CHAPTER 4

ACCOUNTING FOR
FACTORY OVERHEAD
LEARNING OBJECTIVES
Ide nti fy cos t be havi or patterns

Separate semivariable costs into variable and fixed

components

P re pare a budge t for factory overhead cos ts

Account for actual factory overhead

Distribute service department factory overhead costs

to production departments.

Apply factory overhead using predetermined rates.

Account for actual and applied factory overhead

FACTORY
OVERHEAD
• Overhead costs are a very big deal costing
companies, large and small, thousands of
dollars each year.
• It must be allocated in a rational way to all
jobs produced during the period.
• All costs incurred in the factory that are not
chargeable directly to the finished product
are called factory overhead.
FACTORY OVERHEAD
INCLUDES:
• Indirect materials consumed in the factory,
such as glue and nails in the production of
wooden furniture and oil used for maintaining
factory equipment.
• Indirect factory labor, such as wages of
janitors, forklift operators and supervisors, and
overtime premiums paid to all factory workers.
• All other indirect manufacturing expenses, such
as insurance, property taxes, and depreciation
on the factory building and equipment.
COST BEHAVIOR PATTERNS
COST BEHAVIOR
PATTERNS
• Variable costs are costs that vary in
direct proportion to volume changes.
• Fixed costs are costs that remain the
same in total, when production levels
increase or decrease.
• Semivariable costs have
characteristics of both variable and
fixed costs.
TYPES OF
SEMIVARIABLE:
• Type A: Changes as various levels of
production are reached. The increases
are not continuous, and costs will plateau
before another cost change occurs.
• Type B: Varies continuously, but not in
direct proportion to volume changes
because the cost has a variable and a
fixed component.
ANALYZING
S EMIVARIABLE
F ACTORY
O V ERHEAD C O S TS
• It is important for companies to be able to
determine patterns in cost behavior.
• Basic Model in Predicting Costs based on
Production Levels:
Total Costs = Fixed Costs + Variable
Costs
ANALYZING
S EMIVARIABLE F ACTORY
O V ERHEAD C O S TS
• Observation Method relies heavily on the
ability of an observer to detect a pattern of
cost behavior by reviewing past cost and
volume data.
• High-Low Method compares a high
production volume and its related cost to a
low production volume with its related cost.
HIGH -LOW METHOD - SOLVING
 HIGH -LOW METHOD - SOLVING
• Projected Factory Overhead Costs:
Cost per Unit = Estimated Factory Overhead ÷ Number of Units Produced
 HIGH -LOW METHOD - SOLVING
• Cost Formula (Semivariable) = a + bx
a = fixed cost
b = variable cost per unit
x = number of units produced
 HIGH -LOW METHOD - SOLVING
• Cost Formula (Variable) = b(x)
b = variable cost per unit
x = number of units produced
 SCATTERGRAPH
METHOD
estimates a str aig ht line along
which the semivar iable costs will
fall. A line is dr awn by visual
inspection r epresenting the tr end
shown by most of the data points.
U sually, an equal number of data
points fall above and below the line.
LIMITATIONS OF HIGH -
LOW & SCATTERGRAPH
METHODS
• The high-low and statistical scattergraph
methods use historical cost patterns to predict
future costs and are, therefore subject to
limitations that apply to all forecasting
techniques.
• The high-low method bases its solution on two
observations and assumes that all other
unanalyzed relationships will fall along a straight
line between these selected observations.
LIMITATIONS OF HIGH -
LOW & SCATTERGRAPH
METHODS
• The major disadvantage of the
scattergraph method is that the cost line is
drawn through the data points based on
visual inspection rather than mathematical
techniques.
• Statistical software packages are often
used to analyze semivariable factory
overhead.
LEAS T -SQUARES
REG RE SSION METH OD
uses all of the data to separate a semivariable
cost into its fixed and variable elements based
on the equation for a straight line:
Y = a + bX, where:
X = activity level
Y = the total semivarible cost
a = the total fixed cost
b = the variable cost per unit
 LEAST -SQUARES
REGRESSION METHOD
• Example
LEAST -
SQUARES
REGRESSION
METHOD
BUDGETING FACTORY
OV ER HEAD COSTS
• Budgets are management’s operating plans
expressed in quantitative terms, such as
units of production and related costs.
• The segregation of fixed and variable cost
components permits the company to
prepare a flexible budget. A flexible budget
is a budget that shows estimated costs at
different production volumes.
BUDGETING FACTORY
OV ER HEAD COSTS
(EX AMPLE)
Assume that management desires to budget
factory overhead costs at three levels of
production: 10,000, 20,000, and 40,000
units. The variable factory overhead cost is
$5 per unit, and fixed overhead costs total
$50,000. The budgeted costs at these
volumes are as follows:
 BUDGETING FACTORY
OVERHEAD COSTS
FO per Unit = Total Factory Overhead ÷ Level of Production
ACCOUNTING FOR
ACTUAL FACTORY
OVERHEAD
• Cost accounting systems are designed to
accumulate, classify, and summarize the
factory overhead costs actually incurred.
• The subsidiary ledger is known as the
factory overhead ledger, and the control
account is titled “Factory Overhead” or
“Manufacturing Overhead.”
RELATIONSHIP OF
CONTROL ACCOUNT
TO FACTORY
OVERHEAD LEDGER
 FACTORY OVERHEAD
ANALYSIS
SPREADSHEETS
If a company having multiple production
