ACCOUNTING FOR

FACTORY OVERHEAD
JACQUELINE LESLIE S. IGNACIO, CPA, REB, REA, MBA
Learning Objectives
LO1 Determine how to account for
factory overhead.
LO2 Identify the different cost
behavior patterns of factory
overhead costs.
LO3 Compute a factory overhead
rate using the different bases.
Learning Objectives
LO4 Distribute service department
factory overhead costs to
production departments.
LO5 Apply factory overhead using
predetermined rates.
LO6 Account for actual and
applied factory overhead.
 4

The Nature of Factory

Overhead
Factory Overhead is generally
defined as indirect material,
indirect labor and other factory
expenses which cannot be
directly identified with specific
jobs, products, or services.
Accounting for Factory
Overhead
1. Identify cost behavior patterns.
2. Budget factory overhead costs.
3. Accumulate actual overhead costs.
4. Apply factory overhead estimates to
production.
5. Calculate and analyze differences
between actual and applied factory
overhead.
Cost Behavior Patterns
Variable costs are costs that vary in
proportion to volume changes.
Fixed costs remain constant.
Semivariable costs have characteristics of
both fixed and variable costs.
Type A – remain constant over a range of
production, then change abruptly.
Type B – vary continuously but not in direct
proportion to volume changes.
Cost Behavior Patterns

Cost Cost

Volume Volume

Variable Fixed

Cost Cost

Volume Volume

Semivariable Type A Semivariable Type B

Techniques for Analyzing
Semivariable Costs
Observation Method (Account
Classification Method)
High-Low Method
Scattergraph Method
Method of Least Squares
Budgeting Factory
Overhead Costs
Budgets are management’s operating plans
expressed in quantitative terms.
Costs are segregated into fixed and variable
components.
Budgets can be prepared for different levels
of production (flexible budget).
Valuable management tool for planning and
controlling costs.
 10

Use of a Predetermined
Overhead Rate
Because of the impossibility of tracing
overhead to specific jobs or specific
products, overhead cost is apportioned
among jobs and units.
A predetermined overhead rate permits a
consistent and logical allocation to each unit
of output.
FACTORS TO BE CONSIDERED IN
COMPUTING FOR OVERHEAD
RATE

1. Base to be used 2. Activity Level to

 Physical Output Use
 Direct Materials Costs - Normal Capacity
 Direct Labor Costs - Expected Actual
 Direct Labor Hours Capacity
 Machine Hours
FACTORS TO BE CONSIDERED IN
COMPUTING FOR OVERHEAD
RATE

3. Inclusion or Exclusion of Fixed Factory

Overhead
- Absorption Costing – Method used for
cost accounting
- Direct Costing – Method used for
internal reporting (Management Services)
FACTORS TO BE CONSIDERED IN
COMPUTING FOR OVERHEAD
RATE

4. Use of Single Rate or Several Rates

- Plant-wide or blanket rate – one rate for
all producing departments
- Departmentalized rate – one rate for
each producing department.
Basis used in computing for 14

the predetermined
overhead rate

 Physical Output
 Direct Material Cost
 Direct Labor Cost
 Direct Labor Hours
 Machine Hours
 15

PHYSICAL OUTPUT
 Physical output or units of production is the simplest
base for applying factory overhead
Estimated Factory Overhead = Factory Overhead per unit
Estimated units of production

 Example:
 If Estimated Factory overhead is $300,000 and the
company intends to produce 250,000 units during
the next period, then the FOH per unit is charged
$1.2 ( $ 300.000 : 250.000 units).
 Then an order with 1,000 completed units, is
charged 1,000 x $1.2 = $1,200 of Factory Overhead
 16

DIRECT MATERIALS COST BASE

 In some companies, a study of past costs reveals a high
correlation between direct materials cost and
overhead
Estimated Factory Overhead x 100 = Factory Overhead as a percentage
Estimated material cost of direct materials cost

 Example:
 If Estimated Factory overhead totals $300,000 and
est. materials cost $250.000, then the FOH rate is
$300,000 : $250,000 = 1.2 or 120 % of its direct
materials cost.
 So, if the materials cost for an order is $5,000, Factory
Overhead charged to the order would be $5.000 x
1.2 = $6,000
 17

DIRECT LABOR COST BASE

 This method’s use is logical when a strong relationship

between direct labor cost and factory overhead exists
and hourly rates of pay are similar for similar work.

