FACTORY OVERHEAD COST (Contd.)

Overhead Absorption Rate

After preparing estimates of factory overhead for production departments, the next step is to select a factory overhead absorption base for each production department. The base to be selected for this purpose should be the principal cost deriver of factory overhead of the department. Cost Driver is defined as a measure of activity the magnitude of which influences if magnitude of cost of relevant cost objectives. In other words Factory overhead application base should be a measure of activity which has causal relation with incurrence of factory overhead. The most simple and direct measure of activity of a manufacturing concern is number of units produced. It can be safely regarded as the best cost driver for the purpose of factory overhead absorption in such situations where there is a mass production of homogeneous units (i.e. process costing industries) or where a few products are produced in batches (i.e. batch costing industries). In process costing industries like sugar, cement etc. Kg. or a bag may be regarded as unit of output; a bottler may use a bottle or a liter as a unit of output. In bate costing industries the activity is measured “in equivalent number of units produced. For example, a chip-board factory produces three grades of chip board say A, B, and C and a square foot is used as the unit to measure out put. Technical estimates reveal that factory overhead cost of one square foot of grade B and grade C is respectively one-half and one-fourth of grade A. In other words proportion of factory overhead cost of one square foot of chip board among the three grades is 4:2:1. Consequently, for the purpose of factory overhead absorption one square foot of grade A, B, and C shall be regarded as equivalent to 4 Sq, Ft. 2 Sq, Ft. and 1 Sq. Ft. respectively. On the other hand in job costing industries each unit of output is quite different from the other. For example, a furniture manufacturer produces chairs (study chairs, office chairs, easy chairs, dining chairs), tables. (study tables. office tables, dining tables, dressing tables), beds (doubly beds. single beds) and many other items, each according to specifications of customers. In such a situation because of the dissimilarities, a unit of output can neither be used to measure the activity nor as base for factory overhead absorption. Therefore, some other common denominator should be adopted to measure the activity and as base for applying factory overhead to the products. Basis generally selected for this purpose are listed below in descending order of frequency of use:

  1. Direct labor cost;
  2. Direct labor hours;
  3. Machine hours;
  4. Direct materials cost;
  5. Prime cost. No hard and fast rule regarding selection of the absorption base can be prescribed. However, two guiding principles in this respect are: (i) the selected base should give accurate results, and (ii) cost of operating the base should not be greater than the benefit derived from accuracy. Many times we find that factory overhead cost fluctuates with time spent on the products or Jobs, therefore, direct labor hours and machine hours are more suitable cost derivers. But use of direct labor hours or machine hours as factory overhead absorption base requires additional cost and clerical efforts to collect data of time spent on each job, Consequently, for the sake of convenience, management may decide to adopt direct labor cost as base for applying factory overhead, provided that it also gives approximately correct results. Use of direct materials cost as factory overhead absorption base is rarely recommended because prices of materials are subject to violent fluctuation as well as direct materials cost seldom represents a cost driver of factory overhead. Same is the case with prime cost as a base for factory overhead absorption.

PRACTICE QUESTION

Units of output as the Absorption Base. Babul Bottlers produces “Bubble Drink” which is filled in bottles of three sizes i.e. 25 ml. 1 liter and 5 liters. The firm assigns factory overhead cost to its products by using a predetermined factory overhead absorption rate calculated on the basis of units of output. Technical studies reveal that proportion of factory overhead incurred on one bottle of each size mentioned above is 1:2:4 respectively. Estimated production during the coming year is as follow:

Bottle Size Production
250 ml. 80,000 bottles
1 liter 70,000 bottles
5 liter 20,000 bottles

Estimated factory overhead cost for the coming year is Rs 360.000 Required: Calculate predetermined factory overhead rate for each size of bottle.

