4. Factory Overhead Lecture Notes PDF

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FACTORY OVERHEAD: PLANNED, ACTUAL, AND APPLIED LEARNING OUTCOMES: After studying this topic, the student would be able to: 1. 2. 3. 4. 5.

Define factory overhead and its components; Define and calculate Overhead Rates; Accumulate Actual Factory Overhead Costs; Apply factory overhead using predetermined overhead rates; Dispose of over-or underapplied factory overhead.

The Nature of Factory Overhead Factory overhead is defined as indirect materials, indirect labor, and all other factory costs that cannot be conveniently identified with or charged directly to specific products, jobs, lots, or other final cost objects. Other terms used for factory overhead are factory burden, production overhead, indirect production costs, manufacturing expense, manufacturing overhead, factory expense, and indirect manufacturing cost. Factory overhead has 2 characteristics: 1. Overhead’s relationship to the product and 2. Overhead’s relationship to the volume of production Unlike direct materials and direct labor, overhead is an invisible part of the finished product. There is no material requisition or labor time ticket to indicate the amount that enters into a job or product. Yet overhead is as much a part of a product’s manufacturing cost as direct materials and direct labor. Since the onset of technology and automation, overhead has become a larger part of total product cost, while direct labor cost has declined. The second characteristic of overhead deals with how different items of overhead change in response to a change in production volume. Overhead can be fixed, variable or semi-variable. Fixed overhead remains relatively constant regardless of changes in the level of output within the relevant range. Variable overhead per unit is constant. Semi-variable overhead is neither fixed nor variable. Its amount changes, but not in proportion to production volume.

USE OF PREDETERMINED OVERHEAD RATE Overhead costs are charged to all work done during any period. The problem is how to make such a change. It is possible to allocate overhead to all work completed during the month. If production volume is steady from month to month and overhead costs are incurred in level monthly amounts, this method results in a reasonable charge to production each period.

Because several components of overhead cost are incurred and need to be assigned promptly to production, overhead generally is charged to production at predetermined amounts, not at actual amounts incurred. The impossibility of tracing overhead to specific jobs or specific products prompted the need to allocate overhead cost across jobs and units using predetermined overhead rate which permits a consistent and logical allocation to each unit of output. For example, overhead applicable to a job is calculated by multiplying actual machine hours used on the job by the predetermined overhead rate per machine hour. The result is entered on the job order cost sheet. The cost of a job is thus determined at the time the job is completed, rather than being unavailable until month end or year end.

FACTORS CONSIDERED IN SELECTING OVERHEAD RATES Types of overhead rates differ not only from one company to another, but also from one department, cost center, or cost pool to another within the same company. 1. Base to be used a. Physical output b. Direct Material Cost c. Direct Labor Cost d. Direct Labor Hours e. Machine hours f. Transactions or other activities 2. Activity Level Selection a. Theoretical Capacity b. Practical Capacity c. Normal Capacity d. Expected Actual Capacity e. Effect of Capacity on Overhead rates f. Idle Capacity versus Excess Capacity 3. Including or Excluding Fixed Overhead a. Absorption Costing b. Direct Costing 4.

Use of a Single Rate or Several Rates a. Plantwide Rate b. Department Rates c. Subdepartmental and activity rates

