Chapter 8
Accounting for Factory Overhead
Learning objectives
Upon completion of this chapter, you should be able to:
1. Compute a factory overhead rate using the different bases
2. Apply the concept of actual factory overhead and applied factory overhead
3. Identify and compute the different methods of allocating budgeted service
department to producing departments
4. Compute the different factory overhead variances
5. Apply the concept of activity based costing
● All costs incurred in the factory that are not direct materials or direct labor
are generally termed as factory overhead.
● Examples of Factory Overhead include the following:

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
● All costs incurred in the factory that are not direct materials or direct labor
are generally termed as factory overhead.
● Examples of Factory Overhead include the following:

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
Categories of FOH based on their behavior in relation to production
1. Variable overhead
2. Fixed overhead
3. Mixed overhead
Variable FOH costs
● Vary in direct proportion to the level of production, within the relevant range.
o
o
Variable cost per unit – constant as production either increases or
decreases.
Total variable cost – varies in direct proportion to production; the
greater the number of units produced, the higher the total variable
costs.
Fixed FOH costs
● Remain constant within the relevant range regardless of the varying levels of
production.
o
o
Total fixed cost – constant
Fixed cost per unit – varies inversely with the level of production; the
greater the number of units produced, the lower the fixed cost per unit
(this is the advantage of mass production – the more we produce the
lesser the manufacturing cost per unit).
Mixed FOH costs
● Neither wholly fixed nor wholly variable in nature but have characteristics of
both
● Mixed factory overhead costs must ultimately be separated into their fixed
and variable components for purposes of planning and control.
Budgeting FOH costs
● After factory overhead costs have been classified as either fixed, or variable,
budgets can be prepared for expected levels of production.
● The separation of fixed and variable cost components permits the company
to prepare a flexible budget.
Factors to be considered in the computation of OH rate
Base to be used
● The base to be used should be related to functions represented by the
overhead cost being applied.
● If FOH is labor-oriented, the most appropriate base to use is direct labor
hours or direct labor cost.
● If FOH is investment-oriented, the most appropriate base will be machine
hours.
● If FOH 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.
Direct labor hours
● This base should be used if it can establish that there is a direct relationship
between factory overhead and direct labor hours.
● It may be used also if there is a great disparity in hourly wage rates.
Direct labor cost
● This method is recommended if it can establish that there is a direct
relationship between labor cost and factory overhead.
● This base should not be used if there is little relationship between labor cost
and factory overhead.
● For example, if OH is composed largely of depreciation and equipment
related cost.
Machine hours
● This is appropriate when a direct relationship exist between factory
overhead cost and machine hours.
● This may occur in companies or departments that are largely automated so
that majority of the factory overhead cost consist of depreciation on factory
equipment.
● Additional work will be required because each machine will have a time
record to summarize the total machine hours used for each job.
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 very large part of total cost.
● Direct material cost is not appropriate base to when more than one product
is manufactured by a company.
● Different products require different materials and different quantities at that,
so it will be very inconvenient to use materials cost as the base because we
will have to compute a FOH rate for each product.
Units of production
● This is the simplest method to use because units produced are readily
available.
● This method is appropriate when a company or department manufactures
only one product.
Illustrative problem 1
a. Material cost
Illustrative problem 1
b. Units of production
Illustrative problem 1
c. Machine hours
Illustrative problem 1
d. Direct labor cost
Illustrative problem 1
e. Direct labor hours
Illustrative problem 1
● The rates computed are known as the plant-wide or blanket rates.
● All departments in the company will use the same application rate for FOH
and also the same base.
● A single plant-wide FOH 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 FOH.
● Multiple departmental FOH 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 FOH because of the differing amounts of attention each
product receives.
Steps in computation of departmentalized OH rate
1.
2.
3.
4.
5.
Divide the company into segments, called departments, cost centers, to
which expenses are charged.
Estimate the factory overhead for each department (direct departmental
charges + indirect departmental charges).
Select and estimate the base to be used by each department.
Allocate the service department costs to the producing departments.
Compute the factory overhead rate (similar to computation using blanket
rate).
● In a departmentalized company, FOH should be budgeted for each
department.
● The procedures for distributing the budgeted departmental expenses are
identical to those used to allocate the actual FOH expenses.
● Prior to the computation of the departmentalized FOH rate, management
must make sure that the service department costs have been allocated to
the producing departments.
● Departmentalized OH rates are for the producing departments only.
● Producing departments, which include the production lines, are the costaccumulation centers in which work is performed directly on the goods being
produced.
● On the other hand, service departments, which include such activities as
maintenance, personnel, employee services, and the provision of heat,
power, and light, are necessary for the entire factory – including the
producing departments – to remain in operation.