Estimated Factory Overhead x 100 = Factory Overhead as a percentage

Estimated direct labor cost of direct labor cost

 Example:
 If Estimated Factory overhead is $300,000 and total direct
labor cost is estimated at $500,000, then FOH rate is $300,000 :
$500,000 = 0.6 or 60 %.
 So, a job or product with a direct labor cost $12,000 is
charged $12.000 x 60% = $7,200 for Factory Overhead.
 18

DIRECT LABOR HOUR BASE

 The use of the direct labor hour base is justified if

there is a strong relationship between direct labor
hours and factory overhead
Estimated Factory Overhead = Factory Overhead per direct labor hour
Estimated direct labor hours

 Example:
 If estimated Factory overhead totals $300,000
and direct labor hours are est. 60,000, then
factory overhead rate is ($300.000 : 60,000) = $5
per direct labor hour
 A job with 800 DLH, is charged 800 x $5 = $4,000
for factory overhead
 19

MACHINE HOUR BASE

 When machines are used extensively, machine hours may be
the most appropriate basis for applying overhead.
Estimated Factory Overhead = Factory Overhead per machine hour
Estimated machine hours

 Example:
 If estimated factory overhead totals $300,000 and a total of
20,000 machine hours are estimated, the FOH rate is $300,000
: 20,000 machine hours (MH) = $15 per MH
 So, a job or product that requires 120 machine hours is
charged 120 x $15 = $1,800 for Factory Overhead
 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 costs to the producing

departments.

5. Compute the factory oevrhead rate (similar to computation

using the blanket rate.
Distributing Service
Department Expenses
 Service departments are an essential part of the
organization, but they do not work directly on the
product.
 Production departments perform the actual
manufacturing operations that physically change the
units being processed.
 The costs of the service departments must be
apportioned to the production departments.
 An analysis of the service department’s relationship to
other departments must be done.
Common Bases for
Distributing Service
Department Costs
Service Departments Basis for Distribution
Building Maintenance Floor space occupied by other departments

Inspection and Packing Production volume

Machine Shop Value of machinery and equipment

Human Resources Number of workers in departments served

Purchasing Number of purchase orders

Shipping Quantity and weight of items shipped

Stores Units of materials requisitioned

Tool Room Total direct labor hours in departments served

Methods of Distributing Costs
1. Direct Distribution Method
 Service department costs are allocated only to
production departments.
2. Sequential Distribution or Step-Down Method
 Distributes service department costs regressively to
other service departments and then to production
departments.
3. Algebraic Distribution Method
 Distributes costs by simultaneous equations
recognizing the relationship of services rendered by
departments to each other.
Direct Method
SERVICE DEPARTMENT PRODUCING DEPARTMENT
Step Method
SERVICE DEPARTMENT PRODUCING DEPARTMENT
Algebraic Method
SERVICE DEPARTMENT PRODUCING DEPARTMENT
Illustrative Problem
• Kappa Gamma Company’s factory is divided into 4
departments – producing depts. Molding and
Decorating, serviced by Buildings and Grounds and
Factory Administration departments.
• Building and Grounds costs will be allocated using
square feet (floor area) and Factory Administration
costs will be allocated using direct labor hours.
• In computing predetermined overhead rates,
machine hours are used as the base in Molding and
direct labor hours as the base in Decorating
Illustrative Problem
Molding Decorating Bldg & Factory Admin
Grounds
Budgeted FO P400,000 P600,000 P80,000 P120,000
Direct Labor 200,000 100,000
Hours
Floor Area 100,000 60,000 2,000 4,000
Machine Hours 200,000 100,000
Requirements: Allocate the cost of the service departments using:
1. Direct Method
2. Step Method
3. Algebraic Method
Solution to Illustrative Problem:
1. Direct Method

Molding Decorating B&G FA

Budgeted FO P400,000 P600,000 P80,000 P120,000
Allocated fO
B&G 50,000 30,000 (80,000)
FA 80,000 40,000 (120,000)
Total FO P530,000 P670,000
Base 200,000 MHrs. 100,000 DLHrs.
FO Rate P2.65/MHrs. P6.70/DLHrs.
Allocation of B & G Cost:
MOLDING (100/160X P80,000) DECORATING (60/160XP80,000)
Allocation of FA Cost:
MOLDING (200/300X P120,000) DECORATING (200/300XP120,000)
Solution to Illustrative Problem:
2. Step Method
Molding Decorating B&G FA
Budgeted FO P400,000 P600,000 P80,000 P120,000
Allocated fO
B&G 48,781 29,268 (80,000) 1,951
FA 81,301 40,650 (121,951)
Total FO P530,082 P669,918
Base 200,000 MHrs. 100,000 DLHrs.
FO Rate P2.65/MHrs. P6.70/DLHrs.
Allocation of B & G Cost:
MOLDING (100/164X P80,000); DECORATING (60/164XP80,000); FA
(4/164X P80,000)
Solution to Illustrative Problem:
Additional information for the problem:

SERVICES PROVIDED BY:

B&G FA
MOLDING 50% 40%
DECORATING 30% 50%
B&G - 10%
FA 20% -

Algebraic Equation .98BG = 92,000

B & G = 80,000+10% (FA) BG =92,000/.98
FA = 120,000+20%(BG) BG =93,878
Substitution: FA =120,000+20%BG
B & G = 80,000 +10%(120,000+20% BG) =120,000+20%(93,878)
=80,000+12,000+.02BG =138,776
Solution to Illustrative Problem:
3. Algebraic Method (cont.)
Molding Decorating B&G FA
Budgeted FO P400,000 P600,000 P80,000 P120,000
Allocated fO
B&G 46,939 28,163 (93,878) 18,776
FA 55,510 69,388 13,878 (138,776)
Total FO P502,449 P697,551
Base 200,000 MHrs. 100,000 DLHrs.
FO Rate P2.51/MHrs. P6.98/DLHrs.
Capacity Production
 Theoretical, Maximum or Ideal Capacity – no allowance for
human capacity to achieve the maximum production (full
speed without interruptions.)
 Practical Capacity – provides allowance for circumstances that
might result to stoppage of production.
 Expected Actual Capacity – based on short-range outlook
feasible only for firms with seasonal products and where the
market and style changes allow for price adjustments
according to competitive conditions and customer demands.
 Normal Capacity – considers utilization of plant facilities.
 Commonly used in the computation of overhead rates
 34

Applied Factory Overhead

It is the amount of overhead included in the
cost of an item or job.
= Actual Activity X Predetermined FOH Rate
= 20000 hours X $15
= 300,000
 35

Actual Factory Overhead

Some actual factory overhead costs are
recorded when incurred, as transactions are
journalized and posted to general and
subsidiary ledgers.
A basic objectives of accumulating factory
overhead is to provide information for control
(compare the budgeted amount with the
actual incurred).
Actual Factory Overhead
Source documents used for recording
overhead are:
Purchase vouchers - general journal
voucher
Materials requisitions - labor time tickets
Examples of Factory Overhead
Accounts
 Defective Work  Overtime Premium

 Depreciation  Plant Security

 Employee Fringe Benefits  Power

 Fuel  Property Tax

 Heat and Light  Rent

 Indirect Labor  Repairs

 Indirect Materials  Small Tools

 Insurance  Spoilage

 Janitorial Service  Supplies

 Lubricants  Telephone/Fax

 Maintenance  Water

 Materials Handling  Workers’ Compensation Insurance

Normalized Overhead Rates

“Normal” product costs include

an average or normalized
chunk of overhead.

Actual direct material

+ Actual direct labor
+ Normal applied overhead
= Cost of manufactured product
Disposing of Underapplied
or Overapplied Overhead
Supposing that Enriquez Manufacturing
Applied P375,000 to its products, but . . .

it incurred P392,000 of actual

manufacturing overhead during the year.

P392,000 actual overhead

–375,000 applied overhead
P17,000 underapplied overhead

The P375,000 becomes part of Cost of Goods Sold

when the product is sold, however . . .
Disposing of Underapplied
or Overapplied Overhead
The applied overhead is P17,000 less than the
amount incurred. It is:

Overapplied overhead occurs when the amount

applied exceeds the amount incurred.

A company must report actual costs

incurred in its financial statements.
Disposing of Underapplied
or Overapplied Overhead

Accountants uses two methods for the adjustment:

1) Write-off to cost of goods sold

2) Proration, apportioning over- or underapplied

overhead to cost of goods sold, work-in-process
inventory, and finished-goods inventory in
proportion to the ending balances of each
account.
Immediate Write-Off
This method regards the $17,000 as a reduction in
current income and adds it to Cost of Goods Sold.

Manufacturing Overhead
392,000 - 375,000 = 17,000

Cost of Goods Sold

Applied
Overhead
(Budgeted)

Incurred
Overhead
(Actual)
Immediate Write-Off
This method regards the $17,000 as a reduction in
current income and adds it to Cost of Goods Sold.

Manufacturing Overhead
Applied Overhead
375,000
392,000
17,000 (Budgeted)
0

Cost of Goods Sold

17,000
Incurred Overhead
(Actual)
Prorating Among Inventories
This method prorates the P17,000 of
underapplied overhead to Work-In Process (WIP),
Finished Goods, and Cost of Goods Sold accounts
assuming the following ending account balances:

Work-in-Process Inventory P 155,000

Finished Goods Inventory 32,000
Cost of Goods Sold 2,480,000
Total P2,667,000
Prorating Among Inventories

P17,000 × 155/2,667
= 988 to Work-in-Process Inventory

P17,000 × 32/2,667
= P204 to Finished Goods Inventory

P17,000 × 2,480/2,667
= P15,808 to Cost of Goods Sold
Prorating Among Inventories
This method prorates the P17,000 of
underapplied overhead to Work-In-Process (WIP),
Finished Goods, and Cost of Goods Sold accounts.

Companies generally prorate overhead

variances only when material.
Overapplied and Underapplied
Manufacturing Overhead
Summary

Alternative 1 Alternative 2
If Manufacturing Close to Cost
Overhead is . . . of Goods Sold Allocation

UNDERAPPLIED INCREASE INCREASE

Cost of Goods Sold Work in Process
(Applied OH is less Finished Goods
than actual OH) Cost of Goods Sold

OVERAPPLIED DECREASE DECREASE

Cost of Goods Sold Work in Process
(Applied OH is greater Finished Goods
than actual OH) Cost of Goods Sold