FACTORY OVERHEAD ACCOUNTING

Definition of Factory Overhead

Factory Overhead are all other manufacturing costs aside from direct materials and direct labor.
These costs are not conveniently traced to specific jobs. Other terms for Factory Overhead are
factory burden, manufacturing overhead, factory expenses, indirect manufacturing costs, and
manufacturing expenses.

Factory overhead refers to the cost pool used to accumulate all indirect manufacturing costs.
Examples of factory overhead are indirect materials, indirect labor, rent of factory building, and
depreciation and maintenance of factory building and factory equipment. Factory overhead can
be classified based on their behavior in relation to production. It can be classified as variable
factory overhead, fixed factory overhead, and mixed factory overhead.

Variable factory overhead costs vary in direct proportion to the level of production within the
relevant range. As production increases or decreases, variable cost per unit remains constant
while total variable cost varies. The more units are produced, the higher the variable cost.

On the other hand, fixed factory overhead costs remains constant within the relevant range, As
production increases or decreases, total fixed cost remains constant while fixed cost while fixed
cost per unit varies inversely with production. The more units are produced, the lower the fixed
cost per unit. This shows an advantage of mass production wherein the more units are produced,
the lesser is the factory overhead cost per unit.

Lastly, mixed factory overhead costs are neither totally fixed nor totally variable but have
characteristics of both. Taken for example, a factory building is rented for P1,500 per day for only
8 hours of operation, P300 per extended hour. There is a rush order of products from a valued
customer that lead to extending operation hours for 2 more hours just to finish the order. The total
factory rent for that day would be P2,100, with P1,500 fixed and P600 variable. Mixed factory
overhead costs must be separated as to fixed or variable for planning and controlling purposes.

Actual Costing with Actual FOH vs Normal Costing with Applied FOH

The allocation of factory overhead is done either through actual costing or normal costing. Under
actual costing, actual factory overhead incurred are accumulated in Factory Overhead Control
and then transferred to Work-in-Process at the end of the period. However, this costing system is
inconvenient since the complete costing of the jobs finished is yet to be deferred until the end of
the period.

For example, the factory expenses such as lighting power for the products finished before the end
of July are yet to be identified until the end of July or until the bill arrives. On the other hand,
normal costing uses a predetermined overhead rate to facilitate allocation of the factory overhead
cost to various jobs.

Predetermined or Standard Overhead Rate

To compute, predetermined factory overhead rate, it may be computed on three levels:

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 1. Plantwide Overhead Rate - the computed overhead rate is applied to all segments for
the entire plant in determining the Applied Overhead for the current period. This is the
most simple way of computing the rate but its accuracy may be put into question if the
manufacturing company undertakes several activities to produce the finished output.
Hence, this company-wide or plantwide overhead rate is useful when majority if not all of
the overhead costs can be attributed to a common activity.

2. Departmentalized Overhead Rate- this type of overhead rate is useful if the company is
composed of several departments, each having its own activities. In the computation of
the departmentalized overhead rate, the main objective is to allocate and include in the
computation of such overhead rate the costs incurred by service departments which has
rendered services indirectly to the producing departments.

3. Activity-based overhead rate this type of overhead rate is useful in activity based costing
(ABC) as it is based on the activities undertaken by the company. This is useful if the
company has several identifiable activities.

This chapter will focus on the computation and application of the plantwide and departmentalized
overhead rate used in traditional cost accounting system.

Management should know the total manufacturing cost of every job completed so as to facilitate
effectiveness and efficiency in the company. Information about these costs can also aid
management in decision-making. Materials and labor can easily be identified when the job is
finished while factory overhead is not that readily available. Predetermined overhead rates also
adjust for variations in actual overhead costs that are unrelated to the activity and overcome the
problem of changes in activity levels that have no impact on actual fixed factory overhead costs.

Since unit fixed costs vary with activity level changes, a uniform annual predetermined overhead
rate for all units produced during the year is needed to avoid significant variations in unit costs
during the period.

