ACCOUNTING FOR FACTORY OVERHEAD

CLASSIFICATION OF OVERHEAD
1. Indirect materials
2. Indirect labor
3. Indirect expense – all items of manufacturing overhead not classifiable as indirect materials
or indirect labor, such as: heat, light and power for factory; rent on factory building;
depreciation and maintenance of factory building and factory equipment; property taxes on
factory building.

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. 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.

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 be
ultimately separated into their fixed and variable components for purposes of planning and
control.
FACTORS TO BE CONSIDERED IN THE COMPUTATION OF OVERHEAD RATE
1. BASE TO BE USED (physical output, direct materials cost, direct labor cost, direct labor
hours, machine hours)
2. ACTIVITY LEVEL TO USE (normal capacity, expected actual capacity)
3. INCLUSION OR EXCLUDING 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 USE
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 costs.
 If factory overhead is investment-oriented related to operation of machinery, then the most
appropriate base will be machine hours.
 If factory overhead is material-oriented, then materials costs might be considered as the most
appropriate base.

The simplest of all bases is the physical output or units of production.

Illustration
The Round 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 per hour, with 45,000 machine hours.

Required: Compute the predetermined factory rate base on (1) material cost (2) units of production
(3) machine hours (4) direct labor cost (5) direct labor hours.
METHODS OF ALLOCATING SERVICE DEPARTMENT COST TO PRODUCING DEPARTMENT
In a departmentalized company, factory overhead should be budgeted for each department. Prior to
the computation of 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 producing departments only.

Producing departments are cost-accumulation centers in which work is performed directly on the
goods being produced.

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.

Methods of allocating service department cost to producing departments

1. Direct method
2. Step method
3. Algebraic method
DIRECT METHOD
Under this method, service department total budgeted costs are allocated directly to the producing
departments, ignoring any services rendered to each other.

Illustration
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. Bldgs & Factory
Molding Decorating Grounds Adm.
Budgeted Factory Overhead 400,000 600,000 80,000 120,000
Direct labor hours 200,000 100,000
Floor area 100,000 60,000 2,000 4,000
Machine hours 200,000 100,000

Required: Allocate the cost of service departments using direct method and compute the
predetermined overhead rates for Molding and Decorating

3
STEP METHOD
The allocation of budgeted service department costs is performed by a series of steps as follows:
1. The budgeted costs of the service department that provides services to the greater number of
other service departments are usually allocated first.
2. The budgeted costs of the service department that provides services to the next greater number of
service departments are then allocated. Any budgeted costs added to this department from Step 1
are included.

Note that under this method, once a service department’s budgeted costs have been allocated to
other departments, no additional budgeted costs can be allocated back to it.

That is, the department whose budgeted costs were allocated in Step 1 will not receive any cost
allocation from the second department.
3. This sequence is continued, step by step, until all the budgeted service department costs have
been allocated to producing departments.

Illustration
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.
Bldgs & Factory
Molding Decorating Grounds Adm.
Budgeted Factory Overhead 400,000 600,000 80,000 120,000
Direct labor hours 200,000 100,000
Floor area 100,000 60,000 2,000 4,000
Machine hours 200,000 100,000

Required: Allocate the cost of service departments using step method and compute the predetermined
overhead rates for Molding and Decorating.
ALGEBRAIC METHOD
Sometimes called reciprocal method. This method allocates costs by explicitly including the mutual
services rendered among all departments.

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.
Bldgs & Factory
Molding Decorating Grounds Adm.
Budgeted Factory Overhead 400,000 600,000 80,000 120,000
Direct labor hours 200,000 100,000
Floor area 100,000 60,000 2,000 4,000
Machine hours 200,000 100,000

Services Services
provided provided
by B & G by F/A
Molding 50% 40%
Decorating 30% 50%
Building and Grounds 10%
Factory Administration 20%

Required: Allocate the cost of service departments using algebraic method and compute the
predetermined overhead rates for Molding and Decorating.

ACTIVITY BASED COSTING

In highly automated manufacturing environments, overhead application rates based on direct labor
may not be provide accurate overhead charges because they no longer represent cause and effect
relationship between output and overhead costs. The need for more representative overhead
application bases has led to activity-based costing (ABC).

Those activities that consume overhead resources are identified and related to the costs incurred.
The basic premise in activity-based costing is that 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

FIVE BASIC STEPS IN APPLYING ABC

1. Assemble similar actions into activity centers.
2. Classify costs by activity center and by type of expense
3. Select cost drivers
4. Compute a cost function to associate costs and cost-drivers with resource use
5. Assigns cost to the cost objective

Assemble similar actions into activity centers

One way of grouping actions is to classify them with different levels of activities, namely:
a. Unit-level activities – performed each time a unit is produced. Examples are assembly,
stamping, and machining. The costs of these activities vary with the number of units produced.
b. Batch-level activities – performed each time a batch of units is produced. Examples are
machine set-ups, order processing and materials handling. The costs of these activities vary
according to the number of batches but remain fixed for all units in the batch.
c. Product-level activities – performed as needed to support the production of each different
type of product. Examples are production scheduling, product designing and parts and product
testing.
d. Facility-level activities – are those which sustain a facility’s general manufacturing
process. Examples are plant supervision, building occupancy, and personnel administration.

Classify costs by activity center and by type of expense

Costs that are traceable to the activity center should be assigned directly to activity centers.
Other costs shared 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 driver are not needed for
direct costs because these can be traced immediately to production. However, 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

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.

Assign cost to the cost driver

For example, if actual setup hours used is 40 hours, then the allocated cost will be P2,000 (40
hours * P50 per setup hour)

Illustration
NDL Company has three products – N, D, and L, and three related overhead activities, namely:
1. Product line setups - the number of setups refer to the number of times each product is
readied for production.
2. Number of handles – the number of handles refers to the number of times each product is moved
from one work station to another.
3. 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:
Units Total DL Total DL Total DM No. of No. of No. of
Product Produced Hours Cost Cost Setups Handles Parts
N 20 30 300 600 2 2 1
D 100 150 1,500 3,000 1 1 1
L 100 70 700 3,000 3 3 2

Total cost of each activity 2,500 6,600 6,200 3,300 3,000

Required: Compute the following:

1. The factory overhead application rate using direct labor hours as base.
2. Cost per unit of each product. Factory overhead application rate using direct labor hours as
base.
3. The factory overhead application rate using activity-based costing.
4. Cost per unit of each product. Factory overhead application rate using activity-based costing.