GLOBAL RECIPROCAL COLLEGES

College of Accountancy
Caloocan City
COST ACCOUNTING AND CONTROL ML M. DELA CRUZ

AFAR-CA400
COST ACCOUNTING:
ACCOUNTING FOR OVERHEAD

Factory Overhead Defined

Factory Overhead (also known as Manufacturing Overhead) refers to the indirect costs associated with the
production process that cannot be directly traced to a specific product or cost center. These costs are necessary to
support production but are not part of the raw materials or direct labor used in manufacturing.

Factory overhead includes:

1. Indirect Labor: Wages for workers who are not directly involved in the production process, such as
supervisors, maintenance staff, and quality control personnel.
2. Indirect Materials: Materials that are used in the production process but cannot be traced directly to a
specific product, like lubricants, cleaning supplies, and small tools.
3. Other Manufacturing Expenses:
a. Utilities: Costs for electricity, water, gas, and other utilities used to run machinery and equipment in
the factory.
b. Depreciation: The depreciation on factory equipment, machinery, and buildings.
c. Factory Rent: The cost of leasing or owning the factory building.
d. Insurance: Costs for insuring the factory and its equipment.

Factory overhead is an important component of total manufacturing costs and is allocated to products through
various cost allocation methods. These costs are usually accumulated in a Manufacturing Overhead Control
account and then applied to work-in-progress (WIP) during the production process.

Predetermined Overhead Rate

The Predetermined Overhead Rate (POHR) is a vital concept in cost accounting used to allocate factory
overhead (indirect production costs) to products during the production process. Instead of waiting until the end
of the period to calculate actual overhead costs, the POHR allows businesses to estimate and apply overhead costs
to products throughout the period based on a predetermined rate.

Why Use a Predetermined Overhead Rate?

The main purpose of using a predetermined overhead rate is to simplify the allocation of overhead costs. Since
overhead costs, like utilities, maintenance, and depreciation, can be unpredictable, calculating the exact overhead
cost at the time the products are made is not feasible. The POHR allows companies to apply overhead in real-
time, which is essential for accurate cost tracking, financial reporting, and decision-making.

How is the Predetermined Overhead Rate Calculated?

The POHR is calculated before the production period starts, based on estimates of total factory overhead and a
chosen cost driver (usually based on an activity that drives the overhead, such as labor hours, machine hours, or
units produced). The formula to calculate the POHR is:

Estimated Total Factory Overhead

Predetermined Overhead Rate =
Estimated Total Activity Base

Breakdown of the components:

1. Estimated Total Factory Overhead: This is the total expected cost of all indirect manufacturing expenses
for the period. These costs typically include things like utilities, depreciation of equipment, salaries for
indirect workers, and factory supplies.
2. Estimated Total Activity Base: The activity base is a measurable factor that drives overhead costs.
Common activity bases include:
• Direct Labor Hours: Total hours worked by all employees.
• Machine Hours: Total hours of machine usage.

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• Units Produced: The total number of products made.

• Direct Labor Cost: Total wages paid to workers involved in direct production.

Once the POHR is calculated, it is used to apply overhead costs to products as they are manufactured throughout
the year. During production, the company tracks the actual machine hours (or whichever activity base is being
used) for each product. The predetermined overhead rate is then multiplied by the actual activity to determine
how much overhead to apply to that product.

At the end of the period, the company compares the applied overhead (the overhead applied to products using
the predetermined rate) with the actual overhead (the actual overhead costs incurred during production). This
comparison often reveals an over-applied or under-applied overhead situation.

1. Over-applied Overhead: If the company applied more overhead than it actually incurred, the overhead
is said to be "over-applied." This means that the cost allocated to products was higher than the actual costs.
The over-applied overhead is typically adjusted by reducing the cost of goods sold or by adjusting the
work-in-process inventory.
2. Under-applied Overhead: If the company applied less overhead than it actually incurred, the overhead
is said to be "under-applied." This means that the cost allocated to products was lower than the actual
costs. The under-applied overhead is typically adjusted by increasing the cost of goods sold or adjusting
inventory values.

