Republic of the Philippines

Laguna State Polytechnic University

ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited

LSPU Self-Paced Learning Module (SLM)

Course Cost Accounting and Control
Sem/AY First Semester/2020-2021
Module No. 9
Lesson Title Accounting for Factory Overhead
Week
9
Duration
Date December 7 - 12, 2020
Description This lesson discusses the budgeting and estimating of factory overhead in a production
of the as well as the allocation of factory overhead to producing department
Lesson

Learning Outcomes
Intended Students should be able to meet the following intended learning outcomes:
Learning  Identify the different bases of computing factory overheads.
Outcomes  Classify the factory overheads as to variable or fixed and actual or applied.
 Apply the concept of actual and applied factory overheads.
Targets/ At the end of the lesson, students should be able to:
Objectives  Compute the factory overhead rate using the different bases
 Identify the different methods of allocating budgeted service department to
producing departments.
 Compute the different factors overhead variances.

Student Learning Strategies

Online Activities A. Online Discussion via Google Meet, Zoom or Messenger
(Synchronous/ You will be directed to attend in a one (1) hour class discussion on the
Asynchronous) introduction to cost accounting. To have access to the Online Discussion,
refer to this link: ____________________.

(For further instructions, refer to your Google Classroom and see the
schedule of activities for this module)

B. Learning Guide Questions:

1. What are the factors to consider in computing for the overhead rates?
2. What are the bases to be used?

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 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited

3. What is the purpose of departmental overhead rates?

4. What are the production capacity?
5. What are the methods of accumulating factory overhead?

Note: The insight that you will post on online discussion forum using Learning Management
System (LMS) will receive additional scores in class participation.
Offline Activities (e-Learning/Self-Paced)
Lecture Guide

All costs incurred in the factory that arc not direct materials or direct labor are generally termed as facto ry 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

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.

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

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 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.

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.

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.

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 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
FACTORS TO BE CONSIDERED IN THE COMPUTATION OF OVERHEAD RATE
1. BASE TO BE USED
a. Physical output
b. Direct materials cost
c. Direct labor cost
d. Direct labor hours
e. Machine hours

2. ACTIVITY LEVEL TO USE

a. Normal capacity
b. Expected actual capacity'

3. INCLUSION OR EXCLUSING OF FIXED FACTORY OVERHEAD

a. Absorption costing - method used for cost accounting
b. Direct costing - method used for internal reporting (management services)

4. USE OF SINGLE RATE OR SEVERAL RATES

a. Plant-wide or blanket rate - one rate for all producing departments
b. Departmentalized rate - one rate for each producing department.

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. 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
maybe used also if there a great disparity in hourly wage rates. The formula is expressed as:

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑟𝑎𝑡𝑒 =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑟 ℎ𝑜𝑢𝑟𝑠

Factory overhead rate/direct labor hour

2. 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 hours, 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 and equipment related cost. The formula is:

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 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑟𝑎𝑡𝑒 = 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 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. The formula is:

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑟𝑎𝑡𝑒 =
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 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:

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑟𝑎𝑡𝑒 = 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:

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑟𝑎𝑡𝑒 =
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

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 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
e. Direct labor hours

SOLUTION TO ILLUSTRATIVE PROBLEM

a. Factory overhead rate = Est. factory overhead
Est. direct material cost
= 450,000 x 100
600,000
= 75% of direct material costs

b. Factory overhead rate = Est. factory overhead

Est. units of production
= 450,000
90,000 units
= P5/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
= 450,000 x 100
300,000
= 150% of direct labor costs

e. Factory overhead rate = Est. factory overhead

Est. direct labor hours
= P450,000
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 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.

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 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
5. Compute the factory overhead rate (similar to computation using blanket rate).

In a departmentalized company, factory overhead should be budgeted for each department. The procedures for
distributing the budgeted departmental expenses are identical to those used to allocate the actual factory overhead
expenses. Prior to the computation of the departmentalized factory overhead rate, management must make sure that
the service department costs have been allocated to the producing departments. Departmentalized overhead 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

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 & air-conditioning Space occupied, volume occupied
10. Concession rental Space occupied & 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

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 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
METHODS OF ALLOCATING SERVICE DEPARTMENT COST TO PRODUCING DEPARTMENTS
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.

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. 'Hits 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 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.

