Chapter 4

ACCOUNTING FOR FACTORY OVERHEAD

Learning Objectives:
At the end of the chapter, the students are expected to have learned the following:
1. Incurrence of overhead;
2. Selection of activity base;
3. Departmental and plant wide rates; and
4. Allocation of service costs: Direct method, Step method and Algebraic method.

MANUFACTURING OVERHEAD ACCOUNT

Normally, overhead cost charged to jobs is estimated using a predetermined rate because it is impractical
to trace overhead to specific jobs. It is called predetermined overhead rate because this is computed
before the start of an accounting period. To determine the predetermined overhead rate, the budgeted
overhead is divided by the estimated activity level based on normal capacity. The selection of base is
dependent to the functions of overhead cost that is applied to production.

The manufacturing overhead account is used to record the actual overhead incurred and the amount of
overhead applied to the job. This account is debited when overhead is incurred. Examples of
manufacturing overhead charged to the account are: indirect labor, indirect materials like factory supplies
and other materials that are auxiliary to the processing operations, expired factory insurance, cost of
repairs and maintenance, electricity and water consumption and depreciation of property, plant and
equipment.

The amount of overhead applied to the job is calculated using the predetermined overhead rate multiplied
by the actual level of activity. The amount computed is credited to manufacturing overhead account.

At the end of an accounting period, it is unlikely that the total debits and total credits to the
Manufacturing Overhead account will have identical balances. If the total debits are larger than the total
credits, overhead under applied whereas, if the total credits are greater than total debits, overhead is over
applied.

PREDETERMINED OVERHEAD RATE

In a normal cost system of accumulating product costs, the overhead is charged to Work in Process using
a predetermined overhead rate. A predetermined overhead rate is a budgeted and constant charge per unit
of activity. The activity chosen is called the Overhead Allocation Base or Cost Driver.

The commonly used activity bases are:

a. Physical output
b. Direct labor costs
c. Direct labor hours
d. Material costs
e. Machine hours
f. Activities

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑀𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑

𝑃𝑟𝑒𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑅𝑎𝑡𝑒 =
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦
Illustration 1: Determining Overhead Rate

Let us assume that the budgeted annual overhead is composed of: Fixed cost, P1,000,000 and variable
cost is P40 per direct labor hours. The budgeted annual direct labor hours are 125,000. The predetermined
overhead rate is computed as:

𝑃𝑟𝑒𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑅𝑎𝑡𝑒 =

𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝐴𝑝𝑝𝑙𝑖𝑒𝑑 = 𝑂𝐻 𝑟𝑎𝑡𝑒 𝑥 𝐴𝑐𝑡𝑢𝑎𝑙 𝐷𝐿𝐻 𝑢𝑡𝑖𝑙𝑖𝑧𝑒𝑑

The predetermined overhead rate is multiplied by the number of direct labor hours actually utilized in
production to arrive at the amount of overhead applied to the job.

DISPOSITION OF OVER OR UNDER APPLIED OVERHEAD

Under normal costing system, actual overhead rarely equal the amount of overhead applied to the jobs in
process. At the end of accounting period, actual and applied overhead are compared to evaluate the
appropriateness of the predetermined overhead rate. If actual overhead is greater than the applied
overhead, the variance is unfavorable termed as underapplied or underabsorbed overhead, whereas, if the
applied overhead is greater than actual overhead, the variance is favorable and it is termed as overapplied
or overabsorbed overhead. If the amount of variance is immaterial, that is, the variance is so small that
the difference is not expected to affect the management’s decision; the variance is closed to Cost of
Goods Sold. But, it the variance is significant in amount, the variance s closed to all accounts with OH
elements, like Work in Process, Finished Goods and Cost of Sales. The basis of allocation is the OH
component of each inventory account.

Illustration 2: OH variance closed to all accounts with overhead elements

Assume the following data for the period just ended:

Finished goods inventory, end of period:

Direct materials P174,000
Direct labor 261,000
Manufacturing overhead 208,800 643,800
Cost of sales for the year:
Direct materials 696,000
Direct labor 1,479,000
Manufacturing overhead 1,183,200 3,358,200
Work in process, end of year:
Direct materials 87,000
Direct labor 130,500
Manufacturing overhead 104,400 321,900

Applied Manufacturing Overhead 1,496,400

Actual Overhead 1,400,000
Overhead Variance - Overapplied
The overapplied overhead is closed to Finished Goods, Cost of Sales and Work in Process accounts based
on the overhead component in each account.

FG COS WIP Total

Overhead Component
Allocation:

Allocated Amount

Balances of the following accounts after closing the variance:

Cost of Sales

Finished Goods

Work in Process

The entry to close the variance is:

Manufacturing Overhead
Cost of Sales
Finished Goods
Work in Process

If the overhead variance is closed to cost of sales, the balance of the cost of sales account after closing the
variance is

Cost of Sales

The entry to close the variance is:

Manufacturing Overhead
Cost of Sales

Illustration 3: Job Costing using Plant wide rate and Departmental rate.

ISU Manufacturing Company has two producing departments, Assembly and Finishing Department has
significant amount of labor related overhead and it uses direct labor hours as the cost driver while
Finishing Department has significant amount of machine-related overhead and it uses machine hours as
the cost driver.