Applying the predetermined overhead rates also assists the managers to be more aware of
product line profitability as well as the profitability of doing business with a certain customer or
vendor. These are the reasons why predetermined factory overhead rate is used in estimating
factory overhead cost.

Predetermined factory overhead rate is computed by dividing total budgeted factory overhead at
a specified activity level by the volume or quantity of specific activity level. This activity level can
be direct labor hours, machine hours, or any other basis.

Predetermined factory overhead rate = Budgeted factory overhead at specific activity level
Budgeted Activity Base

In selecting the overhead rate, two factors should be considered (1) base to be used; (2) activity
level to be used. In choosing the base, it should be observed that the objective is to have the most
accurate application of overhead cost to the various finished jobs. If factory overhead pertains to
procurement of materials, materials costs can be considered as a base.

Likewise, if factory overhead is labor-related, labor costs or labor hours may be considered a
base. The common bases are: (1) Units of Production; (2) Direct Labor Hours, (3) Machine Hours;
(4) Direct Labor Cost; and (5) Direct Material Cost.

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Given the budgeted data at the beginning of the year:

Direct Materials P 350,000

Direct Labor 280,000
Factory Overhead 135,000
Labor Hours 35,000 hours
Machine Hours 18,000 hours
Units of Production 27,000

1. Units of Production - the most direct method of applying factory overhead and may only
be used if the company produces only one kind of product.

Budgeted factory overhead = Overhead per unit

Budgeted units of production

P135,000 = P5 per unit

27,000 units

For example, given that on January, 5,500 units are produced, the applied overhead for the
job will be P27,500 (5,500 x P5).

2. Direct Labor Hours - this method is best used if the factory overhead costs vary generally
with the number of direct labor hours consumed.

Budgeted factory overhead = Overhead per direct labor hour

Budgeted direct labor hours

P135,000 = P3.86 per unit

35,000 DLH

For example, given that a product requires 3,380 direct labor hours, factory overhead would
be applied at P13,046.80 (3,380 x P3.86).

3. Machine Hours - if operations and production are done by the use machine hour is used
as the base to compute the overhead rate.

Budgeted factory overhead = Overhead per machine hour

Budgeted machine hours

P135,000 = P7.50 per unit

18,000 MH

For example, given that a product requires 1,200 machine hours, factory overhead would be
applied at P9,000 (1,200 x P7.50).

4. Direct Labor Cost - the most widely used method in computing overhead rate specifically
for labor intensive production.

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 Budgeted factory overhead = Overhead rate
Budgeted direct labor cost

P135,000 = 48.21% of direct labor cost

P280,000

For example, given that P260,000 of direct labor costs was incurred for a product, factory
overhead would be applied at P125,346 (P260,000 x 48.21%).

5. Direct Materials Cost - this method may be used only when each production uses more or
less the same quantity of materials.

Budgeted factory overhead = Overhead rate

Budgeted direct material cost

P135,000 = 38.57% of direct materials cost

P350,000

For example, given that P 460,000 of direct materials cost was incurred for a product, Footy
overhead would be applied at P 177,422 (P 460,000 x 38.57%).

Production Capacities / Activity levels

Aside from choosing on which base to use in computing the overhead rate, activity level selection
may also be considered. These activity levels are also called production capacities which may
either be:

a. Theoretical or ideal capacity - this can also be called as maximum capacity. This
assumes 100% effectiveness and efficiency in the production. Losses or other events that
may disrupt production are disregarded though they may really actually happen. This
theoretical capacity is seldom achieved and thus not usually used.

b. Practical capacity - this is equal to theoretical capacity less the unavoidable production
interruptions such as lost time for machine breakdowns, normal delays, repairs, and also
rest days and holidays. However, this does not consider the external factors such as those
delays or interruptions caused by customers.

c. Expected Actual Capacity this capacity is based generally on increases and decreases
in factory overhead and on the quantity of production output for the next accounting period.
This is determined during the budgeting process of the company.

d. Normal Capacity - this is basically the long term average capacity. This measures the
activity levels that satisfy average customer demand over a certain period of time. This
also constantly averages over seasonal or cyclical fluctuations in demand. This capacity
is commonly used in computing overhead rates.