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 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited

Bldgs & Factory

Molding Decorating Grounds Adm.
Budgeted FO P400,000 P600,000 P80,000 P120,000
Direct labor hours 200,000 100,000
Floor area 100,000 60,000 2,000 4,000
Machine hours 200,000 100,000

Requirements: Allocate the cost of the serv ice 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 P400,000 P600,000 P80,000 P120,000
Allocated FO
B&G 50,000 30,000 (80,000)
FA 80,000 40,000 (120,000)
Total FO 530,000 670,000
Base 200.000 MH 100,000 DLH
FO Rate P2.65/MHr P6.70/DLHr

Allocation of B & G cost

100
𝑀𝑜𝑙𝑑𝑖𝑛𝑔 = 𝑥 80,000
160

60
𝐷𝑒𝑐𝑜𝑟𝑎𝑡𝑖𝑛𝑔 = 𝑥 80,000
160
Allocation of FA cost
200
𝑀𝑜𝑙𝑑𝑖𝑛𝑔 = 𝑥 120,000
300

100
𝐷𝑒𝑐𝑜𝑟𝑎𝑡𝑖𝑛𝑔 = 𝑥 120,000
300

2. Step method
Molding Decorating B&G FA
Budgeted FO P400,000 P600,000 P80,000 P120,000
Allocated FO
B&G 48,781 29,268 (80,000) 1,951
FA 81,301 40,650 (121,951)
Total FO P530,082 P669,918
Base 200,000 MH 100,000 DLH
FO Rate P2.65/MHrs P6.70/DLHr

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 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
Allocation of B & G cost
100
𝑀𝑜𝑙𝑑𝑖𝑛𝑔 = 𝑥 80,000
164

60
𝐷𝑒𝑐𝑜𝑟𝑎𝑡𝑖𝑛𝑔 = 𝑥 80,000
164

4
𝐹𝐴 = 𝑥 80,000
164

3. Algebraic method
Additional information for the illustrative problem:
Services provided bv
B&G FA
Molding 50% 40%
Decorating 30% 50%
B&G - 10%
FA 20% -

Algebraic equation:
B&G = 80,000+ 10% (FA)
FA = 120,000 +20% (BG)

Substitution:

B&G = 80,000 + 10% (120,000 + .20BG)

= 80,000+ 12.000+ .02BG
98BG = 92,000
BG = 92,000
.98
= 93,878

FA = 120,000+ 20% (BG)

= 120,000 + 20% (93,878)
= 138,776

The allocation will be as follows:

Molding Decorating B&G FA

Budgeted FO P400,000 P600,000 P80,000 P120,000
Allocated FO
B&G 46,939 28,163 (93,878) 18,776
FA 55,510 69,388 13,878 (138,776)
Total FO P502,449 P697,551
Base 200,000 MH 100,000 DLH
FO rate P2.51/MHr P6.98/PLHr.

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 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
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 w hat 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.
b. 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 seasona l
and cyclical variations. This capacity is commonly used in the computations of overhead rates.

METHOD OF ACCUMULATION OF FACTORY OVERHEAD 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 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.

Entry to charge production with applied overhead:

Work m process - overhead xxx

Factory overhead applied xxx

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 ov erhead applied account.

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 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
Classification of manufacturing overhead variance

a. Underapplied overhead - the difference between actual overhead and applied overhead when the actual is more
than tire 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. Idle capacity or volume variance - the variance due to difference in volume and activity factors.

Computation of manufacturing overhead variance

a. Spending variance
Actual factory overhead incurred P xxx
Less: Budget allowed based on capacity used
Fixed factory overhead P xxx
Variable factory overhead xxx xxx
Spending variance P xxx
b. Idle capacity variance
Budget allowed based on capacity used P xxx
Less: Factory overhead applied xxx
Idle capacity’ variance P xxx

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 yearend, 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.

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 P 1,00/DLHr.
Actual factory overhead P350,000
Actual direct labor hours used 110,000 hrs.

LSPU SELF-PACED LEARNING MODULE: COST ACCOUNTING AND CONTROL

 Republic of the Philippines
Laguna State Polytechnic University
ISO 9001:2015 Certified
Province of Laguna
Level I Institutionally Accredited
Solution:
Spending variance:
Actual factory overhead P350,000
Budget allowed on actual hours
Fixed P200,000
Variable 110,000 310,000
Spending variance - unfavorable P 40,000

Idle capacity' variance:

Budget allowed on actual hours P310,000
Applied factory OH (110,000 x P3.00) 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 100,000 1.00
Total P 300,000 P 3.00

Factory overhead rate = 300,000

100,000hrs.
= P 3.00/DLHr.

Variable overhead cost = 100,000 Hrs. xP 1.00

P100,000

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