Chapter VIII: Accounting for Factory Overhead 1

Learning objectives: Factors to be considered in the computation of overhead rate:

 Compute a factory overhead rate using the different 1. Base to be used – base to be used should be related
bases to functions represented by the overhead costs; if FOH
 Apply the concept of actual factory overhead and is labor-oriented, use direct labor hours or direct labor
applied factory overhead costs; if FOH is investment-oriented, use machine
 Identify then compute using the different methods of hours; if FOH is material-oriented, use direct material
allocating budgeted service departments to producing costs; physical output is the simplest base to used; this
departments methods are used for plant-wide or blanket rate
 Compute the different factory overhead variances
 Apply the concept of activity based costing (ABC) a. Direct labor hours – readily available on the
payroll sheet; may also be used if there is a
great disparity in hourly wage rate
Factory overhead: Factory overhead rate = Estimated factory overhead
Estimated direct labor hours
 All cost incurred in the factory other than direct material = Factory overhead rate/direct labor hour
and labor
 Cost pool to accumulate all indirect manufacturing cost b. Direct labor costs - readily available on the
Categories of factory overhead: payroll sheet; more reliable base than to direct
material costs that often change
1. Variable factory overhead costs – factory overhead
costs that vary in direct proportion to the level of Factory overhead rate = Estimated factory overhead × 100
production; fixed per unit – variable per total Estimated direct labor costs
2. Fixed factory overhead costs – factory costs that = Percentage of direct labor cost
remain constant within the relevant range regardless of
the varying levels of production; fixed per total –
indirectly proportion to the volume per unit
3. Mixed factory overhead costs – have the c. Machine hours – occur in companies that are
characteristics of the both (variable and fixed costs); it largely automated so that majority of the factory
must be separated into fixed and variable component overhead costs consist of depreciation on
for purposes of planning and control factory equipment; additional work is required
because each machine will have a time record

Factory overhead rate = Estimated factory overhead

 Chapter VIII: Accounting for Factory Overhead 2

Estimated machine hours c. Expected actual capacity – capacity concept

= Factory overhead rate/machine hour based on a short range; feasible only for firms
whose products are seasonal or where market
d. Direct material cost – can be used if the and style changes allow price adjustments
company is producing only 1 product according to competition and customer
demands
Factory overhead rate = Estimated factory overhead × 100
Estimated direct material costs
= Percentage of direct material costs d. Normal capacity – this is commonly used in
the computation of overhead rates; capacity of
e. Units of production – most simple method to production taking into consideration the
use because units produced are readily utilization of plant facilities to meet commercial
available; appropriate when a demands that is enough to level out peaks and
company/department manufactures only 1 valley
product
3. Inclusion or exclusion of fixed factory overhead
Factory overhead rate = Estimated factory overhead
Estimated units of production a. Absorption costing – method used for cost
= Factory overhead rate/units of production accounting; fixed factory overhead is part of
product cost
b. Direct costing – method used for internal
2. Activity level to use – capacity of production that reporting (management services)
should be adopted

a. Theoretical, maximum or ideal capacity – 4. Use of single rate or several rates:

capacity to produce at full speed without
interruptions; no allowance for any a. Plant-wide or blanket rate – one rate for all
circumstances that might result to stoppage of producing departments
production b. Departmentalized rate – one rate for each
producing department
b. Practical capacity – capacity of production that
provides allowance for circumstances that might
result to stoppage of production
 Chapter VIII: Accounting for Factory Overhead 3

Steps in computation of departmentalized overhead rate: Step method

1. Divide company into segments (departments) Service Department Producing Department

2. Estimate FOH for each department
3. Select and estimate base to be used
4. Allocate service department cost to producing
departments
5. Compute FOH rate
Typical allocation bases for common costs:
1. Labor-related common costs Algebraic method
2. Machine-related common costs
Service Department Producing Department
3. Space-related common costs
4. Service-related common costs
Methods of allocating service department costs to
producing departments:
1. Direct method – the most widely used method; it
directly allocates each service department total costs to
producing departments; ignore any service rendered by Method of accumulation of factory overhead costs:
one service department to another
2. Step method – also called as sequential method of 1. Non-controlling account system – an account for
allocation; if a service department rendered service to each kind of overhead expense are opened in the
another, it is included to the allocation of cost ledger
3. Algebraic method – also called reciprocal method; 2. Controlling account system – an “overhead control”
this method allocates costs by explicitly including the account is opened
mutual services rendered among all departments NOTE:

Direct method  Factory overhead applied is an account used to

charged factory overhead to the production
Service Department Producing Department
 Factory overhead variance – the difference between
the actual factory overhead control and factory
overhead applied that resulted to under or over-applied
overhead
 Chapter VIII: Accounting for Factory Overhead 4

Causes of the manufacturing overhead variance: Overhead allocation: Traditional costing vs. Activity
Based Costing (ABC)
1. Spending variance – variance due to expense factors
(price) ABC:
2. Idle capacity or volume variances – variance due to
a. Accurately allocate cost on the product (product cost
difference in volume and activity factors
needs to be accurate to set the proper selling price; not
Computation of manufacturing overhead variance: to understate or overstate the selling price)
b. Used to account overhead only; direct materials and
a. Spending variance – direct labor are accounted as the same
= Actual – Flexible (budgeted) c. Identify activities and then used multiple cost drivers
Or
Actual factory overhead xxx Traditional costing:
Less: Budget allowed based on capacity used
a. Used only one cost drivers such as machine hours,
Fixed factory overhead xxx
direct labor hours etc.
Variable factory overhead xxx (xxx)
Spending variance xxx
Overhead variance illustration:
Actual > Budgeted – Unfavorable
Actual < Budgeted – Favorable

b. Volume variance – Actual Budgeted Applied

= Flexible (budgeted) – applied
Or
Budget allowed based on capacity used xxx
Less: Factory overhead applied (xxx)
Volume variance xxx

Budgeted > Applied – Unfavorable Spending variance Volume variance

Budgeted < Applied – Favorable