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Lesson 4
Accounting for Materials
Objectives
After studying this lesson, the students should be able to:
1. Distinguish between period and perpetual inventory systems in recording materials.
2. Identify the forms involved from the procurement up to the issuance of materials to the actual
production.
3. Recognize the common control mechanisms employed by firms on materials management.
4. Know how to determine the cost of materials inventory.
5. Understand the procedures on how to account spoiled, defective, scrap, and waste materials.
Discussion
4.1. Inventory Systems
In our previous lesson, we assume in our illustrations the use of a perpetual inventory
system to facilitate a better understanding of how each element of manufacturing costs was
inventoried. In this lesson, these two inventory systems will be explained further and more
illustrations will be used to differentiate the two in terms of recording transactions relating to the
accounting of materials.
Perpetual inventory system records every movement in the inventory which keeps the
inventory account always updated while in a periodic inventory system, the inventory will only
be updated once there is a physical count of an inventory conducted. In other words, inventory
account under the periodic inventory system remains the same with the last year’s balance unless
another physical count of inventory is made, such balance will be adjusted as to its actual balance
at the end of the current year.
Journal entries in accounting for materials under the perpetual inventory system were
also illustrated in the previous lesson but did not cover other transactions that are normally
present in the actual situation, so in this lesson, we will present more illustrations and compare
the entries under the two inventory systems as indicated below.

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The preceding journal entries provide that inventory account is always used every time
there is a movement in the materials inventory while periodic inventory system used other
accounts such as purchases, freight in, purchase returns, and purchase discounts. “Purchases” is
an account title used when materials are bought. “Freight In” refers to the amount paid for related
shipping charges and it is also termed as “Transportation In”. “Purchase Returns” is used when
there are materials purchased found to be damaged upon inspection and need to be returned to
the supplier. “is used when discounts are availed for the payment made for the materials
purchased within the discount period. Please take note that in computing the discount, the
balance must be net of purchase returns since it is a deduction of the accounts payable.
Another notable difference is in the recording of actual transfers of materials to the actual
production in which work-in-process inventory and factory overhead control accounts were used
for direct and indirect materials issued respectively.
No entry is made under the periodic inventory system. When the physical inventory is
made, the ending materials inventory will be determined and it is only then that the actual
amount being issued to the production department is determined after deducting ending
inventory from the total materials available for use.
To determine the inventory balance under the two systems, we will just post those
transactions involving the inventory account in the ledger or a T-account. Below is the T-account
made for the raw materials inventory for both systems.

It is clearly illustrated in the ledger that in the perpetual inventory system, the inventory
account is always updated while in the periodic inventory system, the account balance remains
the same with the beginning balance if it has a beginning balance simply because inventory
account was not used in recording transactions occurred during the year. Thus, a physical count
of inventory is needed at the end of the year so the inventory account will be updated. However,
in both inventory systems, the inventory account balance remains equal.
SAQ 4-1
1. Provide journal entries of the following transactions for each type of inventory system.

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2. Prepare a T-account for the raw materials inventory for each inventory system.

Exercise 4-1
1. GHI Corporation is using a periodic inventory system. The following transactions occurred
during the year. You are required to provide the journal entries for each transaction.
1. Purchase raw materials amounting to P 200,000.00 from JSS Company on credit. JSS
Company provides a 3% discount if GHI Corporation will pay its account within 15 days.
2. Paid the transportation charges to the preceding transaction to Roble Shipping Lines
amounting to P 5,000.00.
3. Returned damaged merchandise to JSS Company valued at P 20,000.00.
4. Paid the amount owed to JSS Company within 15 days.
5. Issued materials to the production department amounting to P 130,000.00 of which P
90,000 are direct materials and the rest are indirect materials.
2. Assuming the preceding problem uses a perpetual inventory system, prepare the necessary
journal entries. Also, you are required to prepare a T-account for the raw materials inventory
account.
4.2. Commonly Used Business Forms for Transactions Involving Materials
In a normal business transaction involving materials, certain forms are commonly used.
These include purchase requisition, purchase order, receiving report, and material requisition
slip. These forms usually serve as source documents in transactions which eventually become a
basis in the recording. Thus, these forms are very critical in accounting as these can affect the
account balances.

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In a manufacturing setting, it is normal that there is a purchasing department that is

tasked to purchase the materials needed in the production. This department will act only on
request usually written in a preprinted form which specifies the description of the items, unit,
quantity, unit price, and other data needed to place an order. This form is termed as a purchase
requisition. This form is usually prepared in duplicate copies of which the first copy is forwarded
to the purchasing department while the remaining copy is retained by the requesting department.

When the above form is forwarded to the purchasing department, a purchase order will
be made. This is a written request given to the chosen supplier for a list of goods with complete
details such as description, quantity, agreed prices, delivery terms, and payment agreements. This
serves as evidence of the purchase order made to a certain supplier. If acknowledged by the
supplier, this form constitutes a contract among parties. It is typically prepared in five copies of
which the original is sent to the supplier, a copy is to be retained by the purchasing department
and the rest is to be distributed to the accounting, accounts payable, and receiving departments.
Below is a sample purchase order.

