Cost Accounting and Control

Marian G. Magcalas, CPA, MBA

 TABLE OF CONTENTS

Module 8. Accounting for Labor 157

Introduction 157
Learning Outcomes 158
Lesson1. Cost of Labor 158
Lesson 2. Uses of Cost of Labor 158
Lesson 3. Procedures for Recording Payroll Costs 159
Lesson 4. Methods of Wage Payment 159
Lesson 5. Controlling Labor Cost 167
Lesson 6. Accounting for Labor Costs 170
Lesson 7. Overtime Premium 171
Lesson 8. Illustrative Problem on Labor Cost 171
Lesson 9. Employer’s Payroll Taxes 172
Lesson 10. Illustrative Problem 177
Lesson 11. Classification for Labor 179
Assessment Task 8 181
Summary 183
References 183
Module 9. Accounting for Factory Overhead 185
Introduction 185
Learning Outcomes 186
Lesson 1. Definition of Manufacturing Overhead 186
Lesson 2. Cost Behavior Patterns 187
Lesson 3. Methods of Segregating Mixed Costs 188
Lesson 4. Manufacturing Overhead Budget 190
Lesson 5. Factors to Consider in the Computation of Overhead Rate 192
Lesson 6. Bases to Be Used 192
Lesson 7. Steps in the Computation of Departmentalized Overhead 193
Rate 193
Lesson 8. Common Costs 194
Lesson 9. Allocation Bases for Common Costs 195
Lesson 10. Allocation of Service Department Costs 196
Assessment Task 9 197
Summary 198
References
Module 10: Activity Based Costing And Management 200
Introduction 200
Learning Outcomes 201
Lesson 1. Definition of Terms 201
Lesson 2. Activity-Based Management 202
Lesson 3. Manufacturing Cycle Efficiency 203
Lesson 4. Activity-Based Costing 203
Lesson 5. Differences Between Traditional and ABC Costing 204
Lesson 6. Steps in Activity-Based Costing 205
Lesson 7. Illustrative Problem 207
Assessment Task 10 209
Summary 211
References 213
 MODULE 8
ACCOUNTING FOR LABOR

Introduction
Labor is the physical or mental effort expended in manufacturing a product. Labor cost
is the price paid for using human resources. The compensation paid to employees who
engage in production related activities represents factory labor. The principal labor cost is
wages paid to production workers. Salaries are fixed payments made regularly for managerial
or clerical services. However, in practice, the terms “wages” and salaries are often incorrectly
used interchangeably (De Leon, G., De Leon, E., & De Leon, N., 2019) .

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 Learning Outcomes
At the end of this module, students should be able to:
1. Distinguish between account for direct and indirect labor as they are used in the
production process.
2. Identify the three activities involved in accounting for labor.
3. Understand the consequences of and be able to account for employee and
employer taxes and fringe benefit costs.
4. Identify the guaranteed wage and incentive plans that may be used.

Lesson 1. Cost of Labor (Bragg, 2021)

The cost of labor is the salaries and wages paid to employees, plus related payroll
taxes and benefits. The term may also relate to a specific time period or a job (if the
employer is using a job costing system to track costs).
The cost of labor may be subdivided into:
1. The cost of labor related to the production of goods (known as the cost of
direct labor) and
2. The cost of labor related to all other activities (known as the cost of
indirect labor).

Lesson 2. Uses of Cost of Labor (Bragg, 2021)

The cost of labor is useful for a number of reasons, including:

 Cost management. If it is necessary to conduct a layoff, it is useful to
know which costs of labor will be eliminated as the result of an employee
termination.
 Outsourcing. Management should understand its labor costs before
outsourcing any activities to a supplier, in order to estimate the revised
cost structure of the business.
 Union negotiations. If employees are represented by a union,
management must understand the labor cost associated with each
bargaining position, to determine the overall cost to the business.

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Lesson 3. Procedures for Recording Payroll Costs
(De Leon et al., 2019)

The accounting system of a manufacturer must include the following procedures for
recording payroll costs:
1. Recording the numbers of hours used in total and by job.
2. Recording the quantity produced by the workers
3. Analyzing the hours used by employees to determine how time is to be charged.
4. Allocation of payroll costs to jobs and factory overhead accounts.
5. Preparation of the payroll, including computation and recording of the employees
gross earnings, deductions, and net earnings.

Lesson 4. Methods of Wage Payment (Sunita, n.d.)

The following points highlight the top three methods of wage payments. The methods
are:
1. Time Rate System
2. Piece Rate System
3. Incentive Wage System (Modified Wage Plan)

Method # 1. Time Rate System:

Under this method of wage payment, the workers are paid the wages on the basis of
time. In this system of wage payment, the workers are paid the wages on the basis of time as,
per hour, per day, per week, per fortnight or per month etc. This system does not consider the
production of the employees during this time.

The amount of wages under this system is calculated as under:

Wages = Time spent by the worker × Rate of wages according to time.

Suitability of Time Rate System:

This system of Wage Payment is particularly suitable in the following circumstances:
1. When it is not possible to measure the production in terms of units or in any other
terms.
2. When the work is of high standard.

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 3. When it is not possible to divide the production into units.
4. When the production is of the nature that it requires efficiency more than the speed.
5. When the worker is undertraining.

Merits of Time Rate System:

1. Simplicity:
It is very easy to calculate the amount of wage under this system.
2. Certainty of the Amount of the Remuneration:
This system of wage payment provides certainty of the amount of wage
payment to the employee. It develops the feeling of confidence and certainty among
them.
3. High Quality of Production:
As this system of wage payment has no concern with quantity of production,
quality of production produced by the workers under this system is very high.
4. Proper Utilization of the Factors of Production:
As this system is not related with speed, the workers perform their work in very
confident manner. They make the best Utilization of the factors of production.
5. Co-Operation between Labor and Capital:
This system of wage payment brings the industrial peace because it satisfies
the workers and the industrialists. Thus, it develops harmony and cooperation between
labor and capital.
6. Best System for Artistic Work:
This system of wage payment is most suitable for artistic work.
7. Co-Operation and Unity of Workers:
As all the employees doing the work for same nature get the same amount of
wages, this system develops the feeling of co-operation and unity among the
workers.
8. Suitable for the Health of Workers:
This system of wage payment is suitable from the point of view of health of
workers.

Demerits of Time Rate System:

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 1. Need of Intensive Supervision:
This system requires intensive supervision over workers. It increases the cost
of supervision.
2. Lack of Incentive:
This system of wage payment makes equal payment to both the efficient and
inefficient workers. Therefore, efficient workers do not get any incentive for more
production.
3. Encouragement of Labor Unions:
This system encourages labor unions. Sometimes, these labor unions misuse
their powers.
4. Misuse of Time by Workers:
Under this system of wage payment, the workers do not make proper
Utilization by their time.
5. Fall in the Quantity of Production:
Under this system of wage payment, the quantity of production decreases
because the workers do not get any incentive for increasing the production.
7. It Kills the Efficiency of Workers:
As this system does not make any difference between efficient and inefficient
workers, it kills the efficiency of efficient workers.
8. Increase in Cost Per Unit:
This system increases the cost per unit of production. Under this system, the
cost per unit of production is uncertain because the quantity of production differs
from time to time.
9. Difficult to Measure the Efficiency:
Under this system of wage payment, it is very difficult to measure the
efficiency of workers because all the workers of equal status are paid the wages at
equal rate.

Method # 2. Piece Rate System:

Under this system of wage payment, the workers are paid the wages on the basis of
quantity and quality of work performed by them. Under this system, the rates of wages are

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determined according to quantity and quality of work and the workers are paid according to
these rates.
The amount of wages to be paid to a worker under this system is calculated as
under:
Wages = Units of production × Rate per unit.

Suitability of Piece Rate System:

This system of wage payment is very suitable in the following conditions:
1. When the work is of standard nature.
2. When the work can be measured easily.
3. When there is a great need of increase in the production.