5. Use of Separate Rates for Service Activities

Base to be Used The factor measured in the denominator of an overhead rate is called the overhead rate base, the overhead allocation base, or simply the base. Selection of the base is important if a cost system is to provide meaningful cost data. The primary objective in selecting a base is to ensure application of overhead in a reasonable proportion to the indirect factory resources used by the jobs, products or work performed. The base should be closely associated to functions represented by the overhead cost being applied. If overhead is mostly labor oriented, dominated by costs such as supervision and fringe benefits, then the proper base is probably direct labor cost or direct labor hours. If overhead items are predominantly technology oriented resulting from the ownership and operation of machinery, then a machine-hour base is probably most appropriate. If overhead is mainly materials oriented, dominated by costs associated with procuring and handling materials, then materials cost may be suitable as the base. Physical Output Physical output or units of production is the simplest base for applying factory overhead. Its use is illustrated as follows: Factory Overhead per unit = Estimated Factory Overhead Estimated units of Production If estimated factory overhead is P300,000 and the company intends to produce 250,000 units during the next period, each completed unit is charged P1.20 (P300,000/250,000) as its share of factory overhead. An order with 1,000 completed units is charged P1,200 (1,000 x P1.20) of factory overhead. Direct Material Cost Base In some companies, a study of past costs reveals a high correlation between direct materials cost and overhead. For example, when much of the production consists of receiving, inspecting, storing, retrieving, and handling many lots of costly materials. In such cases, a rate based on material cost may be appropriate. The rate is computed by dividing total estimated overhead by total estimated direct materials cost as follos: Factory overhead as a percentage of direct materials cost = Estimated Factory Overhead Estimated Material Cost If estimated factory overhead totals P300,000 and estimated materials cost is P200,000, each job or product is charged an amount of factory overhead equal to 150%(P300,000/P200,000) of its direct material cost. For example, if the material cost of a job is P10,000, the job receives an additional charge of P15,000 (P10,000 x 150%) for factory overhead.

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: Factory Overhead as a Percentage of Direct Labor Cost = Estimated Factory Overhead Estimated direct labor cost If estimated factory overhead is P300,000 and total direct labor cost for the next period is estimated at P500,000, the factory overhead rate is P300,000/P500,000 = 60%. A job or product with a direct labor cost of P12,000 is charged P7,200 (P12,000 x 60%) for factory overhead. The direct labor cost base is relatively easy to use, because the direct labor cost information needed is usually readily available. The weekly payroll provides the direct labor cost without any additional record keeping. This method is logical to use in labor-intensive manufacturing because of a strong relationship between direct labor cost and factory overhead. Direct Labor Hour Base The direct labor hour base is used to balance the amount 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 which can lead to an incorrect distribution of overhead, particularly when operators with different hourly pay rates perform similar operations. The factory overhead rate based on direct labor hours is computed as follows: Factory Overhead per direct labor hour = Estimated Factory Overhead Estimated direct labor hours If estimated factory overhead is P300,000 and direct labor hours are estimated to total 60,000 hours, then the factory overhead rate is P5 per direct labor hour (P300,000/60,000 hours). A job or product that requires 800 direct labor hours is charged P4,000 for factory overhead (800 x P5). Machine HourBase When machines are used extensively, machine hours may be the most appropriate basis for applying overhead. The method is based on the time required to perform identical operations by a machine or group of machines. Total machine hours expected to be used are estimated, and a machine hour rate is determined as follows: Factory Overhead per machine hour = Estimated factory overhead Estimated machine hours If total factory overhead is estimated to be P300,000 and a total of 20,000 machine hours are estimated, the factory overhead rate is P15 per hour (P300,000/20,000). A job or a product that requires 120 machine hours is charged P1,800 for factory overhead (120 x P15)

Transaction Base A group of costs may be associated with a particular activity. For example, set up costs can be assigned more appropriately to products by a rate per set up. Each set up is thus viewed as a transaction, with costs assigned to a product, or batch of products based on the number of transactions required. This transaction approach can also apply to activities such scheduling, inspection, materials movement, and changes in products or processes. The transaction -base approach to overhead allocation is popularly referred to as Activity Based Costing or ABC. ABC recognizes that significant overhead costs may not be caused by volume or output. Rather, in modern multi-product factories, overhead can be caused more by the complexity of the product line and by the handling required for special, low volume items than by the total volume of production. To the extent that overhead cost is driven by transactions that are not proportional to output volume, the use of a volume-of-output base tends to overcost the highvolume products and undercost the low-volume products. Use of transactions base can correct the misallocation.

