Page 1

• Factory Overhead Definition

  • Includes indirect materials, indirect labor, and other factory costs

  • Cannot be directly charged to specific jobs or products

• Characteristics of Factory Overhead

  • Overhead is essential for product cost but invisible in the final product

  • Overhead can be fixed, variable, semi-variable, step-variable, or semi-fixed

• Stabilizing Overhead Costs

  • Different overhead cost behaviors cause fluctuation in per-unit manufacturing cost

  • Stabilization methods are needed to control overhead charged to units produced

Page 2

• Types of Overhead Rates

  • Predetermined overhead rates ensure consistent allocation to each unit of output

  • Factors influencing overhead rate selection include the type of rate and activity level

• Activity-Based Costing (ABC)

  • Involves several activity rates for overhead allocation

• Estimating Factory Overhead

  • Calculated using budgeted total factory overhead and activity application rate

• Accounting for Factory Overhead

  • Includes actual applied factory overhead, work in process, finished goods, and over/underapplied overhead

Page 3

• Cost Allocation Methods

  • Choice between plantwide rate and departmental rates depends on product and production process

• Traditional/Conventional Allocation

  • Plantwide or blanket rate is common in smaller companies

  • Applied factory overhead is computed using actual driver/activity usage and overhead rate

Page 4

• Plantwide Allocation Method

  • Uses a single predetermined overhead rate for the entire factory

  • Simple accounting for overhead with one cost pool and one overhead rate

• Application in Different Organizations

  • Plantwide allocation can be used in both manufacturing and nonmanufacturing organizations

• Cost Assignment Process

  • Direct materials and labor costs are assigned through direct tracing

  • Overhead costs are assigned using predetermined rates and allocation bases

Page 5

• Selecting the Base for Overhead Allocation

  • The base in overhead allocation is crucial for meaningful cost data.

  • Primary objective: Ensure overhead application in proportion to indirect factory resources used.

    • Labor-oriented overhead: Direct labor cost or hours are suitable bases.

    • Technology-oriented overhead: Machine-hour base is appropriate.

    • Materials-oriented overhead: Materials cost may be a suitable base.

  • Correlation analysis aids in base selection.

  • Second objective: Minimize clerical cost and effort by choosing a simple, easily measured base.

• Calculation of Predetermined Overhead Rate

  • Determine activity level for selected base.

  • Estimate each overhead cost item at that activity level to get total estimated factory overhead.

  • Bases for applying factory overhead:

    • Units produced/Physical Output/Unit-level drivers.

    • Direct Materials Cost Base.

    • Direct Labor Cost Base.

    • Direct Labor Hour Base.

    • Machine Hour Base.

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• Calculation Methods for Overhead Rates

  • Direct Materials Cost Base: Overhead rate computed by dividing total estimated overhead by total estimated direct materials cost.

  • Direct Labor Cost Base: Overhead rate computed by dividing estimated overhead by estimated direct labor cost.

  • Direct Labor Hour Base: Overhead rate based on direct labor hours.

  • Machine Hour Base: Overhead rate based on machine hours.

• Traditional/Conventional: Departmental Rates

  • Multiple predetermined overhead rate system for production or service departments.

  • Departmental rates are more accurate as they reflect differences in overhead costs across departments.

  • Department allocation method: Separate cost pool and overhead allocation rate for each department.

  • Plantwide allocation method: Considers the entire plant as one cost pool.

  • Overhead applied in each department according to its own rate as jobs move through.

Page 7

• Illustrative Example 4-1: Plantwide and Departmental Rates

  • Company with two products: AA and BB, produced in Cutting and Finishing departments.

  • Budgeted overhead costs and volumes for each department.

  • Plantwide overhead application rate based on machine hours and direct labor hours.

  • Departmental rates for overhead application using machine hours in Cutting and direct labor hours in Finishing.

Page 8

• Traditional Plantwide and Departmental Overhead Rates

  • Plantwide and departmental rates have been used for decades successfully.

