Cost Accounting

Cost Accounting
Chapter 11
Factory Overhead: Departmentalization,
Planned, Actual, and Applied
Learning Objectives
1. Define factory overhead and its components.
2. Define and calculate overhead rates.
3. Describe the concept of departmentalization.
4. Distinguish between service and producing
departments.
5. Define direct and indirect departmental costs and give
examples of each.
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Learning Objectives
6. Compute departmental overhead rates.
7. Describe departmentalization in nonmanufacturing
and non-for-profit organizations.
8. Accumulate actual factory overhead costs.
9. Apply factory overhead using predetermined rates.
10. Dispose of over- or underapplied factory overhead.
11-1 The Nature of Factory Overhead
• Factory overhead is generally defined as indirect
materials, indirect labor, and all other factory costs
that cannot be conveniently identified with or charged
directly to specific jobs, lots, products, or other final
cost objects.
• Factory overhead has two characteristics that require
consideration.
• The characteristics deal with overhead’s relationships
to the product and to the volume of production.
11-1 The Nature of Factory Overhead
• Overhead is as much a part of a product’s
manufacturing cost as direct materials and direct
labor.
• The second characteristic of overhead deals with how
different items of overhead change in response to a
change in production volume.
11-2 Use of a Predetermined Overhead Rate
• Large variations do occur between months or between
seasons of the year, which would cause work
completed during different months to receive
significantly different charges for overhead.
• The resulting high repair cost and low production
volume results in astronomical unit cost calculations
if actual (high) overhead is charged to actual (low)
production in those months.
• Generally, overhead is charged to production at
predetermined amounts, not at actual amounts
incurred.
11-2 Use of a Predetermined Overhead Rate
• Because of the impossibility of tracing overhead to
specific jobs or specific products, overhead cost is
allocated across jobs and units.
• A predetermined overhead rate permits a consistent
and logical allocation to each unit of output.
11-3 Departmentalization
• Departmentalization means dividing the plant into
segments, called departments, to which overhead
costs are charged.
• Provides improved product costing and promotes
responsible control of overhead costs.
• Allows different departments to have different
overhead rates.
• The plantwide average rate may be too high or too
low for a particular product, especially a product
involving only one or a few departments.
11-3 Departmentalization
• Departmentalization facilitates responsibility
accounting and control of overhead costs by making
costs a responsibility of each department’s manager.
• Estimating or budgeting costs and selecting a proper
base for applying them is still necessary.
• Departmentalizing overhead requires separate
estimates or budgets for each department.
11-4 Producing and Service Departments
• A producing department manufactures the product
by changing the form or material or by assembling
parts.
• A service department renders a service that
contributes in an indirect way to the manufacture of
the product but does not change the form.
11-4 Producing and Service Departments
• Selection of Producing Departments
– A company usually is organized into departments that
perform different kinds of work.
– Organization needed to handle the different operations
efficiently, to obtain the best production flow, and to
establish responsibility for physical control of production.
– The cost information system is designed to reflect the
departmentalization.
– Accumulates production costs by department.
11-6 Indirect Departmental Costs
• Costs shared by all departments are not charged
directly to a department.
• Their cost is allocated among all departments.
• At best, allocations will be intuitively reasonable.
11-6 Indirect Departmental Costs
• Some of the indirect departmental expenses that
require allocation among departments, together with
the bases most commonly used, include the
following:
11-7 Establishing Departmental
Overhead Rates
• The use of departmental rates requires a distinct
consideration of each producing department’s
overhead, which often results in different bases for
different departments.
• All factory overhead ultimately allocated to
producing departments.
Overhead Rates
• The establishment of departmental overhead rates
involves the following steps:
1. Estimate total departmental overhead of producing and
service departments at the expected activity levels.
2. Prepare a survey for the purpose of distributing indirect
departmental overhead and service department costs.
3. Estimate total indirect departmental overhead at the
selected activity levels and allocate these costs among
departments.
Overhead Rates
• The establishment of departmental overhead rates
involves the following steps:
4. Distribute service department costs to benefiting
departments.
5. Calculate departmental overhead rates.
Exhibit 11-1
Overhead Rates
• Factory Survey
– To allocate indirect departmental costs and service
department costs to the benefiting departments, the
necessary data are obtained from a survey of facilities and
records.
EXHIBIT 11-2
Overhead Rates
• Estimating and Allocating Indirect Costs
– The method of allocation is management’s decision.
Overhead Rates
• Distributing Service Department Costs
– Service department costs are distributed either to producing
departments and service departments, or just to producing
departments.
– The distribution is based on a common unit of measure that
correlates closely with the causes of service department
costs.
– The costs of service departments ultimately are distributed
to producing departments to establish predetermined
overhead rates. Common methods for distributing service
department overhead: (1) direct method; (2) step method;
(3) simultaneous method.
Overhead Rates
– Direct Method. Service department costs are distributed
only to producing departments.
EXHIBIT 11-4
Overhead Rates
– Step Method. The step method distributes the costs of
service departments in a sequence of steps; that is, in a
prescribed order by department.
– Also known as sequential method.
– Once cost is distributed from a service department, no other
service department’s cost is distributed back to it in a
subsequent step.
– One approach is to start with the department serving the
greatest number of other departments and receiving service
from the smallest number of other service departments.
EXHIBIT 11-3
EXHIBIT 11-5
Overhead Rates
– Simultaneous Method. When service departments serve
each other, the step method distributes incompletely
because one department is distributed before another and,
therefore, before receiving any cost distribution from the
other.
– The simultaneous method, also called the algebraic
method.
Overhead Rates
– Simultaneous Method.
EXHIBIT 11-6
Overhead Rates
• Calculating Departmental Overhead Rates
– After service department costs have been distributed,
producing department overhead rates can be calculated by
dividing each producing department’s final total factory
overhead by a selected allocation base.
11-8 Multiple Overhead Rates
• Many production settings involve a diverse product
line—a number of very different products, each of
which can be produced in several sizes, grades,
configurations, or types.
11-9 Overhead Departmentalization in Nonmanufacturing
Businesses and Not-for-Profit Organizations
• Responsible control of departmental costs is equally

