MODULE IN

COST ACCOUNTING AND CONTROL

RINCIPLES AND PRACTICES
AE 212

Department of Accountancy
SCHOOL OF ACCOUNTANCY, MANAGEMENT, COMPUTING,
AND INFORMATION STUDIES
 AE 212: COST ACCOUNTING AND CONTROL
Week Topic Learning Outcomes Activities

MODULE 5 – Accounting for Factory Overhead

Week 7 1. Explain the nature of •
factory overhead and
describe the
procedure in
accounting for the
incurrence of actual
factory overhead
costs and the
application of
predetermined
factory overhead
rates.
2. Illustrate the
procedure in
establishing
departmental
predetermined
factory overhead
rates.

Do graded activity

MODULE 5:
ACCOUNTING FOR FACTORY OVERHEAD

FACTORY OVERHEAD COST AND CONTROL

Factory overhead refers to manufacturing costs which cannot be classified either as direct
material cost or direct labor cost. Other terms used are: Manufacturing Overhead, Factory
Burden, Manufacturing Burden, Indirect Costs.
Of the three elements, factory overhead costs are the ones that present the most difficult
problems in practice. Direct material and direct labor costs lend themselves to precise
measurement, but factory overhead offer no feasible method of precise measurement and
consequently must be handles on the basis of good judgment.
The following are the most commonly used accounts for factory overhead:
a. Indirect labor
b. Superintendence

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 c. Repairs and maintenance – Machines
d. Factory supplies expense or Indirect materials used
e. Rent expense – Factory
f. Medical, hospital and leaves
g. SSS, Philhealth, Pag-IBIG contributions - Factory
h. Employees’ compensation insurance
i. Insurance expense – Factory
j. Factory taxes
k. Depreciation expense- Machinery
l. Depreciation expense – Factory building
m. Miscellaneous factory expenses
Unless the amounts involved are significant and/or recurring in the nature, the following factory
expenses are included in the Miscellaneous Factory Expenses: Loss on spoiled goods, loss on
defective goods, inventory loss (due to shrinkage, shortage, theft, etc.), inventory adjustment,
scrap recovery, etc.)

SOURCES OF FACTORY OVERHEAD

The following books and records are the four major sources of factory overhead charges:
a. Voucher Register (purchase vouchers)
Factory Overhead Control xxx
Repairs and maintenance xx
Rent expense-Factory xx
Factory taxes xx
Vouchers payable xxx
b. Stores Requisition Journal (requisition slips)
Factory Overhead Control xxx
Indirect materials used xx
Materials xxx
c. Payroll Book (Clock cards and time tickets)
Factory Overhead Control xxx
Indirect labor xx
Superintendence xx
Factory payroll xxx
d. General Journal (journal vouchers)
Factory Overhead Control xxx
SSS Contributions xx
Depreciation expense-Machinery xx
Insurance expense-Factory xx
SSS payable xxx
Accumulated depreciation-machinery xxx
Prepaid insurance xxx

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 ALLOCATING FACTORY OVERHEAD TO PRODUCTION

There are two basic methods of allocating factory overhead costs to current production.
One method using the actual cost system), is to accumulate and distribute the actual overhead
over the units in production (complete and incomplete) during the accounting period covered.

The second method using either the normal cost system or the standard cost system, which
is the most widely used, applies estimated overhead to units as they are completed or at the end
of the accounting period whichever occurs first. Also, at the end of the accounting period, the
applied and actual overhead are compared and analyzed, then closed, the difference being
either debited or credited normally to cost of goods sold.

The objectionable features of allocating actual overhead costs over the jobs in production
during the period may be summarized as follows:
a. Costing is delayed since it is impossible to determine the cost of the job orders, as they are
completed.
b. Checking of inefficiencies in production is difficult since estimated costs are employed for
purposes of comparison with actual costs.
c. There is the possibility of unreasonably charging a job with overhead cost in periods of low
production or during periods of exceptionally high output.

FACTORY OVERHEAD CONTROL

Individual overhead accounts are kept in the general ledger in small manufacturing firms
where accounts are few. As the company grows and expands, this system becomes
cumbersome. Because the number of expense accounts had become quite large, it is customary
to have a factory overhead control account in the general ledger, while individual overhead
accounts are maintained in a factory overhead subsidiary ledger (factory overhead analysis
sheet). The relationship between the factory overhead control account and its subsidiary ledger
is the same as that between the Accounts receivable control account and its customers’
subsidiary ledgers.