  • Limitations of traditional rates:

    • Overhead costs must be a significant percentage of total manufacturing costs for accurate allocation.

    • Factors impairing unit-based rates accuracy:

      • Large proportion of non-unit-related overhead costs.

      • Great degree of product diversity.

  • Non-Unit-Related Overhead Costs

    • Overhead activities unrelated to units produced can cause cost distortions.

    • Examples: setup costs, product engineering costs.

    • Non-unit-based drivers measure demands on activities.

  • Product Diversity

    • Products consume overhead activities in different proportions.

    • Factors causing diversity: product size, complexity, setup time, batch size.

    • Consumption ratio defines the proportion of each activity consumed by a product.

Page 9

• Selection of Capacity-Level

  • Capacity level selection impacts predetermined overhead rate.

  • Relationship between capacity level and predetermined overhead rate:

    • Greater assumed capacity-level leads to lower predetermined overhead rate.

    • Fixed factory overhead spread over more units at higher capacity levels.

  • Various capacity levels:

    • Theoretical capacity, practical capacity, expected actual capacity, normal capacity.

  • Effect of Capacity on Factory Overhead Rates

    • Illustration in Figure 4-2.

    • Factory overhead rates vary based on capacity levels selected.

Page 10

• Factory Overhead Rates Calculation

  • Computation based on estimated overhead and activity level.

  • Factory overhead rate used to charge overhead to jobs, products, or work performed.

  • Division into fixed and variable components.

• Including or Excluding Fixed Factory Overhead

  • Absorption costing includes both fixed and variable costs in factory overhead rates.

  • Direct costing includes only variable factory overhead in rates.

  • Fixed portion treated as a period cost in direct costing.

• Actual Factory Overhead

  • Determining base, activity level, estimating total overhead, and calculating overhead rate precede actual costs.

  • Factory overhead applied when necessary data available.

  • Actual factory overhead costs recorded independently of overhead application.

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• Accumulating factory overhead for control

  • Reporting costs to department heads

  • Comparing with budgeted amounts

• Applied factory overhead vs. actual factory overhead

  • Actual: indirect costs incurred

  • Applied: cost allocated to output

• Applying factory overhead

  • Predetermined rate: P15 per machine hour

  • Example calculation: 18,900 x P15 = P283,500

• Over- or under-applied factory overhead

  • Adjusting overhead rate if actual differs from budget

  • Entries to close applied factory overhead account

Page 12

• Total actual overhead incurred during the period

• Charging factory overhead costs to Work in Progress

• Backflush costing for just-in-time environment

• Debits and credits in factory overhead control account

• Dealing with over- or under-applied factory overhead

  • Identifying underapplied/overapplied amounts

  • Disposition options: period expense or allocation

• Entries to dispose of underapplied factory overhead

Page 13

• Justification for treating over- or underapplied factory overhead

• Entries to dispose of underapplied factory overhead

• Reporting adjustments in income statement

• Reporting adjustments in cost of goods sold statement

• Management responsibility for over- or underapplied factory overhead

• Reporting in cost of goods sold statement vs. income statement

Page 14

• Cost of goods manufactured

  • P1,163,500

• Cost of goods sold

  • Normal costing: P1,193,500

  • Adjusted for underapplied factory overhead: P1,202,000

• Income Statement

  • Sales: P1,600,000

  • Gross profit: P398,000

  • Operating income: P148,000

• Allocation of Factory Overhead

  • Allocated among work-in-process inventory, finished goods inventory, and cost of goods sold

  • Purpose is to revise all applied factory overhead amounts during the year

• Illustration of Allocation

  • Example of ReSA Company with underapplied factory overhead of P8,000

  • Allocation to Work in Process, Finished Goods, and Cost of Goods Sold

Page 15

• Allocation of Underapplied Factory Overhead

  • Allocation to accounts in proportion to their balances

  • Calculation based on percentages of Work in Process, Finished Goods, and Cost of Goods Sold

• Journal Entry for Allocation

  • Work in Process, Finished Goods, Cost of Goods Sold, and Factory Overhead Control