essential in nonmanufacturing activities.
• The following that commonly are divided into
administrative and supervisory departments for cost
planning and control.
11-9 Overhead Departmentalization in Nonmanufacturing
Businesses and Not-for-Profit Organizations
1. Nonmanufacturing segments of manufacturing concerns
(i.e., marketing and administrative departments)
2. Retail stores
3. Banks and other financial institutions
4. Insurance companies
5. Educational institutions
6. Service organizations, such as hotels, motels, hospitals,
nursing homes, law firms, accounting firms, medical or
dental practices, and realtors
7. Federal, state, and local governments and their agencies
11-10 Factors Considered in Selecting
Overhead Rates
• The five factors are summarized as follows:
1. Base to Be Used
a. Physical output
b. Direct materials cost
c. Direct labor cost
d. Direct labor hours
e. Machine hours
f. Transactions or activities
Overhead Rates
2. Activity Level Selection
a. Theoretical capacity
b. Practical capacity
c. Expected actual capacity
d. Normal capacity
e. Effect of capacity on overhead rates
f. Idle capacity versus excess capacity
Overhead Rates
3. Including or Excluding Fixed Overhead
a. Absorption costing
b. Direct costing
4. Use of a Single Rate or Several Rates
a. Plantwide or blanket rate
b. Department rates
c. Subdepartmental and activity rates
5. Use of Separate Rates for Service Activities
Overhead Rates
• Base to be used
– The primary objective in selecting a base is to ensure the
application of overhead in a reasonable proportion to the
indirect factory resources used by the jobs, products, or
work performed.
– Ordinarily the base should be closely related to functions
represented by the overhead cost being applied
– A second objective in selecting a base is minimization of
clerical cost and effort.
– A second objective in selecting a base is minimization of
clerical cost and effort.
Overhead Rates
• Base to be used
– Physical Output. Physical output or units of production is
the simplest base for applying factory overhead. Its use is
illustrated as follows:
Overhead Rates
• Direct Materials Cost Base.
– In some companies, a study of past costs reveals a high
correlation between direct materials cost and overhead.
– The rate is computed by dividing total estimated overhead
by total estimated direct materials cost, as follows:
– The material cost base is of limited use, because in most