departments lacks a sophisticated accounting
software package, it may choose to use factory
overhead analysis spreadsheets to keep a
subsidiary record of factory overhead expenses
rather than expanding the factory overhead
general ledger to include separate accounts for
each department’s share of different expenses.
 EXPENSE -TYPE ANALYSIS
SPREADSHEET
provides a separate amount column for each department, making it possible to
distribute charges among departments as expenses are recorded.
• Factory Overhead Analysis Spreadsheet – Expense Type
DEPARTMENT -TYPE
ANALYSIS SPREADSHEET
provides a separate amount column for each kind of
expense. This makes it possible to distribute expenses on
a departmental basis as they are recorded. Each column
representing a different expense.
SCHEDULE
OF FIXED
COSTS
GENERAL FACTORY
OVERHEAD EXPENSES
General factory overhead expenses not
identified with a specific department are
charged to departments by a process of
allocation. This allocation is usually made on a
logical basis.
SUMMARY OF FACTORY OVERHEAD
DISTRIBUTING
SE RVICE DEPARTME NT
E XPENSES
• Departments are divided into two classes:
service departments and production
departments.
• A service department is an essential part of
the organization, but it does not work directly
on the product.
• A production department performs the actual
manufacturing operations that physically
change the units being processed.
DIRECT DISTRIBUTION
METHOD
• Direct Distribution Method distributes service
department costs only to production
departments, even though the service
departments perform services for other service
departments.
• This method ignores the extent to which one
service department renders its services to
another service department. Instead, the service
department’s costs are allocated directly and
only to the production departments.
DIRECT DISTRIBUTION METHOD
SEQUENTIAL
DISTRIBUTION OR
STEP -DOWN METHOD
• distributes service department costs regressively
to other service departments and then to
production departments. There are many ways to
determine the order in which to allocate service
department costs:
⚬ The number of other departments served
⚬ The magnitude of total costs in each service
department
• Sequential Distribution Method recognizes the
interrelationships of the service departments.
SEQUENTIAL DISTRIBUTION METHOD
SEQUENTIAL DISTRIBUTION METHOD
• The completed worksheets are the basis for a series of general journal entries.
The following entries are based on the sequential distribution method:
 SEQUENTIAL DISTRIBUTION METHOD
• The allocation of service department costs would be journalized as allows:
SEQUENTIAL DISTRIBUTION METHOD
RECIPROCAL
METHOD
• takes into consideration that some service
departments not only may provide service to, but
also may receive service from, other service
departments.
• To illustrate the distribution process, assume a
company has three service departments:
maintenance, human resources, and a power plant,
which provide services to four production
departments, A, B, C and D.
APPLYING FACTORY
OVERHEAD TO
PRODUCTION
• Predetermined factory overhead rates are
computed by dividing the budgeted factory
overhead cost by the budgeted production.
• The budgeted production may be expressed in
such terms as machine hours, direct labor hours,
direct labor cost, and units produced.
• Management should give a high priority to attaining
the most accurate predetermined factory
overhead rate.
DIRECT LABOR COST
METHOD
uses the amount of direct labor cost that has been charged
to the job as the basis for applying factory overhead.
DIRECT LABOR HOUR
METHOD
overcomes the problem of varying wage rates by applying factory
overhead using the number of direct labor hours worked on a job
or process.
MACHINE HOUR
METHOD
requires substantial preliminary study before installation, and
an additional quantity of records needs to be maintained.
ACTIVITY -BASED
COSTING METHOD
recognizes that not all costs may be classified
as fixed or variable and considers these non-
volume-related activities that create overhead
costs, such as the number of machine setups or
product design changes required of a particular
product line.
ACTIVITY -BASED
COSTING METHOD
ABC provides a different method of classifying the
behavior of factory overhead costs:
• Unit-level Costs are incurred each time a unit is
processed
• Batch-level Costs might include machine setup
or material movement costs
• Product-level Costs are incurred to support a
particular product or type of product
• Facility-level Costs are costs which provide the
capability for the plant to produce products
TO S UC C E SSFULLY
EMPLO Y A N A BC S YS TEM,
A CO MPANY MUS T:
• First, identify non-volume-related factory activities that
create costs.
• Second, to decide on the cost driver, or the basis used to
allocate each of the activity post pools.
• Third, the estimated cost in each activity pool would be
divided by the estimated number of cost driver units,
such as number of machine setups, related to that pool.
• This results in an overhead or activity rate that is used to
charge each product or job based on its consumption of
the resources required to sustain each activity.
 ACCOUNTING FOR ACTUAL AND
APPLIED FACTORY OVERHEAD
Entry to apply estimated FOH to production:
Work in Process XXX
Applied Factory Overhead XXX

