by each product.

Traditional overhead is applied to production using one of the application bases which were have
previously discussed such as direct labor hours, machine hours, direct labor cost, direct material cost
and units of production. Direct labor hours, direct labor costs, machine hours, machine hours, or units
produced are volume based application bases. Volume-based production means that the more units
estimated to be produced, the larger the denominator in the equation used to determine the overhead
rate, thus the smaller the overhead application rate and it follows that the amount of overhead
assigned to each unit will be lesser so overhead will be underapplied which is unfavorable. Activity-
based costing is a simple concept which can provide accurate information about a particular product's
consumption of overhead resources. ABC is an approximation of a user's fee. A user's fee refers to
the process of charging for services consumed by users of the service. ABC is based on the premise
that if a product consumes many resources (activities) that comprise overhead, it should bear a
greater share of overhead costs than other product that does not consume as any activity units. In
other words, activity costing is also like riding the LRT, the more you ride, the more cards you need
to buy. FIVE BASIC STEPS IN APPLYING ABC 1. ASSEMBLE SIMILAR ACTIONS INTO ACTIVITY
CENTERS 2. CLASSIFY COSTS BY ACTIVITY CENTER AND BY TYPE OF EXPENSE 3. SELECT COST DRIVERS 4.
COMPUTE A COST FUNCTION TO ASSOCIATE COSTS AND COST-DRIVERS WITH RESOURCE USE 5. ASSIGN
COST TO THE COST OBJECTIVE Assemble similar activities into activity centers There are several
number of actions performed in any organization so t wil be difficult to relate to the cost of every
action to a cost driver and then to the product. Therefore, it wil be best to combine actions into
activity centers. One way grouping actions is to classify them with different levels of activities; namely,
unit-level activities, batch-level activities, product-level activities, and facilities-levet activities. Unit-level
activities are performed each time a unit is produced. Example - assembly, stamping, and machining.
Costs of these activities vary with the number of units produced. Batch- level activities are performed
each time a batch of units is produced. The costs of these activities vary according to the number of
batches but remain fixed for all units in the batch. Examples - machine set-ups, order processing, and
materials handling. Product-level activities are those performed as needed to support the production of
each different type of product. Examples - production scheduling, product designing, and parts and
products testing. Facility-level activities are those which sustain a facility's general manufacturing
process. Examples - plant supervision, building occupancy, and personnel administration. Classify costs
by activity center and by type of expense. Assign costs to the activity centers where they are
accumulated while waiting to be applied to products. Select the cost drivers The cost drivers are the
links between cost, activity, and product . Cost drivers are not needed for direct costs because these can
be traced immediately to a product. However, indirect costs such as factory overhead need links or
drivers to link a pool of costs in an activity center to the product . Calculate a cost function A cost
function is used to translate the pool of costs and cost driver data into a rate per cost driver unit or a
percentage of other cost amounts, just like the plant-wide or departmentalized factory overhead rate.
For example, if the costs of the setup activity center is P25,000 and the selected cost driver is 500
hours, then the cost function will be P50 per setup hour (P25,000/500 hours). Assign cost to the cost
objective The last step is to allocate the costs to the different users of the resource. This is done by
multiplying the rate determined in the preceding paragraph by the actual data of the cost driver . If
actual setup hours used is 40, then the allocated cost will be P2,000 (40 hours x P50). We now
illustrate ABC by comparing it to one of the volume-based overhead allocation procedures, namely
direct labor hours. For instance, NDL Company has three products, namely: C, D, and E and three
related overhead activities: product-line setups, number of handles and number of parts. The number
of setups refer to the number of times each product line is readied for production. The number of
handles refers to the number of times each product is moved from one work station to another. The
number of parts refers to the number of parts that is used in making each product. The production,
overhead activities and their corresponding costs are shown on the