Merits of Piece Rate System:

1. Incentive to More Work:
This system encourages the workers to do more and more work because
they get their wages according to their work.
2. Proper Utilization of Machines:
Under this system, the workers use their machines and equipment with
proper care because they feel that if their machine is out of order, their work will be
held up and their wages will be low.
3. Increase in the Quantity of Production:
The system of wage payment gets more production because all the workers
make their best efforts to increase the production.
4. Best Utilization of Time:
As the workers are paid according to their work, they make the best possible
utilization of their time. They do not want to waste their time.
5. Decrease in the Cost of Production:
This system decreases the cost of production because the maximum
production is done by the workers in the minimum time. It decreases the cost per unit
of production also.
6. Decrease in the Cost of Supervision and Administration:
This system of wage payment minimizes the needs of supervision. It reduces
the cost of supervision.

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 7. Easy and Simple:
This system of wage payment is very easy to understand and very simple to
calculate.
8. Improvement in the Standard of Living of Workers:
Workers get more wages because they produce more. It increases their
efficiency and productivity. It increases their remuneration also which improves their
standard of living.
9. Mobility of Workers:
This system of wage payment increases the mobility of workers because they
can change their enterprise easily.
10. Measurement of the Efficiency of the Workers:
This system provides an opportunity to measure the efficiency of the workers.
It makes proper distinction between efficient and inefficient working staff of the
enterprise.
11. Justified:
This system of wage payment justified also because the workers are paid the
wages according to the work performed by them.
12. Helpful in Maintaining Industrial Peace:
This system brings industrial peace also because it satisfies both the workers
and the employer.

Demerits of Piece Rate System:

1. Lack of Unity among Workers:
This system lacks the unity and mutual co-operation among workers. They
feel themselves competitor to each other.
2. Loss of Workers on the Failure of Machines etc.:
It because of any reason, the machines fail or the power fails, the work of
workers is held up and they lose their wages.
3. Misuse of the Factors of Production:
The workers do not pay proper attention towards the factors of production.
They only want to increase the speed of production.
4. Adverse Effect on the Health of Workers:

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 This system motivates the workers to do more and more work. It affects the
health of workers adversely.
5. Low Quality of Production:
This system of wage payment does not pay any attention on the quality of
production. As a result of it the quality of production falls down.
6. Unsuitable for Artistic Work:
This system is not suitable for artistic work because artistic work cannot be
paid only on the basis of quantity of production.
7. Uncertainty of Wages:
As the amount of wages depends upon the quantity of production, the actual
amount of wages to be paid is always uncertain. The workers also cannot estimate
their remuneration in advance.

Method # 3. Incentive Wage System (Modified Wage Plan)

There are two basic systems of wage payment—time rate system and piece rate
system. Both the systems have their merits and demerits. No system can be considered
suitable for all times and under all circumstances. To maintain the merits of both the systems
and to overcome the demerits of these systems, some experts have developed the systems
of incentives wage.
These systems are also known as incentive wage systems, progressive wage system
and bonus schemes, modified wage plan etc. Under these systems, both the time and speed
are considered as the basis of wage payment.
These systems provide incentives to the workers to produce more and more
maintaining the quality as well. The workers are paid bonus or premium for the additional
work. It is important to note that almost all the systems incentive wages provide for minimum
guaranteed wages to the workers.

Characteristics of an Ideal Incentive Wage System:

Important characteristics of an Ideal Incentive Wage System are as under:
1. It must be easy to calculate and to understand.
2. The standards of work must be determined on scientific basis.
3. It must establish direct relationship between efforts and remuneration.

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 4. It must give a guarantee of minimum wage to all the workers.
5. It must be in the interests of both the employers and the employees.
6. It must be flexible but stable.
7. It must be framed in the manner so that it may be used widely for all the activities
of the enterprise.
8. It must be helpful in increasing the production as well as productivity.

Advantages of Incentive Wage System:

i. There is increase in the prospect of workers to earn more. As shown by F. Herzberg
good salary is one of the hygiene factors in the absence of which people are unhappy
and dissatisfied. Wage incentive offers them the prospect of earning more.
ii. The scientific work study which is done before introducing a wage incentive plan
brings about improvements in methods, workflow, and man-machine relationship and
so on.
iii. There is effective reduction in the supervision costs Closer supervision of
employees becomes unnecessary because workers become more responsible.
Rather than the supervisor chasing the workers the workers themselves sometimes
chase the supervisor for materials, tools, etc.
iv. Employees promptly expose all such problems before management which retard
their earnings. Management becomes more alert in areas such as flow of process
materials, adequate spares, etc.
v. Employees are encouraged to become “inventive”. They invent and adopt ways and
means to achieve their production targets with lesser exertion and lesser expense of
energy. They come forward with new ideas and suggestions.
vi. There is improvement in discipline and industrial relations. Go-slow and similar
other techniques are not resorted to by the workers to express their dissatisfaction with
management policies and practices. There is increase in workers’ punctuality and
decrease in absenteeism.
vii. There develops a feeling of mutual co-operation among the workers as their
operations are interdependent and any hold-up at one point may affect the production
and earning at other points.

Effects of Incentive Wage System:

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 Experience has shown that incentive compensation is not an unmixed blessing. It
may produce certain ill-effects unless precautionary steps are taken to check them in
advance.
These ill-effects are as under:
i. There is tendency among the workers to sacrifice quality for the sake of quantity.
This calls for a very strict system of checking and inspection.
ii. In the absence of adequate provisions incentive payment brings about certain
rigidity in the operations. This makes it difficult for the management to revise norms
and rates following changes in technology, methods, machines, materials etc.
iii. Employees very often ask for compensation whenever production flow is disrupted
due to the fault of management.
iv. Unless greater vigilance is exercised there is a danger of workers disregarding
safety regulations.
v. Unless a maximum ceiling on incentive earning is fixed some workers tend to
overwork and undermine their health.
vi. Jealousies may arise among workers because some are able to earn more than
others. In the case of group systems, the fast workers may be dissatisfied with the
efforts of the slower members of the group; where heavy work is involved older
workers in particular are likely to be criticized for being too slow. One likely effect of
this is the splitting up of trade unions.
vii. The introduction of a system by results increases the amount and cost of clerical
work since it involves considerably more bookkeeping. This is particularly true when
the production is subdivided into many processes.

Lesson 5. Controlling Labor Cost (De Leon et al., 2019)

Maintaining labor records is the responsibility of the time-keeping and payroll

departments. The time-keeping department accounts for the time spent by the employee in
the factory. the payroll department computes each employee’s gross earnings, the amount of
withholdings and deductions, and the net earnings to be paid to the employee.

The departmental responsibilities of time-keeping and payroll are carried out by

completing and maintaining the following forms and records.
Time-keeping Payroll

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Clock cards Payroll records
Time tickets Employee’s earning records
Production reports Payroll summaries

Figure 8.1. Clock cards (Timeclocks.com.au, n.d.)

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Figure 8.2. Time Ticket (Usautosupplies.net, n.d.)

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 Figure 8.3. Payroll records (Dreambusiness.co, n.d.)

Lesson 6. Accounting for Labor Costs (De Leon et al, 2019)

For all regular hourly employees, the hours worked should be recorded on a time ticket
or individual production report. The time ticket shows the employee’s starting and stopping
time on each job, the rate of pay, and the amount of earnings. Individual production reports
are used instead of time tickets when labor costs are calculated using piece rates.

The time tickets and production reports are sent to payroll on a daily basis. The pay
rates and gross earnings are entered, and the reports are forwarded to accounting.

Cost accountants sort the time tickets and production reports and charge the labor
costs to the appropriate jobs or department and factory overhead. The accounting department
records the earnings in factory overhead ledger and on the labor cost summary.