cases no logical relationship exists between the direct
materials cost of a product and the use or creation of
factory overhead in its production.
Overhead Rates
• Direct Labor Cost Base.
– Using a direct labor cost base for applying factory overhead
to jobs or products entails dividing estimated overhead by
estimated direct labor cost to compute a percentage:
Overhead Rates
• Direct Labor Cost Base.
– The application of this method is logical when a strong
relationship between direct labor cost and factory overhead
exists and hourly rates of pay are similar for similar work.
– It is inappropriate when:
1. Factory overhead includes depreciation of high-cost machinery,
which bears no relationship to the direct labor payroll.
2. Total direct labor cost represents the sum of wages paid to high- and
low-wage production workers doing similar work. By applying
factory overhead on the basis of direct labor cost, a job or product
is charged with more overhead when a high-wage operator
performs work. Such a method can lead to an incorrect distribution
of overhead, particularly when operators with different hourly pay
rates perform similar operations.
Overhead Rates
• Direct Labor Hour Base.
– The direct labor hour base is designed to overcome the
second disadvantage of using the direct labor cost base.
Overhead Rates
• Machine Hour Base.
– When machines are used extensively, machine hours may
be the most appropriate basis for applying overhead.
Overhead Rates
• Selection of Activity Level
– The different activity levels include theoretical capacity,
practical capacity, expected actual capacity, and normal
capacity.
– Theoretical Capacity. The theoretical capacity of a
department, plant, or other facility is its capacity to produce
at full speed without interruptions.
– Practical Capacity. It is highly improbable that any
company can operate at theoretical capacity for more than a
few minutes or hours at a time. Allowances must be made
for unavoidable interruptions
Overhead Rates
– Expected Actual Capacity. Corresponds to the amount of
output expected to be produced during the period. Usually
results in a different predetermined rate for each period,
because of increases or decreases in planned production.
– Normal Capacity. Corresponds to the average activity over
a time period long enough to level out the highs and lows.
This concept seeks to stabilize an overhead rate that
otherwise would fluctuate as facilities are used to different
degrees in different periods.
EXHIBIT 11-7
Overhead Rates
– Idle Capacity Versus Excess Capacity. Idle capacity
results from a temporary lack of sales.
– Excess capacity, in contrast, results either from greater
productive capacity than a company can expect to use, or
from an imbalance in equipment or machinery.
11-11 Calculation of an Overhead Rate
EXHIBIT 11-8
11-12 Actual Factory Overhead
• A basic objective of accumulating factory overhead is
to provide information for control.
11-13 Applied Factory Overhead and the
Over- or Underapplied Amount
• Actual factory overhead is the amount of indirect
cost incurred
• Applied factory overhead is the amount of cost
allocated to output.
• Applying Factory Overhead
• Over- or Underapplied Factory Overhead
– Debits to the factory overhead control account reflect actual
factory overhead costs incurred during the period, while
credits reflect applied amounts.
– A debit balance indicated that factory overhead has been
underapplied; a credit balance means that factory
overhead has been overapplied.
• Disposition of Over- or Underapplied Amount
– If the amount of over- or underapplied factory overhead is
insignificant, it should be closed directly to Income
Summary or to Cost of Goods Sold as a period cost.
EXHIBIT 11-9
– It can be allocated to inventories and the cost of goods sold.
– Required for financial reporting purposes if its effect on the
financial statements are material.
– Expensing a large underapplied factory overhead balance,
for example, generally overstates the cost of goods sold,
understates income, and understates inventory on the
balance sheet.
EXHIBIT 11-10
– The purpose of allocating the underapplied factory
overhead is to revise all the amounts of factory overhead
that were applied during the year. The revision is achieved
by adjusting the three accounts shown, because all applied
factory overhead amounts are contained in the year-end
balances of those three accounts.
– Often the work in process inventory consists mostly of
direct material cost and relatively little overhead, so the
approach just illustrated attributes too much of the
adjustment to Work in Process.
11-14 Changing Overhead Rates
• Overhead rates are reviewed periodically.
• Changes in production methods, prices, efficiencies,
and sales forecasts make review and possible revision
of overhead rates necessary at least annually.

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• Responsible control of departmental costs is equally

– The material cost base is of limited use, because in most

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