FACTORY OVERHEAD: PLANNED,

ACTUAL, AND APPLIED

TUESDAY- November 24,2020

LEARNING OUTCOMES:

After studying this topic, the student would be able to:

1. Define factory overhead and its components;

2. Define and calculate Overhead Rates;
3. Accumulate Actual Factory Overhead Costs;
4. Apply factory overhead using predetermined overhead rates;
5. Dispose of over-or underapplied factory overhead.

The Nature of Factory Overhead (indirect cost)

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 DIFFerent SA MANUFACTUIRNG COST, 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. not
directly traceable 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 bas 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 chnages, 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 ( no
change in volume every month is the same), this method results in a reasonable charge to production
each period.

Ex: 1000 units/12=n a month

Because several components of overhead cost are incurred and need to be assigned promptly to
production, (no need to wait for the end of period—estimate na lang, adjust na lang if over applied or
under applied at the end o period) 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.

Ex: process A is labor intensive you cant use the no.of machine hrs as a base. Dapat direct labor hrs or
direct labor cost ang base.pag dating sa dept B- automated nano laborer more on machine, you cant use
the overhead base ang direct labor hrs dapat no.of machine hrs.

1. Base to be used
a. Physical output-no of units produced
b. Direct Material Cost
c. Direct Labor Cost
d. Direct Labor Hours
e. Machine hours-automated process
f. Transactions or other activities- dapat appropriate base

Budgets are done every year

2. Activity Level Selection
a. Theoretical Capacity good in theory only- no allowance for machine break down, flood fire
etc. perfect operation (100%) not realistic/ not attainable
b. Practical Capacity- considers machine breakdown, acts of nature , labor problems and may
mga allowance for this.
c. Normal Capacity-based on a long term planning/performance
d. Expected Actual Capacity-pababa ng pababa ang activity level, short term planning. near to
the actual level of activity used usually in determining overhead rate. Near the actual
produced units
e. Effect of Capacity on Overhead rates
f. Idle Capacity versus Excess Capacity

3. Including or Excluding Fixed Overhead

a. Absorption Costing- based on account standard/acceptable, cost of product includes
everything(fixed or variable cost, direct or indirect)
b. Direct Costing(consider in determining, units cost only the variable cots included in
computation of product cost: direct material, direct labor, variable factory overhead,
exclude the fixed overhead sa cost of product kase incurred to even if no production ex.
Rental.

4. Use of a Single Rate or Several Rates

a. Plantwide Rate- one plantwide rate is used for every dept
b. Department Rates each dept has different rate(consider if puro machine or labor intensive)
c. Subdepartmental and activity rates under activity based costing. multiple overhead rate for
every activity .
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 rate (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 rate) 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

I f 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=1.5 x 100=150%) 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 r nn 6ate 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. Based sa working skills/experience 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
labor hrs 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. Next topic pa(last sa syllabus)

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 high-
volume products and undercost the low-volume products. Use of transactions base can correct
the misallocation.

Every activity has its own overhead rate

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.
Ex if based on normal capacity ng numerator ganon din sa denominator. If practical
capacity ang base, ganon din sa numer atdeno

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 not attainable

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 38mins

The effect of the various capacity levels on predetermined overhead rates

Normal Expected Practical Theoretical

Percentage of theoretical capacity 75% 80% 85% 100%
Machine Hours 7,500 8,000 8,500 10,000
Budgeted Factory Overhead
Fixed fixed always regardless of capacity level P12,000 P12,000 P12,000 P12,000
Variable 6,000 6,400 6,800 8,000
Total 18,000 18,400 18,800 20,000

Fixed Factory Overhead rate per machine hr P1.60 P1.50 P1.41 P1.20
Inversely proportional 12k/7.5
Add Variable factory overhead rate per machine 0.80 0.80 0.80 0.80
Hour
2.40 2.30 2.21 3.00
Total Factory overhead rate per machine hr.
 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:
Components of factory overhead

Expense Fixed Variable Total

Supervisors P 70,000 P 70,000
Indirect Labor party fixed partly variable 9,000 P 66,000 75,000
Overtime Premium 9,000 9,000
Factory supplies 4,000 19,000 23,000
Repairs and Maintenance 3,000 9,000 12,000
Electric Power 2,000 18,000 20,000
Fuel 1,000 5,000 6,000
Water 500 500 1,000
Labor fringe benefits 10,500 48,500 59,000
Depreciation-building 5,000 5,000
Depreciation – equipment always fixed 13,000 13,000
Property Tax always fixed 4,000 4,000
Insurance (fire) always fixed 3,000 3,000

Total estimated factory overhead P125,000 P175,000 P300,000

======== ======== ========

Factory Overhead Rate = Estimated Factory Overhead = P300,000 = P15 per machine hour
Estimated Machine Hours 20,000

Separated ang fixed at variable:

Fixed factory overhead rate = Estimated fixed factory overhead = P 6.25 per machine hour
Estimated machine hours

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

6.25 + 8.75=15

ACTUAL FACTORY OVERHEAD 50min

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 18,900hrs x P15 rater per machine hr = P283,500 applied
overhead.

Actual and applied 48 min rec

The journal entry to record applied factory overhead:

Work in Process Inventory 283,500
Factory Overhead Control 283,500

The journal entry to record actual factory overhead cost follows:

Factory Overhead Control 292,000

Various Accounts 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.

Credit bal- over applied overhead

Debit bal- under applied?

 Under applied or over applied I aadjust sa end of period

Disposition of Over- or Underapplied Amount

Necessary adjustments:

If the amount of over- or underapplied overhead is insignificant/immaterial , 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 8,500

Factory Overhead Control 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 XXX
Finished Goods Inventory XXX
Cost of Goods Sold XXX
Factory Overhead Control XXX

Example:
Allocate the 8,500

WIP 100,000
Finished goods 200,000
Cogs 150,000
TOTAL 450,000

Answer:
100,000/450,000 x 8500 = 1,888.89
200,000/450,000 x 8500 = 3,777.78
150.000/450,000 x 8500 = 2,833.33
Total 8500

Entry:
Wip 1,888.89
FG3 3,777.78
COGS 2,833.33
Factory overhead control 8,500

CHANGIND 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 of over- or underapplied overhead that will even
itself out during a full year.