The labor cost summary is used as the source for making a general journal entry to
distribute payroll to the appropriate accounts. The entry is then posted to the control accounts:
Work in Process and Factory Overhead in the general ledger.

In preparing the labor cost summary from the tickets, it is important to separate any
overtime from an employee’s regular time because the accounting treatment may be different
for each type of pay. Regular time worked is charged to job debiting Work in Process.

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Overtime may be charged to jobs, to factory overhead, or allocated partly to jobs and partly
to overhead. Overtime distribution depends upon the conditions creating the need for overtime
hours:

Lesson 7. Overtime Premium (Verma,Turan, Bodla, Garg, Singh, n.d)

Overtime premium is paid to workers for the extra time worked than the normal
working hours. The extra time is paid at a higher rate than the normal time rate, for example,
if a worker works beyond 8 hours in a day or 48 hours in a week, he is paid with double the
wages for the extra time worked. The overtime wages consists of two elements
(i) Normal wages for extra time and
(ii) Additional wages paid for the overtime worked

The accounting treatment of overtime premium is given below :

* Overtime hours at the normal rate are treated as direct labor cost and charged to
production on the same basis as time worked during normal hours but the premium
paid during the overtime period is not a direct charge against production but is
recovered as production overhead through overhead recovery rate.
* Where the overtime is worked on a specific job to meet the time schedules or to
carry out specific rush orders for which extra price is recovered, than the entire labor
cost can be charged as direct labor to that job.
* If overtime wages paid due to negligence or delay of worker of a particular
department, it may be charged to the concerned department.
* If the overtime premium is paid due to abnormal causes, it should be charged to
Costing Profit and Loss account.
Lesson 8. Illustrative Problem on Labor Cost
(De Leon et al, 2019)

Assume an employee regularly earns P30 per hour for an 8 hour day. If called upon
to work more than I hours in a working day, the company will have to pay overtime premium
for hours worked in excess of 8 hours. Assuming the employee works 12 hours on Monday,
is paid 50% overtime premium (time-and-half) the earnings would be calculated as follows:

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 Direct labor 8 hours at P30 P240
Direct labor 4 hours at P30 P120
Factory overhead (overtime premium 4 x P15) 60 180
Total Earnings P420

Journal entry:
Work in process 360
Factory overhead control 60
Payroll 420

If the previously mentioned employee is paid a premium of 100% (double-time), the

earnings would be:

Direct labor 8 hours at P30 P240

Direct labor 4 hours at P30 P120
Factory overhead (overtime premium 4 x P30) 120 240
Total Earnings P480

Journal entry:
Work in process 360
Factory overhead control 120
Payroll 480

Lesson 9. Employer’s Payroll Taxes

(Ins-Globalconsulting.com, n.d.)

Employers in the Philippines must observe a range of payroll regulations in

compliance with the Department of Labor and Employment (DOLE) and the Bureau of
Internal Revenue (BIR).

Withholding Taxes
Employers in the Philippines are required to deduct and withhold tax from their
employees’ wages every month in accordance with Philippine Law. They are then required to

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issue BIR Form 2316 (Certificate of Compensation Payment/ Tax Withheld) to the employee,
indicating the withheld amount to be remitted to the Philippines Bureau of Inland Revenue
(BIR). Income tax is thus collected from the employee through payroll, with the employer
acting as the withholding agent.

Income Tax rates

Citizens of the Philippines and foreign nationals must pay income tax on their
earnings at the following progressive rates:
Amount of Taxable Income (PHP) Tax rate applied
Up to 250,000 0%
Over 250,000 – up to 400,000 20%
Over 400,000 – up to 800,000 25%
Over 800,00 – up to 2,000,000 30%
Over 2,000,000 – up to 8,000,000 32%
Over 8,000,000 35%
No withholding of tax is required when an individual’s income does not exceed the
statutory minimum wage, or PHP 5,000.

Social Security contributions

Employees working in the Philippines are required to make contributions to the
mandatory Philippine Social Security System, which comprises of the following three
elements:

Social Security System (SSS): Deductions are taken automatically from the
employee’s salary every month.
Home Development Mutual Fund (HDMF) or Pag-ibig
Philippine Health Insurance (PhilHealth)

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Figure 8.4. SSS Contribution Table (governmentph.com, 2019)

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 Figure 8.5. Pag-ibig Contribution Table (governmentph.com, 2019)

How to compute Pag-IBIG Contributions?

The maximum Pagibig Contribution monthly compensation allowed to compute each
employee’s Pagibig contribution is currently set at P5,000. This means that the
employee and employer will both share P100.

P5,000 * 0.02 = P100

If you are earning more than 5,000 pesos every month, you are automatically
deducted P100 + 100 from your employer. The combined amount serves as a
monthly contribution to Pag-Ibig.

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 Figure 8.6. Philhealth Contributions Table (governmentph.com, 2019)

In its PhilHealth Circular No. 2019-0009 published on November 23, 2019, premium
rate for Direct Contributors shall still be at 2.75% of their monthly basic salary with an
adjusted ceiling of P50,000. In 2020, PhilHealth will increase the rate to 3% and henceforth
adjusted to increments of 0.5% every year until it reaches the 5% limit in 2025 as provided
for by law. Income floor is fixed at P10,000 during the 5-year period, while salary ceiling will
gradually increase by P10,000 each year until it reaches P100,000 in 2025.

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 Figure 8.7. Payroll sheet sample (educba.com, n.d.)

Lesson 10. Illustrative Problem (De Leon et al., 2019)

The Ingrid Manufacturing Company pays employees every two weeks. Monday, May
1 is the beginning of a new payroll period. The following payroll summary is prepared by the
payroll department and forwarded to accounting for recording ( figures are assumed and not
based on the updated tables for payroll taxes):

Payroll Summary
For the period May 1- 15

Factory Sales and

Workers Admin. Employees Total
Gross Earnings P10,000.00 P20,000.00 P30,000.00
Withholdings and deductions:
Income tax P 1,979.25 P 2,833.33 P 4,812.58
SSS Premiums 333.30 500.00 833.30
Philhealth contributions 125.00 250.00 375.00
Pag-ibig contributions 100.00 100.00 200.00
Total deductions P 2,537.55 P 3,683.33 P 6,220.88
Net earnings P 7,462.45 P16,316.67 P23,779.12

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After the data are verified, a payroll voucher is authorized and recorded as follows:

May 15 Payroll 30,000

Withholding Tax Payable 4,812.58
SSS premiums payable 833.30
Philhealth contributions payable 375.00
Pag-ibig Funds contributions payable 200.00
Vouchers Payable 23,779.12

To record the payment of the net earnings to employees, the following entry is required:

May 15 Vouchers payable 23,779.12

Cash 23,779.12

Assuming that of the total factory payroll of P10,000, P3,000 is indirect labor, the entry to
record the distribution of the payroll is:

Work in process 7,000

Factory overhead control 3,000
Selling and Admin Expense Control 20,000
Payroll 30,000

The following schedule provides the information necessary to record the employer’s payroll
taxes for the period.

SSS premiums Philhealth Pag-ibig Total

Factory payroll 706.70 125 100 931.70
Selling and admin 1,060.00 125 100 1,285.00
Total 1,766.70 250 200 2,216.70

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The entry to record the employer’s payroll taxes is as follows:

Factory overhead control 931.70

Selling and Admin Expense control 1,285.00
SSS premiums payable 1,766.70
Philhealth Contributions payable 250.00
Pag-ibig funds contributions payable 200.00

Lesson 11. Classification for Labor (De Leon et al., 2019)

1. Direct labor- labor identified with particular products which is considered feasible to
be measured and charged to specific production order cost sheet.

Work in process xxxx

Payroll xxxx

2. Indirect labor-
a. Labor identified with particular products but which is not considered
feasible to measure and charge to a specific production order.
b. Labor expected for the benefit of production in general and not identified
with particular products.