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If the supplier delivers the ordered items, it is received by the receiving departments and
a receiving report is made. This report shows the details on the as indicated in the purchase order
except for the quantity ordered. This ensures that the receiving department will count the items
delivered. The sample below provides an example of how a receiving report looks like. The
receiving department will retain the original copy and the rest will be distributed to purchasing,
accounts payable, accounting, and requisitioning departments.

When the requisitioning department receives a copy of the receiving report alerting them
that the items requested were already received by the receiving department, a material
requisition slip will be prepared and forwarded to the storekeeper for issuance. This form entails
the request of a specific department for materials available in the warehouse. A sample form is
provided below to have a better picture of such a form.

SAQ 4-2
1. What departments should be distributed with copies of receiving reports?
2. List the common forms used involving materials in business transactions.
Exercise 4-2

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1. What do you think are the reasons why the accounting department should have copies of the
purchase order and receiving report?
4.3. Inventory Control Mechanisms
Materials are very critical to a manufacturing business. It is, therefore, a very important
task for manufacturers to have a desired level of inventory primarily to keep the production going
without interruption. However, maintaining an inventory will not always beneficial to companies
especially if it costs them a lot. In other words, inventory will only be valuable if maintaining such
will entail a very minimal cost. To keep the inventory costs at a minimal level, there are commonly
used control procedures which include order cycling, min-max method, two-bin method,
automatic order system, and ABC plan.
Order cycling is a method where the materials needed in the production are ordered on a
regular, periodic, or review basis. This cycle is also termed as a review cycle since the order is
placed at the onset of the review to bring back the desired inventory level. It is only during the
review when and how many are to be ordered.
Min-max method is an inventory control method in which a minimum and maximum levels
of inventory are determined. The minimum level serves as a signal for the company to place an
order to bring back the inventory level to its maximum so as stock out will be prevented.
The two-bin method is an inventory control method in which two bins are maintained.
The first bin, once emptied, alerts the company to place an order. The second bin is utilized until
the order is received to refill both bins.
The automatic order system is an inventory control method that uses computers that
automatically orders suppliers when the inventory reaches the level determined by the company
beforehand.
ABC plan is an inventory control method that categorizes materials into clusters. Each
cluster will have different control mechanisms depending on their characteristics. This applies to
companies whose material requirements are vast.
In controlling materials, it involves physical and investment control. Effective physical
controls include limited access, segregation of duties, and accuracy in recording while effective
investment controls contain the determination of order point and economic order quantity
Providing limited access to the storage warehouse will promote proper monitoring of
materials coming in and out of the warehouse. In this manner, the issuance of materials and
releasing of completed goods will be properly controlled. Conflicting duties such as purchasing,
receiving, storage, production, and recording should be properly segregated to discourage
misappropriation of inventories. Inventories should be accurately valued to come up with
profitable pricing. Without accurate data, it will result in over/undervaluation of inventories in
the financial statements.
To maintain the right amount of inventory, the company must know when to order and
how many to order. The order point is determined using the data on usage, lead time, and safety
stock. Usage is the number of materials used regularly, e.g. daily, weekly, or monthly. Lead time
refers to the interval that the company places the order until it arrives. Safety stock serves as a
buffer stock as protection from running out of stock. Order point can be expressed using this
formula, “Order point = (usage x lead time) + safety stock”. Assuming, JSS Company uses a certain
material at a weekly rate of 10,000 units. It usually takes three weeks from the order is placed

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When the inventory level reaches 32,000 units, JSS Company should make an order to the
supplier.
Economic order quantity (EOQ) refers to the most economical quantity of materials to be
ordered to a supplier. It simply described as the most economic order size which also refers to
the number of quantity to be ordered. This concept considers the information on the ordering
cost, carrying cost, and the total needed materials annually.
Ordering cost refers to the costs incurred every time you make an order. This includes
remuneration of the employees involved in making and completing an order, communication
expenses, and other related costs. Total ordering cost is computed by multiplying the total
number of orders during a production cycle to the cost incurred per order. Carrying cost refers
to the cost of holding an inventory unit from the time it arrives in the warehouse until it is issued
to the actual production. This includes storage and handling, maintaining the warehouse, losses
from theft, deterioration, and obsolescence, and salaries and wages of people involved in holding
these inventories.
Total carrying cost is calculated by multiplying average inventory to carrying cost per
inventory unit. The average inventory is derived by simply dividing the order size by two.
In computing the economic order quantity, the following formula can be used:

Let us consider the following illustrative problem to apply the above formula.
Assuming, MSS Company needs 100,000 liters of oil a year for its food production business. The
cost per order is estimated at P 1,000.00 while the cost of carrying a liter of oil is assessed at P
2.00. Compute the EOQ and the total ordering and carrying costs.
Applying the formula,

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MSS Company must make 10,000 liters of oil each order to achieve the most economical
cost.
After computing the EOQ, we can now compute the total ordering and carrying cost using
this tabular method.

