CHAPTER 4

ACCOUNTING FOR FACTORY OVERHEAD

Learning Outcomes:

After this chapter, the learner will be able to:

• Journalize incurrence of various manufacturing overhead.

• Determine appropriate cost drives for overhead application

• Compute a factory overhead rate using the different bases

• Compute the different factory overhead variances

• Allocate service department overhead costs to producing departments using direct method,
step method and reciprocal method.

All costs incurred in the factory that are not direct materials or direct labor are generally termed as
factory overhead. Factory overhead refers to the cost pool used to accumulate all indirect
manufacturing costs. Examples of factory overhead include the following:

Indirect materials and indirect labor; heat, light and power for the factory; rent on factory
building; depreciation on factory building and factory equipment.

Normally, overhead costs 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 the 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.

BUDGETING FACTORY OVERHEAD COSTS

Budgets are management’s operating plans expressed in quantitative terms, such as units of
production and related costs. After factory overhead costs have been classified as either fixed or
variable, budgets can be prepared for expected levels of production. The separation of fixed and
variable cost components permits the company to prepare a flexible budget.

PREDETERMINED OVERHEAD RATE

A predetermined overhead rate is a budgeted and constant charge per unit of activity. The activity
chosen is called Overhead Allocation Base or Cost Driver.
Factors to be Considered in the Computation of Predetermined Overhead Rate

A. Base to be Used

a) Physical output

This is the simplest method to use because units produced are readily available. This
method is appropriate when a company or department manufactures only one
product.

Estimated Factory Overhead

Factory Overhead rate =
Estimated units of production
b) Direct materials cost

This method is appropriate if it can be inferred that factory overhead costs are directly
related to direct material cost as in cases where direct materials are a very large part
of total cost. Direct material cost is not appropriate base to when more than one
product is manufactured by a company. Different products require different materials
and different quantities at that, so it will be very inconvenient to use material cost as
the base because we will have compute a factory overhead rate for each product.

Estimated Factory Overhead

Factory Overhead rate = Estimated Direct Materials x 100
Cost

c) Direct labor cost

This method is recommended if it can establish that there is a direct relationship

between labor cost and factory overhead. Just like the direct labor hours, the direct
labor cost is readily available on the payroll sheet. Labor rates do not change as often
as material cost, so this base is more reliable than material cost. This base should not
be used if there is little relationship between labor cost and factory overhead. For
example, if overhead is composed largely of deprecation and equipment related cost.

Estimated Factory Overhead

Factory Overhead rate = x 100
Estimated Direct Labor Cost

d) Direct labor hours

This is the most commonly used base or denominator in the computation of the
predetermined factory overhead rate. The number of direct labor hours spent for a
particular is readily available on the payroll sheet. This base should be used if it can
be established that there is a direct relationship between factory overhead and direct
labor hours. It may be used also if there is a great disparity in hourly wage rates.

Estimated Factory Overhead

Factory Overhead rate =
Estimated direct labor hours
 e) Machine Hours

This is appropriate when a direct relationship exists between factory overhead cost and
machine hours. This may occur in companies or departments that are largely automated
so that majority of the factory overhead cost consist of depreciation of factory equipment.
Additional work will be required because each machine will have a time record to
summarize the total machine hours used for each job.

Estimated Factory Overhead

Factory Overhead rate =
Estimated machine hours

B. Use of single rate or several rates

a) Plant-wide or blanket rate

b) Departmentalized Rate

C. Activity Level to Use

a) Normal Capacity

b) Expected actual capacity

D. Inclusion or Exclusion of Fixed Factory Overhead

a) Absorption Costing

b) Direct Costing

E.

ILLUSTRATIVE PROBLEM

The TLR Company estimates its factory overhead for the next period at P1,000,000. It is estimated
that 20,000 units will be produced at a materials cost of P800,000 and will require 50m000 direct
labor hours at an estimated cost of P5000,000. The machines will run about 160,000 hours.