Factory overhead control xxxx

Payroll xxxx

3. Labor overhead
a. Waiting time or idle time- cost of non-productive hours of direct labor
caused by lack of work, waiting for materials delays from scheduling,
machine breakdown and machine set-up.

Work in process (actual) xxxx

Factory overhead control (idle) xxxx
Payroll xxxx

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b. Make-up pay- when payments to an employee are based solely on the
number of units produced, the employee is said to be paid at a
“piecework” rate but with guaranteed minimum wage. If the output
multiplied by the piece rate is less than the guaranteed pay, the difference
is called make-up pay.

Work in process (guaranteed less make-up) xxxx

Factory overhead control (make-up) xxxx
Payroll xxxx

c. Overtime premium- represents the amount paid, in excess of regular rate,

to employees working in excess of 8 hours in a day, or working during
holidays or their rest day.

Work in process (regular rate) xxxx

Factory overhead control (overtime premium only) xxxx
Payroll xxxx

d. Shift premium- extra pay to work during less desirable evening shift (2pm
to 10 pm) or night shift (10 pm to 6 am).

Work in process (regular rate) xxxx

Factory overhead control (shift premium only) xxxx
Payroll xxxx

e. Employer’s payroll taxes- amounts remitted to different government

agencies for SSS premiums, Philhealth contributions, and Pag-ibig
contributions.
Factory overhead control xxxx
Selling expense control xxxx
Admin expense control xxxx
SSS premiums payable xxxx

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 Philhealth cont payable xxxx
Pag-ibig funds payable xxxx

Assessment Tasks

Assessment Task 8-1

State whether the following statements are True or False:
1. Labor is the cost of hiring the human resources.
2. Labor cost which is not specifically incurred for or cannot be readily charged to or
identified with a specific job, contract work order or any other unit of cost is called as
direct labor.
3. Time for which employer pays to the labor but obtains no direct benefit is called as
productive cost.
4. Time keeping and time booking cannot be used interchangeably.
5. Rate of change in labor force due to resignation, retirement or retrenchment is
called as labor turnover.
6. Payment to workers for holidays and payment for overtime can be used
interchangeably.
7. In ideal circumstances, each payroll check is delivered personally to the employee
who signs an receipt for it.
8. The amount of income taxes withheld from employee gross pay is an expense to
the employer.
9. Remuneration for manual labor, both skilled and unskilled, is commonly referred to
as salaries.
10. Payroll deductions are based on the gross earnings of the employee (regular
plus overtime pay).

Assessment Task 8-2

1. Calculate total monthly remuneration of three workers: A, B and C.

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(a). Standard production per month per worker 1,000 units.
(b). Actual production during the month:

A: 850 units
B: 750 units
C: 950 units

(c). Piece work rate is Php10 per unit (actual production)

(d). Additional production bonus is Php100 for each percentage of actual production
exceeding 80% actual production over standard.
(e). Dearness pay fixed P5,000 per month over and above actual outputs.

2. An operator engaged in machining certain components receives an ordinary day rate of

P160 per day of 8 hours. The standard output for machining the components has been fixed
at P0.80 per hour (time fixed for premium bonus). On a certain day the output of the worker
on this machine is 800. Find labor cost per 100 pieces and the wages that would have been
actually earned by the workman under the following:

1: If a bonus of P19.00 is paid per 100 of extra output.

2: If paid for on straight piece work basis at the standard rate.

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 Summary

Labor refers to the work force which contributes towards the completion of the
manufacturing process of any organization.
Labor which is directly associated with a manufacturing process or his contribution is
directly identifiable with a particular process will be called as direct labor.
Worker’s remuneration is based on the hours spent by the workers on the job under
time wage payment system. Under this system workers are more concerned about completing
their time on the job rather than the output on the job.
Under piece wage payment system compensation is paid on the basis of units
produced by the workers. Time spent by the workers on the workplace is irrelevant for the
wage calculation under this method.
Incentive plans are used by the employers to motivate the workers and for improving
their efficiency at the work place. These plans are also helpful in overcoming the loopholes of
both types of payment plans be it piece wage system or time wage system.

References

Bragg, Steven. (2021). Cost of Labor. https://www.accountingtools.com/articles/what-is-the-

cost-of-labor.html

De Leon, G. M. Jr., De Leon E. D., De Leon, N. D. (2019). Cost Accounting and Control.
Manila City, Phils. GIC Enterprises & Co., Inc.

Educba.com. (n.d.) Payroll in Excel. https://www.educba.com/payroll-in-excel/

Ins-Global Consulting. (n.d.). Payroll and Tax Solutions in the Philippines. https://ins-
globalconsulting.com/payroll-tax-solutions-in-philippines/

Sunita, C. (n.d.). Top Three Methods of Wage Payments.

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https://www.economicsdiscussion.net/labour/top-3-methods-of-wage-payment-production-
economics-2/29320

Timeclocks.com. (n.d.). https://www.timeclocks.com.au/time-cards.php?seiko-qr-375-payroll-

time-card

Usautosupplies.net. (n.d.) https://usautosupplies.net/products/job-time-tickets

http://www.dreambusiness.co/b2b-marketing/specialist-pay-roll-for-excel.html

Verma, H.L, Turan, M. S., Bodla, B. S., Garg, M. C., Singh, M. C. (n.d.) Cost & Managerial
Accounting. Directorate of Distance Education Guru Jambheshwar University. Hisar, India.
Competent Printing Press.

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 MODULE 9
ACCOUNTING FOR FACTORY OVERHEAD

Introduction

In the world of manufacturing—as competition becomes more intense and customers

demand more services—it is important that management not only control its overhead but
also understand how it is assigned to products and ultimately reported on the company's
financial statements.
Overhead is viewed as two types of costs: manufacturing overhead and non-
manufacturing costs. This module focuses on the manufacturing overhead (Averkamp, n.d.).

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 Learning Outcomes
At the end of this module, students should be able to:
1. Compute a factory overhead rate using different bases.
2. Apply concept of actual factory overhead and applied factory overhead.
3. Identify and compute the different methods of allocating budgeted service
departments to producing departments.
4. Compute the different factory overhead variances.

Lesson 1. Definition of Manufacturing Overhead

(Averkamp, n.d.)

Manufacturing overhead (also referred to as factory overhead, factory burden, and

manufacturing support costs) refers to indirect factory-related costs that are incurred when a
product is manufactured. Along with costs such as direct material and direct labor, the cost of
manufacturing overhead must be assigned to each unit produced so that Inventory and Cost
of Goods Sold are valued and reported according to generally accepted accounting principles
(GAAP).
Manufacturing overhead includes such things as the electricity used to operate the
factory equipment, depreciation on the factory equipment and building, factory supplies and
factory personnel (other than direct labor). How these costs are assigned to products has an
impact on the measurement of an individual product's profitability.

According to generally accepted accounting principles (GAAP), manufacturing

overhead must be included in the cost of Work in Process Inventory and Finished Goods
Inventory on a manufacturer's balance sheet, as well as in the Cost of Goods Sold on its
income statement.

As their names indicate, direct material and direct labor costs are directly traceable to
the products being manufactured. Manufacturing overhead, however, consists
of indirect factory-related costs and as such must be divided up and allocated to each unit
produced. For example, the property tax on a factory building is part of manufacturing
overhead. Although the property tax covers an entire year and appears as one large amount

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on just one tax bill, GAAP requires that a portion of this amount be allocated or assigned to
each product manufactured during that year.
Some of the costs that would typically be included in manufacturing overhead include:

 Material handlers (forklift operators who move materials and units).

 People who set up the manufacturing equipment to the required

specifications.

 People who inspect products as they are being produced.

 People who perform maintenance on the equipment.

 People who clean the manufacturing area.

 People who perform record keeping for the manufacturing processes.

 Electricity, natural gas, water, and sewer for operating the

manufacturing facilities and equipment.

 Computer and communication systems for the manufacturing function.

