Factory Overhead: Planned, Actual, and Applied

1
The Nature of Factory Overhead
Factory Overhead is generally defined
as indirect material, indirect labor and
other factory expenses which cannot be
directly identified with specific jobs,
products, or services.

2
Use of a Predetermined Overhead Rate
Because of the impossibility of tracing overhead to
specific jobs or specific products, overhead cost is
apportioned among jobs and units.
A predetermined overhead rate permits a
consistent and logical allocation to each unit of
output.

3
Basis used in predtermined overhead Rates
 Physical Output
 Direct Material Cost
 Direct Labor Cost
 Direct Labor Hours
 Machine Hours

4
Physical Output
Physical output or units of production is the simplest base
for applying factory overhead
Estimated Factory Overhead = Factory Overhead per unit
Estimated units of production
 Example:
 If Estimated Factory overhead is $300,000 and the company intends to
produce 250,000 units during the next period, then the FOH per unit is
charged $1.2 ( $ 300.000 : 250.000 units).
 Then an order with 1,000 completed units, is charged 1,000 x $1.2 = $1,200
of Factory Overhead

5
Direct Materials Cost Base
In some companies, a study of past costs reveals a high
correlation between direct materials cost and overhead
Estimated Factory Overhead x 100 = Factory Overhead as a percentage
Estimated material cost of direct materials cost
 Example:
 If Estimated Factory overhead totals $300,000 and est. materials cost
$250.000, then the FOH rate is $300,000 : $250,000 = 1.2 or 120 % of its
direct materials cost.
 So, if the materials cost for an order is $5,000, Factory Overhead charged
to the order would be $5.000 x 1.2 = $6,000

6
Direct Labor Cost Base
This method’s use is logical when a strong
relationship between direct labor cost and factory
overhead exists and hourly rates of pay are similar
for similar work.
Estimated Factory Overhead x 100 = Factory Overhead as a percentage
Estimated direct labor cost of direct labor cost

Example:
 If Estimated Factory overhead is $300,000 and total direct labor
cost is estimated at $500,000, then FOH rate is $300,000 :
$500,000 = 0.6 or 60 %.
 So, a job or product with a direct labor cost $12,000 is charged

$12.000 x 60% = $7,200 for Factory Overhead.

7
Direct Labor Hour Base
The use of the direct labor hour base is justified if there is a
strong relationship between direct labor hours and factory
overhead
Estimated Factory Overhead = Factory Overhead per direct labor hour
Estimated direct labor hours
 Example:
 If estimated Factory overhead totals $300,000 and direct labor hours are
est. 60,000, then factory overhead rate is ($300.000 : 60,000) = $5 per
direct labor hour
 A job with 800 DLH, is charged 800 x $5 = $4,000 for factory overhead

8
Machine Hour Base
When machines are used extensively, machine
hours may be the most appropriate basis for
applying overhead.
Estimated Factory Overhead = Factory Overhead per machine hour
Estimated machine hours

Example:
 If estimated factory overhead totals $300,000 and a total of 20,000
machine hours are estimated, the FOH rate is $300,000 : 20,000
machine hours (MH) = $15 per MH
 So, a job or product that requires 120 machine hours is charged 120

x $15 = $1,800 for Factory Overhead

9
Applied Factory Overhead
It is the amount of overhead included in the cost of an
item or job.
= Actual Activity X Predetermined FOH Rate
= 20000 hours X $15
= 300,000

10
Actual Factory Overhead
Some actual factory overhead costs are recorded
when incurred, as transactions are journalized and
posted to general and subsidiary ledgers.
A basic objectives of accumulating factory
overhead is to provide information for control
(compare the budgeted amount with the actual
incurred).
Source documents used for recording overhead
are:
Purchase vouchers - general journal voucher
Materials requisitions - labor time tickets

11
Applied Factory Overhead and the Over- or
Under applied Amount

At the end of the month or year, applied factory

overhead and actual factory overhead are compared.

Actual factory overhead: $140,000

The amount of indirect cost incurred.

