UNIT III – JOB ORDER COSTING

Lesson 4 – Accounting for Factory Overhead

Factory Overhead - includes all costs related to the manufacturing of a product except direct materials
and direct labor. It includes:
• indirect materials - materials which cannot be readily identified with any particular item
manufactured.
• indirect labor - wages and salaries of employees who are required for the manufacturing process
but who do not work directly on the units being manufactured.
• other manufacturing expenses such as depreciation of factory building, machinery and equipment,
factory supplies, heat light, power maintenance, insurance, etc.
• Divided into 3 categories:
a. fixed – overhead costs that remain constant within the relevant range regardless of the level of
production.
b. variable – overhead cost that vary in direct proportion to the level of production. indirect materials
c. mixed – overhead costs that are partly fixed and partly variable. The fixed and variable
component must be separated for purposes of planning and control.

Control of Factory Overhead Costs

• The size of the company and the types of products are the key factors to be considered to account
for factory overhead.
• If there are many types of overhead costs, factory overhead analysis sheet should be maintained.
This is a subsidiary ledger for Factory overhead Control account in the general ledger, which
represents the actual factory overhead incurred during the period.

Charging Factory Overhead to Production

a. Budgeting factory overhead costs

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

b. the budgeted factory overhead based on a certain level of activity or production is the basis in the
computation of predetermined overhead rate or overhead application rate.

c. the overhead for each job is applied by determining the actual base selected on the job multiplied by
the factory overhead predetermined rate or application rate.

d. Normal costing is commonly used by most companies to avoid delays in costing the job wherein direct
materials and direct labor are applied at actual costs while factory overhead costs are applied based a
predetermined rate.

Factors to be considered in the computation of overhead rate:

1. Base to be used - should be related to the functions represented by the overhead cost being applied.
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 rate:

a. Plant-wide or blanket rate – one rate for all producing departments
b. Departmentalized rate – one rate for each producing department

BASE TO BE USED
1. Physical Output or units of production – the simplest method and appropriate if a company or
department manufactures only one product. The formula is:

FOH rate/unit = Estimated Factory overhead

Estimated units of production

2. Direct Material Cost - appropriate if factory overhead costs are directly related to direct materials and
direct materials are a very large of the total cost. This base is not appropriate if a company
manufactured more than one product. The formula is:

FOH rate (Percentage of direct material cost) = Estimated Factory overhead x 100
Estimated direct material cost

3. Direct Labor cost - appropriate if factory overhead costs are directly related to direct labor costs. The
formula is:

FOH rate (Percentage of direct labor cost) = Estimated Factory overhead x 100
Estimated direct labor cost

4. Direct Labor hours – most commonly used base in the computation of FOH application rate. The
formula is:

FOH rate/ direct labor hour = Estimated Factory overhead

Estimated direct labor hours

5. Machine hours – appropriate when there is a direct relationship between factory overhead cost and
machine hours. The formula is:

FOH rate/ machine hour = Estimated Factory overhead

Estimated machine hours

Capacity production – the capacity of production that should be adopted in estimating the factory
overhead costs.
1. Theoretical, maximum, or idle capacity – capacity to produce at full speed without interruption. It
gives no allowance for human capacity to achieve the maximum nor due allowance to for any
circumstances that might result to stoppage of production within or not within the control of
management. The plant is assumed to function 24 hours a day, 7 days a week and 52 weeks a
year.

2. Practical capacity - a capacity of production that provides allowance for circumstances that might
result to stoppage of production.
 3. Expected actual capacity – a capacity concept based on a short-range outlook which is feasible
only for firms whose products are seasonal or where the market and style changes allows price
adjustment according to competitive conditions and customer demands.

4. Normal capacity – a capacity of production taking into consideration the utilization of the plant
facilities to meet commercial demands served over a period long enough to level out the peaks and
valleys which come with seasonal variations. This capacity is commonly used in the computation of
overhead rates.
Methods of accumulation of factory overhead costs

1. Non-controlling account system – an account for each kind of overhead expense according to their
nature is opened in the ledger and charges to such account are made upon incurrence of the
expense.

2. Controlling account system – a Factory Overhead Control account is opened in the general
ledger wherein the overhead expenses are charged, and a subsidiary ledger or overhead analysis
sheet is maintained to show in detail the nature and account of the expense. This method is
commonly adopted by companies because overhead analysis sheets or subsidiary ledgers for
overhead permit a greater degree of control as related accounts can be grouped together and the
various expenses incurred by different departments can be described in detail.

