ACCOUNTING FOR FACTORY

OVERHEAD
MODULE 8
 FACTORY OVERHEAD COST
Factory overhead costs are divided into three categories on the basis of their
behavior in relation to production. The categories are (1) variable overhead (2) fixed
overhead and (3) mixed overhead.
Variable factory overhead costs - these are the factory overhead costs that vary in
direct proportion to the level of production, within the relevant range. Variable cost
per unit remains constant as production either increases or decreases. Total variable
cost varies in direct proportion to production, that is, the greater the number of
units produced, the higher the total variable costs
 FACTORY OVERHEAD COST
Fixed factory overhead costs - these are the factory overhead costs that remain
constant within the relevant range regardless of the varying levels of production.
The total remains constant but the fixed cost per unit varies inversely with the
production,that is, the greater the number of units produced, the lower the fixed
cost per unit (this is the advantage of mass production - the more we produce the
lesser the manufacturing cost per unit).
Mixed Factory overhead costs - these factory overhead costs are neither wholly
fixed nor wholly variable in nature but have characteristics of both. Mixed factory
overhead costs must ultimately be separated into their fixed and variable
components for purposes of planning and control.
 FACTORY OVERHEAD COST
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.
 FACTORY OVERHEAD COST
FACTORS TO BE CONSIDERED IN THE COMPUTATION OF OVERHEAD RATE
1. BASE TO BE USED
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
 FACTORY OVERHEAD COST
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 RATES

a. Plant-wide or blanket rate one rate for all producing departments
b. Departmentalized rate - one rate for each producing department
 FACTORY OVERHEAD COST
BASE TO BE USED
The base to be used should be related to functions represented by the
overhead cost being applied. If factory overhead is labor oriented, the
most appropriate base to use is direct labor hours or direct labor cost.
If factory is investment-oriented, related to operation of machinery,
then the most appropriate base will be machine hours. On the other
hand, if factory overhead is material-oriented, then material cost might
be considered as the most appropriate base. The simplest of all bases is
physical output or units of production.
 FACTORY OVERHEAD COST
1. 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 established that there is a direct relationship between factory
overhead and direct labor hours. It maybe used also if there is a great disparity
in hourly wage rates. The formula is expressed as:
Factory overhead rate= Estimated factory overhead
Estimated direct labor hours

= Factory overhead rate/direct labor hour

 FACTORY OVERHEAD COST
2. Direct labor cost
This method is recommended if it can established that there is a direct relationship between
labor cost and factory overhead. Just like 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 that 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
depreciation and equipment related cost. The formula is
Factory overhead rate = Estimated factory overhead x 100
Estimated direct labor cost

= Percentage of direct labor cost

 FACTORY OVERHEAD COST
3. Machine hours
This is appropriate when a direct relationship exist 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 on 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. The formula is:
Factory overhead rate = Estimated factory overhead
Estimated machine hours

= Factory overhead rate/machine hour

 FACTORY OVERHEAD COST
4. Direct material 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 materials cost as the base because we will have to
compute a factory overhead rate for each product.
The formula is:
Factory overhead rate = Estimated factory overhead x 100
Estimated direct material cost

= Percentage of direct material cost

 FACTORY OVERHEAD COST

5. Units of production
This is most simple method to use because units produced are readily available. This method is
appropriate when a company or department manufactures only one product. The formula is:
Factory overhead rate = Estimated factory overhead
Estimated units of production

= Factory overhead rate/unit of production

 ILLUSTRATIVE PROBLEM

The Round Table Company estimates factory overhead at P450,000 for the next fiscal year. It is
estimated that 90,000 units will be produced at a material cost of P600,000.
Conversion will require an estimated 100,000 direct labor hours at a cost of P3.00 per hour, with
45,000 machine hours.
Required: Compute the predetermined factory rate based on:
a. Material cost
b. Units of production
c. Machine hours
d. Direct labor cost
e. Direct labor hours
 ILLUSTRATIVE PROBLEM
SOLUTION TO ILLUSTRATIVE PROBLEM1
a. Factory overhead rate = Est. factory overhead
Est. direct mat. cost

= P 450,000 x 100
P 600,000

= 75% of direct mat. cost

 ILLUSTRATIVE PROBLEM

b. Factory overhead rate = Est. factory overhead

Est. units of production
= P450,000
90,000 direct labor hours
= P 5.00/unit
c. Factory overhead rate = Est. factory overhead
Est. machine hours