 Repair parts for the manufacturing equipment and facilities.
 Supplies for operating the manufacturing process.
 Depreciation on the manufacturing equipment and facilities.
 Insurance and property taxes on the manufacturing equipment and
facilities.
 Safety and environmental costs.

Lesson 2. Cost Behavior Patterns (Verma et al., n.d.)

Depending on the variability behavior costs can be classified into variable and fixed
costs. The distinction between fixed and variable cost is important in forecasting the effect of
shortrun changes in volume upon costs and profits.

(a) Variable cost :

The variable cost is a cost that tends to vary in accordance with level of activity
within the relevant range and within a given period of time. The product costs i.e.,
direct material, direct labor and direct expenses tend to vary in direct proportion to
the level of activity. An increase in the volume means a proportionate increase in

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 the total variable costs and a decrease in volume will lead to a proportionate
decline in the total variable costs. There is a linear relationship between volume
and variable costs. They are constant per unit.

(b) Fixed cost :

The fixed cost is a cost that tends to be unaffected by changes in the level of
activity during a given period of time. The fixed costs remain constant in the total
regardless of changes in volume up to a certain level of output. They are not
affected by changes in the volume of production. There is an inverse relationship
between volume and fixed cost per unit. Fixed costs tend to remain constant for all
levels of activity within a certain range. It follows that some fixed costs will continue
to be incurred even when the activity comes down to nil. Some fixed costs are
liable to change from one period to another. For example salaries bill may go up
because of annual increments or due to change in the pay rates and due to pay
structure.

(c) Semi-variable cost or semi-fixed cost

Many costs fall between these two extremes. They are called as semi-variable
cost or semi- fixed costs. They are neither perfectly variable nor absolutely fixed in
relation to changes in volume. They change in the same direction as volume but
not in direct proportion thereto.

An example is found in telephone charges. The rental element is a fixed cost

whereas charges for call made are a variable cost.

Lesson 3. Methods of Segregating Mixed Cost (iedunote, n.d.)

To segregate semi-variable cost into fixed cost and variable cost is necessary
because, with this, we can add a fixed cost proportion in total fixed cost and variable cost
proportion in total variable cost.

Some of the methods used are the following

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 1. Graphical Method

With the graphical method, draw the graphic line of semi-variable cost by taking
output on the x-axis and total semi-variable cost at the y-axis.

2. High Points and Low Points Method

Under this method, Total sales and total costs are calculated at the highest level of
production. Then calculate total sale and total cost at the lowest level of production because
semi-variable cost has both variable and fixed costs.

Then, calculate the variable rate with the following formula:

Variable Cost (b) = (Highest value-Lowest value) / (Highest activity – Lowest activity)

Estimate the fixed Cost Level:

Fixed Cost (a) = Total Cost – Variable Cost.

3. Analytical Method

Under this method, some analysis is done by dividing semi-variable cost into fixed
cost and variable cost. After this, calculate fixed cost using the rate.

4. Level of Activity Method

In this method, compare two-level of production with the number of expenses in

these levels. Variable cost will be calculated with the following method.

Level of Activity = Change in semi-variable cost / Change in production volume

5. Least Square Method

This method is based on the linear equation y = mx+c, y is the total cost, x is the
volume of output, and c is a total fixed cost. By solving this equation mathematically,
variable cost(M) can be calculated at different levels of production.

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Lesson 4. Manufacturing Overhead Budget (Bragg, 2021)

The manufacturing overhead budget contains all manufacturing costs other than direct
materials and direct labor. The information in this budget becomes part of the cost of goods
sold line item in the master budget.
The total of all costs in this budget are converted into a per-unit overhead allocation,
which is used to derive the cost of ending finished goods inventory, and which in turn is listed
on the budgeted balance sheet. The information in this budget is among the most important
of the various departmental budget models, since it may contain a large proportion of the total
amount of a company's expenditures.
This budget is typically presented in either a monthly or quarterly format.

Other Manufacturing Overhead Budget Issues

A less-common format for the overhead budget is to group the line items into fixed
expense and variable expense classifications. It can be difficult to determine the fixed or
variable status of a cost, in which case you can add a third cost grouping for mixed costs that
contain both fixed and variable cost characteristics. Separate treatment of variable expenses
is useful if you want to create a flexible budget, where the budgeted amount of variable costs
change to match the amount of actual revenues earned.
In a simplified budgeting environment, the overhead budget may be as simple as an
overhead rate that is multiplied by some form of activity, such as direct labor hours or machine
time used. This approach is generally not recommended, since it does not reveal the precise
nature of the various types of expenses incorporated into the overhead rate, and could even
be used by a less ethical manager to increase his manufacturing budget without making it
visible to the rest of the management team.
Given the considerable size of the expenditures a budget, one must guard against the
inclusion of an incorrect figure, since the result could be a seriously inaccurate overall budget.
One way to spot incorrect numbers is to match the budgeted totals by period against the actual
amounts incurred for the same periods in the immediately preceding year, for reasonableness.
It is not customary to include a cash requirements calculation as part of the
manufacturing overhead budget. Instead, the cash requirements are calculated for all of the
revenues and expenditures of a business as a whole, and are then summarized on a separate
page of the budget.

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Example of the Manufacturing Overhead Budget
Delphi Furniture produces Greek-style furniture. It budgets the wood raw materials
and cost of its artisans in the direct materials budget and direct labor budget, respectively.
Its manufacturing overhead costs are outlined as follows:

Table 9.1. Example of Manufacturing Overhead Budget

Delphi Furniture
Manufacturing Overhead Budget
For the Year Ended December 31, 20XX

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Administrative salaries $142,000 $143,000 $144,000 $145,000

Administrative payroll taxes 10,000 10,000 11,000 11,000

Depreciation 27,000 27,000 29,000 29,000

Freight in and out 8,000 7,000 10,000 9,000

Rent 32,000 32,000 32,000 34,000

Supplies 6,000 5,000 7,000 6,000

Travel and entertainment 3,000 3,000 3,000 3,000

Utilities 10,000 10,000 10,000 12,000

Total manufacturing $238,000 $237,000 $236,000 $237,000

overhead

Lesson 5. Factors to be Considered in the Computation of

Overhead Rate (De Leon et al., 2019)
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 1. Base to be used
a. Physical output
b. Direct materials cost
c. Direct labor cost
d. Direct labor hours
e. Machine hours

2. Activity level to use

a. Normal capacity
b. Expected actual capacity

3. Inclusion or exclusion 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 departments.

Lesson 6. Bases to Be Used (De Leon, et al, 2019)

Base to be used Factory overhead rate formula

1.Direct labor hours = Estimated Factory Overhead = Factory overhead rate/direct labor hour
Estimated direct labor hours

2.Direct labor cost =Estimated Factory overhead x 100 = Percentage of direct labor cost
Estimated direct labor cost

3.Machine hours =Estimated factory overhead = Factory overhead rate/machine hour

Estimated machine hours

4.Direct material cost =Estimated factory overhead x 100 = Percentage of direct material cost
Estimated direct material cost

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5.Units of production =Estimated factory overhead = Factory overhead rate/unit of production
Estimated units of production

Lesson 7. Steps in Computation of Departmentalized

Overhead Rate (De Leon et al., 2019)

In a departmentalized company, factory overhead should be budgeted for each

department. The procedures for distributing the budgeted departmental expenses are
identical to those used to allocate the actual factory overhead expenses:

1. Divide the company into segments, called departments, cost centers, to which
expenses are to be charged.
2. Estimate the factory overhead for each department (direct departmental charges
+ indirect departmental charges).
3. Select and estimate the base to be used by each department.
4. Allocate the service department costs to the producing department.
5. Compute the factory overhead rate (similar to computation using blanket rate).

