University of Luzon

COLLEGE OF ACCOUNTANCY Accounting for Overhead

1st Semester 2023-2024 ACC206 Cost &Cost Management II

Accounting for Overhead

Variable overhead costs, such as power and supplies, move in direct proportion to changes in
production. Fixed overhead costs, such as property taxes, insurance, and straight-line
depreciation, remain unchanged as production levels change. Semivariable overhead costs
have characteristics of both variable and fixed costs. They are sometimes called mixed costs or
semifixed, if the cost is more fixed than variable. Type A semivariable costs, also known as step-
variable costs, change as certain levels of production are reached (for example, inspection and
handling costs). If the steps are especially wide before moving up to the next level of costs, such
as the salaries of factory supervisors, they are known as step-fixed costs. Those costs that vary
continuously, but not in direct proportion to volume changes (for example, maintenance costs),
are Type B semivariable costs.

The methods used for isolating the fixed and variable elements of a semivariable expense include
(1) the observation method, (2) the high-low method, (3) the scattergraph method, and (4) the
least squares regression method. With the observation method, also called the account
analysis method, the relationship of the change in cost to the change in production is examined
by observation and a decision is made to either treat the semivariable cost as a variable item or a
fixed item, depending upon which it more closely resembles. The high-low method compares a
high volume and its related cost to a low volume and its related cost and thus determines the
variable amount per unit and the fixed element of the semivariable cost. The scattergraph
method estimates a straight line along which the semivariable costs will fall. The point where the
straight line intersects the y-axis represents total fixed costs. The variable cost per unit is
computed by subtracting fixed costs from total costs at any point on the graph and then dividing
by the volume level for that point. The least squares regression method uses all of the data to
separate a semivariable cost into its fixed and variable elements based on the equation for a
straight line, Y = a + bX. The isolation of fixed and variable cost components using one of the
above methods permits the preparation of a flexible budget that shows the expected factory
overhead at any anticipated level of production within a relevant range of activity.

In a small manufacturing company having one production department, all the factory overhead
accounts may be kept in the general ledger. When the factory overhead accounts are
numerous, a factory overhead subsidiary ledger, known as the factory overhead ledger, is
kept and the control account in the general ledger is Factory Overhead.

In a departmentalized manufacturing company, each factory overhead expense should be

analyzed carefully to determine the kind and amount of expense to charge to each department. In
a moderately sized company, the factory overhead ledger can be expanded to include a separate
account for each department’s share of each kind of expense. In larger companies, factory
overhead analysis sheets are used to keep a subsidiary record of factory overhead expenses.
An expense-type analysis sheet system has a separate sheet for each type of expense that
contains amount columns for each department. A department-type analysis sheet system has
a separate sheet for each department, with each sheet containing separate amount columns for
each type of expense. General factory overhead expenses not identified with a specific
department are charged to departments by a process of allocation.

A production department, such as machining or assembly, is one in which actual

manufacturing operations are performed, and the materials being processed are physically
changed. A service department, such as building maintenance or the power plant, does not
work on the product but rather services the needs of the production departments. Total product
costs should therefore include a share of service department costs. The cost of operating each
service department should be distributed to the production departments in proportion to the
benefit that each service department renders to each production department. The type of work
done by each service department should be determined and a basis for distributing costs, such
as floor space or number of workers, should be selected that equitably allocates the service
department cost to the production departments.

Methods used for distributing service department costs to production departments include
(1) the direct distribution method, which distributes service department costs directly to
production departmentsonly; (2) the sequential distribution or step-down method,
University of Luzon
COLLEGE OF ACCOUNTANCY Accounting for Overhead
1st Semester 2023-2024 ACC206 Cost &Cost Management II

whichdistributes service department costs sequentially to other service departments and to

production departments; or (3) the algebraic distribution method, which distributes service
department costs to other service departments and to production departments using algebraic
methods. When service department costs are allocated to producing departments only, the
results may be more easily attained but are less accurate than the allocations obtained using the
other methods. Under the sequential distribution method, two of the more common methods
used to determine the order in which to allocate the service costs are to distribute first the costs
of the service department that services the greatest number of departments or the department
with the largest total overhead should be distributed first.

Since management needs to know the cost of a job or process soon after its completion, the job
must be charged with an estimated amount of overhead upon completion rather than at the end
of the period when the actual overhead is known. The predetermined factory overhead rate is
determined by dividing the budgeted factory overhead by the budgeted production for the
period. Budgeted production usually is expressed in terms of direct labor costs, direct labor
hours, or machine hours. In a departmentalized company, a separate predetermined factory
overhead rate should be used for each production department. The cost allocation base used
should reflect how the overhead costs are incurred.