When all postings have been properly made to the factory overhead control account
coming from the voucher register, general journal, or any special journal; and appropriate
postings have likewise been made to the corresponding subsidiary ledger at the end of the period,
the total of the factory overhead control account in the general ledger, as well as the sum total
of the individual factory overhead accounts in the subsidiary ledger must be equal.

ESTIMATED FACTORY OVERHEAD

It is customary to prepare at the beginning of each year a budget showing among others the
estimated factory overhead costs that may be incurred for the year. This budget also serves
several purposes, among which are the following:
a. It sets up a plan for all types of expenditures that will be made during the period.
b. It serves as a basis for estimating costs that will be incurred in manufacturing which will be
useful in sales planning and pricing.
c. It provides a basis against which recorded (actual) costs can be compared to determine
how closely actual performance measures up to planned expectations. A comparison
between the budgeted and actual overhead costs is an essential part of cost control.

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 Estimating costs that will be incurred at different levels of capacity is not easy. Unlike direct
material and direct labor costs, not all factory overhead costs increase and decrease in
proportion to the number of units being manufactured. Estimating factory overhead costs requires
a clear understanding of cost behavior patterns.

COST BEHAVIOR PATTERNS

When manufacturing costs are studied in relation to volume of production, three basic
behavior patterns are apparent.
1. Fixed costs
2. Variable costs
3. Semivariable costs

CONCEPTS OF CAPACITY

Choice of the volume, or capacity to be used must be resolved after consideration of the
plant’s physical facilities, the organization to operate these facilities, and the firm’s anticipated
sales. Several possibilities present themselves as possible measures of volume or capacity. Among
them, are the following:
1. Maximum capacity (also referred to as theoretical capacity, ideal capacity) is the volume of
production that would be attained if the plant equipment and personnel were in continuous
operation at peak efficiency at all times. At this level, the plant is assumed to operate 24 hours
a day, 7 days a week, and 52 weeks a year without interruptions. This capacity makes no
allowances for delays of any kind, even stoppages that could be described as normal and
unavoidable.
2. Practical capacity (also referred to as realistic productive capacity) is the volume that does
not expect full utilization and does make allowance for unavoidable idleness of men and
machinery, including delays caused by maintenance and repair, machine set-up, fatigue and
time lost through vacations and holidays. Practical capacity does not, however, take into
consideration equipment and personnel made idle by a lack of sales orders.
3. Normal capacity (also referred to as long-run productive capacity) is the average annual
volume of production needed to meet ordinary and usual sales demands over a cycle of
years (usually 5 years) long enough to even out cyclical fluctuations in sales volume.
Depending on the volume of sales that can be expected, normal capacity may be equal to
or less than practical capacity.
4. Expected actual capacity (also referred to as short-run productive capacity) is the volume of
production required to meet the sales demand anticipated for a single year. Expected actual
capacity differs from normal capacity in the length of time used in the calculation.

For example, January Company is capable of turning out twenty (20) completed units
every hour. The plant normally operates six days a week on a single eight-hour shift. Each year
the factory is closed twelve (12) working days for holidays. Equipment is idle 598 hours for cleaning,
oiling, and maintenance. Normal sales demand averages 37,000 units a year over a five-year
period. The expected sales volume for the year is 35,000 units.
The fixed costs of operating the plant amount to P185,000 per year.

REQUIRED:
1. Determine the base capacity (in labor hours) for each of the following: (a) Maximum
capacity; (b) Practical capacity; (c) Normal capacity; and (d) Expected actual capacity

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 2. Compute the fixed costs per hour under each of the four capacities
3. Compute the fixed unit costs under each of the four capacities
4. Compute the idle capacity costs under each of the four capacities if the plant operated
at 3,400 hours.

SOLUTION:
1. Base capacity (in labor hours):

a. Maximum capacity: 365 days x 8 hrs/day 2,920

b. Practical capacity:
Maximum capacity 2,920
Less: Idle capacity
Sunday – 52 x 8 hrs 416
Holidays – 12 x 8 96
Repairs, maintenance, set up, 508 1,020
and other unavoidable stoppages
Practical Capacity 1,020

c. Normal capacity :
37,000 units / 20 units per hour 1,850

d. Expected annual capacity:

35,000 units / 20 units per hour 1,750

2. Fixed costs per hour:

Maximum capacity:
P185,000 / 2,920 hrs P 63.36 per hour
Practical capacity:
P185,000 / 1,900 hrs P 97.37 per hour
Normal capacity:
P185,000 / 1,850 hrs P100.00 per hour
Expected actual capacity:
P185,000 / 1,750 hrs) P105.71 per hour

3. Fixed Cost per unit

Maximum capacity:
P 63.36 / 20 units P 3.17 per unit
Practical capacity:
P 97.37 / 20 units P 4.87 per unit
Normal capacity:
P100 / 20 units P 5.00 per unit
Expected actual capacity:
P105.71 / 20 units P 5.29 per unit

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 As the base decreases, the unit cost increases.