Solution:

Bottle Estimated Points Estimated Estimated Estimated Predetermine
Size output Assigned Total FOH Per FOH for FOH rate per
Bottles Points Point Each Size Bottle
Rs. Rs Rs.
250 ml. 80,000 1 80,000 1.20 96,000 1.20
1 liter 70,000 2 140,000 1.20 168,000 2.40
5 liter 20,000 4 80,000 1.20 96,000 4.80
300,000 360,000

Notes: Estimated FOH per point= Total FOH/Total point = Rs. 360.000/300.000 point Estimated FOH for each size Predetermined FOH rate per bottle=Rs. 1.20 = Estimated FOH per point or Estimated points of each size = Estimated FOH for each size/Estimated output of each size

Q. 2 Following figures are presented to you by Alfa Manufacturing Company.

Items Budgeted Figures for operations During 2006 Actual Figures for operations during January 2006
Direct materials (Rs ) Direct labor (Rs.) Factory overhead (Rs.) Direct labor hours Machine hours Dept A 6,000,000 1,500,000 1,200,000 150,000 300,000 Dept B 2,400,000 1,200,000 1,800,000 100,000 360,000 Dept A 50,000 145,000 14,000 26,000 Dept B 250,000 105,000 9,500 28,000

Required:

(i)Calculate predetermined factory overhead absorption rates for the departments using five different bases. (Present your answer by enlisting the rates in descending order of approximate frequency of their use).
(ii)Calculate total product cost of output during January 2006 under all of the three bases, Solution:
(i)Predetermined Factory Overhead Absorption Rates:
FOH Absorption Bases Predetermined FOH Absorption Rates
Department Department B
(1) Direct labor cost base (2) Direct labor hours base (3) Machine hours base (4) Direct materials cost base (5) Prime cost base 80% Rs.8 Rs.4 20% 16% 150% Rs 18 Rs. 5 75% 50%

NOTE:

FOH absorption rate = Estimated FOH for the year x 100 (if base is in Rs) Estimated base for the year

Total Product Cost for January 2006

Particulars (1) Direct Labor Cost Base (2) Direct Labor Hours Base (3) Machine Hours Base
Department A Direct materials Direct labor Factory overhead applied Rs. 450,000 145,000 116,000 Rs. 450,000 145,000 112,000 Rs. 450,000 145,000 104,000
Total Department B: Direct materials Direct Labor Factory overhead applied 711,000 707,000 699,000
250,000 105,000 157,500 250,000 105,000 171,000 250,000 105,000 140,000
Total 512,500 526,000 495,000
Total product cost 1,223,500 1,233,000

NOTES:

Factory Overhead Applied:

Department A:

(1) Rs 145,000 x 80% = Rs. 116,000

(2)14,000 hours x Rs 8 = Rs. 112,000
(3)26,000 hours x Rs. 4 = Rs, 104,000

Department B:

(1)Rs, 105.000 x 150% = Rs, 157,500
(2)9.500 hours x Rs. 18 = Rs. 171,000
(3)28,000 hours x Rs. 5 = Rs. 140,000

Selection of Capacity Level

Capacity Level means ability to produce. The term is synonymous as Activity Level or Volume. Industries producing homogeneous units may express their capacity level in terms of units of output, whereas, Job costing industries may measure it in terms of direct labor cost, direct labor hours, machine hours etc. For the purpose of calculating predetermined factor overhead absorption rate it is necessary to select an appropriate capacity level at which the cost and the cost driver should be estimated. In cost accounting literature we find reference to following types of capacity levels.

Theoretical Capacity It is the maximum capacity level that could be achieved if there were 100% utilization of time. This capacity level can never be achieved because of unavoidable interruptions e.g. Fridays, holidays, repair and maintenance, machine breakdown, electricity breakdown, shortage of materials, lack of demand etc. Theoretical capacity is the starting point for measurement of practical capacity.