Typical allocation bases for common costs
Methods of allocating service dept. cost to producing depts.
1. Direct method - the most widely used 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.
Methods of allocating service dept. cost to producing depts.
2. Step method – sometimes called sequential method of allocation. This method
recognizes service 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 departments 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 cost are allocated,
no subsequent service department costs are allocated to it.
Methods of allocating service dept. cost to producing depts.
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 Administration
departments. Buildings 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.
Required: Allocate the cost of the service departments using:
1. Direct method
2. Step method – start with Bldgs & Grounds
3. Algebraic method
Illustrative problem 2
1. Direct method
Illustrative problem 2
1. Direct method
Illustrative problem 2
2. Step method
Illustrative problem 2
2. Step method
Illustrative problem 2
3. Algebraic method
Illustrative problem 2
3. Algebraic method
Illustrative problem 2
3. Algebraic method
Capacity production
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, 52 weeks a year without any interruptions in
order to yield the highest physical output possible.
b. Practical capacity - A capacity of production that provides allowance for
circumstances that might result to stoppage of production.
Capacity 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
computation of overhead rates.
Method of accumulation of FOH costs
1. Non-controlling account system - an account for each kind of overhead expense
according to their nature is opened in the ledger and charges to such account are
made upon incurrence of the expense.
2. Controlling account system – an overhead control account is opened in the general
ledger wherein the overhead incurred are charged and a subsidiary ledger is
maintained to show in detail the nature and account of the expense.
● 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 OH chargeable to individual cost sheets – FOH applied
● After the FOH application rate has been determined, it is used to apply (or
match) estimated FOH costs to production.
● The estimated factory overhead costs are applied to production on an ongoing basis as goods are manufactured, according to the base used.
● Applied factory overhead can be computed by multiplying the actual factor
incurred per cost sheet by predetermined overhead rate.
● Entry to charge production with applied OH
FOH variance
● It is 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 FOH variance
a. Underapplied overhead – the difference between actual overhead and
applied overhead when the actual is more than applied.
b. Overapplied overhead – the difference between actual overhead and
applies overhead when the actual is less than the applied.
Causes of FOH variance
a. Spending variance - the variance due to expense factors.
a. Idle capacity or volume variance - the variance due to difference in
volume and activity factors.
Computation of FOH variance
Spending variance
Computation of FOH variance
Idle capacity or volume variance
Accounting for FOH 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.
Accounting for FOH variance
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.
Illustrative problem 3
The Davidson Corporation made the following data available from its accounting
records and reports.
Illustrative problem 3
Activity-based costing (ABC) or Transaction costing
● In highly automated manufacturing environments, overhead application
rates based on the direct labor may not provide accurate overhead charges
because they no longer represent cause and effect relationship between
output and overhead costs.
● Activities (transactions) that consume overhead resources are identified and
related to the costs incurred.
● 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.
Activity-based costing (ABC) or Transaction costing
● A simple concept which can provide accurate information about a particular
product’s consumption of overhead resources.
● It is an approximation of a user’s fee.
● User’s fee refers to the process of charging for services consumed by users
of the service.
● It is based on the premise that if a product consumes many resources that
compromise overhead, it should bear a greater share of overhead costs than
other product that does not consume as any activity units.
Five basic steps in applying ABC
1.
2.
3.
4.
Assemble similar actions into activity centers.
Classifying costs by activity center and by type of expense.
Select cost drivers.
Compute a cost function to associate costs and costs- drivers with resource
use.
5. Assign cost to the cost objective.
Assemble similar activities into activity centers
● One way of grouping actions is to classify then with different level of activities:
namely, unit-level activities, batch-level activities, product-level activities and
facilities-level activities.
Assemble similar activities into activity centers
● 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.
Assemble similar activities into activity centers
● 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 setups, order processing, and materials handling.
Assemble similar activities into activity centers
● 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.
Assemble similar activities into activity centers
● 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.
● Costs that are traceable to the activity center should be assigned directly to
activity centers.
● Other costs share by two or more activity centers should be assigned
according to some cost driver that controls the utilization of the costs
involved.
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.
● 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 drivers 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 (P25,000/500hours).
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).
Illustrative problem
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
table below:
Illustrative problem
Illustrative problem
Using DLH as the base, FOH will be applied to the three products as follows:
Illustrative problem
The applied FOH when combined with the prime cost of each product will show
the following:
Illustrative problem
Under activity-based costing, the FOH rate is determined by dividing the total
costs of each OH activity by the total frequency for each activity.
Illustrative problem
The full cost per unit of each product will be determined as follows:
Illustrative problem
The applied overhead cost of the products were determined as follows:
Illustrative problem
● Under the traditional method, direct labor does not explain the cause-effect
relationship between the products and incurring of OH costs.
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