Allocating Overhead Costs

Comparison of Plant-Wide Rate and Departmental Rate for Allocating Overhead Costs

Aspect Plant-wide Rate Departmental Rate

Definition A single overhead rate applied across the Separate overhead rates for each department,
entire plant, using one cost driver (e.g., labor based on departmental-specific activities or
hours, machine hours). cost drivers.
Simplicity Simpler to calculate and apply since only one More complex, as multiple rates are
rate is used for the whole plant. calculated and applied across departments.
Accuracy Less accurate, as it assumes all departments More accurate, as it allocates costs based on
use overhead resources similarly. each department’s specific usage of overhead
resources.
Cost Allocates overhead evenly across all products, Allocates overhead based on the actual
Allocation regardless of the department they pass activities and resource consumption of each
through. department.
Use Case Best for small businesses or when overhead Best for larger organizations with distinct
costs are evenly distributed across departments and varying overhead cost
departments. structures.

In summary, the plant-wide rate is simple but may lack accuracy, while the departmental rate offers more
precision but is more complex to implement.

Departmentalization: Service Allocation Methods

Departmentalization of Factory Overhead is the process of allocating manufacturing overhead costs to

different departments within a factory. Each department has distinct overhead costs associated with the activities
it performs. By departmentalizing overhead, companies can more accurately allocate costs to products based on
the specific resources and activities consumed in each department, leading to better cost control, more precise
product costing, and more informed decision-making.

The reason for departmentalizing factory overhead is to reflect the reality that different departments within a
manufacturing facility use overhead resources in different ways. A single overhead rate applied across the entire
factory may not fairly allocate the actual overhead costs for products produced in different departments. For
example:
• One department may rely heavily on machine hours, while another depends more on labor hours.
• Some departments may have higher utility costs or require more maintenance than others.

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By departmentalizing overhead, a more accurate cost allocation is made, allowing for better tracking of each
department's efficiency and the real cost of producing goods.

Advantages of Departmentalizing Factory Overhead

1. More Accurate Costing: By allocating overhead costs based on department-specific activities, businesses
can ensure that the cost of production reflects actual resource consumption, leading to more accurate
product costing.
2. Improved Cost Control: Departmentalization allows for easier identification of cost inefficiencies in
specific areas of production. Managers can see which departments are consuming more resources and take
steps to improve efficiency.
3. Better Pricing Decisions: Accurate costing ensures that products are priced appropriately, accounting for
the actual overhead costs incurred in their production.
4. Improved Decision-Making: Department-specific overhead allocation helps managers evaluate the
profitability of products more accurately. They can see how much overhead each department is
contributing to product costs and make better decisions about product mix, process improvements, and
resource allocation.

Disadvantages of Departmentalizing Factory Overhead

1. Complexity: Departmentalizing factory overhead can be more complex and time-consuming than using
a plant-wide rate. It requires identifying departments, estimating costs, and calculating rates for each
department.
2. Higher Administrative Costs: Managing multiple overhead rates and tracking departmental costs
requires additional administrative effort and resources. For larger businesses, this could require a more
sophisticated costing system.
3. Overhead Allocation May Still Be Arbitrary: Although departmental overhead rates improve cost
allocation accuracy, the allocation base used (e.g., labor hours or machine hours) may still not perfectly
reflect how resources are consumed. Thus, there may still be some degree of arbitrary cost allocation.

Service Allocation Methods are used in cost accounting to allocate overhead costs that are incurred by support
or service departments to the production or operating departments. Service departments typically provide internal
services that aid in the production process, such as maintenance, human resources, information technology, and
janitorial services. These costs must be allocated to the production departments to ensure that products or services
are appropriately charged for all the indirect costs involved.