4. Idle capacity costs

Base Capacity Idle Fixed cost Idle capacity
Base
capacity utilized capacity per hour costs
Maximum 2,920 1,700 1,220 P63.36 P77,299.20
Practical 1,900 1,700 200 97.37 19,474.00
Normal 1,850 1,700 150 100.00 15,000.00
Expected 1,750 1,700 50 105.71 5,285.50
actual
As the base decreases, fixed costs applied increase and the idle capacity cost decreases.

FACTORY OVERHEAD RATE BASES

The primary purpose of using a predetermined overhead rate is to charge a fair share of overhead
costs to each job. A number of bases for determining overhead rates may be used. The most
common bases are as follows:
P Units of production
P Materials costs
P Machine hours
P Direct labor hours
P Direct labor costs

The cost and production figures used in the calculations are usually derived from budget
estimates. To demonstrate the computation procedure for each basis, the following budgeted
data is given for a manufacturing plant.
Factory overhead costs for the year P96,000
Number of units of production in the year 120,0000 units
Direct material costs for the year P240,000
Machine hours for the year 12,000 hours
Direct labor hours for the year 15,000 hours
Direct labor costs for the year P60,000

UNITS OF PRODUCTION BASIS

Overhead may be applied on the basis of the number of units manufactured during the
period. The estimated factory overhead costs are divided by the estimated total number of units
of production to get the overhead cost to be applied per unit of production.

Estimated factory overhead = Overhead Cost per

Estimated units of production Unit of Production

Using the figures given above,

P 96,000.00 = P0.80 per unit
120,000 units

Therefore, if a job of 600 units were produced, the overhead applied to the job would be P480
(600 units x P0.80)

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 MATERIALS COSTS BASIS

Overhead may be applied on the basis of direct materials used to produce the product.
The estimated factory overhead costs are divided by the estimated direct materials costs. This
calculation gives the percentage of materials costs to be applied as overhead.

Estimated factory overhead = Percentage of Overhead

Estimated direct materials costs Cost to materials costs

Again, using the figures given above,

P 96,000.00 = 40% of materials costs
P240,000.00

Therefore, if direct materials consumed on a specific job cost P11,000, the overhead
applied to that job would be P4,400 (P11,000 x 40%)
For materials costs to make a good rate basis, each article manufactured must require
approximately the same of amount of materials, or material usage must be distributed uniformly
throughout the manufacturing process. In practice, most overhead costs bear little relationship
to materials consumed, so this basis is seldom appropriate.

MACHINE HOUR BASIS

When work is performed primarily by machines, a large part of the factory overhead costs
consists of depreciation, power, repairs, taxes and other costs associated with machinery. Thus,
a logical relationship exits between the use of the machinery and the amount of cost incurred. To
determine this basis, divide the estimated factory overhead costs by the estimated number of
machine hours to get the rate per machine hour.

Estimated factory overhead = Overhead Rate per

Estimated machine hours Machine hour

Using the figures given previously,

P 96,000.00 = P 8 per machine hour
12,000 machine hours

Therefore, if a job requires 200 machine hours, the overhead costs applied would be P1,600
(200 machine hours x P8).

In a highly automated factory where machine perform most of the labor and each item
goes through a similar sequence of machines, this basis makes sense. However, a machine hours
basis is not accurate if different kinds of machines are used for various products. In such a case,
variations in original cost, operating costs, machine speed, and labor costs would make this rate
inappropriate as an overall formula. A further objection to this method is the additional clerical
work required to keep a record of the number of machine hours used on each job.

DIRECT LABOR HOUR BASIS

This frequently used method assumes that overhead costs tend to vary with the number of hours
of direct labor used. The estimated factory overhead costs are divided by the estimated number
of direct labor hours to obtain an application rate per hour.