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Idle Capacity vs Excess Capacity

ldle capacity is caused by decrease in demand for the product that leads to less production for
the period. This idle capacity is restored when sales demand will increase. Budgeted idle cpacity
is only included in the product cost if the overhead rate is computed using the expected actual
capacity as the denominator. When idle capacity exists, a firm can take on an incremental order
without increasing the fixed costs. Idle capacity is actually the capacity available but is not being
used, On the other hand, excess capacity is caused by excessive production capacity compared
to the company's expected operations. Also, this can be used by imbalance in machinery used.

Actual and Applied Factory Overhead

Illustration:

Taken for example that the direct materials cost and direct labor cost for the month are p 680,000
and P 720,000 respectively, factory overhead is applied at 80% of direct labor. The journal entry
to record the applied factory overhead would be:

Work-in-Process (P720,000 x 0.80) 576,000

Applied Factory Overhead 576,000
Overhead applied to production
for the month

Assuming that the actual factory overhead costs incurred amounted to P446,000, this amount is
recorded as an aggregate debit to Factory Overhead Control taken from various source
documents about factory overhead incurred for the month.

Factory Overhead Control 446,000

Various Accounts 446,000
Actual factory overhead incurred
for the month

To close the actual and applied factory overhead, the variance (Over or Under-applied) factory
overhead will be recorded as:

Applied Factory Overhead 576,000

Factory Overhead Control 446,000
Cost of Goods Sold 130,000

The difference between applied and actual factory overhead is called either the over-applied or
under-applied overhead. When applied factory overhead is more than the actual, there is over-
applied factory overhead (there is credit balance) while if the actual factory overhead is more than
the applied, there is under-applied factory overhead (there is debit balance). Over- or under-
application of factory overhead is caused by two factors: cost differences and utilization
differences. These utilization differences are the spending and volume variance. Spending
variance is the difference between the actual factory overhead estimated factory overhead based
on the capacity utilized. It is the variance due to expense factors. Volume variance is the
difference between the estimated factory overhead based on capacity utilized and the applied
factory overhead. Volume variance is due to differences in volume and activity factors.

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Disposition of Factory Overhead Variance

The disposition of under-applied and over-applied overhead (overhead variance) is based on the
materiality of the amount. If the amount is immaterial, factory variance is directly closed to Cost
of Goods Sold. From the above illustration, the journal entry to close over- applied factory
overhead is:

Factory Overhead Control 130,000

Cost of Goods Sold 130,000
To close over-applied
factory overhead for the month

However, if the amount is material, the overhead variance should be allocated pro rata to Work-
in-Process, Finished Goods, and Cost of Goods Sold.

Illustration:

Given that the actual factory overhead for the month is P550,000 and applied factory overhead is
P230,000. Allocation of the P320,000 under-applied factory overhead will be as follows:

Inventories Balances Fraction Allocated Amount

Work in Process P 120,000 120/960 P40,000
Finished Goods 240,000 240/960 80,000
Cost of Goods Sold 600,000 600/960 200,000
Total P960,000 P320,000

The journal entry to close under-applied factory overhead and adjust the inventory accounts at
the end of the month would be:

Work-in-Process 40,000
Finished Goods 80,000
Cost of Goods Sold 200,000
Factory Overhead Control 320,000
To close under-applied
factory overhead for the month

As shown in this illustration, when there is under-applied overhead, Cost of Goods Sold (CGS) is
increased in the closing process. This is because the amount that was applied to the production
for factory overhead during the period was understated. Consequently, when there is over-applied
overhead, Cost of Goods Sold (CGS) is decreased in the closing process since it was initially
overstated.