Practical Capacity It is the maximum capacity level that can he attained under efficient working conditions. When loss of time due to unavoidable interruptions as mentioned above, is deducted from theoretical capacity the remainder is practical capacity. Expected/Normal Capacity It is the capacity level expected to be attained during the accounting, year. Expected/normal capacity is dependent of market demand for the products. It may be equal to or less than the practical capacity. Most of the experts make a slight difference between expected and normal capacity. They are of the opinion that normal capacity is the average of expected capacity over a number of years. This average is used to smooth the seasonal, cyclical and trend variations over the years.

Selection of an appropriate capacity level is necessary because:

(1)Fixed factory overhead absorption rate is inversely related with capacity level i.e. the fixed rate is higher at a lower capacity level and it is lower at a higher capacity level,
(2)Amount of unabsorbed fixed factory overhead at the end of an accounting period is used to denote cost of failing to achieve the target production i.e. cost of unutilized capacity (the idle capacity variance to be discussed later).

Practical capacity is seldom selected for the purpose of budgeting. It is the expected/normal capacity that is used to budget or estimate the costs. Long term planning prospective advocates selection of normal capacity level. However, on account of difficulties in estimating with reasonable accuracy beyond one year. expected actual capacity is most commonly adopted. Following practice question shows affects of capacity level on factory overhead, application rate and on the amount of unabsorbed fixed factory overhead.

PRACTICE QUESTION

At beginning of the year 2006 Shahbaz & Co. estimated its fixed factory overhead at Rs. 350,000 and variable factory overhead at Rs. 500,000 for a normal volume of 125,000 units. Practical volume was estimated at 140,000 units per year. During 2006 the company could produce only 100,000 units. Required: Compute each of the following on the bases of (i) Expected volume and (ii) Practical

volume:

(a)Predetermined factory overhead application rate:
(b)Amount of factory overhead applied during 2006 and

Solution:

(a)Predetermined Factory Overhead Application Rate ; Estimated Factory Overhead Estimated Capacity Level
(i)At normal capacity

(Rs. 350,000 Fixed + Rs 500,000 Variable) = Rs 6.80 per unit 125,000 units

(ii) At practical capacity level

(Rs. 350,000 Fixed + Rs. 500,000 Variable) = Rs 6.07 per unit 140,000 units

(b)Factory Overhead Applied During 2006: Capacity attained x Factory overhead application rate at normal capacity
(i)Using the rate at expected capacity

100.000 units x Rs 6.80 = Rs. 680,000

Blanket Rate

A blanket absorption rate is a single rate of absorption used throughout an organization’s production facility and based upon its total production costs and activity. The use of a single blanket rate makes the apportionment of overhead costs unnecessary since the total production costs are to be used. How ever this is not recommended for the following reasons:

  • It relies on a single activity measure being appropriate for the entire production function.
  • It does not distinguish between the miming costs of particular activities or departments when absorbing costs into cost units.

Accounting for Factory Overhead Cost

Factory overhead cost includes indirect materials cost, indirect labor cost and other indirect manufacturing costs. Most of the factory overhead cost items are recorded (identified) straight away as factory overhead cost; these include some sort of indirect material items, indirect labor, electricity, insurance, rent, repair etc. etc. Accounting entry for these costs is: Factory overhead control a/c xxx

Bank/cash/accounts payable a/c xxx Some of the factory overhead cost items are allocation or transfer of cost from another accounting head. Accounting entry for these costs is: Factory overhead control a/c xxx

Depreciation a/c xxx Prepaid rent a/c xxx Etc. . xxx

Applied factory overhead is entered in the work in process account. In order to journalize total applied factory overhead following accounting entry is passed:

Work in process control a/c xxx

Factory overhead applied a/c xxx The amounts are then posted to relevant ledger accounts. Actual factory overhead continues to accumulate on debit side of factory overhead control account throughout the year and applied factory overhead cost on credit side of factory overhead applied account. At the end of year factory overhead applied account is closed to factory overhead control account by passing following accounting entry: Factory overhead applied a/c xxx

Factory overhead control a/c xxx Actual and applied overhead are never equal. They could be equal only when estimates of factory overhead cost and the capacity level prepared for calculating the absorption rate are 100% correct. In practice it is impractical to achieve this much accuracy. As a result, after the close of applied account, factory overhead control account shows either a debit balance representing under applied factory overhead or a credit balance representing over applied factory overhead. Under applied factory overhead means that factory overhead cost charged to production is less than the actual factory overhead and the cost of production is understated. On the other hand over applied factory overhead means that factory overhead charged to production is more than the actual factory overhead and the cost of production is overstated. This under or over applied balance is disposed off by adopting anyone of the following four methods.