The goal of service allocation is to ensure that the final cost of production includes not only the direct costs (such
as raw materials and direct labor) but also the indirect or overhead costs associated with support services.

1. Direct Allocation Method

The Direct Allocation Method is one of the simplest and most straightforward methods for allocating
service department costs. In this method, the costs incurred by service departments are directly allocated
to the production departments based on a predetermined allocation base (such as labor hours, machine
hours, or units produced). This method does not take into account any interactions or services provided
between different service departments.

2. Step-Down (Sequential) Allocation Method

The Step-Down Method, also known as the Sequential Allocation Method, is a more detailed approach
compared to the Direct Allocation Method. It allocates costs of service departments to both production
departments and other service departments, but it does this in a specific sequence. The service department
that provides the most services to other departments (whether service or production) is allocated its costs
first. Then, the costs of the next service department are allocated, and so on. Once a service department's
costs have been allocated to other departments, no further costs are re-allocated to that department.

3. Reciprocal (Algebraic) Allocation Method

The Reciprocal Allocation Method is the most accurate and complex of all service allocation methods.
It recognizes that service departments not only provide services to production departments but also to
other service departments. Unlike the Step-Down Method, the Reciprocal Method considers the mutual
services exchanged between service departments and allocates these costs accordingly. This method

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involves solving a set of simultaneous equations to allocate the costs between service departments and
production departments.

Summary of Service Allocation Methods

Method Description Advantages Disadvantages

Direct Allocates service department Simple and easy to Ignores interactions between
Allocation costs directly to production apply. Requires service departments; can be
departments, ignoring service minimal data and inaccurate.
department interrelations. calculations.
Step-Down Allocates service department More accurate than The order of allocation
(Sequential) costs in a sequence, considering Direct Allocation; impacts results; does not fully
service department interactions to easier to apply than account for interdepartmental
some extent. Reciprocal. exchanges.
Reciprocal Allocates service department Most accurate Complex and time-consuming;
(Algebraic) costs while fully accounting for method, accounts for requires solving simultaneous
interdepartmental service all service department equations.
exchanges. interactions.

Factory Overhead Variance Disposition

Actual Overhead refers to the real costs that a company incurs for factory overhead during a specific period.
These are the actual expenses incurred in the production process, including actual costs for items like electricity,
factory rent, maintenance, and salaries for factory supervisors. These costs are recorded as they occur in the
accounting records.

Applied Overhead refers to the overhead that is applied to products during the production process based on a
predetermined overhead rate. The predetermined rate is typically established at the beginning of the period based
on estimated overhead costs and an allocation base, such as direct labor hours or machine hours. The applied
overhead is calculated by multiplying the predetermined overhead rate by the actual level of the allocation base
(such as the actual machine hours or labor hours used).

Overapplied and Underapplied Overhead

After comparing the actual and applied overhead, the difference between the two is the overapplied or
underapplied overhead:
• Overapplied Factory Overhead occurs when the applied overhead exceeds the actual overhead. This means
that more overhead was applied to production than was actually incurred.
• Underapplied Factory Overhead occurs when the actual overhead exceeds the applied overhead. This
means that less overhead was applied to production than was actually incurred.

Disposition of Factory Overhead Variance

At the conclusion of each accounting period, any discrepancies between actual and applied factory overhead
(overapplied or underapplied) must be addressed. The method of disposition depends on the materiality of the
variance.
• Immaterial Variance: When the variance is deemed insignificant, it is typically closed directly to Cost
of Goods Sold (COGS). This treatment does not affect the unit cost and considers the entire variance as
a period expense.
• Material Variance: In cases where the variance is material, it is allocated proportionally among Work in
Process (WIP), Finished Goods, and Cost of Goods Sold (COGS). This allocation reflects that some
units are still in production, some remain unsold, and others have been sold. This method ensures that the
cost per unit is appropriately adjusted, reflecting the actual incurred overhead costs.