Please take note that the number of orders is computed by dividing the annual
requirement by the order size. In this example, 100,000/10,000=10.
SAQ 4-3
1. What physical controls should companies employ to avoid the incurrence of losses in
accounting for materials?
2. What are the common control procedures in handling materials?
3. What is the difference between ordering and carrying costs?
Exercise 4-3
1. PDSS Inc. uses material at a monthly rate of 20,000 units. It usually takes two months from the
order is placed until it arrives. To avoid from out of stock, the company maintains 3,000 units as
buffer stock. When the company should make an order?
2. ZSS Inc. needs 10,000 sacks of rice a year for its food production business. The cost per order
is estimated at P 10,000.00 while the cost of carrying a sack of rice is assessed at P 50.00. Compute
the EOQ and the total ordering and carrying costs.
4.4. Methods of Inventory Costing
Maintaining an inventory has become normal in many manufacturing firms especially in
avoiding interruptions in production. In cost accounting, inventories must be properly valued as
it relates to preparing the statement of financial position and the statement of financial
performance. Specifically, the value of inventories is very much needed in computing the
statement of cost of goods sold which is also important in computing the total income of the
company. With this significance, the methods of costing inventories must be taken into
consideration. Inventory costing would not be a problem if only there are no changes in prices of
the inventories which are impossible since prices in the market will change from time to time.
There are three common methods employed in costing inventories namely, First-in, Firs-
out (FIFO), weighted average, and moving average cost method.
Under the FIFO method, it is assumed that manufacturing companies utilized those
materials entered the warehouse first and should be taken out to the production units. It is very
much helpful especially when the materials needed have expirations. In this manner, spoilage will
be minimized as those items nearing expirations will be forwarded first to the production area.
To better understand this concept, let us make use of the following illustrative example.

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Assuming that the company is employing a periodic inventory system, the physical count
of inventory reveals that the number of units remaining at the end of the month is 170 units. What
does the total ending inventory cost?
Under the periodic system, to determine the value of ending inventory, the cost of the
remaining units will be assigned based on the most recent costs.

After determining the value of ending inventory, the cost of direct materials issued to the
production will now be determined using the following format.

If the company is employing a perpetual inventory method, the inventory is always

updated. Below is a sample stock card to illustrate how the inventory was computed.

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Based on the above stock card, the ending inventory as of February 28 is computed by
adding 160.00+405.00+208.00=773.00 while the total of materials issued is computed by adding
(80 units at 5.00 + 20 units at 5.00 + 10 units at 4.00) = 400.00 + 100.00 + 40.00 = 540.00.
If we are going to compare both methods, it yields the same cost of ending inventory and
the cost of materials issued.
Weighted average cost method (WACM) is applied when the company is employing a
periodic inventory method in which the weighted average unit cost is first computed and then
multiplied to the ending inventory to get the total ending inventory cost. Using the same above
illustration, the weighted average unit cost is computed as follows.

Total units are calculated by adding the beginning inventory units and units purchased
and its associated costs are added to get the total costs. Then, the total cost is divided by the total
units to get the weighted average unit cost.

Moving average cost method (MACM) is used when a firm is using a perpetual inventory method
in which the average unit cost is updated whenever there is a purchase being made. Using the
same above illustration, the moving average unit cost is determined as follows.

Based on the above table, the ending inventory determined at its balance amounting to
806.00 while the total of materials issued is computed by adding (80 units at 4.60 + 30 units at
4.60) = 368.00 + 138.00 = 506.00.
To compare the three methods, we can notice some differences in the amount. Please
observe that sometimes there is a slight difference between computed values primarily due to
rounding off.

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SAQ 4-4
1. Which of the average method would be most appropriate to be used if the company is using the
periodic inventory method?
2. Is the cost of inventory always equal under the FIFO method regardless of the inventory method
being used by a manufacturing firm?
Exercise 4-4
1. The following transactions occurred for ZDSS Corp. for the month of March 2020. Compute the
cost of ending inventory and cost of materials used using the FIFO, weighted average cost method,
and moving average cost method.

4.5. Accounting for Spoiled, Defective, Scrap and Waste Materials

In the actual situation, it is inevitable that there will always be materials being spoiled,
defective, scrapped, and wasted. These common occurrences in a manufacturing firm entail
different accounting treatments.
Spoiled materials are materials that do not meet the standards and no further work can
be done and need to be taken out from the production. Since these materials are integrated into
the work-in-process inventory account, a reversing entry should be made to deduct the
corresponding spoiled materials. If it is charged against all production, then it is debited to factory
overhead control.
Defective materials are materials that do not meet the standards but can still be used if
further work is done. Since work is needed, the accompanying cost shall be debited as factory
overhead control if charged against all production unless for a specific job, then it is debited to
work-in-process inventory.
Scrap materials are leftover materials that can be used for other purposes and can still be
sold to outsiders. If it is traceable to a specific job, the sales proceeds are treated as a deduction
to the work-in-process inventory otherwise it is credited as miscellaneous income.
Waste materials are still leftover but of no resale value and require another cost to dispose
of this kind of material. If this waster material is traceable to a specific job, then it is debited as

