CHAPTER 4: ACCOUNTING FOR FACTORY OVERHEAD
factory building and equipment.
- For RETAIL. Overhead cost would not be included in
the cost of the merchandise inventory or in the
COGS on the IS.
- FO. All costs incurred in the factory that are not
chargeable directly to the fin-goods
o Operating cost of the factory cannot be
traced specifically to a unit of production
o Indirect factory expense, indirect
manufacturing costs, or factory burden.
- Determining factory expenditure as overhead.
Compare it to the classification standards
established for direct M and L.
o If an expenditure cannot be charged to
either of these categories, it is FO
o Indirect M consumed in the factory (oil
used in maintaining factory equipment),
indirect L (wages of janitors, forklift
operators and supervisors, and overtime
premiums paid to all factory workers), and
all indirect manufacturing expenses
(insurance, property taxes, and
depreciation on PPE)
- Accounting for FO.
1. Identifying the cost behaviour patterns
2. Budgetary FO costs
3. Accumulating actual overhead costs
4. Applying factory overhead estimates to
production
I. IDENTIFYING COST BEHAVIOUR PATTERNS
- VARIABLE COSTS. Costs that vary in direct
proportion to volume needed.
- FIXED COSTS. Unchanging costs
- SEMIVARIABLE COSTS. Also called MIXED COSTS.
o Have characteristics of both variable and
fixed costs
- Classification as variable and fixed.
o How it reacts to changes in business activity
- FO CLASSIFICATION
o Variable – supplies that behave in the same
pattern as DM and DL.
: Electricity used to power machines,
depreciation expense computed on the
units-of-production basis, and small tools
expense
o Fixed – plant manager’s salary since it
remain unchanged when production varies
as long as production levels have not
exceeded the limits of the plant’s capacity.
: electricity used to heat and light the
factory, factory property taxes,
depreciation of equipment computed on a
straight-line basis, and insurance on
o Mixed – cost of utilities have to be broken
into their variable and fixed components
before they can be predicted at diff. volume
levels
: TYPE A: Changes as various levels of
production are reached
 STEP-VARIABLE COST – cost will
remain constant over a range of
production and then abruptly
change.
: The increase are not continuous,
and costs plateau before another
cost change occur.
: Inspection and handling costs,
and other indirect L costs where up
to a certain level of production a
fixed no. of employees can handle
the task, but beyond this level new
hires need to be made to handle
the increased volume
 STEP-FIIXED COST – if the steps are
especially wide before moving up to
the next level of costs
: salaries of factory supervisors w/c
stays the same in total over a wide
range of production but increase
once production rose significantly
:TYPE B: Varies continuously but not in
direct proportion to volume changes
because the cost has a variable and fixed
component
: electricity costs and maintenance costs
for the factory equipment.
II. ANALYZING SEMIVARIABLE FO
- A model that describes a company’s cost behaviour
might be used to determine w/c products the
company should produce or what price should be
charged to customers in order to make a reasonable
profit.
A. OBSERVATION METHOD
- ACCOUNT ANALYSIS METHOD
- Relies heavily on the ability of an observer to detect
a pattern of cost behaviour by reviewing past cost
and volume data
- The reaction of an exp. to past changes in prod is
observed, and a decision is made to classify the exp.
as either variable or fixed and ignoring that many
overhead are SEMIVARIABLE
o Electricity will be V if the majority of the
electricity is used to power the machines
rather than heating and lighting
 o Companies believe that the discrepancy
between actual and forecast costs will be
INSIGNIFICANT and will not affect mgmt.
- Subjective results
B. HIGH-LOW METHOD
- Compares high prod vol. and its related cots to a
low prod vol. w/ its related costs
- The diff in vol. between the 2 points being
compared is LINEAR and will fall along a straight
line
- The variable rate will be determined by comparing
the amount of vol. change when moving from the
point of lowest vol. to the point of highest vol.
C. SCATTERGRAPH METHOD
- Estimates a straight line along w/c the semivariable
costs will fall.
- Y-axis. The cost being analysed
- X- axis. The activity level (no. of unit produced)
- The line. Represent the trend
- Total fixed costs. The point where the straight line
intersects the Y-AXIS
- Variable cost per unit. Subtracting the fixed costs
from total costs at any point on the graph and then
dividing the activity level for that point read from
the x-axis.
LIMITATION OF HIGH-LOW AND SCATTERGRAPH
METHODS
- Use historical cost patterns to predict future costs
and are subject to the limitations that apply to all
forecasting techniques.
- The use of mathematical techniques does not
ensure accurate forecasts
- The accuracy of a forecast depends on the validity
of the data used
- High-low method. Bases its solution on 2
observations and assumes that all other unanalysed
relationships will fall a straight line between these
selected observations
o The assumption is UNREALISTIC because the
2 observations may not be representative
of the group from w/c the data were
selected.
o IT WILL BE RELIABLE if additional pairs of
data are analysed and the results
approximate those obtained from the first
observation.