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 Estimated factory overhead = Overhead Rate per direct
Estimated direct labor hours labor hour

Using the figures given previously,

P 96,000.00 = P6.40 per direct labor hour
15,000 direct labor hours

Therefore, if a job required 1,100 direct labor hours to complete, the overhead costs applied would
be P7,040 (1,100 direct labor hours x P6.40).

The direct labor hours basis is usually appropriate if labor operations are a major part of
the production process and the wage rates paid different workers vary considerably. As a general
rule, there is a correlation between total factory overhead costs and the number of direct labor
hours worked. However, the direct labor method requires a record of the number of direct labor
hours spent on each job, which may necessitate additional record keeping. (Total labor cost are
part of normal factory records; however, a separate computation of total hours is not typically
maintained.)

DIRECT LABOR COSTS BASIS

This method is the most widely used overhead application basis because it is simple and
easy to apply. Information concerning direct labor costs of each department and each job is
available from the payroll records and the time tickets. Labor costs are normally accumulated by
job as a routine cost accounting procedure, so that no extra clerical work is involved. The
estimated factory overhead costs are divided by the estimated direct labor costs. This calculation
results in the percentage of direct labor costs.

Estimated factory overhead = Percentage of Overhead

Estimated direct labor cost Costs to Direct Labor Costs

Using the figures given previously,

P 96,000.00 = 160% of Direct labor costs
P60,000.00

Therefore, if direct labor costs incurred on particular job totaled P4,000, the applied
overhead would be P6,400 (P4,000 x 160%).
The direct labor costs basis is not generally used in cases where the large proportion of overhead
costs related to use of machinery. Also, if labor hourly wage rates vary widely between different
workers on the same job in the same department, the method will result in a larger amount of
overhead being charged to those jobs on which higher paid workers are used. Just because an
employee is paid more does not necessarily mean that the employee will use more heat, light,
power, etc.

After determining the factory overhead rate, it can now be used to determine the factory
overhead cost applied to a product.

For example, a summary of the budget data for the Assembling Department of the Trust Company
for the year is given below:

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 Factory overhead costs P 750,000
Units of production 375,0000 units
Direct material costs P3,000,000
Direct labor costs P 625,000
Direct labor hours 120,000 hours
Machine hours 62,500 hours

REQUIRED:
1. Determine the applied overhead rates under each of the following bases. Round off
percentages to one decimal point and rates to the nearest whole centavo.
a. Units of production
b. Direct materials costs
c. Machine hours
d. Direct labor hours
e. Direct labor costs

2. Prepare a schedule showing the total cost and amount of overhead that would be
applied to Job 88 using each application rate. Assume the following data related to
the job.
Direct material costs P 23,480
Direct labor costs P 5,210
Direct labor hours 964 hours
Machine hours 495 hours
Number of units 3,210 units

SOLUTION:

1. Applied overhead rates:

Basis Computation Overhead Rate

a. Units of production P750,000 / 375,000 units P 2.00 / unit
b. Direct materials P750,000 / P3,000,000.00 25% of materials cost
costs
c. Machine hours P750,000 / 62,500 hours P12 / machine hour
d. Direct labor hours P750,000 / 120,000 hours P 6.25 / direct labor hour
e. Direct labor costs P750,000 / P625,000.00 120% of labor cost

2. Total Cost of Job 88:

Direct Direct Factory Total Cost *Computation
materials labor overhead*
a. Units of P23,480 P5,210 P6,420 P35,110 3,210 u x P2
production
b. Direct materials 23,480 5,210 5,870 34,560 P23,480 x 25%
costs
c. Machine hours 23,480 5,210 5,940 34,630 495 hrs x P12
d. Direct labor hours 23,480 5,210 6,025 34,715 964 hrs x P6.25
e. Direct labor costs 23,480 5,210 6,252 34,942 P5,210 x 120%

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 APPLYING FACTORY OVERHEAD

Factory overhead is applied to jobs and departments after direct materials and direct
labor costs have been recorded. If direct labor hours or machine hours are the basis for overhead
charges, these data must also be available to the cost department. The job order cost sheet
would receive postings as soon as weekly materials or labor data become available. A special
section of a job order cost sheet is used for factory overhead.

