Chapter 7

Accounting for Factory Overhead

Entries are made in the general journal

for indirect materials and indirect labor
from the summary of materials issued and
the labor cost summary.
Other factory overhead expenses are
recorded in the general ledger from the
invoices and schedules for fixed costs.
A factory overhead subsidiary ledger may
be used if the number of factory overhead
accounts becomes too large.

Accounting for Factory Overhead

Defective Work
Depreciation
Employee Fringe Benefits
Fuel
Heat and Light
Indirect Labor
Indirect Materials
Insurance
Janitorial Service
Lubricants
Maintenance
Materials Handling

Overtime Premium
Plant Security
Power
Property Tax
Rent
Repairs
Small Tools
Spoilage
Supplies
Telephone/Fax
Water
Workers Compensation
Insurance

Examples of Factory Overhead

Accounts

AC9

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 Behavior Patterns

Cost

Volume

Volume

Fixed

Variable

Volume

Volume

Semivariable Type A

Semivariable Type B

1. BASE TO BE USED

Cost

Cost

Cost

A. Physical output
B. Direct materials Cost
C. Direct labor Cost
D. Direct labor Hours
E. Machine Hours

Budgeting Factory Overhead Costs

2. ACTIVITY LEVEL TO USE

3. INCLUSION OR EXCLUSION OF FIXED FACTORY

OVERHEAD

4. USE OF SINGLE OR SEVERAL RATES

A. Normal Capacity
B. Expected actual capacity
A. Absorption Costing
B. Direct Costing

A. Plant-wide or blanket rate

B. Departmentalized rate

FACTORS TO BE CONSIDERED IN
THE COMPUTATION OF THE
OVERHEAD RATE

AC9

Budgets are managements 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.

Direct Labor Cost Method

Direct Labor Hour Method if factory OH
is labor-oriented
Machine Hour Method if factory if
investment-oriented
Direct materials Cost Method if factory
is material-oriented
Physical output

Methods of Predetermined Factory

Overhead Rates

Direct Labor Cost Method

Direct Labor Hour Method

Uses the amount of direct labor cost that

has been charged to the product as the
basis for applying factory overhead.
FO Rate = FO / DL Cost = % of DL Cost

Estimated factory overhead cost is

divided by the estimated direct labor
hours to be worked.
FO Rate = FO / DL Hours = rate per hr

Job 100
Direct materials

Job 100
$1,000

Direct materials

3,000

Direct labor (500 hours)

Factory overhead (50% of direct labor)

1,500

Factory overhead (300 hours @ 4/hr.)

Total cost of completed job

$5,500

Machine Hour Method

Uses the amount of direct material cost

that has been charged to the product as
the basis for applying factory overhead.
FO Rate = FO / DM Cost = % of DM Cost
Job 100

$1,000

Direct materials

Direct labor (500 hours)

3,000

Direct labor

Factory overhead (300 machine hours @ 10/mhr)

3,000

Factory overhead (150% of direct material )

Total cost of completed job

1,200
$5,200

Direct Material Cost Method

This method best serves highly automated

departments where the amount of factory
overhead cost incurred on a job primarily is
a function of the machine time that a job
requires.
FO Rate = FO / Machine Hours = rate per hr

Direct materials

3,000

Total cost of completed job

Job 100

AC9

$1,000

Direct labor

$7,000

Total cost of completed job

$1,000
3,000
1,500
$5,500

Units of production

This method simplest to use. Most

appropriate when only one product is
produced.
FO Rate = FO / units of production =
rate per unit

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 departments
relationship to other departments must be
done.

Distributing Service Department

Expenses

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

Common Bases for Distributing

Service Department Costs

AC9

1.

2.

3.

Direct Distribution Method

Service department costs are allocated only

to production departments.

Sequential Distribution or Step-Down

Method

Distributes service department costs

regressively to other service departments
and then to production departments.

Algebraic Distribution or Reciprocal

Method

Distributes costs by simultaneous equations

recognizing the relationship of services
rendered by departments to each other.