- Scattergraph method. Improved method than high-
low method because it uses available info
o The visual inspection of the graph enables
nonrepresentative data point (OUTLIERS) to
be identified.
o DIS: the cost line is drawn through data
points based on visual inspection rather
than mathematical techniques.
- Many other factors affect cost behaviors and should
not be ignored (price changes, advancements in
technology and mgmt. policies)
SIMILARITIES
- Stress the importance of the relationship of cost
factors to vol. of activity (units of prod or DL hrs.
worked)
D. LEAST-SQUARES REGRESSION METHOD
- Employ statistical software packages and are usually
covered in statistics courses
- Use all the data to separate a semivariable cost into
its fixed and variable elements based on the
equation of a straight line
- Straight line equation: Y = a + bX
X – the activity level
Y – total semivariable cost
a – total fixed cost
b – variable cost per unit
- Coefficient of determination (R^2). Indicates the %
of the variation in the dependent variable
(semivariable cost – dependent on the level of
activity for the period) that is explained by variation
in the independent variable (activity level – causes
the variation in the costs)
III. BUDGETING FACTORY OVERHEAD COSTS
- Budget. Mgmt.’s operating plans expressed in
quanti terms (units of prod and related costs) and
used in planning and controlling
- Budgets for expected levels of prod can be prepared
after FO costs are classified into Fixed or Variable
thus creating FLECIBLE BUDGETS
- Flexible budget. A budget that shows estimated
costs at diff prod vol.
o Aids mgmt. in establishing realistic prod
goals and in comparing actual costs w/
budgeted costs.
- Factory cost per unit DECREASES as the vol. of prod
INCREASES
o The total fixed cost is spread over a larger
number of units
IV. ACCOUNTIGN FOR ACTUAL FACTORY
OVERHEAD
- Cost acc systems are designed to accumulate,
classify, and summarize the FO costs actually
incurred
- Specidic procedures used to account for actual FO
costs depend on the nature and organizational of
the manufacturing firm.
- Small manufacturing company w/ one prod
department. FO may be accounted for in much the
same manner as S&A exp.
o All other FO accounts such as IDL and IDM
may be kept in the general ledger.
o IDM and IDL are recorded FIRST in the
GENERAL LEDGER that are made from the
summary of materials issued and returned
and the labor cost summary.
 The INVOICES are the source for the
entries.
o Schedule of fixed costs – source for general
journal adjusting entries to record taxes,
depreciation, insurance, etc.
o Factory overhead ledger (subsidiary
ledger)
o At the end of the period, the balance of the
FO control account is verified by the
balance to the total of the account balances
in the subsidiary factory overhead ledger
A. FACTORY OVERHEAD ANALYSIS SPREADSHEET
- Chosen by companies w/ many prod departments
but lacks an acc software package to record factory
overhead expenses rather than expand the FO
general ledger to include separate account for each
department’s share of diff expenses
- Separate analysis spreadsheet is used to record
each exp, w/ indiv columns for the departmental
classification of the exp
- Serve as subsidiary ledgers and controlled by the
FO account in the ledger
- Expense-type analysis spreadsheet. A separate
amount of column for each depart, making it
possible to distribute charges in each depart as exp
are recorded
o Separate ledger account as the
departments
o Each columns represents a department
o Advantage: provides only the amount
columns as there are departments,
however, a summary is prepared at the end
of the period to determine the total
expenses incurred in each department
- Expense-type analysis spreadsheet. Separate
amount column for each kind of expense and
distribute exp on a departmentalize basis as they
are recorded
o Each column represents expense
o Separate ledger account for each expense
B. SCHEDULE OF FIXED COSTS
- FC are assumed not to change in amount from
month to month (insurance, property taxes, prepaid
and accrued expense)
- Can be prepared for several periods
- Posted at the end of the month
C. GENERAL FACTORY OVERHEAD EXPENSES
- Factory manager’s salary, security guards’ wages
- Not identified w/ a specific department are charged
to departments by a process of allocation
- Either as each item or accumulated
D. SUMMARY OF FO
- Recorded on the FO analysis spreadsheet and FO
control account in the General Ledger
- Confirms the balance of the FO overhead control
account
- Shows the items of FO expenses by department and
in total
V. DISTI=RBUTING SERVICE DEPARTMENT
EXPENSES
- Classes of departments
o Service. Essential but does not work directly
on the product
 serve the needs of the department
 generates the power of the
factory, building maintenance
department or the HR responsible
for hiring employees
o Production. Actual manufacturing
operations that physically change the units
being processed
 Total product costs should include a
share of service department costs