The journal entry for summarizing overhead charges to job order sheets is:
Work in process – Overhead xxx
Applied factory overhead xxx

Charges made to subsidiary records (the job order cost sheets) list in detail applied
overhead charged to jobs. The debit to the work in process control account brings total overhead
applied into the general ledger. The applied factory overhead account is subsequently closed
out to the factory overhead control account by the entry:

Applied factory overhead xxx

Underapplied factory overhead xxx
Factory overhead control xxx
To close applied overhead.
(or)

Applied factory overhead xxx

Overapplied factory overhead xxx
Factory overhead control xxx
To close applied overhead.

Debits to the factory overhead control account are for actual expenses incurred during the
period. The factory overhead control account collects actual expenses as debits and applied
expenses as credits. It is seldom that the two are equal. There is usually a debit or a credit balance.

A debit balance indicates that overhead has been underapplied; a credit balance
means that overhead has been overapplied. These over- or underapplied balances must be
analyzed carefully for they are the source of much information needed by management for
judging the efficiency of the operations and the use of available capacity during a particular
period.

ACCOUNTING FOR OVER- OR UNDERAPPLIED OVERHEAD

1. When interim financial statements are prepared and factory overhead is closed monthly or
quarterly, the under or overapplied overhead costs resulting from normal causes are carried
forward on the balance sheet as deferred charges for underapplied costs, or deferred credits
for overapplied costs.
2. At the end of the year, under- or overapplied factory overhead costs may be closed using
one of the following methods:
a. Closed to the Cost of Sales account – as a mater of expediency or if the amount involved
is normal and not significant
b. Closed to the Cost of Sales, Finished Goods, and Work in Process accounts – if the amount
involved is significant to warrant correction.

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 c. Closed to Income Summary – of the rates used as well as the applied overhead are
accepted as correct, and the variances are caused by abnormal circumstances.

To illustrate, the following data were obtained from the company’s cost records as of June 30:
Job Order Direct Direct Labor
No. Materials Hours Cost
1001 P 9,450.00 1,950 P 4,350.00
1002 24,900.00 5,500 11,550.00
1003 21,750.00 12,100 27,400.00
1004 8,100.00 2,250 4,850.00
1005 12,300.00 4,800 9,900.00
1006 5,550.00 1,470 3,150.00

Factory overhead is charged to jobs on the basis of P4.50 per direct labor hour. Actual overhead
for the month totaled P136,800. There was no beginning work in process in June.
During the month of June, Jobs 1001, 1002, 1003, and 1004 were completed. Jobs 1001 and 1002
were shipped out and the customers were billed in the accounts of P27,700.00 and P69,300.00
respectively.

REQUIRED: Entries in general journal form to record:

a. Actual overhead cost incurred
b. Applied overhead cost charged to production
c. Cost of completed units
d. Sale of completed units and Cost of sales
e. Over- or underapplied factory overhead (Not closed out until the end of the year)

SOLUTION:
a. Factory overhead control 136,800
Vouchers payable or Sundry credits 136,800
To record actual overhead costs.

b. Work in process - overhead 126,315

Applied factory overhead 126,315
To record applied overhead charged to production.
(Total Direct labor hours 28,070 x P4.50)

c. Finished goods 210,450

Work in process - materials 64,200
Work in process - labor 48,150
Work in process - overhead 98,100
To record cost of completed units.

Computation:
Direct Applied
Job No. Direct labor Total cost
materials overhead
1001 P 9,450.00 P 4,350.00 P 8,775.00 P 22,575.00
1002 24,900.00 11,550.00 24,750.00 61,200.00
1003 21,750.00 57,400.00 54,450.00 103,600.00

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 1004 8,100.00 4,850.00 10,125.00 23,075.00
Total P64,200.00 P48,150.00 P98,100.00 P210,450.00

d. Accounts Receivable 97,000

Sales 97,000
To record sale of Jobs 1001 and 1002.

Cost of Sales 83,775

Finished goods 83,775
To record cost of Jobs 1001 and 1002.

e. Applied factory overhead 126,315

Underapplied factory overhead 10,485
Factory overhead control 136,800
To close applied factory overhead.

Computation:
Actual factory overhead P136,800
Less: Applied factory overhead 126,315
Underapplied P 10,485

DEPARTMENTALIZATION OF FACTORY OVERHEAD

A small company, producing only one product or a few products, may simply keep a
separate general ledger account for each factory overhead cost. If there are many different
types of overhead costs, factory overhead analysis sheets would be maintained. These analysis
sheets function as a subsidiary ledger that is controlled by the Factory Overhead Control account
in the general ledger. This account summarizes the analysis sheets.
In large businesses, it is necessary to divide the factory operations into departments. The
departments become the centers for effective control of costs. There are two methods of
achieving cost departmentalization.