Lesson 8. Common Costs (Bragg, 2021)

A common cost is a cost that is not attributable to a specific cost object, such as a
product or process. When a common cost is associated with the manufacturing process,
it is included in factory overhead and allocated to the units produced. When a common
cost is associated with administrative functions, it is charged to expense as incurred.

This means that common costs associated with production may be capitalized into
inventory and carried forward for several reporting periods, while common costs
associated with administration are charged straight to expense.

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Example of a Common Cost

The cost of rent for a production facility is not directly associated with any single
unit of production that is manufactured within that facility, and so is considered a common
cost.

Lesson 9. Allocation Bases for Common Costs

(De Leon et al., 2019)

Most common costs can be grouped into four:

a. Labor-related common costs
b. Machine-related common costs
c. Space-related common costs
d. Service-related common costs
The typical allocation bases for common costs are:
Common Costs Typical Allocation Base
Labor-related
1. Supervision No. of employees, payroll amount or DLHrs
2. Personnel services Number of employees
Machine-related
1. Insurance on equipment value of equipment
2. Taxes on equipment value of equipment
3. Equipment depreciation machine-hours, equipment value
4. Equipment maintenance number of machines, machine hours
Space-related
1. Building rental space occupied
2. Building insurance space occupied
3. Heat and air conditioning space occupied, volume occupied
4. Concession rental space occupied and desirability of location
5. Interior building maintenance space occupied
Service-related
1. Material handling quantity or value of materials
2. Billing and accounting number of documents

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 3. Indirect materials value of direct materials

Lesson 10. Allocation of Service Department Costs

(lumenlearning.com, n.d.)

The operating departments perform the primary purpose of the company—to produce
goods and services for consumers. Examples of operating departments are the assembly
departments of manufacturing firms and the departments in hotels that take and confirm
reservations.
The costs of service departments are allocated to the operating departments because
they exist to support the operating departments. Examples of service departments are
maintenance, administration, cafeterias, laundries, and receiving. Service departments aid
multiple production departments at the same time, and accountants must allocate and account
for all of these costs. It is crucial that these service department costs be allocated to the
operating departments so that the costs of conducting business in the operating departments
are clearly and accurately reflected.
Accountants allocate service department costs using some type of base. When the
companies’ managers choose bases to use, they consider such criteria as the types of
services provided, the benefits received, and the fairness of the allocation method. Examples
of bases used to allocate service department costs are number of employees, machine-hours,
direct labor-hours, square footage, and electricity usage.

There are three methods for allocating service department costs:

The first method, the direct method, is the simplest of the three. The direct method
allocates costs of each of the service departments to each operating department based on
each department’s share of the allocation base. Services used by other service departments
are ignored.
The second method of allocating service department costs is the step method. This
method allocates service costs to the operating departments and other service departments
in a sequential process. The sequence of allocation generally starts with the service
department that has incurred the greatest costs. After this department’s costs have been
allocated, the service department with the next highest costs has its costs allocated, and so

194
forth until the service department with the lowest costs has had its costs allocated. Costs are
not allocated back to a department that has already had all of its costs allocated.
The third method is the most complicated but also the most accurate. The reciprocal
method (or algebraic method) allocates services department costs to operating departments
and other service departments. Under the reciprocal cost, the relationship between service
departments is recognized and cost is allocated to and from each service department for
services provided.

Assessment Tasks
True or False
1. Selling, general and administrative costs are part of manufacturing overhead.
2. To be in compliance with generally accepted accounting principles, selling and
administrative expenses and interest expense should be allocated to the cost of
products manufactured in order to properly value inventories on a manufacturer's
balance sheet.
3. Manufacturing overhead must be assigned to both work-in-process inventory and
finished goods inventory for external financial reporting purposes.
4. Only direct manufacturing costs are assigned to inventories and cost of goods sold.
5. Commissions paid to sell products are reported as part of the cost of goods sold.
6. The use of a plant-wide rate will be more equitable than the use of departmental
rates for allocating manufacturing overhead.
7. The salary of the president of a manufacturer is part of the manufacturing overhead
costs.

Problem solving:
The IQIZ Company estimated its factory overhead of the next period at P160,000. It
is estimated that 40,000 units will be produced at a materials cost of P200,000. Production
will require 40,000 man-hours at an estimated wage cost of P80,000. The machines will run
about 25,000 hours.

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 Required: The factory overhead rate that may be used in applying FOH to production
on each of the following bases:
(1). Materials cost
(ii). Direct labour cost
(iii). Direct labour hours
(iv). Machine hours
(v). Units of production

Summary

Manufacturing overhead (also referred to as factory overhead, factory burden, and

manufacturing support costs) refers to indirect factory-related costs that are incurred when a
product is manufactured. Along with costs such as direct material and direct labor, the cost of
manufacturing overhead must be assigned to each unit produced so that Inventory and Cost
of Goods Sold are valued and reported according to generally accepted accounting principles
(GAAP).
Manufacturing overhead includes such things as the electricity used to operate the
factory equipment, depreciation on the factory equipment and building, factory supplies and
factory personnel (other than direct labor). How these costs are assigned to products has an
impact on the measurement of an individual product's profitability.
Depending on the variability behavior costs can be classified into variable and fixed
costs. The distinction between fixed and variable cost is important in forecasting the effect of
shortrun changes in volume upon costs and profits.
The variable cost is a cost that tends to vary in accordance with level of activity within
the relevant range and within a given period of time. The product costs i.e., direct material,
direct labor and direct expenses tend to vary in direct proportion to the level of activity. An
increase in the volume means a proportionate increase in the total variable costs and a
decrease in volume will lead to a proportionate decline in the total variable costs.
The fixed cost is a cost that tends to be unaffected by changes in the level of activity
during a given period of time. The fixed costs remain constant in the total regardless of

196
changes in volume up to a certain level of output. They are not affected by changes in the
volume of production. There is an inverse relationship between volume and fixed cost per unit.
Many costs fall between these two extremes. They are called as semi-variable cost or
semi- fixed costs. They are neither perfectly variable nor absolutely fixed in relation to changes
in volume. They change in the same direction as volume but not in direct proportion thereto.
Factors to be considered in the computation of overhead rate are: the base to be used,
activity level to use, inclusion or exclusion of fixed factory overhead, and the use of single rate
or several rates.
A common cost is a cost that is not attributable to a specific cost object, such as a
product or process. When a common cost is associated with the manufacturing process,
it is included in factory overhead and allocated to the units produced. When a common
cost is associated with administrative functions, it is charged to expense as incurred.
There are three methods for allocating service department costs: direct method, step
method and reciprocal or algebraic method.

References

Averkamp, H. (n.d.) Manufacturing Overhead.

https://www.accountingcoach.com/manufacturing-overhead/explanation

Bragg, Steven. (2021). Common Cost.

https://www.accountingtools.com/articles/2017/5/5/common-cost

Bragg, Steven. (2021). Manufacturing Overhead Budget/Overhead Budget.

https://www.accountingtools.com/articles/2017/5/17/manufacturing-overhead-budget-
overhead-budget

De Leon, G. M. Jr., De Leon E. D., De Leon, N. D. (2019). Cost Accounting and Control.
Manila City, Phils. GIC Enterprises & Co., Inc.

197
Iedunote.com. (n.d.) Cost Behavior: Fixed, Variable and Mixed.
https://www.iedunote.com/cost-behavior

Lumenlearning.com.(n.d.) Allocation of Service Department Costs.

https://courses.lumenlearning.com/managacct/chapter/allocation-of-service-department-
costs/

Verma, H.L, Turan, M. S., Bodla, B. S., Garg, M. C., Singh, M. C. (n.d.) Cost & Managerial
Accounting. Directorate of Distance Education Guru Jambheshwar University. Hisar, India.
Competent Printing Press.