Required. The predetermined factory overhead rate based on:

1. Units of production
2. Material cost
3. Direct labor cost
4. Direct labor hours
5. Machine hours

Solution:

1. Units of production
₱ 1,000,000.00
Factory Overhead rate =
20000 units

Factory Overhead rate = P50.00 per units

 2. Material cost
₱ 1,000,000.00
Factory Overhead rate = x 100
800,000.00

Factory Overhead rate = 125% of direct material cost

3. Direct labor cost

₱ 1,000,000.00
Factory Overhead rate = x 100
500,000.00

Factory Overhead rate = 200 % of direct labor cost

4. Direct labor hours

₱ 1,000,000.00
Factory Overhead rate =
50,000.00

Factory Overhead rate = P20.00 per direct labor hour

5. Machine Hour

₱ 1,000,000.00
Factory Overhead rate =
160,000.00

Factory Overhead rate = P6.25 per machine hour

NEED FOR DEPARTMENTALIZATION

In large businesses, factory operations are divided into departments. This is called
departmentalization. This provides greater accuracy in job costing and product costing.

Departmentalization requires the use of different overhead rates for applying manufacturing
overhead. Various amounts of manufacturing overhead, instead of a single overhead are charged to
jobs or products as they pass through the different departments. A job or product is charged with
manufacturing overhead for work done in a particular department based on the department’s
predetermined overhead rate.

CLASSIFICATION OF DEPARTMENTS

Departments are classified into two categories: producing departments and service departments.
Producing departments are those departments directly engaged in the manufacturing activities (for
ex. Assembly, finishing, and packaging department). Service departments are those departments that
assist indirectly by rendering services (ex. Purchasing, medical and maintenance departments) to
producing departments.
STEPS in Computation of Departmentalized Overhead Rate

1. Divide the company into segments, called departments, cost centers, to which expenses are
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 cost to the producing departments.
5. Compute the factory overhead rate (similar to computation using plant-wide rate)

Typical Allocation Bases for Common Costs

Common Cost Typical allocation base

Labor related
Supervision
Personnel Services
Machine-related
Insurance on Equipment
Taxes on Equipment
Equipment depreciation
Equipment maintenance
Space Related
Building rental
Building insurance
Heat & Airconditioning
Concession rental
Interior bldg. maintenance
Service Related
Material handling
Billing and accounting
Indirect materials
No. of employees, payroll amount of DLHrs
Number of employees
Value of equipment
Value of equipment
Machine-hours, equipment value
Number of machines, machine hours
Space occupied
Space occupied
Space occupied, volume occupied
Space occupied & desirability of location
Space occupied
Quantity or value of materials
Number of documents
Value of direct materials

METHODS OF ALLOCATING SERVICE DEPARTMENT COST TO PRODUCING DEPARTMENTS

I. DIRECT METHOD
- The most widely used method. This method ignores any service rendered by one service
department to another, it allocates each service department’s total cost directly to the
producing department.

EX. The following data for each department during April 2020 are obtained:

Department Costs Number of Floor Space Kilowatt

Employees hours
Service Department
Personnel P3,600 5 1,500
Building Maintenance 2,000 4 2,500
Power plant 1,000 2 4,000
Producing Department
Machining 11,800 10 10,000 7,000
 Assembly 8,600 20 10,000 3,000

Under this method, the costs of each service department are allocated only to producing
departments. The bases to be used under direct allocation of service department’s costs to
Machining and Assembly are presented below:

Machining Assembly Total

Personnel 10 20 30
Building Maintenance 10,000 10,000 20,000
Power plant 7,000 3,000 10,000

The direct allocation of service department overhead costs for the month is as follows:

Department Costs Machining Assembly

Personnel P3,600 P1,200 P2,400
Building Maintenance 2,000 1,000 1,000
Power plant 1,000 700 300
P6,600 P2,900 P3,700

II. STEP METHOD

This method allocated service department costs to all service departments as well as
producing departments. This method ignores the fact that reciprocal services are used between
some service departments. The generally accepted procedures of allocation are:

1) Select the service department serving the most other service departments. When more than
one service department services an equal number of service departments, select the
department with highest costs.
2) Allocate the costs of the service department selected in step 1 to the producing
departments and other service departments based on a relative level of the apportionment
base.
3) Allocate the costs of each remaining service department selected in the same manner as
describe in step 1.
4) Costs of service departments are never allocated back to departments whose cost have
already been allocated.

Ex.