• Adjustment of Inventories

  • Inventories reported on the balance sheet at adjusted amounts

• Reversal of Journal Entry

  • Portions involving inventories reversed at the beginning of the next year

Page 16

• Changing Overhead Rates

  • Reviewed periodically due to changes in production methods, prices, efficiencies, and sales forecasts

  • Revision depends on factors affecting overhead rates and management's need for current cost data

• Cost Management Systems

  • Traditional (unit-based) and Activity-Based Costing Systems

  • Traditional systems more widely used but may not work well in advanced manufacturing environments

• Unit-Based Product Costing

  • Assigns overhead costs to products using predetermined rates based on unit-level drivers

• Predetermined Overhead Rates

  • Used in normal cost systems for assigning overhead costs

• Transaction Base

  • Setup costs assigned based on rate per setup

• Activity-Based Costing (ABC)

  • Recognizes overhead costs not caused by volume of output

• Transactions-Based Approach

  • Popularly known as Activity-Based Costing (ABC)

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• Overhead costs are influenced more by product complexity and handling requirements for low-volume items than by total production volume.

  • Overhead costs driven by transactions not proportional to output volume lead to over costing high-volume products and under costing low-volume products.

• Activity-Based Costing (ABC) shifts overhead costs from high-volume products to low-volume products.

  • ABC focuses on activities performed in an organization to collect costs based on the nature and extent of those activities.

  • ABC assigns costs to products and services based on activities conducted to produce, distribute, or support them.

• Three fundamental components of ABC:

  • Recognizing different cost levels and accumulating costs into related cost pools.

  • Using multiple cost drivers to assign costs to products and services.

  • Using multiple cost drivers to assign costs to services.

Page 19

• Companies use ABC to allocate corporate overhead costs based on activities like reports, documents, or customers.

• ABC offers greater product costing accuracy but at a higher cost.

• Companies with diverse products, high overhead costs, significant automation, unexplained profit margins, and varying product profitability benefit from ABC.

• Six essential steps in designing an ABC system:

  • Identify, define, and classify activities and key attributes.

  • Assign resource costs to activities and cost objects.

  • Assign secondary activity costs to primary activities.

  • Identify cost objects and specify activity consumption.

  • Calculate primary activity rates.

  • Assign activity costs to cost objects.

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• ABC is useful for companies with a wide variety of products or services, high overhead costs not proportional to unit volume, significant automation, unexplained profit margins, and varying product profitability.

• An ABC system traces costs to activities and then to products and other cost objects.

• Steps in designing an ABC system include identifying, defining, and classifying activities and key attributes.

Page 21

• Activity Identification involves listing actions taken or work performed by equipment or people for others.

• Activity Definition uses attributes to define activities, including financial and nonfinancial information.

• Activity Classification categorizes activities as primary or secondary for costing purposes.

• Gathering data for an ABC system can be done through interviews, questionnaires, surveys, and observations.

Page 23

• Activity Dictionary

  • Names activity

  • Describes tasks

  • Classifies as primary or secondary

  • Lists users and activity output measure

• Assigning Costs to Activities

  • Cost of resources consumed by each activity

  • Resources include labor, materials, energy, and capital

  • Resource costs assigned using direct and driver tracing

• Classifying Activities

  • Primary and secondary activities

  • Intermediate stages if secondary activities exist

  • Costs of primary activities assigned to products based on activity drivers

Page 24

• Drivers in ABC

  • Resource driver for allocating resource costs to activities

  • Activity driver for allocating activity costs to products

  • Different levels of activity drivers: unit, batch, product, organization/plant

• Levels of Costs

  • Unit, batch, product, organization/plant levels

  • Examples of activities, costs, and activity drivers at each level

Page 25

• Activity Categories

  • Unit-level, batch-level, product-level, and organizational/plant-level

  • Improve product costing accuracy

  • Provide insights into root causes of activities

• Unit-Level Activities

  • Vary with number of units produced and sold

  • Examples and drivers of unit-level activities

  • Examples of unit-level costs

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• Batch-Level Activities

  • Vary with number of batches produced and sold

  • Examples of batch-level activities

• Level of Costs

  • Distinctions between batch- and unit-level costs

  • Batch-level activities and examples of costs

Page 27

• Product-Level Activities/Drivers

  • Activities performed to support the production and sale of different products

  • Examples include product design, engineering changes, and product prototyping

• Organizational/Facility/Plant-Level Activities/Drivers

  • Sustain a factory's general manufacturing processes

  • Includes product line level, process level, department level, and plant level activities