THE CONCEPT OF DEPARTMENTALIZATION

Departmentalization of factory overhead means dividing the plant into segments called
“departments” or “cost centers” to which expenses are charged. For accounting purposes, the
main reason for dividing a plant into separate departments are:
Ø To fix responsibility for control of overhead costs, and
Ø To attain more accurate costing of jobs and products.

Responsible control is possible because departmentalization makes the incurrence of

expenses the responsibility of a foreman or supervisor. Expenses which originate directly and
completely in a department are identified with the foreman responsible for the supervision of that
department.
The entire process of departmentalizing factory overhead is an extension of methods
previously discussed. Estimating or budgeting expenses and selecting a proper basis for applying
them is still necessary; but , in addition, departmentalizing overhead requires separate estimates
or budgets for each department. Actual expenses of a period must still be recorded in a Factory
Overhead Control account and a factory overhead subsidiary ledger for each department,

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 according to the nature of the expense. This procedure permits comparison of actual
departmental expenses with departmentally applied factory overhead. Over- or underapplied
factory overhead is computed departmentally and analyzed separately to determine
departmental spending and capacity variances.

DEPARTMENT, DEFINED

A department is a group of employees or machines performing similar operations in a

factory.

A producing department is a department where actual manufacturing operations are

done such as cutting, mixing, painting, and others.

A service department is one not involved in actual processing operations but facilitates
the operations of the producing departments. Examples are Maintenance department, Factory
luncheon or cafeteria, Factory office, Toolroom, Storeroom, Planning and Drafting department,
Factory clinic.

SELECTION OF PRODUCING DEPARTMENTS

A manufacturing company is usually organized along departmental lines for production

purposes. Manufacturing processes dictate the type of organization needed to handle the
different operations efficiently, to obtain the best production flow, and to establish responsibility
for physical control of production.

The cost information system is designed to fit the departmentalization required for
production purposes. The system accumulates manufacturing costs according to such
departmentalization whether operations are of the job type or the continuous process type.
Factors to be considered in deciding the kinds of department required for establishing accurate
departmental overhead rates with which to control costs are:
1. Similarity of operations, processes, and machinery in each department,
2. Location of operations, processes and machinery,
3. Responsibilities for production and costs,
4. Relationship of operations to flow of product
5. Number of departments or cost centers.

The establishment of producing departments for the purpose of costing and controlling
expenses is a problem for the management of every company, for which no hard and fast rules
can be given, the most common approach divides the factory along lines of functional activities
of the factory into separate, interrelated, and independently governed units is important for the
proper control of factory overhead and the accurate costing of jobs and products.

The number of producing departments used depends on the emphasis the cost system
puts on cost control and the development of overhead rates. If the emphasis is on cost control,
separate departments might be established for the plant manager and for each superintendent
or supervisor. When the development of departmental overhead rates emphasizes on accurate
costing, fewer departments might be used. Sometimes, the number of departments needed for
cost control is larger that needed for overhead rates. In such cases, the cost control system can
be adapted to proper overhead rates by combining departments, thus reducing the number of
rates used without sacrificing control of costs.

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 In certain instances, particularly when different types of machines are used, departments
are further subdivided for cost control and overhead rate purposes. This results in a refinement in
applying and controlling overhead with respect to the jobs or products passing through a
department.

SELECTION OF SERVICE DEPARTMENTS

The selection and designation of service departments has considerable bearing on

effective costing and control. Services available for the benefit of producing departments and
other service departments can be organized in several ways by 1) establishing a separate
department for each function, 2) combining several functions into one department, or 3) placing
service costs in a department called “ general factory cost pool”. The specific service is not
identified if service costs applicable to producing and service functions are accumulated in a
general factory cost pool.

Determination of the kinds and number of service departments should consider the
number of employees needed for each service function, the cost providing the service, the
importance of the service, and the assignment of supervisory responsibility. Establishing a separate
department for every service function is rarely done even in large companies. When relatively few
employees are involved and activities are closely related, service functions are generally
combined for the sake of economy and expediency. Decisions with respect to combining service
functions are governed by the individual circumstances existing in each company. Since factory
overhead rates for job and product costing are calculated for producing departments only,
service department expenses are transferred ultimately to producing departments for rate setting
and variance analysis.