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work-in-process inventory otherwise it is debited as factory overhead control. The complexities

of the accounting procedures of this kind of material are explained further in cost accounting
subjects.
SAQ 4-5
1. What is the difference between spoiled and defective materials?
2. What is the difference between scrap and waste materials?
Exercise 4-5
1. Why is it necessary to study these kinds of materials in cost accounting?
Summary
1. Perpetual inventory system records every movement in the inventory which keeps the
inventory account always updated while in a periodic inventory system, the inventory will only
be updated once there is a physical count of an inventory conducted.
2. In a normal business transaction involving materials, certain forms are commonly used which
include purchase requisition, purchase order, receiving report, and material requisition slip.
3. To keep the inventory costs at a minimal level, there are commonly used control procedures
which include order cycling, min-max method, two-bin method, automatic order system, and ABC
plan. In controlling materials, it involves physical and investment control. Effective physical
controls include limited access, segregation of duties, and accuracy in recording while effective
investment controls contain the determination of order point and economic order quantity.

4. There are three common methods employed in costing inventories namely, First-in, First-out
(FIFO), weighted average, and moving average cost method.
5. Accounting treatments for spoiled, defective, scrap and waste materials vary depending on its
nature and can be charged either against all products or to a specific job.

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Answer to Self-Assessment Questions

ASAQ 4-1

ASAQ 4-2
1. The receiving department will retain the original copy and the rest will be distributed to
purchasing, accounts payable, accounting, and requisitioning departments.
2. Purchase requisition, purchase order, receiving report and material requisition slip
ASAQ 4-3
1. Limited access, segregation of duties and accuracy of recording
2. Order cycling, min-max method, two-bin method, automatic order system, and ABC plan
3. Ordering cost refers to the total cost associated with placing an order while carrying cost refers
to the cost of handling an inventory unit.
ASAQ 4-4
1. Weighted average cost method
2. Yes
ASAQ 4-5

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1. Spoiled materials are materials that do not meet the standards and no further work can be done
and need to be taken out from the production while defective materials are materials that do not
meet the standards but can still be used if further work is done.
2. Scrap materials are leftover materials that can be used for other purposes and can still be sold
to outsiders while waste materials are still leftover but of no resale value and it requires another
cost to dispose of this kind of material.
Suggested Readings
1. Read pp. 157-186, Cost Accounting (2016) by Norma D. De Leon et al.
References
1. Aliling, L. E. & Anastacio, M. L. (2015). Management Accounting 1. Manila, Philippines: Rex Book
Store.
2. De Leon, N. D., De Leon, E. D., and De Leon, G. M. (2016). Cost Accounting 2016 Edition. Manila,
Philippines: GIC Enterprises & Co. Inc.
3. Nobles, T. L., Mattison, B. L. & Matsumura, E. (2015). Horngren's Accounting Tenth Edition
Global Edition. USA: Pearson Education Limited.

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Lesson 5
Accounting for Labor
Objectives
After studying this lesson, the students should be able to:
1. Define the different wage plans.
2. Know the procedures for controlling labor costs.
3. Describe the procedures in accounting labor costs.
4. Prepare payroll.
5. Recognize how to account for special remunerations.

Discussion
5.1. Wage Plans
Labor is very essential in the conversion of raw materials into finished goods. Employees
who are hired for the production are remunerated either through salaries if fixed payments such
as monthly and wages if payments are made on an hourly and weekly basis. Other than salaried
employees, most of the employees in a manufacturing setting are paid depending on the wage
plan being employed by the company. Some of these are the hourly-rate plan, piece-rate plan, and
modified wage plan. In an hourly rate plan, employees are paid for every hour of service. This is
commonly applied to part-time jobs in which an employee can only devote a little time to the
company. In this plan, the wages are computed by multiplying the rate per hour to the number of
hours rendered. A piece-rate plan is used when employees are paid based on the number of pieces
produced. Under this plan, wages are computed by multiplying rate per piece to the number of
pieces produced by the employee. A modified wage plan is a combination of an hourly-rate plan
and a piece-rate plan. In this plan, employees are first paid on an hourly basis regardless of
meeting the quota or not, otherwise, over the quota will be paid on per piece basis.
SAQ 5-1
1. How to compute the wages of employees under the piece-rate plan?
Exercise 5-1
1. What do you think is the most favorable wage plan for companies engaging in the production
of furniture?
5.2. Labor Cost Control Mechanisms
Computing labor costs heavily rely on the records maintained by the company. Needless
to say, labor records must be kept accurately so as the employees are paid fairly as to rendered
services at the same time, the company can reliably account the total labor cost associated with
the production. It is the responsibility of the payroll department in computing earnings per
employee as well as the corresponding deductions if any. This department also maintains the
following records such as payroll records, employee’s earning records, and payroll summaries.
The payroll summary provides a basis for distributing payroll to the appropriate accounts as it
summed up direct and indirect labor costs. The time-keeping department maintains the following
records such as clock cards, time tickets, production reports to control the actual labor provided

