Chapter 4Chapter 4

Accounting for Factory OverheadAccounting for Factory Overhead

Learning ObjectivesLearning Objectives

LO1LO1 Identify cost behavior patterns.Identify cost behavior patterns.

LO2LO2 Separate semivariable costs into Separate semivariable costs into variable and fixed components.variable and fixed components.

LO3LO3 Prepare a budget for factory Prepare a budget for factory overhead overhead costs.costs.

LO4LO4 Account for actual factory overhead Account for actual factory overhead costs.costs.

Learning ObjectivesLearning Objectives

LO5LO5 Distribute service department Distribute service department factory factory overhead costs to production overhead costs to production departments.departments.

LO6LO6 Apply factory overhead using Apply factory overhead using predetermined rates.predetermined rates.

LO7LO7 Account for actual and applied Account for actual and applied factory factory overhead.overhead.

Accounting for Factory Accounting for Factory OverheadOverhead

1.1. Identify cost behavior patterns.Identify cost behavior patterns.2.2. Budget factory overhead costs.Budget factory overhead costs.3.3. Accumulate actual overhead costs.Accumulate actual overhead costs.4.4. Apply factory overhead estimates to Apply factory overhead estimates to

production.production.5.5. Calculate and analyze differences Calculate and analyze differences

between actual and applied factory between actual and applied factory overhead.overhead.

Cost Behavior PatternsCost Behavior Patterns

Variable costsVariable costs are costs that vary in are costs that vary in proportion to volume changes.proportion to volume changes.

Fixed costsFixed costs remain constant. remain constant. Semivariable costsSemivariable costs have characteristics have characteristics

of both fixed and variable costs.of both fixed and variable costs. Type A – remain constant over a range Type A – remain constant over a range

of production, then change abruptly.of production, then change abruptly. Type B – vary continuously but not in Type B – vary continuously but not in

direct proportion to volume changes.direct proportion to volume changes.

Cost Behavior PatternsCost Behavior Patterns

Cost

Volume

FixedVariable

Cost

Volume

Semivariable Type A Semivariable Type B

Cost Cost

VolumeVolume

Techniques for Analyzing Techniques for Analyzing Semivariable CostsSemivariable Costs

Observation Method (Account Observation Method (Account Classification Method)Classification Method)

High-Low MethodHigh-Low Method Scattergraph MethodScattergraph Method Method of Least SquaresMethod of Least Squares

Budgeting Factory Budgeting Factory Overhead CostsOverhead Costs

Budgets are management’s operating Budgets are management’s operating plans expressed in quantitative terms.plans expressed in quantitative terms.

Costs are segregated into fixed and Costs are segregated into fixed and variable components.variable components.

Budgets can be prepared for different Budgets can be prepared for different levels of production (flexible budget).levels of production (flexible budget).

Valuable management tool for planning Valuable management tool for planning and controlling costs.and controlling costs.

Accounting for Factory Accounting for Factory OverheadOverhead

Entries are made in the general journal for Entries are made in the general journal for indirect materials and indirect labor from the indirect materials and indirect labor from the summary of materials issued and the labor cost summary of materials issued and the labor cost summary.summary.

Other factory overhead expenses are recorded Other factory overhead expenses are recorded in the general ledger from the invoices and in the general ledger from the invoices and schedules for fixed costs.schedules for fixed costs.

A factory overhead subsidiary ledger may be A factory overhead subsidiary ledger may be used if the number of factory overhead used if the number of factory overhead accounts becomes too large.accounts becomes too large.

Examples of Factory Examples of Factory Overhead AccountsOverhead Accounts

Defective WorkDefective Work DepreciationDepreciation Employee Fringe BenefitsEmployee Fringe Benefits FuelFuel Heat and LightHeat and Light Indirect LaborIndirect Labor Indirect MaterialsIndirect Materials InsuranceInsurance Janitorial ServiceJanitorial Service LubricantsLubricants MaintenanceMaintenance Materials HandlingMaterials Handling

Overtime PremiumOvertime Premium Plant SecurityPlant Security PowerPower Property TaxProperty Tax RentRent RepairsRepairs Small ToolsSmall Tools SpoilageSpoilage SuppliesSupplies Telephone/FaxTelephone/Fax WaterWater Workers’ Compensation Workers’ Compensation

InsuranceInsurance

Factory Overhead Factory Overhead Analysis SheetsAnalysis Sheets

These sheets may be These sheets may be used to keep a used to keep a subsidiary record of subsidiary record of factory overhead factory overhead expenses.expenses. Expense-type Expense-type

analysis spreadsheetanalysis spreadsheet Department-type Department-type

analysis spreadsheetanalysis spreadsheet

Schedule of Fixed CostsSchedule of Fixed Costs

Fixed costs are assumed not to vary in amount Fixed costs are assumed not to vary in amount from month to month.from month to month.