Department Costs Number of Floor Space Kilowatt

Employees hours
Service Department
Personnel P3,600 5 1,500
Building Maintenance 2,000 4 2,500
Power plant 1,000 2 4,000
Producing Department
Machining 11,800 10 10,000 7,000
Assembly 8,600 20 10,000 3,000
Solution:

Allocated costs
Department Cost Personnel Building Power Plant Machining Assembly
Maintenance
Personnel P3,600 (P3,600) P400 P200 P1,000 P2,000
Bldg. 2,000 (400+2,000) P400 P1,000 P1,000
Maintenance
Power Plant 1,000 (200+400+1,000) P1,120 P480

Total P3,120 P3,480

III. 1

The reciprocal method provides a way to adjust for the reciprocal services provided among the
service departments. Using this method, service department costs and service department
reciprocal service relationships are described by an algebraic equation. Then, the equations are
solved simultaneously providing a more precise allocation of costs to producing departments
because it considers the mutual services provided among the service departments.

Illustrative problem

Assume the following data for Departments A, B and C which provides services to each other and
to producing departments X and Y.

Percentage of Services
Total Cost A B C X Y
A P200,000 - 15% 5% 55% 25%
B 140,000 10% - 9% 18% 63%
C 100,000 - - - 20% 80%

Based on the above data, the reciprocal method considers only services from A to B and B to A

If all reciprocal services are recognized, linear algebra may be used to reach a solution. The
following equations may be developed:

A (costs) = P200,000 + .10B

B (costs) = P140,000 + .15A
C (costs)= P100,000 + .05A+ .09B

The simultaneous equations may be solved algebraically as follows:

1. Substituting the equation for A into the B equation gives the value of B as follows:
 B = 140,000 + .15(200,000 + .10B)
B = 140,000 + 30,000 + 0.015B
.985B = 170,000
B= P172,589

2. Substitute the value of B into the A equation gives the value of A as follows:

A= P200,000 + .10 (172,589)

A = P217,259

3. The equation C can then be solved by substituting the calculated values of A and B as
follows:

C= P100,000 + .05 (217,259) + .09 (172,589)

C = P100,000 + 10,863 + 15,533

C = P126,396

The allocation of costs of Service Departments A, B and C according to percentage of services

can now be made as follows:

Percentage of Services
A B C X Y
Cost prior to allocation P200,000 P140,000 P100,000 P- P-
Allocation of A (217,259) 32,589 10,863 119,492 54,325
Allocation of B 17,259 (172,589) 15,533 31,066 108,731
Allocation of C (126,396) 25,279 101,117
P-0- P-0- P-0- P175,837 P264,163

DISPOSITION OF OVER OR UNDER APPLIED OVERHEAD

Under the normal costing system, actual overhead rarely equals 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 under absorbed
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 is immaterial, it is customary to close underapplied or overapplied overhead costs

directly to the Cost of Goods Sold account.

If the amount is material, the overapplied or underapplied overhead should be allocated

proportionately to all goods that have been worked on during the year.
To illustrate, assume that the year end balances of inventories and cost of goods sold were as follows:

Work in Process Finished Goods Cost of Goods Sold

Direct Materials P10,000 P40,000 P100,000
Direct Labor 15,000 20,000 90,000
Applied Overhead 15,000 20,000 90,000
Total P40,000 P80,000 P280,000

Assuming there is underapplied overhead of P100,000; and it is material, the allocation and the journal
entry to close the underapplied overhead are as follows:

Account balances Percentage to total Allocated amount

Work in Process P40,000 10% P10,000
Finished Goods 80,000 20% 20,000
Cost of Goods Sold 280,000 70% 70,000
Total P400,000 100% P100,000

Journal entry:

Work in process inventory P10,000

Finished Goods Inv. 20,000

Cost of goods sold 70,000

Mfg Overhead P100,000

IF the amount is immaterial, the entry journal entry would be:

Cost of Goods Sold P100,000

Mfg. Overhead P100,000

Causes of the manufacturing overhead variance:

a) Spending variance- the variance due to expense factors

b) Idle capacity or volume variance – the variance due to difference in volume and activity
factors.
The Victory Company has two service departments and two producing departments. The following are
the overhead costs of each department:

Service Department
Factory administration P129,000
Building and Grounds 105,000
Producing Department
Machinery 416,000
Assembly 380,000

Additional information:

Department Estimated total Labor hours Square Footage

Factory administration 2,900 1,200
Building and Grounds 1,100 1,500
Machinery 2,000 1,900
Assembly 1,600 3,200

The cost of factory administration are allocated based on estimated labor hours; building and ground
costs are allocated based on square footage. The producing department uses machine hours, with
30,000 for machinery and 22,800 for assembly.

Allocate the cost of the service departments to the producing departments by using the following
methods:

a) Direct method
b) Step method
c) Reciprocal method