By applying these treatments according to the significance of the variance, companies ensure the accuracy of their
financial statements and maintain precise cost allocations across all stages of production.

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DISCUSSION DRILLS

Drills 400-1
Morningstar Corp. expects to produce 10,000 widgets in 2025, which is 80% of its normal capacity. The estimated
unit costs are ₱40 for materials and ₱60 for direct labor, with direct labor being paid at a rate of ₱24 per hour. The
widget shaper, the most expensive piece of machinery, operates for 20 minutes to produce each widget. The total
estimated overhead for the year is ₱400,000 for variable overhead and ₱400,000 for fixed overhead.

Required: Compute the overhead rate for each of the following bases, using the expected actual capacity activity
level:
1. Physical output
2. Materials cost
3. Direct labor cost
4. Direct labor hours
5. Machine hours

Drills 400-2
Decker Co. uses the job order costing system. Factory overhead is applied to jobs on the basis of direct labor cost.
The following estimates are made at the beginning of the year (in Philippine Peso):

Fabricating Machining Assembly Total

Direct labor 600,000 300,000 900,000 1,800,000
Factory overhead 1,050,000 1,200,000 270,000 2,520,000

The following are the cost required by each department:

Fabricating Machining Assembly Total

Direct materials 9,000 600 4,200 13,800
Direct labor 8,400 1,500 18,600 28,500
Factory overhead ? ? ? ?

At the end of the year, the following are the actual cost data relating to all jobs processed during the year:

Fabricating Machining Assembly Total

Direct materials 570,000 48,000 342,000 960,000
Direct labor 630,000 324,000 786,000 1,740,000
Factory overhead 1,080,000 1,260,000 252,000 2,592,000

The company uses plant-wide overhead rate to apply the factory overhead cost to jobs.

Required:
1. Using plant-wide factory overhead rate
a. Compute the factory overhead rate.
b. Compute the amount of factory overhead applied to the job.

2. Assume the company used separate factory overhead rate for each department
c. Compute the factory overhead rate for each department.
d. Compute the amount of factory overhead cost applied to the job.

3. Compute the over or under-applied factory overhead for the year (1) assuming the plant-wide overhead
rate is used; (2) assuming the departmental overhead rates are used.

Drill 400-3
Espinoza Company is exploring ways to allocate the cost of its service departments namely, Quality Control and
Maintenance to the company’s production departments namely, Machining and Assembly. The controller of the
company has provided the following information:

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Quality
Maintenance Machining Assembly Total
Control
Overhead costs before allocation ₱350,000 ₱200,000 ₱400,000 ₱300,000 ₱1,250,000
Machine hours — — 50,000 — 50,000
Direct labor hours — — — 25,000 25,000
Hours of service of quality control — 7,000 21,000 7,000 35,000
Hours of service of maintenance 10,000 — 18,000 12,000 40,000

Required:
1. Under the direct method of allocating service department costs, what are the total service costs allocated
to the machining and assembly departments, respectively?
2. Under the step-down method of allocating service departments costs from quality control to maintenance,
what are the total service costs allocated to the machining and assembly departments, respectively?
3. Under the algebraic/reciprocal method of allocating service department costs, what are the total amount
of quality control costs and total amount of maintenance costs, respectively, to be allocated to the
producing department?
4. Under the algebraic/reciprocal method of allocating service department costs, what are the total service
costs allocated to the machining and assembly departments, respectively?

Drill 400-4
The records of Maze Corporation revealed the following data for 2025:

Raw Materials ₱500,000

Work In Process 150,000
Finished Goods 450,000
Cost of Goods Sold 600,000

The actual factory overhead cost is ₱120,000 and the applied factory overhead cost is ₱100,000.

Required: Prepare the journal entry assuming: (1) the variance is material; (2) the variance is immaterial.

Success is the sum of small efforts, repeated day in and day out.
Robert Collier

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