Actual Factory Overhead for the period is recorded as follows:

Factory Overhead XXX
Accounts Payable (an d oth er cr ed its ) XXX

To begin each new month with a zero balance in Factory Overhead, the debit or credit balance in
the account is usually transferred to an account titled “Under- and Overapplied Factory Overhead:

Under- and Overapplied Factory Overhead XXX

Factory Overhead XXX
Closed debit balance (underapplied) in factory overhead control account.
UNDER AND OVER
APPLIED FACTORY
OVERHEAD
• The debit balance indicates that the
factory overhead costs were underapplied
or underabsorbed.
• The credit balance indicated that the
factory overhead costs were overapplied
or overabsorbed.
 UNDER AND OVER
APPLIED FACTORY
OVERHEAD
• A t t h e en d of t h e y ear , t h e b alan ce
o f t h e u n d er - an d over ap p li ed
acco u n t wi ll b e clos ed t o C os t of
Go o d s S o ld , or allocat ed on a p r o
r at a b as i s t o W or k i n P r oces s ,
Fi n i s h ed Go o d s , an d C o s t o f Good s
Sold.
• Th e b al an ce s h o u l d b e p r o r at ed t o
al l t h r ee accou n t s i f i t wou ld
m at er i al l y d i s t o r t n et i n co m e t o
ch ar ge t h e en t i r e am ou n t t o C O GS .
PERIOD COST
Costs that directly reduce net income for the
current period.

PRODUCT COST
Costs that are included as part of the
inventories and expensed when the goods are
sold.
THANK YOU!