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by the employees to the production. A clock card, also known as time card or time ticket, is a
document that accounts for the hours each employee works during a period. Production reports
are used when labor costs are calculated using piece-rate.
SAQ 5-2
1. What department is responsible for the computation of earnings for the services rendered by
employees?
Exercise 5-2
1. Is it possible to compute the wages of all employees with labor records? Justify your answer.
5.3. Accounting for Labor Costs
Labor costs include direct and indirect components. Direct labor is debited to workin-
process inventory when assigned while indirect labor is debited as factory overhead control.
Direct labor may be computed depending on the wage plan being implemented by the company.
However, if such labor is not product related, then it is recorded as part of the general and
administrative or sales and marketing expenses whichever is more applicable.
Assuming, ZDSS Corporation hires employees using an hourly rate plan. Each employee
will work for eight hours a day and earn P 40.00 per hour. When an employee is requested to
work beyond the regular working hours and overtime pay will be paid at a premium rate of 100%.
Let say, the employee was requested to work for another four hours during that day. Compute
the total wages earned by the employee on that day.

If the total earnings can be attributed to a specific job, it is debited to work-inprocess

inventory otherwise it shall be recorded as factory overhead control. In most cases, overtime can
be traced directly to specific jobs. The entries below illustrate how direct labor should be
recorded in the books.
Work-in-Process Inventory 640.00
Accrued Payroll 640.00
Assuming further that said labor is indirect labor since it cannot be assigned to a specific
job, it will be recorded in the books as follows.
Factory Overhead Control 640.00
Accrued Payroll 640.00
Assuming further that said labor is tasked in general and administrative services of the
company, it will be recorded in the books as follows.
General and Administrative Expenses 640.00
Accrued Payroll 640.00

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SAQ 5-3
1. How should direct and indirect labor incurred by a manufacturing company be recorded in the
books?
Exercise 5-3
1. PZDS Inc. hires employees using a weekly-rate plan. Each employee will work six days a week
and earn P 500.00 per day. Assuming that week, the employee completed five days of work.
Compute the wages earned by the employee.
5.4. Payroll Preparation
Payroll is a document prepared as evidence of the computation of the total earnings made
by a group of employees. It also shows the basic deductions normally withheld by companies as
this is mandated by law such as contributions to SSS, PhilHealth, Pagibig, and withholding taxes
if any. These are deducted from the gross earnings made by the employee.
SSS premiums are contributed by private employees to the Social Security System
primarily for retirement pension benefits, however, an employee can avail other services such as
salary loan if warranted. Normally, each employee must contribute 12% of the gross monthly
earnings to the SSS to be shared by employees (4%) and employer (8%). PhilHealth premiums
are contributed to PhilHealth Insurance Corporation for hospitalization benefits. Each employee
must contribute 3% from the monthly gross earnings to the PhilHealth to be shared equally by
the employee and employer. Pag-ibig premiums are remitted to Home Development Mutual Fund
for housing plans of employees at a rate of 3% from the basic earnings or P 100.00 whichever is
lower. The employer will also contribute equally to the contribution of the employee. Pag-ibig
provides loan services to employees such as multipurpose, salary, and calamity loans. If an
employee whose net taxable income exceeds P 250,000.00 a year, then such an employee must
pay income tax for compensation based on the Bureau of Internal Revenue schedule.
Assuming that Portia Company prepares the following payroll summary for the three
employees for the period covered March 1-31, 2020. The following assumptions are considered
in the preparation of payroll:
o Employee A is paid monthly of P 30,000.00, Employee B is compensated weekly of P
5,000.00; Employee C is paid on an hourly basis of P 60.00. As of March 31, 2020,
Employee A incurred no absences while Employee B worked for only three weeks.
Moreover, Employee C rendered only 200 hours during the month.
o SSS premiums are computed as 12% of gross earnings per month of which 8% for the
employer and 4% for employees.

o Pag-ibig contribution per employee is P 100.00 per month and the same amount as
counterpart by the employer.
o PhilHealth contribution is calculated as 3% of the gross earnings per month to be shared
equally by the employer and the employee.

