CHAPTER ACCOUNTING FOR FACTORY

4: OVERHEAD

TOPICS
1. Definition of Factory Overhead
2. Categories of Factory Overhead Costs
3. Budgeting Factory Overhead Costs
4. Methods of Allocating Service Department Cost to Producing Departments
5. Factory Overhead Variances

LEARNING OUTCOMES
1. Compute the 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.

TOPIC 1: DEFINITION OF FACTORY OVERHEAD

All costs incurred in the factory that are not direct materials or direct labor are
generally termed as factory overhead. One method to determine whether a factory
expenditure is a factory overhead item is to compare it to the classification standard
established for direct materials and direct labor costs. If the expenditure cannot be
charged to either of these two “direct” factory accounts, it is classified as factory
overhead. Factory overhead refers to the cost pool used to accumulate all indirect
manufacturing costs. 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

TOPIC 2: CATEGORIES OF FACTORY OVERHEAD COSTS

Factory overhead costs are divided into three categories on the basis of their
behavior in relation to production. The categories are (1) variable overhead (2) fixed
overhead and (3) mixed overhead.

1. Variable factory overhead costs – these are the 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. Total variable cost
varies in direct proportion to production, that is, the greater the number of units
produced, the higher the total variable costs.

2. Fixed factory overhead costs – these are the factory overhead costs that remain
constant within the relevant range regardless of the varying levels of production. The

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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 (this
is the advantage of mass production – the more we produce the lesser the
manufacturing cost per unit.

3. Mixed factory overhead costs – these factory overhead costs are 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.

TOPIC 3: BUDGETING FACTORY OVERHEAD COSTS

Budgets are management’s operating plans expressed in quantitative terms,

such as units of production and related 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 COMPUTATIOIN OF THE OVERHEAD RATE

1. BASE 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.a. Direct labor hours

This is the most commonly used base or denominator in the computation of the
predetermined factory overhead rate. The number of direct labor hours spent for a particular is
readily available on the payroll sheet. This base should be used if it can be established that is a
direct relationship between factory overhead and direct hours. It may be used also if there a
great disparity in hourly wage rates. The formula is expressed as:

Factory overhead rate = Estimated factory overhead

Estimated direct labor hours
= Factory overhead rate/direct labor hour

1.b. Direct labor cost

This method is recommended if it can be established that there is a direct relationship

between labor cost and factory overhead. Just like direct labor hour, the direct labor cost is
readily available on the payroll sheet. Labor rates do not change as often as material cost, so this
base is more reliable that material cost. This base should not be used if there is little relationship
between labor cost and factory overhead. For example, if overhead is composed largely of
depreciation equipment related cost. The formula is:

Factory overhead rate = Estimated factory overhead x 100

Estimated direct labor cost
= Percentage of direct labor cost

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1.c. Machine hours

This is appropriated when a direct relationship exists 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 for each job. The formula is:

Factory overhead rate = Estimated factory overhead

Estimated machine hours
= Factory overhead rate/machine hour

1.d 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. 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 compute a factory overhead rate for each product. The formula is:

Factory overhead rate = Estimated factory overhead x 100

Estimated direct material cost
= Percentage of direct material cost

1.e 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

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 based on:

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

Solution to Illustrative Problem

a. Factory overhead rate = Est. factory overhead

Est. direct mat, cost
= P 450,000 x100
P 600,000
= 75% of direct mat cost

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b. Factory overhead rate = Est. factory overhead
Est. units of production
= P 450,000
90,000 units of production
= P 5.00/unit

c. Factory overhead rate = Est. factory overhead

Est. machine hours
= P 450,000
45,000 machine hours
= P 10.00/machine hour

d. Factory overhead rate = Est. factory overhead

Est. direct labor cost
= P 450,000 x 100
P 300,000
= P 150% of direct labor cost

e. Factory overhead rate = Est. factory overhead

Est. direct labor hours
= P 450,000
100,000 direct labor hours
= P 4.50/direct labor hour

The rate computed above is 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 charge dissimilar amounts of applied factory
overhead because of the differing amounts of attention each product receives.

TOPIC 4: METHODS OF ALLOCATING SERVICE

DEPARTMENT COST OF PRODUCING DEPARTMENTS

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.

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

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that render 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.

Algebraic method

Sometimes called reciprocal method. This method allocates costs by explicitly including
the mutual services rendered among all departments.