DIRECT DEPARTMENTAL EXPENSES

The majority of direct departmental overhead costs can be categorized as follows:

1. Supervision, indirect labor, and overtime
2. Labor fringe benefits
3. Indirect materials and factory supplies
4. Repairs and maintenance
5. Equipment depreciation.
These expense categories are generally readily identified with the originating department,
whether producing or service.

INDIRECT DEPARTMENTAL EXPENSES

Expenses such as power, light, rent and depreciation of factory when shared by all
departments, are not charged directly to a department. These expenses do not originate with
any specific department. They are incurred for all to use and must, therefore, be prorated to any
or all departments using them.
Some of the indirect departmental expenses that require prorating together with the bases most
commonly used are:

INDIRECT DEPARTMENTAL EXPENSES DISTRIBUTION BASIS

Factory rent . . . . . . . . . . . . . . . . Square footage*

Property tax . . . . . . . . . . . . . . . . Square footage

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 Depreciation- building . . . . . . . . . Square footage
Insurance- building. . . . . . . . . . . Square footage
Insurance-machinery . . . . . . . . . Value of machinery
Building repairs . . . . . . . . . . . . . . Square footage
Superintendence . . . . . . . . . . . . . Number of Employees
Telephone and telegraph . . . . . . . Number of Employees
or number of telephones
Employee’s compensation contributions Department payroll
Light . . . . . . . . . . . . . . . . . . . . . Kilowatt hours
Freight in . . . . . . . . . . . . . . . . . Materials used
Power . . . . . . . . . . . . . . . . . . . . . Horsepower – hours
*Area of space occupied

After the distribution bases have been selected, a survey of the factory must be made to
secure the information needed to permit the distribution. Information such as total square footage
and its breakdown by departments, number of employees in each department, investment in
machinery by departments and estimates of kilowatt- hours and horsepower hours are items listed
in the survey.

ESTABLISHING DEPARTMENTAL OVERHEAD RATES

Factory overhead is usually applied on the basis of direct labor cost or hours when one
factory overhead rate is used for the entire plant, since this procedure is considered most
convenient and acceptable. The use of departmental rates requires distinct consideration of
each producing department’ overhead, which often results in the use of different bases for
applying overhead for different departments.
Since all factory overhead, whether of a general nature or from service departments, must be
included in producing departments, and establishment of departmental factory overhead rate
proceeds in the following manner:

1. Estimating or budgeting total direct factory overhead of producing and service

departments at the selected activity levels; determining, if possible, the fixed (F) and
variable (V) nature of each expense category
2. Preparing a factory survey for the purpose of distributing indirect factory overhead and
service department costs
3. Estimating or budgeting total indirect factory overhead such as electric power, fuel, water,
building depreciation, property tax, and fire insurance at the selected activity levels
4. Distributing service department costs
5. Calculating departmental factory overhead rates

DISTRIBUTING SERVICE DEPARTMENT COSTS

The number and types of service departments in a company depend on its operations
and the degree of expense control desired. Each service department is charged with its direct
overhead. These costs and any indirect departmental expenses charged to the service
department should be distributed equitably to either producing departments and service
departments or just to producing departments, again depending on management’s decision.
The distribution might be based on number of employees, kilowatt-hour consumption,

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 horsepower-hour consumption, floor space, asset value, or cost of materials to be requisitioned.
The expenses of service departments must ultimately be transferred to producing departments to
establish predetermined factory overhead rates and to analyze variances.

After allocating the factory overhead of service departments (producing and service)
using the factory survey data and other bases (if any), the service department charges are
redistributed to the producing departments using any of the following methods: (a) Direct
method; (b) Step method or Multi-step; or (c) Linear Algebra.

Direct Method. Factory overhead of service departments are distributed directly to the producing
departments. This method is simpler because the order of allocation each service department
costs does not matter, although it is usually unsatisfactory. The costs of each service department
are allocated only to producing departments, and no service department costs are prorated to
other service departments. This saves time and work but often results in an inaccurate cost
allocation.

Step Method. Service department costs are first allocated to other service departments and to
producing departments which have received their services. A service department frequently
renders some service to other service departments as well as to producing departments. This
mutual exchange of services might cause difficulty in allocating service department costs
because the allocation and reallocation could be repeated endlessly. To solve this problem some
generally accepted rules are adopted as follows:
1. Distribute the costs of the service department that serves the greatest number of other
departments first.
2. Distribute the costs of the service department that serves the next greatest number of other
departments second.
3. Follow step 2 until all service department costs are distributed
4. If no one department serve a larger number of other service departments, distribute the
costs of the service department with the largest expenditures first.
5. Once the costs of a service department have been distributed, no further costs are
prorated to it.