Less: Applied factory overhead: (130,000)

The amount of cost allocated to output.
Under applied 10000

12
Over- or Underapplied Factory Overhead
Disposition
Underapplied:
 Cost of Goods Sold 10,000
Factory overhead 10,000
Overapplied:
 Factory overhead 10,000
Cost of Goods Sold 10,000

13
Disposition of Over- or Underapplied Amount
DeWitt Products
Income Statement
For Year Ending December 31, 20-

Sales $1,600,000
Less: COGS 1,193,000
Underapplied FOH 8,500
COGS Adjusted 1,202,000
Gross Profit 398.000

14
Activity-Based Costing
Study
Study Objectives
Objectives
1. Recognize the difference between traditional
costing and activity based costing.

2. Identify the steps in the development of an

activity-based costing system.

3. Know how companies identify the activity cost

pools used in activity-based costing.

4. Know how companies identify and use cost

drivers in activity-based costing.
Study
Study Objectives
Objectives
5. Understand the benefits and limitations of
activity-based costing.
6. Differentiate between value-added and
non-value-added activities.

7. Understand the value of using activity levels

in activity-based costing.

8. Apply activity-based costing to service

industries.
Traditional
Traditional Costing
Costing
To allocate as fairly as possible the true costs
of the products.
When management has more accurate costs,
better decisions can be made.
Direct Materials and Direct Labor costs are
easiest to trace through:
Material requisitions.
Payroll time sheets.

SO 1: Recognize the differences between traditional costing and

activity-based costing.
Traditional
Traditional Costing
Costing and
and ABC
ABC
Traditional
Traditional Costing
Costing
Allocates overhead using a single
predetermined rate.
Job order costing: Direct labor cost is
assumed to be the relevant activity base.
Assumption was satisfactory when direct
labor was a major portion of total
manufacturing costs.
There should be of a high correlation
between direct labor costs and overhead
costs.

SO 1: Recognize the differences between traditional costing and

activity-based costing.
Traditional
Traditional Costing
Costing
Allocates overhead using a single
predetermined rate.
Process Costing: Machine hours is assumed to
be the relevant activity base.
Assumption was satisfactory when machine
hours was a major portion of total
manufacturing costs.
There should be of a high correlation between
machine hours and overhead costs.

SO 1: Recognize the differences between traditional costing and

activity-based costing.
Why
Why Do Do Companies
Companies Need Need aa
New
New Approach?
Approach?
Tremendous change in manufacturing and service
industries.

Decrease in amount of direct labor usage.

Significant increase in total overhead costs.

May be inappropriate to use plant-wide predetermined

overhead rates based on direct labor or machine
hours when a lack of correlation exists.

Complex manufacturing processes may require multiple

allocation bases; this approach is called Activity-
Based Costing (ABC).
Activity-Based
Activity-Based Costing
Costing
Is another approach (other than traditional costing) to
allocate manufacturing overhead.
An overhead cost allocation system that allocates
overhead to multiple activity cost pools,
and
Assigns the activity cost pools to products or services by
means of cost drivers that represent the activities used.

SO 1: Recognize the differences between traditional costing and

activity-based costing.
 ABC
ABC Definitions
Definitions
Activity: Any event, action, transaction, or work
sequence that causes a cost to be incurred in
producing a product or providing a service.
Activity Cost Pool: The overhead cost attributed
to a distinct type of activity.
Examples:
Purchasing materials.
Setting up machines.
Cost Drivers: Any factors or activities that have a
direct cause-effect relationship with the
resources consumed.
SO 1: Identify the steps in management’s decision-making process.
 Activity-Based
Activity-Based Costing
Costing
ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity

cost pools.

Stage 2: The overhead costs allocated to the cost

pools is assigned to products using cost drivers.

The more complex a product’s manufacturing

operation, the more activities and cost drivers
likely to be present.

SO 1: Recognize the differences between traditional costing and

activity-based costing.
OVERHEAD
OVERHEAD COSTS
COSTS
Overhead
Overhead Costs
Costs
Activity-Based
Activity-Based Costing
Costing
ABC does not replace an existing job
order/process cost system.

ABC does segregate overhead into various

cost pools to provide more accurate cost
information.

ABC, thus, supplements – it does not

replace – the traditional cost system.