The following data are available for ISU Manufacturing Company for the year just ended:

Budgeted Data: Assembly Finishing

Manufacturing overhead P1,890,000 P1,260,000
Direct labor hours 52,000 20,000
Machine hours 15,000 80,000
Actual Data:
DM used per unit P120 P50
Direct labor costs per unit 2 hrs @ P37.5 per hour .75 hr @ P37.5 per hour
Machine time used per unit 30 min. 3 hrs.
Actual Production, 25,000 units

Required: Determine the total cost of producing the 25,000 units assuming (a) Plant wide rate based on
direct labor hours and (b) Department rates.
(a) Production costs of 25,000 units using
Plant wide rate based on direct labor hours

Cost Elements Assembly Finishing Total

DM
DL
FOH
Total Costs

Overhead Rate:

Overhead Applied:

(a) Production costs of 25,000 units using Department Rates

Assembly Dept. uses Direct Labor Hours while Finishing Dept. uses Machine Hours

Cost Elements Assembly Finishing Total

DM
DL
FOH
Total Costs

Overhead Rate:

Overhead Applied:

ALLOCATION OF SERVICE DEPARTMENT COSTS

Service or support department is a unit in an organization that contributes in a very indirect way to the
conversion of raw materials into a finished product. In short, they are involved directly in producing the
goods or services. However, a service department does provide a service that enables the organization’s
production process take place. These units are the purchasing, personnel, warehousing and maintenance
department. Since these departments support the production department, the costs incurred must be
allocated to production departments to determine the full costs of a product.

Below are possible bases of allocating service costs:

Type of Cost Allocation Base

a. Personnel costs Number of employees, direct labor costs
b. Maintenance costs Number of machine hours
c. Administrative costs Peso value of asset employed
d. Research and development costs Asset employed, new products developed
e. Cafeteria costs Number of employees
f. Public relations and corporate function Amount of sales
g. Legal costs Assets employed
h. Warehousing costs Area occupied
i. Materials and storeroom costs Number of materials move
j. Power costs Kilowatt hours used
k. Engineering costs Number of hours utilized
 l. Shipping costs Number of orders shipped
m. Purchasing costs Number of purchase orders

Methods of Allocating Service Costs indirect cost

The above costs can be allocated to production departments using Direct, Step or Algebraic method.

Direct Method allocates service costs directly to production department only and does not consider
services provided by one service department to another. This is the most widely used method.

Step Method or Sequential Allocation Method allocates service costs step by step. The service
departments are first ranked according to the amount of service rendered and received. Normally, the
service department that renders the highest percentage of total services to other service departments is
ranked first. Once cost has been allocated from service department, no other service department’s cost is
allocated back to that department.

Algebraic or Simultaneous or Reciprocal Method.

Illustration 4: Direct Method and Step Method

CBM Manufacturing Company has four departments. Two producing departments, Assembly and
Finishing, and two service departments, Cafeteria and Maintenance. The overhead cost of Cafeteria is
allocated based on number of employees while the overhead cost of Maintenance is allocated based on
estimated factory overhead. Assembly department used direct labor hours and Finishing department used
machine hours as bases in computing for predetermined overhead rates.

Service Department Producing Department

Cafeteria Maintenance Assembly Finishing
Est. Dept OH P250,000 P150,000 P100,000 P60,000
Est. DLH 200,000 100,000
Est. MH 150,000 250,000
# of employees 100 20 1,500 1,000

Required: Allocate the service departments costs using (a) Direct Method and (b) Sequential Method.
Compute the predetermined overhead rates of the producing departments.

Direct Method

Cafeteria Maintenance Assembly Finishing

Estimated Dept OH costs
Cafeteria Costs:

Maintenance Costs:

Total estimated factory OH

Assembly Finishing
Total estimated factory OH
Divide by
Manufacturing OH rate
Sequential Method

Cafeteria Maintenance Assembly Finishing

Estimated Dept OH costs
Cafeteria Costs:

Maintenance Costs:

Total estimated factory OH

Assembly Finishing
Total estimated factory OH
Divide by
Manufacturing OH rate

Illustration 5: Direct Method and Step Method

BS Entrep Company has two producing departments and two service departments. The producing
departments, Assembly and Finishing receive services from Personnel and Administration. Personnel
keep all employees records and handles payroll; Administration handles all other administrative tasks.
Each service department provides services to the other service department as well as to the two operating
departments. Data for the most recent month follow:

Department Direct Costs No. of employees

Personnel P 200,000 10
Administration 500,000 30
Assembly 1,800,000 100
Finishing 3,000,000 300
Total P5,500,000 440

BS Entrep Company allocates Administration costs based on direct costs of the departments and
Personnel costs based on the number of employees. Start with the department that serves the most other
service departments.

Required:

(1) Using direct method, the total service costs allocated to Assembly is _____________________

(2) Using direct method, the total service costs allocated to Finishing is _____________________

(3) Using step method, the total service costs allocated to Assembly is _____________________

(4) Using step method, the total service costs allocated to Finishing is _____________________