1. Adjusting Cost of Entire Production of the Period. This is the most accurate method and gives correct figures for income determination and for balance sheet. At the end of a year total production of the year stands divided into

a) cost of goods sold, b) finished good inventory’ and c) work in process inventory.

An under or over absorbed factory overhead means respectively under or overstated cost of goods sold, finished goods inventory and work in. process inventory. Therefore mathematically correct method is to adjust all of these three accounts by distributing under or over applied overhead to these accounts in the proportion of their respective balances. Assume that at the end of year factory overhead control account shows an over applied balance of Rs. 100,000. Balances of cost of goods sold, finished goods and work in process control accounts are Rs. 1,600,000 .Rs. 300,000 and Rs. 100,000 respectively. The over applied factory overhead shall be disposed off by passing following entry in general journal.

Factory overhead over-applied a/c 100,000 Cost of goods sold a/c 80,000 Finished goods a/c 15,000 Work in process a/c 5,000

The above entry closes factory overhead control account and reduces the balance of cost of goods sold, finished goods, and work in process control accounts by the accounts by which these are overstated. Had the factory overhead cost under absorbed, the above entry would have been reversed.

1. Closing the Variance to Cost of Goods Sold.

Posting of under or over applied factory overhead to the subsidiary ledgers of finished goods and work in process control accounts is a tedious .job requiring much clerical efforts especially in job-order and batch costing industries, Therefore, when the amount of under or over absorbed factory’ overhead is insignificant. The cost accountants prefer to close it only to cost cost management accounting  FACTORY OVERHEAD COST (Contd.)of goods sold. In this case the entry to be passed in general journal to dispose off an over applied balance is as follow:

Factory over head over-applied a/c xxx

Cost of goods sold a/c xxx Obviously the entry to dispose of an under applied balance shall be opposite to the above entry. This method though theoretically not very sound, is justified on the ground of convenience.

2. Closing the Variance to Income Statement.

Where factory overhead variance is on account of some abnormal factors e.g. idle capacity caused by strikes or lockouts, unlawful spending, poor utilization of production facilities, mismanagement in production etc. the amount of variance is closed to Income Summary/Profit and Loss Account. The above noted factors result in under absorption of factory overhead. The general journal entry to dispose off such under applied factory overhead is as follow:

Income summary/Profit & loss a/c xxx Factory overhead under-applied a/c xxx

In this case, cost of goods sold at normal is deducted from the net sales. The resulting gross profit is termed as gross profit at normal. Then from the gross profit at normal amount of under absorbed factory overhead is deducted and the remainder is called gross profit at actual. Alternatively this amount of under absorbed factory overhead may also be deducted from the net profit/income.

PRACTICE QUESTION

City Links Limited applies factory overhead @ 60% of direct labor cost. During the year just

completed following actual costs were recorded:

Direct labor cost Rs. 580,000

Factory overhead cost Rs. 428,000 At the end of the year following balances appear in some of the control accounts:

Cost of goods sold Rs. 1,750,000
Finished goods Rs. 500,000
Work in process Rs. 250,000
Required:

a) Determine under or over applied factory overhead.

b) Pass accounting entry to close factory overhead applied account at the end of year.

c) Pass accounting entries to dispose off under or over applied factory overhead in following cases: i) The variance is regarded as a significant amount. ii) The variance is regarded as an insignificant amount.

iii) The variance is regarded as cause by poor scheduling of production and excessive spending.