Because fixed costs are predictable, schedules Because fixed costs are predictable, schedules can be prepared in advance.can be prepared in advance.

A journal entry to record the total fixed costs A journal entry to record the total fixed costs can be prepared from these schedules.can be prepared from these schedules.

Example of Schedule of Example of Schedule of Fixed CostsFixed Costs

Schedule of Fixed CostsSchedule of Fixed Costs

JanuaryJanuary FebruaryFebruary MarchMarch

Depreciation-MachineryDepreciation-Machinery

Dept. ADept. A $300$300 $300$300 $300$300

Dept. BDept. B 200200 200200 200200

TotalTotal $500$500 $500$500 $500$500

Property TaxProperty Tax

Dept. ADept. A $280$280 $280$280 $280$280

Dept. BDept. B 270270 270270 270270

TotalTotal 550550 550550 550550

Total Fixed CostsTotal Fixed Costs $1,050$1,050 $1,050$1,050 $1,050$1,050

General Factory General Factory Overhead ExpensesOverhead Expenses

When factory overhead expenses are not When factory overhead expenses are not identified with a specific department, they identified with a specific department, they are charged to departments by a process are charged to departments by a process of allocation.of allocation.

Allocations may be made for each item of Allocations may be made for each item of expense incurred, or expenses may be expense incurred, or expenses may be accumulated as incurred and the accumulated as incurred and the allocations made at the end of the allocations made at the end of the accounting period.accounting period.

Summary of Factory Summary of Factory OverheadOverhead

Summary of Factory OverheadSummary of Factory Overhead

ExpensesExpenses Dept. ADept. A Dept. BDept. B Dept. CDept. C TotalTotal

Indirect Indirect materialsmaterials

$100$100 $50$50 $40$40 $190$190

Indirect laborIndirect labor 200200 150150 140140 490490

PowerPower 150150 140140 120120 410410

DepreciationDepreciation 300300 200200 150150 650650

General factory General factory expensesexpenses

150150 350350 200200 700700

TotalTotal $900$900 $890$890 $650$650 $2,440$2,440

Distributing Service Distributing Service Department ExpensesDepartment Expenses

Service departments are an essential part of Service departments are an essential part of the organization, but they do not work directly the organization, but they do not work directly on the product.on the product.

Production departments perform the actual Production departments perform the actual manufacturing operations that physically manufacturing operations that physically change the units being processed.change the units being processed.

The costs of the service departments must be The costs of the service departments must be apportioned to the production departments.apportioned to the production departments.

An analysis of the service department’s An analysis of the service department’s relationship to other departments must be relationship to other departments must be done.done.

Common Bases for Common Bases for Distributing Service Distributing Service Department CostsDepartment CostsService DepartmentsService Departments Basis for DistributionBasis for Distribution

Building MaintenanceBuilding Maintenance Floor space occupied by other departmentsFloor space occupied by other departments

Inspection and PackingInspection and Packing Production volumeProduction volume

Machine ShopMachine Shop Value of machinery and equipmentValue of machinery and equipment

Human ResourcesHuman Resources Number of workers in departments servedNumber of workers in departments served

PurchasingPurchasing Number of purchase ordersNumber of purchase orders

ShippingShipping Quantity and weight of items shippedQuantity and weight of items shipped

StoresStores Units of materials requisitionedUnits of materials requisitioned

Tool RoomTool Room Total direct labor hours in departments servedTotal direct labor hours in departments served

Methods of Distributing Methods of Distributing CostsCosts

1.1. Direct Distribution MethodDirect Distribution Method Service department costs are allocated only Service department costs are allocated only

to production departments.to production departments.2.2. Sequential Distribution or Step-Down MethodSequential Distribution or Step-Down Method

Distributes service department costs Distributes service department costs regressively to other service departments regressively to other service departments and then to production departments.and then to production departments.

3.3. Algebraic Distribution MethodAlgebraic Distribution Method Distributes costs by simultaneous equations Distributes costs by simultaneous equations

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

Applying Factory Applying Factory Overhead to ProductionOverhead to Production

Factory overhead costs may not be known until Factory overhead costs may not be known until the end of the accounting period.the end of the accounting period.