MODULE 10

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 ACTIVITY BASED COSTING AND
MANAGEMENT

Introduction

The traditional product costing methods assume that individual product cause costs.
When the major cost components of a product are direct materials, direct labor, or overhead
that can be directly associated with individual products, traditional methods are quite accurate.
In situations where manufacturing overhead is a significant cost and is not directly related to
volume of products, traditional product costing methods can generate inaccurate product
costs. These inaccurate product costs can lead to poor decision making regarding product
marketing, product design, investment, and budgeting issues, causing the company to be less
competitive. Overhead allocation is most troublesome in multiple-product companies
(Punzalan, 2012).

Learning Outcomes

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At the end of this module, students should be able to:
1. Define activity-based management, activity, cycle efficiency, value-added and
nonvalue-added activities, activity based costing (ABC), cost driver, homogenous
activities, cost levels, unit level cost, batch level cost, product level cost, facility cost
and cost pools.
2. State the rationale behind activity-based costing.
3. Compute for unit cost using activity-based costing.
4. Compare product costing using the traditional method and ABC method.

Lesson 1. Definition of Terms (Harina, 2003)

Activity-Based Management is using information about activities to manage many aspects of

Activity-Based Costing
Activity Center
Cost Pool
Plantwide Allocation
Departmental Allocation
Cost Driver
an organization, and focuses on processes and on tasks and
activities within processes, rather than simply managing costs.
It is a method of assigning indirect costs, including non-
manufacturing overhead, to products and services. It first
assigns costs to activities, then to the products based on each
product’s use of activities. It is a premise that products consume
activities and activities consume resources.
Unit of the organization that performs a set of tasks.
Means indirect cost pool. Refer to groupings or aggregations
Leof costs, usually for subsequent analysis.
uses the entire plant as a cost pool. Then, allocate all costs from
that pool to product using a single overhead allocation rate, or
one set of rates, to all the products of the plant, independent of
the number of departments in the plant.
Each department is a separate cost pool, which accumulates
costs. Then, using separate rates, or sets of rates, for each
department, allocate from each cost pool to products produced
in that department.
A factor that causes or “drives” an activity’s costs.

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 Cost Pools Group Costs Into Either:
1. Plants, which are entire factories, stores, banks, and so forth.
2. Departments within the plants.
3. Activity centers

Lesson 2. Activity-Based Management (Mejorada, 2006)

Activity-based management is concerned with planning and controlling activities

involved in the production/performance process to improve a “firm’s cycle efficiency”. For a
manufacturing firm, it is to improve the manufacturing cycle efficiency. For a service concern,
it is to improve service cycle efficiency and for a retailer, retail cycle efficiency. Activities are
classified into value-added and no-value added with the intention of minimizing, if not
eliminating the latter.

Non-value adding activities merely increase the time expended on a product or

service. However, some of them may result in minimal increase in product customer value.
Examples of value-added and no-value-added activities in a manufacturing firm are the
following:

Value Adding Activities

Extracting
Machining
Assembling
Finishing

Non-Value Adding Activities

Storing
Waiting for next step in processing
Inspection in addition to required quality control
procedures
Transfer of products from one point to another

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 After determining what are value adding and those that are not, activity-based
management (ABM) determines how the non-value adding activities can be minimized, if not
eliminated. To do so, ABM must look into their possible causes. Non-value activities may arise
from inadequacy of human resource training, limitations of plant facilities and from poor
production planning.

Lesson 3. Manufacturing Cycle Efficiency (Mejorada, 2006)

Manufacturing Cycle Efficiency (MCE) refers to the percentage of value-adding

processing time based on total cycle time. It is the ratio of the total time expended on value-
added activities to cycle time (or to the total time expended on both VA and NVA activities.

The formula is as follows:

MCE = Value-adding processing time

Manufacturing cycle time
Thus, in a firm wherein non-value adding activities account for 40% cycle time,
manufacturing cycle efficiency would be 60%. It is the objective of ABM to raise this ratio.

Lesson 4. Activity-Based Costing (De leon et al., 2019)

The growth in the automation of manufacturing has brought many challenges to

product costing. Increased use of robotics, specialized machinery, and other computer-driven
processes has changed the nature of manufacturing and the composition of total product cost.
In many highly automated manufacturing businesses the significance of direct labor
cost has diminished and overhead costs have increased. The cost of acquiring, installing,
maintaining, and operating state-of-the-art manufacturing technologies has greatly increased
overhead costs. In addition, costs that used to be classified as indirect such as quality control,
computer programming, trouble shooting, and middle level management costs have become
major components of total production cost.

The need for more representative overhead application bases has led to activity-based
costing (ABC) which is also known as transaction costing. Those activities (transactions) that
consume overhead resources are identified and related to the costs incurred. The basic

202
premise in activity-based costing is that the 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.

ABC is a simple concept which can provide accurate information about a particular
product’s consumption of overhead resources. ABC is an approximation of a user’s fee. A
user’s fee refers to the process of charging for services consumed by users of the service.
ABC is based on the premise that if a product consumes many resources (activities) that
comprise overhead, it should bear a greater share of overhead costs than other product that
does not consume as any activity units.

Lesson 5. Differences Between Traditional and ABC Costing

(Harina, 2003)

Traditional
a. Cost pools one or a limited number
b. Applied rate volume-based, financial
c. Suited for labor intensive, low
overhead companies
d. Benefits Simple, inexpensive
ABC
Many,to reflect different activities
Activity based, non-financial.
Capital intensive, product-
diverse high overhead
companies.
Accurate product costing,
non-value added activities

Lesson 6. Steps in Activity-Based Costing (Harina, 2003)

1. Identify the activities that consume resources, and assign costs to those activities.
Example: purchasing of materials.
2. Identify the cost driver/s associated with each activity. Example: Number of orders is
a cost driver in purchasing of materials. Each activity could have multiple cost drivers.
3. Compute a cost rate per cost driver unit. Example: the cost per purchase order in a
driver cost rate.

203
4. Assign costs to products by multiplying the cost driver rate times the volume of cost
drivers consumed by the product. Example: number of purchase orders required for a
particular product times the cost per purchase order.

Major Categories of Activities in ABC System

1. Unit-level Activity- are those performed each time a unit is produced or sold. The costs
these activities are the typical variable costs. Examples: Materials, energy to run
machines.
2. Batch-level Activity- are those that a company performs when it makes a group of
units, regardless of how many units in a batch. Examples: Machine Set-ups, Quality
inspections.
3. Product (Customer) Sustaining Activities- arise because a Company does particular
types of business, or maintains a particular product or service. Examples: Customer
records and files, Product specifications, Customer service.
4. Facility-level Activities- relate to an entire plant, office, or company as a whole.
Examples: Plant management, Building depreciation and rent, Heating and lighting.

Criteria used for selecting cost drivers:

1. Causal relation- choose a cost driver that causes the cost. Although this is ideal but
is not always possible because indirect costs are generally not casually linked to cost
objects.
2. Benefits received- choose a cost driver so costs are assigned in proportion to benefits
received.
3. Reasonableness- costs are assigned based on fairness or reasonableness, if costs
cannot be linked based on causality or benefits received.

Examples of Cost Drivers:

Manufacturing labor hours or cost Number of customers
Machine hours items produced or sold
Machine set-ups flight hours
Kilos of materials handled number of operations
Purchase orders scrap/rework orders
Quality inspections computer time

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 Number of parts in a product Hours of testing time
Square footage number of billing hours
Design time number of vendors
Asset value
Non-Manufacturing: Number of hospital beds occupied
Number of take-offs and landing for an airline
Number of rooms occupied in a hotel
Number of trips for a bus company
Number of kilometers driven

Computing a Cost rate per Cost Driver

Predetermined Indirect Cost rate = Estimated Indirect Cost

Estimated volume of the allocation base

Lesson 7. Illustrative Problem (Harina, 2003)

ABM Manufacturing Inc. provided the following information for the month of June, 2020.
Units
Machine A produced 600
Machine B produced 1,000

Cost Driver Units

Activities Machine A Machine B
Purchasing materials 600 packs 1,000 packs
Machine set-ups 10 set-ups 25 set-ups
Inspections 150 hours 200 hours
Running machines 500 hours 1,000 hours

Additional Data:
Machine A Machine B
Direct materials per unit P500 P800

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 Direct labor per unit P100 P180

Factory overhead is applied at the rate of 150% based on direct labor cost. The estimated
overhead for June, 2020, amounts to P360,000.