Recording Factory Overhead Costs

1. Applied Factory Overhead - the application of factory overhead to jobs, pro forma entry is:

Debit Credit
Work in Process xxx
Factory Overhead Applied xxx
To record applied factory overhead

2. Actual Factory Overhead Incurred – the incurrence of factory overhead expenses, pro forma entry
is:
Debit Credit
Factory Overhead Control xxx
Cash/Accounts xxx
Payable/Payroll/Materials
To record actual factory overhead

Factory Overhead variance

• The difference between the actual factory overhead and applied factory overhead charged to
production.
• Classification of factory overhead variance

a. Overapplied – FOH applied is greater than Actual Factory overhead (favorable variance) Pro-
forma entry (amounts are assumed)
Debit Credit
Factory Overhead Applied 120,000
Factory overhead control 110,000
Overapplied Factory overhead 10,000
To close factory overhead accounts
 b. Underapplied – FOH applied is less than Actual Factory overhead (unfavorable variance).
Pro-forma entry (amounts are assumed)
Debit Credit
Factory Overhead Applied 120,000
Underapplied Factory Overhead 10,000
Factory overhead control 130,000
To close factory overhead accounts

• Disposition of Overapplied or underapplied Factory overhead

a. If the amount is immaterial – close the underapplied or overapplied Factory overhead to Cost
of Goods Sold. The entry would be: (This is usually used in practice)
Debit Credit
Cost of Goods sold 10,000
Underapplied Factory Overhead 10,000
To close underapplied factory overhead
 b. if the amount is material, the overapplied or underapplied factory overhead should be allocated
proportionately to all goods that have been worked during the year – Work in Process, Finished Goods and
Cost of Goods Sold, pro forma entry is:

Debit Credit
Work in process, inventory xxx
Finished goods inventory xxx
Cost of Goods sold xxx
Underapplied Factory Overhead xxx
To close underapplied factory overhead

Causes of Factory overhead variance

a. Spending variance – the variance is due to expense factor
b. idle capacity or volume variance – the variance is due to difference in volume and activity factors

Computation:

1. Spending variance:
Actual factory overhead xxx
Less: Budget allowed based on capacity used:
Fixed factory overhead xxx
Variable factory overhead xxx xxx
Spending variance xxx

Note: If actual FOH is more than budget allowed, the variance is unfavorable.

2. Volume variance or idle capacity

Budget allowed based on capacity used xxx
Less: Applied factory overhead xxx
Volume variance xxx

Note: If applied FOH is more than budget allowed, the variance is favorable

Illustration:
Selected data for PMP Manufacturing Company for the year 2019 follow:

Budgeted for the year Actual for the year

Direct labor hours 260,000 248,300
Factory overhead
Fixed P 585,000 578,400
Variable 1,092,000 1,039,940
Total 1,677,000 1,618,340

Overhead is applied on the bases of direct labor hours.

Determine: 1. Predetermined overhead rate and variable overhead rate

2. over or underapplied factory overhead for the year
3. spending variance
4. volume variance

Solution:
1. Predetermined overhead rate = Budgeted overhead = P 1,677,000 = P 6.45/DLH
 Budgeted direct labor hours 260,000

Variable overhead rate = Budgeted variable overhead = P 1,092,000 = P

4.20/DLH
Budgeted direct labor hours 260,000

2. Over or underapplied FOH

Actual factory overhead 1,618,340
Applied factory overhead ( P 6.45 x 248,300hrs) 1,601,535
Underapplied overhead (unfavorable) 16,805

3. Spending variance:
Actual factory overhead 1,618,340
Less: Budget allowed based on capacity used:
Fixed factory overhead 585,000
Variable factory overhead ( P 4.20 x 248,300) 1,042,860 1,627,860
Spending variance (Favorable) (9,520)

4. Volume variance or idle capacity

Budget allowed based on capacity used 1,627,860
Less: Applied factory overhead 1,601,535
Volume variance – unfavorable 26,325

Net variance (unfavorable) 16,805

FACTORY OVERHEAD - DEPARTMENTALIZATION

• Departmental overhead application rate is appropriate if manufacturing company has several

departments that incur overhead cost relating to different activity level.
• Departments are classified into:
a. producing departments – departments that are directly engaged in manufacturing activities, such
as: assembly, finishing and packaging departments.
b. service departments - departments that assist indirectly by rendering services to production, such
as: purchasing, medical, maintenance, etc.
• Departmentalized overhead rate are for producing departments only.
• Steps in computation of Departmentalized Overhead rate:
1. Divide the company into segments called departments, cost centers, to which expenses are
charge.
2. Estimated the factory overhead for each department (direct departmental charges plus 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

• Typical allocation for common costs

Common cost Typical allocation base
Labor related
1. Supervision No. of employees, payroll amount of DLHs
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, value of equipment
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. Interior building maintenance Space occupied

Service oriented
1. Material handling Quantity, value of materials
2. Billing and accounting Number of documents
3. Indirect materials Value of indirect materials

METHODS OF ALLOCATING SERVICE DEPAPRTMENT COST TO PRODUCING DEPARTMENTS

1. Direct method
❖ most widely used
❖ costs of each service department are allocated only to producing departments.
❖ Ignores any services rendered by one service department to another service department.