The cost of a job is needed soon after The cost of a job is needed soon after completion, so a method to estimate the completion, so a method to estimate the amount of factory overhead applied must be amount of factory overhead applied must be established.established.

This enables companies to bill customers on a This enables companies to bill customers on a more timely basis and to prepare bids for new more timely basis and to prepare bids for new contracts more accurately.contracts more accurately.

Methods of Methods of Predetermined Factory Predetermined Factory Overhead RatesOverhead Rates

Direct Labor Cost MethodDirect Labor Cost Method Direct Labor Hour MethodDirect Labor Hour Method Machine Hour MethodMachine Hour Method Activity-Based Costing (ABC) MethodActivity-Based Costing (ABC) Method

Direct Labor Cost MethodDirect Labor Cost Method

Uses the amount of direct labor cost that has Uses the amount of direct labor cost that has been charged to the product as the basis for been charged to the product as the basis for applying factory overhead.applying factory overhead.

Job 100Job 100Direct materialsDirect materials $1,000$1,000

Direct laborDirect labor 3,0003,000

Factory overhead (50% of direct labor Factory overhead (50% of direct labor $)$)

1,5001,500

Total cost of completed jobTotal cost of completed job $5,500$5,500

Direct Labor Hour MethodDirect Labor Hour Method

Estimated factory overhead cost is divided by Estimated factory overhead cost is divided by the estimated direct labor hours to be worked.the estimated direct labor hours to be worked.

Job 100Job 100Direct materialsDirect materials $1,000$1,000

Direct labor (500 hours)Direct labor (500 hours) 3,0003,000

Factory overhead (500 hours @ $4)Factory overhead (500 hours @ $4) 2,0002,000

Total cost of completed jobTotal cost of completed job $6,000$6,000

Machine Hour MethodMachine Hour Method

This method best serves highly automated This method best serves highly automated departments where the amount of factory departments where the amount of factory overhead cost incurred on a job primarily is a overhead cost incurred on a job primarily is a function of the machine time that a job function of the machine time that a job requires.requires.

Job 100Job 100Direct materialsDirect materials $1,000$1,000

Direct labor (500 hours)Direct labor (500 hours) 3,0003,000

Factory overhead (300 machine hours @ Factory overhead (300 machine hours @ $10)$10)

3,0003,000

Total cost of completed jobTotal cost of completed job $7,000$7,000

Activity-Based Costing Activity-Based Costing MethodMethod

The company must first identify activities in the The company must first identify activities in the factory that create costs. factory that create costs.

Then a basis or cost driver must be decided Then a basis or cost driver must be decided upon to allocate each of the activity cost pools.upon to allocate each of the activity cost pools.

This approach is best when the company has This approach is best when the company has significant nonvolume-related costs in its plant significant nonvolume-related costs in its plant which are not caused by traditional cost drivers which are not caused by traditional cost drivers such as labor hours and machine hours.such as labor hours and machine hours.

Accounting for Actual and Accounting for Actual and Applied Factory Applied Factory OverheadOverhead

Entry to apply estimated factory overhead to productionEntry to apply estimated factory overhead to production

Work in ProcessWork in Process XXXX

Applied Factory OverheadApplied Factory Overhead XXXX

At the end of the period, the applied factory At the end of the period, the applied factory overhead account is closed to factory overhead account is closed to factory overhead.overhead.

Applied Factory OverheadApplied Factory Overhead XXXX

Factory OverheadFactory Overhead XXXX

Under- and Overapplied Under- and Overapplied Factory OverheadFactory Overhead

After the applied factory overhead account is After the applied factory overhead account is closed, the underapplied (debit) or overapplied closed, the underapplied (debit) or overapplied (credit) balance in the factory overhead (credit) balance in the factory overhead account is moved to work in process.account is moved to work in process.

Under- and Overapplied Factory OverheadUnder- and Overapplied Factory Overhead XXXX

Factory OverheadFactory Overhead XXXX

Cost of Goods SoldCost of Goods Sold XXXX

Under- and Overapplied Factory Under- and Overapplied Factory OverheadOverhead

XXXX

Period Costs and Product Period Costs and Product CostsCosts

Period CostsPeriod Costs All costs that are not assigned to the All costs that are not assigned to the

product, but are recognized as expense product, but are recognized as expense and charged against revenue in the and charged against revenue in the period incurred.period incurred.

Product CostsProduct Costs Costs that are included as part of Costs that are included as part of

inventory costs and expensed when inventory costs and expensed when goods are sold.goods are sold.