Factory Overhead

Factory overhead / Manufacturing overhead

– the sum of all the indirect elements of cost incurred to manufacture a product.

Classification of Overhead

1. Indirect materials
2. Indirect labor
3. Indirect expenses – all items of manufacturing overhead not classifiable as indirect
materials or indirect labor.

Six Steps to Summarize the Accounting for Factory Overhead

1. Select a cost application base that serves as a common denominator for all the products manufactured.

2. Prepare a budget of total overhead cost and the related volume of the application base for the coming year.

3. Compute the predetermine factory overhead rate:

Factory overhead rate = Budgeted total factory overhead

Budgeted volume of application base

4. Obtain the actual application base data as the year unfolds.

5. Apply the overhead to individual jobs:

Applied overhead = OH x Actual data of base

6. At the year end account of any difference between the amount of overhead actually incurred and overhead
applied to jobs (products).

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 Exclusioning of Fixed Overhead

 a. Absorption costing
b. Direct costing

4. Used of Single Rate or Several Rates

a. Plant –wide or blanket rate

b. Departmentalized rate
c. Cost center or cost pool rates

Base to be Used

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

Steps in Computation of Departmentalization Overhead Rate

1. Divide the company into segments, so 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 services department cost to the producing departments.
5. Compute the factory overhead rate – similar to the computation using blanket rate.

Typical Allocation Bases For Common Cost

Most common cost can be group into four:

a. Labor related common cost

b. Machine related common cost
c. Space related common cost
d. Service related common cost.

Methods of Allocating Service Department Cost to 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 departments total cost directly to the producing departments.

Step Method – sometimes called sequential method of allocation. This method recognizes services rendered by
the service department to another service department and is more complicated because It require a sequence of
allocation. The sequence typically starts with the department that renders service to the greatest number other
service departments and ends with the department that renders service to the least number of other departments.
Once a service department's cost have been allocated, no subsequent service department cost are allocated to it.

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