Selection of Activity Level In calculating a predetermined overhead rate, a great deal depends on the activity level selected. The numerator of the overhead rate is an estimate of overhead at a certain activity level and the denominator is the estimate of the allocation base at the same level of activity. The greater the assumed activity level, the lower the predetermined overhead rate; this relationship exists because factory overhead consists of fixed and variable portions. The higher the activity level, the smaller the fixed portion of the factory overhead rate, because fixed factory overhead is being spread over a greater number of units of activity. The variable portion of the rate tends to remain constant at different activity levels within the relevant range The different activity levels include theoretical capacity, practical capacity, normal capacity and expected actual capacity. Theoretical Capacity The theoretical capacity of a department, plant, or other facility is its capacity to produce at full speed without interruptions. It is achieved if the plant or department produces a 100% of its rated capacity. Operating at theoretical capacity is an unattainable goal for periods as long as a month, a quarter, or a year. 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, such as crew changes, preventive maintenance, repairs, set ups, failures, unsatisfactory materials, delay in delivery of materials, labor shortages and absences, Sundays, holidays, vacations, inventory counting and pattern and model changes. These factors reduce theoretical capacity to practical

capacity. The reduction from theoretical to practical capacity ranges from 15%-25% resulting in a practical capacity level of 75% to 85% of theoretical capacity. Normal Capacity Normal capacity corresponds to the average activity over a time period long enough to level out the highs and lows. The normal capacity concept seeks to stabilize an overhead rate that otherwise would fluctuate as facilities are used to different degrees in different periods. A job or product should not cost more to produce in any one accounting period just because production was lower and fixed costs were spread over fewer units. The rate is changed, however, when prices of overhead items change. Using normal capacity as the assumed capacity level usually means applied overhead will differ from factory overhead incurred. Expected Actual Capacity Expected actual capacity corresponds to the amount of output expected to be produced during the period. This activity level usually results in different predetermined rate for each period, because of increases or decreases in planned production. Effect of Capacity on Factory Overhead Rates The effect of the various capacity levels on predetermined overhead rates Normal Percentage of theoretical capacity Machine Hours Budgeted Factory Overhead Fixed Variable Total

75% 7,500

Expecte d 80% 8,000

P12,000 6,000 18,000

P12,000 6,400 18,400

P12,000 6,800 18,800

P12,000 8,000 20,000

Fixed Factory Overhead rate per machine hr Variable factory overhead rate per machine Hour

P1.60

P1.50

P1.41

P1.20

0.80

0.80

0.80

0.80

2.40

2.30

2.21

3.00

Total Factory overhead rate per machine hr.

Practical

Theoretical

85% 8,500

100% 10,000

If the normal capacity level is selected, the factory overhead rate is P2.40 per machine hour. At Higher capacity levels, the rate is lower because the fixed factory overhead is spread over more Machine hours.

IDLE CAPACITY VERSUS EXCESS CAPACITY Idle capacity results from a temporary lack of sales. When sales demand increases, the idle production workers and facilities are restored to use. When idle capacity is budgeted for the period, its

cost is included in the overhead rate only when expected actual capacity is used as the denominator. In that event, the cost of idle capacity becomes a part of the product cost; this is achieved by setting the denominator of the overhead rate at a lower level that reflects the idleness expected. If idle capacity exists but was not budgeted, there is a resulting variance related to idle facilities. 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. This imbalance occurs when the capacity of one machine does not match the capacity of other machines with which it must be synchronized. Calculation of an Overhead Rate The first step in calculating the overhead rate is determining the activity level to be used for the base selected. Then each individual overhead cost item is estimated or budgeted at that activity level, arriving at the total estimated factory overhead. For example, assume that ABC Products has an expected capacity level of 20,000 machine hours. At that activity level, factory overhead is estimated to total P300,000. This amount of overhead is classified into fixed and variable as shown below: Expense Supervisors Indirect Labor Overtime Premium Factory supplies Repairs and Maintenance Electric Power Fuel Water Labor fringe benefits Depreciation-building Depreciation – equipment Property Tax Insurance (fire)