Methods of Distributing Costs

A. Theoretical, maximum or ideal

capacity a capacity to produce at full
speed without interruptions. At this capacity
level, the plant is assumed to function 24
hours a day, 7 days a week, and 52 weeks a
year without any interruptions in order to
yield the highest physical output possible.
B. Practical capacity a capacity of
production that provides allowance for
circumstances that might result to stoppage
of production.

Capacity Production

Non-controlling account system an

account for each kind of OH expense
according to their nature is opened every
time such expense is incurred
Controlling account system an OH
account is opened in the GL wherein the
OH incurred is charged and a SL is
maintained to show in detail the nature
and account of the expense

Method of Accumulation of Factory

Overhead Costs

AC9

C. Expected actual capacity a capacity

concept based on a short range outlook;
feasible with seasonal and cyclical variations.
(allow price changes according to competitive
condition and customer demands); planned
capacity
D. Normal capacity a capacity of
production that considers utilization of plant
facilities to meet the demands over a long
period of time to level out the peaks and
valleys.

Capacity Production

Applied factory overhead is computed by

multiplying the actual factor incurred per
cost sheet by the predetermined OH rate.

Entry to apply estimated factory overhead to production

Work in Process

XX

Applied Factory Overhead

XX

At the end of the period, the applied factory overhead account

is closed to factory overhead.
Applied Factory Overhead

XX

Factory Overhead

XX

Accounting for Overhead

Actual costs will almost never equal budgeted

costs. Accordingly, an imbalance situation
exists between the two overhead accounts.
FOH variance is the difference between the
actual FOH and the applied FOH.

After the applied factory overhead account

is closed, the underapplied (debit) or
overapplied (credit) balance in the factory
overhead account is moved to work in
process.
Under- and Overapplied Factory
Overhead

If Overhead Control (actual) > Overhead Applied

(allocated) = Underapplied Overhead
If Overhead Control (actual) < Overhead Applied
(allocated) = Overapplied Overhead

Factory Overhead
Cost of Goods Sold
Under- and Overapplied Factory
Overhead

Accounting for Overhead

This difference will be eliminated in the

end-of-period adjusting entry process,
using one of three possible methods
The choice of method should be based on
such issues as materiality, consistency
and industry practice

AC9

XX
XX
XX

Under- and Overapplied Factory

Overhead

Three Methods for Adjusting

Over/Underapplied Overhead

Accounting for Overhead

XX

Adjusted Allocation Rate Approach all

allocations are recalculated with the actual,
exact allocation rate.
Proration Approach the difference is
allocated between Cost of Goods Sold,
Work-in-Process, and Finished Goods based
on their relative sizes
Write-Off Approach the difference is
simply written off to Cost of Goods Sold

FOH variance the difference between

the actual Factory Overhead as shown by
the FOH Control account and the
Overhead charged to production as shown
by the factory overhead applied account.

Overhead Variance

Given:
Budgeted FOH:

Solution:
Actual FOH

Budgeted FOH:

600,000
P 640,000
200,000

P 640,000
P 600,000
340,000
P 940,000

Applied FOH:

Spending variance = Actual Budgeted = P 300,000 Favorable

Volume variance = Budgeted Applied = P 400,000 Unfavorable
Net variance
= Actual Applied =
P 100,000 Underapplied

(200,000 x 2.70)

Illustration

P 540,000

Spending variance the variance due to

expense factors. (Actual FOH incurred less
Budget allowed based on capacity used)
Idle capacity or volume variance the
variance due to difference in volume and
activity factors. (Budget allowed based on
capacity used less Applied FOH)

Overhead Variance

600,000

Fixed OH cost
Variable OH Cost (1,020,000/600,000)X200,000
Total Budget Allowed

AC9

Fixed OH cost
P
Variable OH Cost P 1,020,000

Budgeted DL Hours
Actual FOH
Actual DL Hours

The company must first identify activities

in the factory that create costs.
Then a basis or cost driver must be
decided upon to allocate each of the
activity cost pools.
This approach is best when the company
has significant nonvolume-related costs in
its plant which are not caused by
traditional cost drivers such as labor
hours and machine hours.

Activity-Based Costing Method