Normally, the step method is preferable to the direct method, since it recognizes the benefits
rendered by one service department to other service departments. However, the step method
fails to recognize a situation where one service department may have rendered some reciprocal
service to other service departments. The method of allocations using linear algebra considers
these reciprocal services

Linear Algebra Method. The linear algebra or simultaneous equations method achieves greater
exactness that the step method because it recognized reciprocal services between service
departments. However, this greater exactness can be achieved only if the estimated level of
service that departments render to each other is valid. In complex decisions regarding product
pricing or make-or-buy decisions, the linear algebra is more time-consuming and more costly to
implement, it should be used only if the step method does not provide the allocation refinements
and precision needed.

For example, the Galaxy Production Company distributes its two service departments Cafeteria
and Maintenance to its two production departments, Mixing and Processing. They have
estimated that the departments receive the following percentage of service:

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 Service provided by
Departments Cafeteria Maintenance
Production:
Mixing 30% 45%
Processing 30% 40%
Service:
Cafeteria - 15%
Maintenance 40% - .
100% 100%
Estimated departmental charges before allocations:
Mixing department P124,000
Processing department 136,000
Cafeteria 21,540
Maintenance 25,600
Base: Direct labor hours
Mixing department 12,000 hours
Processing department 14,000 hours
REQUIRED: On the basis of the above data, set up schedules
1. Showing service department overhead allocation using
a. Direct method
b. Step method with maintenance distributed first
c. Linear algebra method
2. Determine the overhead application rate per direct labor hour under each method. Round
to the nearest centavo.

SOLUTION:
a. Direct Method
Producing Departments Service Departments
Particulars Mixing Processing Cafeteria Maintenance
Departmental charges P 124,000 P 136,000 P 21,540 P 25,600
Allocation of service dept costs:
Cafeteria 10,770 10,770 (21,540)
Maintenance 13,553 12,047 (25,600)
Total charges P 148,323 P 158,817
Basis (direct labor hrs) 12,000 14,000
Applied overhead rate P 12.36 P 11.34

Take note that since Cafeteria serves Mixing up to 30% and Processing up to 30% also, Cafeteria
cost will be allocated on the basis of 30:30 or equally to the producing departments.
Maintenance serves Mixing up to 45% and Processing up to 40%, thus Maintenance cost should
be allocated to the producing departments in the ratio of 45:40.

b. Step Method
Producing Departments Service Departments
Particulars Mixing Processing Cafeteria Maintenance
Departmental charges P 124,000 P 136,000 P 21,540 P 25,600
Allocation of service dept costs:
Cafeteria 12,690 12,690 (25,380)
Maintenance 11,520 10,240 3,840 (25,600)
Total charges P 148,210 P 158,930
Basis (direct labor hrs) 12,000 14,000
Applied overhead rate P 12.35 P 11.35

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 Since Maintenance has the larger amount it will be distributed first, Cafeteria receiving its 15%
share. Cafeteria will be allocated only to Mixing and Processing departments in the ratio of 30:30,
or equally.

c. Linear Algebra Method

Producing Departments Service Departments
Particulars Mixing Processing Cafeteria Maintenance
Departmental charges P 124,000 P 136,000 P 21,540 P 25,600
Allocation of service dept costs:
Cafeteria 8,100 8,100 (27,000) 10,800
Maintenance 16,380 14,560 35,460 (36,400)
Total charges P 148,480 P 158,660
Basis (direct labor hrs) 12,000 14,000
Applied overhead rate P 12.37 P 11.33
The total cost of Cafeteria available for distribution is P21,540 plus its share from Maintenance
which is 15%. The total cost of Maintenance available for distribution is P25,600 plus its share from
Cafeteria which is 40%. For distribution, see equation below:
Let X = Cafeteria department cost
Y = Maintenance department cost

Thus X = P21,540 + .15Y (equation 1)

Y = P25,600 + .40X (equation 2)
Substituting:
X = P21,540 +.15 (25,600 + .40X)
Solving:
X = P21,540 + 3,840 + .40x
.60X = P25,380
X = P27,000
Substituting:
Y = P25,600 + .40(27,000)
Y = P36,400

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