2. Step Method - sequential method of allocation

❖ Recognizes services rendered by one service department to another service department.
❖ The allocation starts with the department that renders service to greatest number of other service
departments and ends with the department that renders service to the least number of other
departments. Once a service department’s cost is allocated , no subsequent service department
cost is allocated to it.

3. Algebraic method - reciprocal method

❖ Allocates costs by explicitly including the mutual services rendered among all departments.
❖ Service department costs and service department reciprocal service relationships are described by
an algebraic equation.

Illustration (source: Cost Accounting and Control by Norma D De Leon, et.al)

Kappa Gamma Company’s factory is divided into four departments – producing departments – Molding and
Decorating – serviced by the Buildings and Grounds and the Factory Administration Departments. Building
and Grounds cost will be allocated using square feet (floor area) and the Factory Administration cost will
be allocated using direct labor hours. In computing the predetermined overhead rates, machine hours are
used as the base for Molding and direct labor hours as the base for Decorating.

Molding Decorating Bldg. & Grounds Factory Adm.

Budgeted FOH P 400,000 P 600,000 P 80,000 P 120,000
Direct labor hours 200,000 100,000
Floor area 100,000 60,000 2,000 4,000
Machine hours 200,000 100,000

REQUIRED: allocate the cost of the service departments and compute the predetermined FOH rate using:
1. Direct method
2. Step method – start with buildings and grounds
3. Algebraic method

Solution:
1. Direct Method
Molding Decorating Bldg. & Grounds Factory Adm.
 Budgeted FOH P 400,000 P 600,000 P 80,000 P 120,000
Allocated FO:
Bldgs. & Grounds 50,000 30,000 (80,000)
Factory Adm. 80,000 40,000 (120,000)
Total Factory overhead P 530,000 P 670,000
Base 200,000 Mhrs 100,000 DLhrs
Factory overhead rate P 2.65/Mhr P 6.70/DLHr

Allocation of Bldg. & Ground costs (sq. ft) Allocation of Factory Adm. Cost( DLHrs)
Molding = 100/160 x 80,000 = 50,000 Molding = 200/300 x 120,000 = 80,000

Decorating = 60/160 x 80,000 = 30,000 Decorating = 100/300 x 120,000 = 40,000

2. Step Method

Molding Decorating Bldg. & Grounds Factory Adm.

Budgeted FOH P 400,000 P 600,000 P 80,000 P 120,000
Allocated FO:
Bldgs. & Grounds 48,781 29,268 (80,000) 1,951
Factory Adm. 81,301 40,650 (121,951)
Total Factory overhead P 530,082 P 669,918
Base 200,000 Mhrs 100,000 DLhrs
Factory overhead rate P 2.65/Mhr P 6.70/DLHr

Allocation of Bldg. & Ground costs (sq. ft) Allocation of Factory Adm. Cost( DLHrs)
Molding = 100/164 x 80,000 = 48,781 Molding = 200/300 x 121,951 = 81,301

Decorating = 60/164 x 80,000 = 29,268 Decorating = 100/300 x 121,951) = 40,650

Factory Adm. 4/164 x 80,000 = 1,951

3. Algebraic Method
Additional information for the illustrative problem:

Service provided by:

Bldg. & Factory Adm.
Grounds
Molding 50% 40%
Decorating 30% 50%
Bldgs. & Grounds - 10%
Factory Adm. 20% -

Solution:
Algebraic equation:
Buildings and Grounds = 80,000 + 10%(FA)
Factory Administration = 120,000 + 20% (B&G)

Substitution:
Buildings & Grounds = 80,000 + 10% (120,000 + 20% (B&G)
= 80,000 + 12,000 + .02BG
 BG - .02BG = 92,000
BG = 92,000 /.98
BG = 93,878

Factory Administration = 120,000 + 20% (BG)

= 120,000 + 20% (93,878)
= 120,000 + 18,776
FA = 138,776

Allocation of costs:
Molding Decorating Bldg. & Grounds Factory Adm.
Budgeted FOH P 400,000 P 600,000 P 80,000 P 120,000
Allocated FO:
Bldgs. & Grounds 46,939 28,163 (93,878) 18,776
Factory Adm. 55,510 69,388 13,878 (138,776)
Total Factory overhead P 502,449 P 697,551
Base 200,000 Mhrs 100,000 DLhrs
Factory overhead rate P 2.51/Mhr P 6.98/DLHr