• Significant Product-Level Costs

  • Costs of patents, market research, and product promotions

  • Example in service business: cost of acquiring new software for a new service

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• Two-Stage/Step Cost Allocation

  • Allocation of costs in cost pools to individual cost objects

  • First stage: resource costs allocated to activities based on resource drivers

  • Second stage: costs of activities allocated to products or final cost objects

• Reducing Size and Complexity of ABC System

  • Merit in reducing the number of activity rates without significant decrease in cost assignment accuracy

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• Determining Product Profitability and Company Profit

  • Calculation of total product revenue, total product cost per unit, and net product margin

  • Allocation of costs over unit-level, batch-level, and product/process-level costs

• Organizational/Facility/Plant-Level Costs

  • Includes corporate/divisional administration and facility/plant depreciation

Page 30

• Tracing Costs in an Activity-Based Costing System

  • Cost flow diagram showing cost allocation using activity drivers

• Cost Flow Diagram: Two-Stage Cost Allocation System

  • Illustrates the flow of costs in a two-stage cost allocation system

Page 31

• Two-Stage Cost Allocation: First-Stage Allocation to Departments

  • Grouping overhead accounts into cost pools for allocation to products

• Comparison of ABC and Traditional Costing

  • Differences in collection of financial and operational data

  • Traditional costing uses volume-related measures for allocating overhead costs.

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• Activity driver / cost pool in ABC systems

  • ABC systems have multiple overhead cost pools and allocation bases.

  • Costs are attached to products based on activities performed.

  • Traditional systems used a single cost pool or base.

  • Homogeneity of costs within an activity driver/cost pool is essential in ABC.

• Cost allocation in ABC systems

  • ABC systems are two-stage costing systems.

  • Resource costs are allocated to cost centers first and then to products.

  • Traditional systems may be one- or two-stage.

• Selection of activity drivers in ABC

  • ABC systems use a large number of activity cost pools and drivers.

  • Traditional systems identified overhead as a total and allocated it based on one activity.

Page 33

• Illustrative Example 4-2: ABC Costing Versus Traditional Costing

  • Example of allocating costs in a Factory Maintenance Department using ABC and traditional costing methods.

  • Allocation based on different activity drivers in ABC compared to traditional costing.

Page 34

• Strengths and Weaknesses of ABC

  • ABC provides more credible product cost information.

  • ABC is superior in allocating plant-level costs.

  • ABC shows batch-level and product-level activity for each product.

  • Data-gathering efforts for ABC go beyond traditional costing systems.

• Criticisms of ABC

  • ABC requires significant time and cost to implement.

  • Overcoming individual, organizational, and environmental barriers is crucial for successful implementation.

  • ABC is not a solution for all managerial concerns.

  • It is necessary to justify new systems like ABC in terms of benefits generated.

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• Barriers to Implementing ABC

  • Recognize the barriers exist

  • Investigate the causes

  • Communicate information about ABC to all concerned parties

  • Top management involvement and support are crucial

  • Education needed for employees and managers on new techniques

• Challenges with ABC

  • Non-conformance with GAAP

  • Use for internal reporting while maintaining traditional systems

  • Lack of promotion for total quality management and continuous improvement

• ABC II and DBC

  • ABC II focuses on customer needs and cost-benefit analyses

  • DBC simplifies ABC stages, focusing on time and practical capacity

  • DBC eliminates the need for detailed resource driver determination

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• **Time-Driven Activity Based Costing (TDABC)