Overhead Estimates for 2020

Estimated Estimated
Activity Cost Driver No. of Cost Driver units Overhead costs
Purchasing Materials No. of Packs 20,000 Packs P 500,000
Machine Set-ups No. of Set-ups 400 Set-ups 2,000,000
Inspections Inspection hours 4,000 Hours 800,000
Running Machines Machine hours 20,000 Hours 1,000,000
Total Estimated Overhead P4,300,000
Required: Compute for the following:
1. Pre-determined annual overhead rates for Activity-based costing.
2. Overhead costs assigned to Machine A and machine B using Activity-based costing.
3. Cost per unit of Machine A and Machine B using the Activity-Based costing.
4. Cost per unit of Machine A and Machine B using the Traditional Approach.
Solution
X Y
1. Estimated Estimated ( Y ÷ X)
Activity No. of Cost Driver units Overhead costs Cost Driver Rate
Purchasing Materials 20,000 Packs P 500,000 P 25 per Pack
Machine Set-ups 400 Set-ups 2,000,000 5,000 per Set-up
Inspections 4,000 Hours 800,000 200 per Hour
Running Machines 20,000 Hours 1,000,000 50 per Hour
Total Estimated Overhead P4,300,000

2. Machine A
Actual Cost
Activity Cost Driver Rate Cost Driver Units Allocated
Purchasing Materials P 25 per Pack 600 P15,000
Machine Set-ups 5,000 per Set-up 10 50,000

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Inspections 200 per Hour 150 30,000
Running Machines 50 per Hour 500 25,000
Total Overhead Costs Allocated to Machine A P120,000
Overhead cost per unit (P120,000 ÷ 600 units) P 200

Machine B
Actual Cost
Activity Cost Driver Rate Cost Driver Units Allocated
Purchasing Materials P 25 per Pack 1,000 P 25,000
Machine Set-ups 5,000 per Set-up 25 125,000
Inspections 200 per Hour 200 40,000
Running Machines 50 per Hour 1,000 50,000
Total Overhead Costs Allocated to Machine A P240,000
Overhead cost per unit (P240,000 ÷ 1,000 units) P 240

3.Activity-Based Costing Machine A Machine B

Direct materials P 500 P 800
Direct labor 100 180
Overhead 200 240
Total Cost per Unit P800 P1,220

4.Traditional Costing Machine A Machine B

Direct materials P500 P800
Direct labor 100 180
Overhead (150% of Direct labor) 150 270
Total Cost per Unit P750 P1,250

Remarks:
It can be observed that in this problem, there are differences in the computation of
unit cost for Machine A and Machine B. Using the traditional costing approach, the unit cost
of Machine B is overstated, while Machine A is understated. By using the ABC approach, we
can come up with a more realistic and accurate costing than using the traditional approach.

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 Assessment Task

True or False
1.Traditional costing systems use multiple predetermined overhead rates.
2.Traditionally, overhead is allocated based on direct labor cost or direct labor hours.
3.Current trends in manufacturing include less direct labor and more overhead.
4.Activity-based costing allocates overhead to multiple cost pools and assigns the cost pools
to products using cost drivers.
5.A cost driver does not generally have a direct cause-effect relationship with the resources
consumed.".
6. The first step in activity-based costing is to assign overhead costs to products, using
costdrivers..
7. To achieve accurate costing, a high degree of correlation must exist between the cost
driver and the actual consumption of the activity cost pool.
8. Low-volume products often require more special handling than high-volume products.
9. When overhead is properly assigned in ABC, it will usually decrease the unit cost of high-
volume products.
10.ABC leads to enhanced control over overhead costs.
11.ABC usually results in less appropriate management decisions.
12.ABC is generally more costly to implement than traditional costing.
13.ABC eliminates all arbitrary cost allocations.
14.ABC is particularly useful !hen product lines differ greatly in volume and manufacturing
complexity.
15.ABC is particularly useful when overhead costs are an insignificant portion of total costs.
16.Activity-based management focuses on reducing costs and improving processes.
17.Any activity that increases the cost of producing a product is a value-added activity.
18.Engineering design is a value-added activity.
19. onvalue-added activities increase the cost of a product but not its maket value.
20.Machining is a nonvalue-added activity.

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Problem Solving
XYZ Manufacturing Inc. provided the following information for the month of September,
2020.
Units
Model X produced 450
Model Y produced 800

Cost Driver Units

Activities Model X Model Y
Materials Handling 900 kilos 3,200 kilos
Production set-ups 9 Runs 15 Runs
Quality Inspections 80 Hours 120 Hours
Machine Depreciation 280 hours 505 hours

Additional Data:
Model X Model Y
Direct materials per unit P400 P600
Direct labor per unit P 90 P150

Factory overhead is applied at the rate of 100% based on direct labor cost. The estimated
overhead for September, 2020, amounts to P160,500.

Overhead Estimates for 2020

Estimated Estimated
Activity Cost Driver No. of Cost Driver units Overhead costs
Materials Handling No. of Kilos 50,000 Kilos P 400,000
Production Set-ups No. of Runs 300 Runs 900,000
Quality Inspections Inspection hours 4,000 Hours 800,000
Machine Depreciation Machine hours 20,000 Hours 400,000
Total Estimated Overhead P2,500,000

Required: Compute for the following:

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 1. Pre-determined annual overhead rates for Activity-based costing.
2. Overhead costs assigned to Model X and Model Y using Activity-based costing.
3. Cost per unit of Model X and Model Y using the Activity-Based costing.
4. Cost per unit of Model X and Model Y using the Traditional Approach.

Summary

The traditional product costing methods assume that individual product cause costs.
When the major cost components of a product are direct materials, direct labor, or overhead
that can be directly associated with individual products, traditional methods are quite accurate.
In situations where manufacturing overhead is a significant cost and is not directly related to
volume of products, traditional product costing methods can generate inaccurate product
costs. These inaccurate product costs can lead to poor decision making regarding product
marketing, product design, investment, and budgeting issues, causing the company to be less
competitive. Overhead allocation is most troublesome in multiple-product companies.

Activity-based management is concerned with planning and controlling activities

involved in the production/performance process to improve a “firm’s cycle efficiency”. For a
manufacturing firm, it is to improve the manufacturing cycle efficiency. For a service concern,
it is to improve service cycle efficiency and for a retailer, retail cycle efficiency. Activities are
classified into value-added and no-value added with the intention of minimizing, if not
eliminating the latter.

Non-value adding activities merely increase the time expended on a product or

service. However, some of them may result in minimal increase in product customer value.

Activity based costing (ABC) is a simple concept which can provide accurate
information about a particular product’s consumption of overhead resources. ABC is an
approximation of a user’s fee. A user’s fee refers to the process of charging for services
consumed by users of the service. ABC is based on the premise that if a product consumes

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many resources (activities) that comprise overhead, it should bear a greater share of overhead
costs than other product that does not consume as any activity units.

References

De Leon, N.D,, De Leon, E.D., De Leon, G.M. Jr. (2019). Cost Accounting and
Control. Manila City, Phils. GIC Enterprises & Co. Inc.

Mejorada, N.D. (2006). Cost Accounting. Quezon City, Philippines. Goodwill Trading
Co. Inc.

Roque, R.S. (2013). Reviewer in Management Advisory Services. Manila City,

Philippines. GIC Enterprises and Co.,Inc.

Punzalan, A.R. (2012). CPA Examination Practical Accounting 2. Manila City,

Philippines. GIC Enterprises & Co., Inc.

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