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SAQ 5-4
1. What are the common deductions from the gross monthly earnings of employees in preparing
a payroll?
Exercise 5-4
Assuming that Zachary Company prepares the following payroll summary for the three
employees for the period covered February 1-28, 2020. The following assumptions are
considered in the preparation of payroll:
o Employee X is paid monthly of P 40,000.00; Employee Y is compensated weekly of P
6,000.00; Employee Z is paid on an hourly basis of P 70.00. As of February 28, 2020,
Employee X incurred no absences while Employee Y worked for only two weeks.
Moreover, Employee Z rendered only 300 hours during the month.
o SSS premiums are computed as 12% of gross earnings per month of which 8% for the
employer and 4% for employees.
o Pag-ibig contribution per employee is P 100.00 per month and the same amount as
counterpart by the employer.
o PhilHealth contribution is calculated as 3% of the gross earnings per month to be shared
equally by the employer and the employee.
Prepare payroll for the month of February 2020.
5.5. Accounting for Special Remunerations
Compensations provided to employees vary from company to company. In most cases,
shift premiums, leave benefits, bonuses, and allowances are provided to employees as they are
mandated by the law. These are recorded in the books depending on where such labor can be
associated. If such labor, be it direct or indirect is assigned in the production unit, then it is part
of the product costs. If such labor is assigned to the non-production units, then it is categorized
as a period cost and to be expensed outright.
Shift premiums are given to workers who are assigned to undesirable hours such as night,
holiday, and weekends. It is but fair enough that a differential pay must be given to those
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employees assigned in those shifts. Leave benefits are provided to employees allowing them to
take time off from their job. It can be either paid or unpaid. Providing leave incentives to
employees promote labor productivity in return. Bonuses are given to employees as incentives
or rewards for providing exemplary performance to the company. There are regular bonuses as
mandated by law to be provided to qualified employees. There are also extra bonuses given to
outstanding employees. Allowances are given to employees for special purposes such as
communication, housing, traveling, and other activities needing extra money to be given to
employees in exercising their regular functions.
SAQ 5-5
1. What is the difference between bonuses and allowances?
Exercise 5-5
1. Make an interview with some employees regarding their benefits received from their
respective companies. Make a list of these benefits and describe each.
Summary
1. Common wage plans implemented by companies include an hourly-rate plan, a piece-rate plan,
and a modified wage plan.
2. Payroll and time-keeping departments are tasked to employ necessary controls in accounting
for labor costs as they are directly involved in the computation of the earnings for each employee.
3. Labor costs are accounted in the books depending on their nature such as production and non-
production related. Production related labor costs are either recorded as work-in-process and
factory overhead control while nonproduction related are expensed outright.
4. The preparation of payroll considers the actual services rendered by each employee, labor rate,
and other mandatory deductions as provided by law.
5. Special remunerations include shift premiums, leave benefits, bonuses, and allowances.
Assignment 5-1
A production plant pays its workers on a modified wage plan basis. A bonus is paid if the actual
output exceeds the standard allowable output. The bonus rate is P 2.00 per excess output. How
much will each of the following employees earn for the week?

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Answer to Self-Assessment Questions

ASAQ 5-1
1. Wages are computed by multiplying rate per piece to the number of pieces produced by the
employee
ASAQ 5-2
1. Payroll department
ASAQ 5-3
1. Direct labor is debited to work-in-process inventory when assigned while indirect labor is
debited as factory overhead control.
ASAQ 5-4
1. Basic deductions normally withheld by companies include contributions to SSS, PhilHealth,
Pag-ibig, and withholding taxes if any.
ASAQ 5-5
1. Bonuses are given to employees as incentives or rewards for providing exemplary performance
to the company while allowances are given to employees for special purposes such as
communication, housing, traveling, and other activities needing extra money to be given to
employees in exercising their regular functions.
Suggested Readings
1. Read pp. 245-253, Cost Accounting (2016) by Norma D. De Leon et al.
References
1. Aliling, L. E. & Anastacio, M. L. (2015). Management Accounting 1. Manila, Philippines: Rex Book
Store.
2. De Leon, N. D., De Leon, E. D., and De Leon, G. M. (2016). Cost Accounting 2016 Edition. Manila,
Philippines: GIC Enterprises & Co. Inc.
3. Nobles, T. L., Mattison, B. L. & Matsumura, E. (2015). Horngren's Accounting Tenth Edition
Global Edition. USA: Pearson Education Limited.

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Lesson 6
Accounting for Factory Overhead
Objectives
After studying this lesson, the students should be able to:
1. Categorize factory overhead costs.
2. Compute the predetermined overhead rate.
3. Apply factory overhead using a predetermined overhead rate.
4. Account factory overhead costs including variance.
Discussion
6.1. Categories of Factory Overhead Costs
Factory overhead is categorized as variable overhead, fixed overhead, and mixed
overhead. Variable factory overhead costs are overhead costs that vary in total as the production
output changes. It remains constant per unit. As the production output increases, the total
variable overhead costs also increase. Fixed factory overhead costs are overhead costs that
remain in total and vary per unit. As production increases, fixed overhead costs per unit
decreases. Mixed factory overhead costs are overhead costs that have the characteristics of both
variable and fixed overhead. These concepts are very essential in cost accountings systems which
are discussed in the succeeding module.
SAQ 6-1
1. What are the three categories of factory overhead costs?
Exercise 6-1
1. Put a checkmark on the type of overhead cost to where each of the listed expenses below
belongs.

6.2. Predetermined Overhead Rate

Actual overhead costs are usually determined at the end of the production cycle; thus it
would be hard to determine the pricing of products if total costs will not be known beforehand.
This problem gives rise to the use of estimates so as product costing will be facilitated and the
corresponding price will be easily determined. Unlike labor and materials, overhead costs are

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difficult to control since it covers several production-related expenses. Thus, estimated or

budgeted factory overhead is allocated to various products using a predetermined overhead rate.
With this rate, products will be costed easily and can be sold immediately.
Predetermined overhead rate is an allocation rate of estimated factory overhead costs
among cost objects or departments for a specified period. Predetermined overhead rate is
computed using the traditional methods which include production units, direct labor cost
method, direct labor hour method, and machine hour method, and activity-based costing method.
In units of production method, the overhead rate is computed by dividing the estimated
factory overhead costs by estimated units of production.