Illustrative Problem

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 are) 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 hours
as the base in Decorating.
Bldgs. & Factory
Molding Decorating Grounds Adm.
Budgeted FO P 400,000 P 600,000 P 80,000 P 120,000
Direct labor hours P 200,000 P 100,000
Floor area 100,000 60,000 2,000 4,000
Machine hours 200,000 100,000

Requirements Allocate the cost of the service departments using.

1. Direct method
2. Step method – start with Bldgs. & Grounds
3. Algebraic method

Solution to Illustrative Problem

1. Direct method

Molding Decorating B&G FA

Budgeted FO P 400,000 P 600,000 P 80,000 P 120,000
Allocated FO
B&G P 50,000 P 30,000 (P 80,000)
FA P 80,000 P 40,000 (P 120,000)
Total FO P 530,000 P 670,000
Base 200,000 MHrs. 100,000 DLHrs.
FO Rate P 2.65/MHr. P 6.70/DLHr.

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Allocation of B & G cost
Molding = 100 x P 80,000
160
Decorating = 60 x P 80,000
160

Allocation of FA cost
Molding = 200 x P 120,000
300
Decorating = 100 x P 120,000
300

2. Step method

Molding Decorating B&G FA

Budgeted FO P 400,000 P 600,000 P 80,000 P 120,000
Allocated FO
B&G P 48,781 P 29,268 (P 80,000) P 1,951
FA P 82,301 P 40,650 (P 121,951)
Total FO P 530,082 P 66,918
Base 200,000 MHrs. 100,000 DLHrs.
FO RATE P 2.65/MHrs. P 6.70/DLHr.

Allocation of B & G cost

Molding = 100 x P 80,000
164
Decorating = 60 x P 80,000
164
FA = 4 x P 80,000
164

3. Algebraic method

Additional information for the illustrative problem

Services provided by:
B & G FA
Molding 50% 40%
Decorating 30% 50%
B&G - 10%
FA 20% -

Algebraic equation:
B&G = P 80,000 + 10% (FA)
FA = P 120,000 + 20% (BG)
Substitution
B&G = P 80,000 + 10% (P 120,000 + 20BG)
= P 80,000 + P 12,000 + .02BG
98BG = P 92,000
BG = P 92,000
.98
= P 93.878

FA = P 120,000 + 20% (BG)

= P 120,000 + 20% (93,878)
= P 138.776

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The allocation will be as follows:
Molding Decorating B&G FA
Budgeted FO P 400,000 P 600,000 P 80,000 P 120,000
Allocated FO
B&G P 46,939 P 28,163 (P 93,878) P 18,776
FA P 55,510 P 69,338 P 13,878 (P 138,776)
Total FO P 502,449 P 697,551
Base 200,000 MHrs. 100,000 DLHrs.
FO rate P2.51/MHr. P6.98/DLHr.

TOPIC 5: FACTORY OVERHEAD VARIANCES

Factory overhead variance 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 manufacturing overhead variance

1. Underapplied overhead – the difference between actual overhead and applied overhead
when the actual is more than the applied.

2. Overapplied overhead – the difference between actual overhead and applied overhead when
the actual is less than the applied.
Computation of manufacturing overhead variance

1. Spending variance
Actual factory overhead incurred P xxx
Less: Budget allowed based on capacity used
Fixed factory overhead P xxx
Variable factory overhead P xxx P xxx
Spending variance P xxx

2. Idle capacity variance

Budget allowed based on capacity used P xxx
Less: Factory overhead applied P xxx
Idle capacity variance P xxx

Accounting for overhead variance

1. During the period 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.

2. At the end of the accounting period.

a. 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.
b. 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.

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Illustrative problem:

The Davidson Corporation made the following data available from its accounting records
and reports.

Budgeted factory overhead P300,000

Budgeted direct labor hours 100,000 hrs.
Variable factory overhead rate P1.00/DLHr.
Actual factory overhead P350,000
Actual direct labor hours used 110,000 hrs.

Solution

Spending variance:
Actual factory overhead P350,000
Budget allowed on actual hours
Fixed P 200,000
Variable P 110,000 P 310,000
Spending variance – unfavorable P 40,000

Idle capacity variance:

Budget allowed on actual hours P 310,000
Applied factory OH (110,000 x P3.00) P 330,000
Idle capacity variance – favorable (P 20,000)

To understand fully the computation of the variance, the following table may be prepared:
Total Per hour
Fixed overhead P 200,000 P 2.00
Variable overhead P 100,000 P 1.00
Total P 300,000 P 3.00

Factory overhead rate = P 300,000

100,000 hrs.
= P 3.00/DLHr.
Variable overhead cost = 100,000 Hrs. x P 1.00
= P 100,000

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