ACCOUNTING FOR FACTORY OVERHEAD To illustrate, assume that the following overhead costs

Factory overhead were incurred at the following months:

All costs incurred in the factory that are no chargeable
Months Electricty Cost for the Month Units Produced
directly to the finished product are called factory
July 4,500.00 1,600.00
overhead. These operating costs of the factory cannot be August 3,000.00 1,000.00
traced specifically to a unit of production. September 4,600.00 1,800.00
October 5,000.00 2,000.00
Accounting for factory overhead involves the following November 4,050.00 1,500.00
steps: December 3,350.00 1,200.00
1. Identifying cost behavior patterns Total 24,500.00 9,100.00
2. Budgeting factory overhead costs
3. Accumulating actual overhead costs Cost Units
High 5,000.00 2,000.00
4. Applying factory overhead estimates to production
Low 3,000.00 1,000.00
5. Calculating and analyzing differences between actual Difference 2,000.00 1,000.00
and applied factory overhead
m = 2000/1000
m = 2/unit
STEP 1: IDENTIFYING COST BEHEVAIOR
PATTERNS
To determine the fixed and variable components
The following are the cost classifications based on substitute the X in the y = mx + b formula with m being
behaviour: the cost per unit, x being the number of units produced
1. Variable Cost and y being the total cost, as follows:
2. Fixed Cost
3. Mixed Cost/Semi variable Cost 5000 = (2 X 2000) + b
b = 1,000
Variable cost
Costs that moves directly proportional to the volume b is the fixed cost
changes or changes in the level of activity. m is the variable cost per unit

To illustrate, assume that the cost of factory supplies is These are most useful when management wishes to
Php0.50 per each unit produced. If there are 5,000 units estimate a cost at a certain level of production.
produced, the cost of factory supplies is Php2,500.
To further illustrate, assume that management wishes to
Fixed cost determine the electricity cost at 15,000 units produced.
Costs that remain the same regardless of the change in This will be estimated as follows:
volume or level of activity.
Y = (2 X 15,000) + 1,000
To illustrate, regardless of the level of production, the Y = 31,000.00
monthly payroll expense of a factory supervisor remains
the same. 3. Scattergraph method
cost analysis through plotting of the data in a graph.
Semi-variable cost
Cost with a fixed component and variable component. 4. Least-squares regression method
The issue here is on how to determine the variable and uses a more sophisticated approach in separating the
the fixed component. fixed and variable components of a semi variable
cost.
Analyzing Semivariable Factory Overhead Costs
The following methods may be used to
STEP 2: BUDGETING FACTORY OVERHEAD
separate/determine the variable and fixed component of
a semivariable cost: COSTS
Budgets are management's operating plans expressed in
1. Observation method quantitative terms, such as units of production and related costs.
also called account analysis method which relies
After factory overhead costs are classified as variable and fixed,
heavily on the ability of an observer to detect a pattern it permits the preparation of a flexible budget (budget that shows
of cost behaviour by reviewing past cost and volume estimated costs at different production volume).
date. This approach is very subjective and is not
heavily favored. Assume that management desires to budget factory overhead
costs at three levels of production - 10,000, 20,000 and 40,000
2. High-low method units. The variable factory overhead cost is Php5 per unit and the
fixed factory overhead cost is Php50,000.
compares a high production volume and its related
cost to a low production volume with its related cost. The budgeted cost at these volumes are as follows
The difference between the two points being Units
compared is linear and will fall along a straight line 10,000.00 20,000.00 40,000.00
(y=mx + b). Variable cost 50,000.00 100,000.00 200,000.00
Fixed cost 50,000.00 50,000.00 50,000.00
Total factory overhead 100,000.00 150,000.00 250,000.00
Factory overhead per unit 10.00 7.50 6.25
 The following are the commonly used cost allocation
STEP 3: ACCUMULATING ACTUAL
bases:
OVERHEAD COSTS 1. Direct labor cost
Actual factory overhead costs are accumulated based on actual The predetermined or estimated factory overhead cost is
costs incurred and are maintained in the control account and applied as a percentage of the direct labor hours. For
subsidiary legder called Factory Overhead and Factory Overhead example, if the company estimates that it will incur direct
Ledger, respectively (simply put, actual factory overhead costs labor cost of Php200,000 and factory overhead of
incurred are debited to factory overhead account). Php100,000. Using this cost allocation base, we will apply
factory overhead to production as 50% of the direct labor cost
The following are typical examples of factory overhead costs (Php100,000/Php200,000). Furthermore, assume that in job
(which must be related to the factory building and machinery 1, we determined that direct labor cost incurred is Php10,000,
and/or factory operations): we will apply a factory overhead of Php5,000 which is 50% of
1. Defective work the direct labor cost.
2. Depreciation
3. Employee fringe benefits 2. Direct labor hours
4. Fuel
The predetermined or estimated factory overhead cost is
5. Heat and Light
6. Indirect labor applied based on the direct labor hours incurred (estimated
7. Indirect materials factory overhead cost divided by the estimated direct labor
8. Insurance hours). For example, if a company estimates it will incur
9. Janitorial services factory overhead cost at Php100,000 with direct labor hours
10. Lubricants of 20,000, the factory overhead cost to be applied per direct
11. Maintenance
labor hour is Php5 (Php100,000/20,000 direct labor hours).
12. Materials Handling
13. Overtime premium Furthermore, assume that in job 1, we determined that direct
14. Plant security labor hours incurred is 10,000, we apply a factory overhead
15. Power cost of Php50,000 (Php5 X 10,000 direct labor hours).
16. Property tax
17. Rent 3. Machine hours
18. Repairs
19. Small tools The predetermined or estimated factory overhead cost is
20. Spoilage applied based on the machine hours incurred (estimated
21. Supplies factory overhead cost divided by the estimated machine
22. Telephone/Fax hours). For example, if a company estimates it will incur
23. Worker's compensation insurance factory overhead cost at Php100,000 with machine hours of
20,000, the factory overhead cost to be applied per machine
hour is Php5 (Php100,000/20,000 direct labor hours).
STEP 4: APPLYING FACTORY OVERHEAD Furthermore, assume that in job 1, we determined that
ESTIMATES TO PRODUCTION machine hours incurred is 10,000, we apply a factory
overhead cost of Php50,000 (Php5 X 10,000 machine hours).
Applied Factory Overhead
This is the estimated factory overhead charged to 4. Activity-based
This method recognizes that there may be more than 1 cost
production since determining actual factory overhead base or cost drivers that drives the movement of the factory
may take time to determine and some may only be overhead cost. Hence, this allows a company to determine
determined at yearend. multiple cost bases or cost driver to allocate the estimated
factory overhead. For example, assume that the factory
The following are the steps to determine the standard overhead budget for the period is Php100,000. The
factory overhead rate to be applied: allocation bases, expected level of activity for each cost pool
1. Budget estimated amount of factory overhead for each job or cost driver, and overhead rates follow:
based on the expected level of production volume for the
Factory overhead cost Expected Expected level of Overhead
coming period. For example, Job 1 is estimated to have a pool amount allocation base rate
Php300,000 budget over the factory overhead costs. Direct labor usage 35,000.00 20,000 direct labor hours 1.75 per direct labor hour
2. Allocate budgeted service department expenses to the Machine usage 40,000.00 10,000 machine hours 4.00 per machine hour
Machine set-up 15,000.00 100 set ups 150.00 per set up
producing departments (service departments are Design changes 10,000.00 25 design changes 400.00 per design change
departments within a company which are not directly related
to the production but are necessary to produce the finished
goods. Examples of these sre maintenance department and Assume that job 100, now completed, required Php1,000
factory office costs). For example, allocated budget to direct materials, Php3,000 direct labor, 400 direct labor
maintenance and factory office amounts to Php60,000 and hours, 75 machine hours, 4 set ups and 2 design
Php40,000, respectively. changes. The cost for the job would be completed as
3. Select a cost allocation basis (direct labor hours, machine follows:
hours, etc.) that causes the overhead to occur. For example,
Direct materials 1,000.00
for labor-extensive jobs, the most common base is the direct
labor hours. Direct labor 3,000.00
4. Obtain data from the upcoming period's production budget as Factory overhead:
to the amount of the selected cost allocation base expected Direct labor usage #
to be used. For example, if the selected base is the direct Machine usage #
labor hours, we determine the direct labor hours. Assume Machine set-up #
that for this instance, the direct labor hours is 20,000 direct Design changes # 2,400.00
labor hours. (Kindly note that if there are multiple available TOTAL COST 6,400.00
cost allocation bases, select the one with the highest
correlation level with the estimated factory overhead. To
determine this, you can use the least-squares regression).
5. Determine the factory overhead rate to be applied by dividing
the estimated amount of factory overhead by the cost
allocation base. In our example, the estimated factory
overhead rate per direct labor hour is Php20
((Php300,000+Php60,000+Php40,000)/20,000 direct labor
hours).
 STEP 5: CALCULATING AND ANALYZING
DIFFERENCES BETWEEN ACTUAL AND
APPLIED FACTORY OVERHEAD