Solution:

(a)Under or Over applied Factory Overhead: Actual factory overhead Rs. 428,000 Capacity attained x application rate Rs. 580,000 x 60% 348,000 Under applied 80,000
(b)Entry to Close Factory Overhead Applied a/c: Factory overhead applied a/c 348,000

Factory overhead control a/c 348,000

Under applied Factory overhead a/c 80,000 Factory overhead control a/c 80,000

(c)ntries to dispose off under or over applied Factory Overhead:
(i)Cost of goods sold a/c 56,000 Finished goods a/c 16,000 Work in process a/c 8,000

Factory overhead under applied a/c 80,000 Rs. 80,000 x 1,750 =Rs. 56,000 2,500 x 500 =Rs. 16,000 x 250 =Rs. 8,000

(ii) Cost of goods sold a/c 80,000

Factory overhead under applied a/c 80,000

(iii) Income summary a/c 80,000

Factory overhead under applied a/c 80,000

Factory overhead variance means the difference between actual factory overhead incurred and factory overhead applied during the year. Under applied factory overhead is regarded as an unfavorable sign because actual factory overhead cost is greater than the factory overhead absorbed by the production, On the other hand. Over applied factory overhead is considered as favorable sign because actual factory overhead is less than the factory overhead absorbed. This total variance is analyzed to determine the causes. The causes of variance lie in the following two factors:

a) The variance may be due to the difference between capacity level budgeted for calculating

predetermined factory overhead absorption rate and the capacity level actually attained till

the end of year: and

b) The variance may be due to the difference between factory overhead budgeted for capacity

attained and the factory overhead cost actually incurred

If the variance is caused by difference in capacity i.e. the first factor mentioned above, it is called Capacity Variance or Volume Variance. On the other hand, if the variance is caused by difference in budgeted and actual costs. i.e. the second factor mentioned above, it is called Budget Variance or

Spending Variance

In practice the total variance is composed of both of these two factors. The total variance is decomposed into capacity variance and budget variance in order to determine the magnitude of variance caused by each of the two factors listed above.

Capacity/Volume Variance

Capacity variance is on account of presence of fixed factory overhead. Predetermined factory overhead absorption rate is the sum of fixed rate and variable rate. We know that total fixed factory overhead remains unchanged within a designated range of activity level and the fixed rate

changes inversely with changes in activity level Assume that for an estimated activity level of 50,000 machine hours budgeted factory overhead is Rs. 150,000 which includes Rs 100.000 of fixed cost. The absorption rate and its composition in this case is as follow:

FOH absorption rate:

Rs, 150,000/ 50.000 machine hrs = Rs. 3 per machine hr. The fixed rate: Rs. 100,000/50.000 machine hrs = Rs. 2 per machine hr. The variable rate: Rs 3 per machine hr less Rs. 2 per machine hr = Rs. 1 per machine hr.

It is very easily understood that Rs, 100.000 of fixed factory overhead can be absorbed only when capacity attained till the end of year is 50,000 machine hours If capacity attained is less than the budgeted capacity it means an unfavorable capacity variance, which will be signified by unabsorbed fixed factory overhead. Assume that the capacity attained is 48,000 machine hours. At this capacity level only Rs 96,000 of fixed factory overhead is absorbed (i.e. 48,000 hrs x Rs. 2) and the under absorbed fixed cost of Rs 4,000(i.e. Rs. 100,000 less Rs. 96,000) represents the portion of factory overhead variance cause by unfavorable capacity variance. Similarly, where capacity attained is more than the budgeted capacity it is a favorable capacity variance which will be signified by over absorbed fixed factory overhead. In other words capacity variance can be computed by multiplying the difference in capacity (budgeted and attained) by the fixed rate. The same result is obtained by taking. the difference between absorbed factory overhead and budgeted factor* overhead for capacity attained. Budget/Spending Variance Budget variance is the difference between budgeted factory overhead for capacity attained and actual factory overhead incurred. It represents either over-spending or under-spending. If actual factory overhead is more than the budgeted, it is unfavorable budget variance. On the other hand if actual factory overhead is less than the budgeted it is favorable budget variance. In order to determine exact causes of budget variance, the difference between actual and budgeted figures of each item of factory overhead is computed and communicated to the responsible person for the purpose of control. The budget variance may be due to fixed factory overhead items or it may be due to the variable items or the both. Following practice question explains the computation and presentation of the variance and its analysis.