= P 450,000
45,000 machine hours

= P 10.00/machine hour
 ILLUSTRATIVE PROBLEM
d. Factory overhead rate = Est. factory overhead
Est. direct labor cost

= P 450,000 x 100
P 300,000
= P150% of direct labor cost
e. Factory overhead rate = Est. factory overhead
Est. direct labor hours

= P450,000
100,000 direct labor hours
= P 4.50/direct labor hour
 FACTORY OVERHEAD COST
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 overhead rate (similar to computation using blanket rate)
 FACTORY OVERHEAD COST

In a departmentalized company, factory overhead should be budgeted for each department. The procedures
for distributing the budgeted departmental expenses are identical to those used to allocate the actual factory
overhead expenses. Prior to the computation of the departmentalized factory overhead rate, management
must make sure that the service department costs have been allocated to the producing departments.
Departmentalized overhead rates are for the producing departments only. Producing departments, which
include the production lines, are the cost-accumulation centers in which work is performed directly on the
goods being produced. On the other hand, service departments, which include such activities as maintenance,
personnel, employee services, and the provision of heat, power, and light, are necessary for the entire factory –
including the producing departments – to remain in operation.
 FACTORY OVERHEAD COST
COMMON COST TYPICAL ALLOCATION BASES
Labor – related
1. Supervision No. of employees, payroll amount of DLHrs
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, equipment value
4. Equipment maintenance Number of machines, machine hours
 FACTORY OVERHEAD COST
Space-related
1. Building rental Space occupied
2. Building insurance Space occupied
3. Heat and air-conditioning Space occupied, volume occupied
4. Concession rental Space occupied & desirability of location
5. Interior bldg. maintenance Space occupied
Service-related
12. Material handling Quantity or value of materíals
13. Billing and accounting Number of documents
14. Indirect materials Value of direct materials
 FACTORY OVERHEAD COST
METHODS OF ALLOCATING SERVICE DEPARTMENT COST TO PRODUCING DEPARTMENTS
1. 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 departments.
2. Step method - sometimes called sequential method of allocation. This method recognizes
services rendered by servjce departments to other service departments and is more
complicated because it requires a sequence of allocation. The sequence typically starts with
the department that renders service to the 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 costs are allocated, no subsequent service
department costs are allocated to it.
 FACTORY OVERHEAD COST
3. Algebraic method sometimes called reciprocal method. This method allocates costs by explicitly
including the mutual services rendered among all departments
ILLUSTRATIVE PROBLEM 2
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.
Buildings and Grounds cost will be allocated using square feet (floor area) and Factory Administration
cost 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.
 FACTORY OVERHEAD COST
Bldgs. & Factory
Molding Decorating Grounds Adm. PL
Budgeted FO P400,000 P600,000 P80,000 P120,000
Direct labor hours 200,000 100,000
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 - start with Bldgs. & Grounds
3. Algebraic method
 FACTORY OVERHEAD COST
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. 100,000DLHrs.
FO Rate P2.65/MHr P6.70/DLHr.

Allocation of B & G cost

Molding = 100 x 80,000
160
Decorating = 60 x 80,000
160
 FACTORY OVERHEAD COST
Allocation of FA cost
Molding = 200 x 120,000
300

Decorating = 100 x 120,000

300

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 P2.60/MHrs. P6.70/DLHr
 FACTORY OVERHEAD COST
Allocation of B& G cost
Molding = 100 x 80,000
164

Decorating = 60 x 80,000
164
FA = 4 x 80,000
164
 FACTORY OVERHEAD COST
3. Algebraic method
Additional information for the illustrative problem:
Services provided by
B&G FA
Molding 50% 40%
Decorating 30% 50%
B&G - 10%
FA 20% -
Algebraic equation:
B&G = 80,000+10% (FA)
FA = 120,000+ 20% (BG)
 FACTORY OVERHEAD COST
Substitution:

B &G = 80,000+ 10% (120,000+ .20BG)

= 80,000+ 12,000+.02BG
.98BG = 92,000
BG = 92.000
.98
= 93,878

FA = 120,000+ 20%(BG)
= 120,000+20%(93,878)
= 138,776
 FACTORY OVERHEAD COST
The allocation will be as follows:

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/MHr. P6.98/DLH