1. Actual factory overhead charges are debited to

"Factory overhead" account
2. Applied factory overhead (as discussed in step 4) is
credited to "Applied factory overhead" account
3. Since we will apply the applied factory overhead cost
to a job, the entry to transfer the applied factory
overhead to production is:
3. Since we will apply the applied factory overhead cost to a job, the
entry to transfer the applied factory overhead to production is:

Work in process XX
Applied factory overhead XX
4. The "Factory overhead" and "Applied factory overhead" balances
will then be closed any difference between the actual and applied
factory will be charged to cost of goods sold if the difference is
immaterial or allocated to the work in process, finished goods and
cost of goods sold based on their carrying amounts if the difference is
material.

To illustrate, assume that the company uses a predetermine factory

overhead rate at Php5 per direct labor hour and the job actually
incurred 1,000 hours. To record the applied factory overhead to
production, the entry will be:

Work in process 5,000.00

Applied factory overhead 5,000.00

Also assume that the actual factory overhead cost incurred (on
account) is Php5,500 which will be recorded as follows:

Factory overhead 5,500.00

Accounts payable 5,500.00

The entry to close the factory overhead and applied factory overhead
accounts is:

Applied factory overhead 5,000.00

Under and overapplied factory overhead 500.00
Factory overhead 5,500.00

If the company assessed that the difference is immaterial, it will

simply close the difference to cost of goods sold as follows:

Cost of goods sold 500.00

Under and overapplied factory overhead 500.00

If the company assessed that the difference is material, it will be

closed and allocated among the work in process, finished goods and
cost of goods sold. Example, if as of yearend, the carrying amounts of
the relevant accounts are as follows:

Work in process 10,000.00 10%

Finished goods 30,000.00 30%
Cost of goods sold 60,000.00 60%
100,000.00

The entry to close the difference and allocate it is as follows:

Work in process 50.00

Finished goods 150.00
Cost of goods sold 300.00
Under and overapplied factory overhead 500.00