SO 2 Identify the steps in the development of an activity-based system.

 Activity-Based
Activity-Based Costing
Costing
Atlas Company produces two automotive antitheft
devices:
The Boot: A high volume item with sales totaling 25,000 per year.
The Club: A low volume item with sales totaling 5,000 per year.

Each product requires 1 hour of direct labor

Total annual direct labor hours (DLH) 30,000 (25,000 + 5000).
Direct labor cost $12 per unit for each product.

Expected annual manufacturing overhead costs

$900,000
Direct materials cost:
The Boot - $40 per unit.
The Club - $30 per unit.
 Costing
Costing Under
Under Traditional
Traditional
Costing
Costing
Products
Manufacturing Costs The Boot The Club
Direct Materials $40 $30
Direct Labor 12 12
Overhead 30 30*
Total unit cost $82 $72

* Predetermined overhead rate: $900,000 ÷ 30,000 DLH = $30 per DLH

Overhead = predetermined overhead rate times direct labor hours
($30 × 1 hr. = $30)
Four
Four Steps
Steps of
of Activity-Based
Activity-Based
Costing
Costing
Identify and classify the major activities and
allocate manufacturing overhead costs to the
appropriate cost pools.

Identify the cost driver that has a strong

correlation to the costs in the cost pool.

Compute the overhead rate for each pool.

Assign overhead costs for each cost pool to

products using the overhead rates.
Activity
Activity Cost
Cost Pools
Pools and
and
Estimated
Estimated Overhead
Overhead

Activity Cost Pools Estimated Overhead

Setting up machines $300,000
Machining 500,000
Inspecting 100,000
Total $900,000
 Identify
Identify Cost
Cost Drivers
Drivers
Expected Use
of Cost Drivers
Activity Cost Pools Cost Drivers Per Activity
Setting up machines Number of setups 1,500
Machining Machine hours 50,000
Inspecting Number of Inspections 2,000
 Formula
Formula for
for Computing
Computing Activity-
Activity-
Based
Based Overhead
Overhead Rate
Rate
Estimated Overhead Per Activity
= Activity-Based Overhead Rate
Expected Use of Cost Drivers Per Activity

Expected Use
Estimated of Cost Drivers Activity-Based
Activity Cost Pools Overhead Per Activity Overhead Rates
Setting up machines $300,000 1,500 setups $200 per setup
Machining 500,000 50,000 machine hrs. $ 10 per mach. hour
Inspecting 100,000 2,000 inspections $ 50 per inspection
Total $900,000
Expected
Expected Use
Use of
of Costs
Costs to
to
Products
Products
Benefits
Benefits of
of Activity-Based
Activity-Based
Costing
Costing
More accurate product costing through:
Use of more cost pools to assign overhead
costs.
Enhanced control over overhead costs.
Better management decisions.

SO 5 Understand the benefits and limitations of activity-based costing

Limitations
Limitations of
of Activity-Based
Activity-Based
Costing
Costing
Can be expensive to use
(Cost/Benefit).
Some arbitrary allocations continue.

SO 5 Understand the benefits and limitations of activity-based costing

Use
Use ABC
ABC When
When One
One or
or
More
More of
of the
the Following
Following Exist:
Exist:
Products differ greatly in volume/manufacturing complexity.
Products lines are:
Numerous.
Diverse.
Require different degrees of support services.
Overhead costs are a significant portion of total costs.
Significant change in manufacturing process or number of
products.
Managers ignore data from existing system and instead use
“bootleg” costing data.
Classification
Classification of
of Activity
Activity
Levels
Levels
Unit-level activities:
Performed for each unit of production.
Batch-level activities:
Performed for each batch of product.
Product-level activities:
Performed in support of an entire product line,
but not always performed every time a new
unit or batch is produced.
Facility-level activities:
Required to support or sustain an entire production
process.
Hierarchy
Hierarchy of
of Activity
Activity Levels
Levels
Major
Major Difficulty
Difficulty of
of
Implementing
Implementing ABC
ABC
A larger proportion of
overhead costs are
company-wide costs that
cannot be directly traced
to specific services.
- The End -

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