Fixed P 70,000 9,000

Total estimated factory overhead

P125,000 ========

4,000 3,000 2,000 1,000 500 10,500 5,000 13,000 4,000 3,000

Variable P 66,000 9,000 19,000 9,000 18,000 5,000 500 48,500

P175,000 ========

Total P 70,000 75,000 9,000 23,000 12,000 20,000 6,000 1,000 59,000 5,000 13,000 4,000 3,000 P300,000 ========

Factory Overhead Rate = Estimated Factory Overhead = P300,000 = P15 per machine hour Estimated Machine Hours 20,000 Fixed factory overhead rate = Estimated fixed factory overhead Estimated machine hours

=

P 6.25 per machine hour

Variable factory overhead rate = Estimated variable factory overhead = P8.75 per machine hour Estimated machine hours

ACTUAL FACTORY OVERHEAD Determining the base and the activity level, estimating total overhead and calculating the overhead rate take place prior to incurring or recording actual costs. Factory overhead may be applied each week or month, as soon as the necessary data – such as the predetermined rate and the actual machine hours – are available. Each day, however, some actual factory overhead costs are recorded when incurred, as transactions are journalized and posted to general and subsidiary ledger, this recording is independent of the application of factory overhead. A basic objective of accumulating factory overhead is to provide information for control. Control requires first reporting costs to the individual department heads responsible for them, and then making comparisons with amounts that would be budgeted for the level of activity actually achieved, collecting overhead cost data relies on the chart of accounts, which indicates the accounts to which various overhead accounts are to be charged. The principal source documents used for recording overhead in the journals are purchase vouchers, materials requisitions, labor time tickets, and general journal vouchers.

APPLIED FACTORY OVERHEAD At the end of the month or year, applied factory overhead and actual factory overhead are compared. Actual factory overhead is the amount of indirect cost incurred, while applied factory overhead is the amount of cost allocated to output. A predetermined factory overhead of P15 per machine hour was calculated previously for ABC Products, using estimated factory overhead and estimated machine hours. Assume ABC Products’ actual machine hours totaled 18,900 machine hours and actual factory overhead totaled P292,000. The factory overhead applied during the period is 18,900 x P15 = P283,500. The journal entry to record applied factory overhead: Work in Process Inventory Factory Overhead Control

283,500 283,500

The journal entry to record actual factory overhead cost follows: Factory Overhead Control Various Accounts

292,000 292,000

After the preceding entries are recorded, the factory overhead control account has a debit balance of P8,500 representing underapplied factory overhead. An underapplied overhead results to an understatement of costs and therefore costs should be adjusted.

: Disposition of Over- or Underapplied Amount If the amount of over- or underapplied overhead is insignificant, it should be closed directly to Cost of Goods Sold. In that case the entry to dispose of underapplied factory overhead on the books of ABC Products is: Cost of Goods Sold Factory Overhead Control

8,500 8,500

If the amount of 0ver- or underapplied overhead is significant, the adjustment is made to inventories and cost of goods sold on a pro-rata basis: Work in Process Inventory Finished Goods Inventory Cost of Goods Sold Factory Overhead Control

XXX XXX XXX XXX

CHANGING OVERHEAD RATES Overhead rates usually are reviewed periodically. Changes in production methods, prices, efficiencies, and sales forecasts make review and possible revision of overhead rates necessary at least annually. The extent to which a company revises its overhead rates depends on the frequency of changes, on factors that affect overhead rates, and on management’s need and desire for current cost data. An overhead rate can be incurred because of misjudgments regarding estimated overhead or anticipated activity. A large over- or underapplied factory overhead figure does not necessarily mean that the overhead rate was wrong. When the overhead rate is based on expected actual conditions, seasonal variations can result in a large interim amount o...