In the direct labor cost method, the overhead rate is computed by dividing the estimated
factory overhead costs by estimated direct labor cost.

In the direct labor hour method, the overhead rate is calculated by dividing the estimated
factory overhead cost by estimated direct labor hours.

Under the machine hour method, the overhead rate is computed by dividing the estimated
factory overhead cost by estimated machine hours.

Assuming, Dominic, Inc. estimates its factory overhead for the next period at P
600,000.00. It is estimated that 20,000 units will be produced and will require 30,000 direct labor
hours at an estimated cost of P 300,000.00. The machines will run about 100,000 hours. You are
required to determine the predetermined factory overhead rate based on the following: units of
production, direct labor cost, direct labor hours, and machine hours.
1. Units of Production

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2. Direct Labor Cost

3. Direct Labor Hours

4. Machine Hours

In an activity-based costing method, each type of overhead has its specific overhead rate
using the most appropriate cost driver. In this method, cost drivers are very important since it
connects the cost, activity, and the product. Overhead costs are first allocated to activity cost pools
and each cost pool allocates overhead costs to products using cost drivers. In this manner, the
overhead cost is allocated fairly and products will be costed properly.
Assuming, MSS Corp. engaged in bread and pastry production which has the following
departments namely, mixing, fermenting, baking, cooling, and packaging. The illustration below
demonstrates how overhead costs are allocated to cost pools and cost pools down to the products.
In our illustration, cost pools are mixing, fermenting, baking, cooling, and packaging. Machine
hours are cost drivers for mixing and baking activities while space area for fermenting and
cooling. Labor hour is the cost driver for packaging. Using the cost drivers, cost pools are allocated
to the products namely, bread, cookies, and cakes.
Assuming further, MSS Corp. estimated that it will produce in the next year 20,000 pieces
of bread, 40,000 pieces of cookies, and 5,000 pieces of cakes. MSS Corp also projected that the
total overhead costs are P 300,000.00 with the following allocation:

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In computing the overhead rate per cost pool, simply divide estimated overhead cost per
cost pool by the estimated usage per cost pool.

After computing the overhead rates, compute the allocated overhead cost per cost pool
per product by multiplying the overhead rate by the usage allocation per cost pool per product.
To get the total allocation per product, sum up the allocated cost per cost pool per product.

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In a big manufacturing company, different departments are established to work for

specific jobs. These departments, in most cases, shared common expenses among them. It would
not be appropriate to apply a single allocation rate among departments especially if the
department is producing multiple products. In this situation, the allocation of common costs
among departments is done using multiple allocation bases. These common costs can be labor-
related, machine-related, space-related, and service-related. In each related cost, there is a more
specific allocation basis in which the allocation of this particular cost among departments is
proportionately shared. In this manner, the departmental cost would most likely provide reliable
information to top-level management especially in controlling costs centers.
Three methods are being used in allocation common costs among departments namely,
direct method, step method, and algebraic method. In the direct method, the common costs are
allocated directly to the producing department. In the step method, the allocation of common
costs will be done on a sequential basis in which the cost of one service department will be shared
first to the remaining departments. The same procedure will be done until all the costs of service
departments are allocated to the producing departments. In the algebraic method, all services
available mutually by each department are considered first before the allocation will be done. An
algebraic formula will be generated to allocate the costs of each serving department among them
which eventually will zero-out the costs of the servicing departments. Thus, it is also called a
reciprocal method.
It will be explained further in management accounting and cost accounting subjects.
SAQ 6-2
1. What are the methods of calculation predetermined factory overhead rates?
2. Which of the methods do you think would give the proper allocation of overhead costs? Why?
Exercise 6-2
1. Carla, Inc. estimates its factory overhead for the year 2021 at P 200,000.00. It is estimated that
5,000 units will be produced and will require 5,000 direct labor hours at an estimated cost of P
50,000.00. The machines will run about 20,000 hours. You are required to determine the
predetermined factory overhead rate based on the following: units of production, direct labor
cost, direct labor hours, and machine hours.
2. ALS Corp. is engaged in the bakery business and most producing different types of bread. It is
estimated that it will produce in the next year 100,000 pieces of Pandesal, 50,000 pieces of Elorde,
and 40,000 pieces of Shakoy. ALS Corp also projected that the total overhead costs are P
100,000.00 with the following allocation:

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Applying the ABC costing, you are required to compute the overhead rate per activity cost pool
and to allocate the overhead costs among the three bread products.
6.3. Application of Factory Overhead Costs
We have discussed in the preceding topics the importance of overhead rates in allocating
overhead costs among products for them to have a basis in making cost estimates for a particular
product as an input in setting a price. When overhead costs are allocated using overhead rates,
this shall be called applied factory overhead and recorded in the books as factory overhead
applied. Since this is based on estimates, there will always be a difference compared to actual
overhead expenses. This difference is termed factory overhead variance. This variance is
classified into two: under applied overhead when the actual is greater than the applied overhead
and over applied overhead when the applied is greater than the actual overhead. Variances
usually occur when there is a difference between the actual overhead from the budgeted
overhead and this is called spending variance and when there is a difference between the
budgeted and the actual capacity or activity level and this is called volume variance. If the actual
cost is greater than the budgeted cost, it is called as unfavorable variance, otherwise, it is
favorable variance.
This will be discussed further on standard costing.
SAQ 6-3
1. What is the difference between under applied and over applied overhead?
2. What is the difference between spending and volume variance?
Exercise 6-3
1. Which is good to the company, favorable or unfavorable variance? Why?
6.4. Accounting Factory Overhead Costs
Actual overhead costs are incurred on a day-to-day basis. In recording these costs, companies
may use non-controlling or controlling account systems. In the non-controlling account system,
each kind of overhead cost is recorded separately per ledger.
Factory Overhead Expenses xxx
Cash xxx
In a controlling account system, a controlling account is used to record all the overhead
costs incurred. It is usually recorded as factory overhead control.
Factory Overhead Control xxx
Cash xxx
In applying the factory overhead to the products using overhead rates, below is the illustrative
journal entry.
Work-in-Process Inventory xxx
Factory Overhead Applied xxx

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If there is under applied factory overhead and it is immaterial, it is closed to the cost of goods
sold. If it is material, it is prorated to work-in-process inventory, finished goods inventory and
cost of goods sold.
If immaterial,
Cost of Goods Sold xxx
Factory Overhead Applied xxx
If material,
Work-in-Process Inventory xxx
Finished Goods Inventory xxx
Cost of Goods Sold xxx
Factory Overhead Applied xxx
If there is over applied factory overhead and it is immaterial, it is closed to the cost of
goods sold. If it is material, it is prorated to work-in-process inventory, finished goods inventory
and cost of goods sold.
If immaterial,
Factory Overhead Applied xxx
Cost of Goods Sold xxx
If material,
Factory Overhead Applied xxx
Work-in-Process Inventory xxx
Finished Goods Inventory xxx
Cost of Goods Sold xxx
SAQ 6-4
1. What is the difference between controlling and non-controlling account system of accumulating
overhead costs?
Exercise 6-4
1. Provide the journal entries of the following transactions assuming the company is using a
controlling accounting system.
a. Paid actual overhead expenses in cash amounting to P 10,000.00.
b. The company assigned factory overhead to the production of 990 units at P 10.00 each.
c. The company found an immaterial difference between actual and applied overhead and
closed the said difference accordingly
Summary
1. Factory overhead is categorized into variable, fixed, and mixed factory overhead.

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2. The predetermined overhead rate is calculated using traditional and activitybased costing
methods and is used in applying factory overhead to the production.
3. Factory overhead is applied to the production using overhead rates which may result in
under/over applied if there is a difference between the actual from the budgeted factory
overhead.
4. Actual overhead costs are recorded either by the controlling account system or non-controlling
account system.
Assignment 6-1
1. Sera, Inc. projects its factory overhead for the year 2021 at P 100,000.00. It is estimated that
10,000 units will be produced and will require 10,000 direct labor hours at an estimated cost of
P 90,000.00. The machines will run about 15,000 hours. You are required to determine the
predetermined factory overhead rate based on the following: units of production, direct labor
cost, direct labor hours, and machine hours.
Answer to Self-Assessment Questions
ASAQ 6-1
1. Factory overhead costs are categorized as a variable, fixed, and mixed factory overhead.
ASAQ 6-2
1. Predetermined factory overhead rates are calculated using traditional and activity-based
costing methods. Traditional methods usually include units of production, direct labor cost, direct
labor hours, and machine hours as allocation base in computing overhead rate.
2. ABC costing would provide the best allocation of overhead costs since it uses specific cost
drivers that link cost, activity, and products.
ASAQ 6-3
1. Underapplied overhead occurs when the actual overhead is greater than the applied overhead
while over applied overhead occurs when applied overhead is greater than the actual overhead.
2. Spending variance occurs when there is a difference between actual overhead and budgeted
overhead while volume variance occurs when there is a difference between budgeted from actual
capacity.
ASAQ 6-4
1. The controlling account system uses a controlling account in recording actual overhead
expenses while a non-controlling account system uses a specific account per actual expense
incurred.
Suggested Readings
1. Read pp. 205-223, Cost Accounting (2016) by Norma D. De Leon et al.
References
1. Aliling, L. E. & Anastacio, M. L. (2015). Management Accounting 1. Manila, Philippines: Rex Book
Store.

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2. De Leon, N. D., De Leon, E. D., and De Leon, G. M. (2016). Cost Accounting 2016 Edition. Manila,
Philippines: GIC Enterprises & Co. Inc.
3. Nobles, T. L., Mattison, B. L. & Matsumura, E. (2015). Horngren's Accounting Tenth Edition
Global Edition. USA: Pearson Education Limited.

PRICING AND COSTING MANILYN E. ABAQUITA