The most popular methods of applying factory overhead to jobs or processes are (1) the direct
labor cost method, (2) the direct labor hour method, (3) the machine hour method, and (4) the
activity-based costing method. The direct labor cost method uses theamount of direct labor
cost that has been charged to the product as the basis for applying factory overhead. The direct
labor hour method overcomes the problem of varying wage rates inherent in the direct labor
cost method by using only the number of direct labor hours spent on the job as the basis for
applying overhead. The machine hour method uses the number of machine hours that have
been worked on the job or process as the basis for applying factory overhead. Activity-based
costing (ABC) considers non-volume related activities that create overhead costs, such as the
number of machine setups or product design changes, as well as volume-related activities, such
as machine hours or direct labor hours. It is important to select the method that allocates the
estimated factory overhead in a manner that reflects the actual usage of overhead items by jobs.

The estimated factory overhead is applied to production by a debit to Work in Process and a
credit to Applied Factory Overhead. At the end of the period, the applied factory overhead
account is closed to the factory overhead control account. If the factory overhead control
account has a debit balance after the applied factory overhead is closed to it, that means the
actual factory overhead (debits) was greater than applied factory overhead (credits) and
overhead is said to be underapplied. A credit balance in Factory Overhead, after closing
Applied Factory Overhead to it, indicates that more overhead was applied than was actually
incurred and overhead is said to be overapplied. If the year-end balance in Under and
Overapplied Factory Overhead will not materially change net income, it is closed toCost of
Goods Sold; whereas if it will materially alter net income, it should be prorated to Work in
Process, Finished Goods, and Cost of Goods Sold.

PROBLEMS FOR DISCUSSION:

University of Luzon
COLLEGE OF ACCOUNTANCY Accounting for Overhead
1st Semester 2023-2024 ACC206 Cost &Cost Management II

High-low method of separating costs

The Mooney Company has accumulated the following data over a six-month period:
Machine Electricity Expense
Hours
July......................................... 460 P 25,000
August................................... 620 30,000
September........................... 580 28,000
October................................. 680 35,000
November............................ 320 22,000
December............................ 720 38,000
3,380 P 178,000

Instructions: Separate the electricity expense into its fixed and variable components using the
high-low method.
Machine Electricity
Hours Expense
High volume.......................
Low volume........................
Difference............................
Variable cost per machine hour:
Total fixed cost:

Sequential distribution of service department costs.

Worldwide Chemical Co. consists of three production departments and four service departments.
For the purpose of creating factory overhead rates, the accountant prepared the cost distribution
sheet, shown on the next page, containing collected operational data. For the distribution of
expenses of the service departments, the following procedures and order of distribution had been
decided upon:
a. Utilities: 70% on metered hours—power; 30% on floor square footage—heating and lighting.
b. Maintenance: Maintenance hours excluding Utilities
c. Materials Handling: 45% to Preparation; 35% to Mixing; and 20% to Packaging
d. Factory Office: Preparation, 50%; Mixing, 40%; Packaging, 10%

Instructions: Complete the cost distribution sheet using the sequential (step-down) method.
Factory overhead rates should be based on pounds handled in Preparation and Mixing (500,000 in
Preparation; 300,000 in Mixing) and on direct labor cost of $10,000 in Packaging. (Round all
amounts to the nearest dollar or the nearest whole percent.

Total Production Departments Service Departments

Material Factor
Preparatio Mixing Packagin Utilitie Maintenanc s y
n g s e Handling Office
Operational
data:
Floor space— 53,000 18,000 13,000 12,000 3,000 2,000 1,000 4,000
sq. ft..............................
Maintenance 7,000 3,000 1,500 600 1,000 — 600 300
hours............................
Metered 5,000 1,500 1,800 700 — 500 300 200
hours............................
Expenses:
Indirect labor............ P26,00 P4,500 P4,000 P3,500 P6,000 P3,500 P2,500 P2,000
0
Payroll taxes.............. 2,500 450 400 350 500 350 250 200
Indirect 6,000 900 1,100 3,000 500 200 50 250
materials.....................
Depreciation.............. 1,000 150 200 100 200 150 75 125
Total.............................
P35,50 P6,000 P5,700 P6,950 $7,200 P4,200 P2,875 P2,575
University of Luzon
COLLEGE OF ACCOUNTANCY Accounting for Overhead
1st Semester 2023-2024 ACC206 Cost &Cost Management II

0
Distribution
of service
departments:
Utilities:
70% metered
hours............................
30% sq.
footage.........................
P P
Maintenance.............. P
P P
Materials P
handling......................
Factory office............ P
P P P P
Bases:
Pounds
handled.......................
Direct labor
costs..............................
Rates.............................

Determining job costs using activity-based costing.

Job 007 requires P10,000 of direct materials, P4,000 of direct labor, 400 tons of material, 200
machine hours, two setups, ten inspection hours, and one design change. The manufacturing
overhead cost pools and overhead rates in each pool follow:
Cost Pool Overhead Rate
Material handling............................... P20/ton of material
Machine usage..................................... P40/machine hour
Machine setups.................................... P1,000/setup
Design changes.................................... P2,000/design change
Inspection…………………………P50/inspection hour
Instructions: Determine the cost of Job 007.