PRACTICE QUESTION

Shahzewaz Associates prepared following estimates for the year 2006. Fixed factory overhead Variable factory overhead

Direct labor hours Actual results for the year 19xx were as follow:

Fixed factory overhead Rs. 450,000
Variable factory overhead Rs. 600,000
Direct labor hours 200,000
Required: Calculate
(i) Total factory overhead variance.
(ii) Capacity variance.
(iii) Budget variance.
Solution:
(i) Total Factory Overhead Variance
Actual factory overhead
Fixed FOH + Variable FOH
Rs. 450.000 + Rs. 680,000 Rs. 1,130,000
Absorbed factory overhead
Capacity attained x Absorption rate
220,000 hours x Rs. 5.25 1,155,000
Over applied 25,000
(ii) Capacity Variance
Absorbed factory overhead (220,000 x 5.25) Rs. 1.155.000
Budgeted factory overhead for capacity attained
Fixed factory overhead + (Capacity attained x Variable rate)
(Rs. 450,000 + 220,000 hours x Rs. 3) 1,110,000
Favorable 45,000
(iii) Budget Variance
Budgeted factory overhead for capacity attained Rs. 1,110,000
Actual factory overhead 1,130,000
Unfavorable 20,000

Supporting Calculations Absorption rate = (Rs 450.000 + Rs. 600,000)

200.000 direct labor hours = Rs. 5.25 per direct labor hour Variable rate = Rs. 600.000

2,00,0000 direct labor hours = Rs. 3 per direct labor hour

It should be remembered here that no definite conclusions can be drawn only on the basis of factory overhead variance analysis, as presented above Analysis of factory overhead variance is a part of whole process of variance analysis whereby direct materials variance and direct labor variance are also computed and analysed. Complete study of variance analysis is a part of advanced courses of cost accounting. In the above practice question capacity attained in terms of direct labor hours is greater than the budgeted capacity. This seemingly favorable capacity variance may, in fact, be due to unfavorable factors. For example, direct labor may be less efficient and as a result same quantity of output is produced by working greater number of hours, or it may be due to defective materials which require more conversion time and as such the hours worked over and above the budgeted capacity have not resulted in extra output Similarly an unfavorable budget variance may be on account of higher spending on preventive repairs and maintenance or higher spending on training of workers, which is in effect beneficial for the organisation. Here a practice question is discussed to explain High and Low Point Method. This method is a technique to segregate fixed and variable portions of a total/semi-variable cost.

Practice Question

Predetermined factory overhead absorption rate computed by AI-Nasr Associates Rs. 6 per machine hour. Budgeted factory overhead for activity level of 150.000 machine hours is Rs. 800,000 and for activity level of 100,000 machine hours it is Rs. 700,000. Actual factory overhead incurred during the year is Rs. 710,000 at an actual volume of 120,000 machine hours. Required:

(i)Variable factory overhead absorption rate.
(ii)Budgeted fixed factory overhead,

(iii) Budgeted activity level on which the absorption rate is based

(iv)Over or under absorbed factory overhead.
(v)Volume variance
(vi)Spending variance

Solution:

(i) Variable Factory Overhead Absorption Rate:

Activity Level Budgeted FOH
(Machine Hours) (Rs.)
High 150,000 800,000
Low 100,000 700.000
50,000 100,000

For a change of 50,000 machine hour’s m activity level there is a change of Rs, 100,000 in budgeted factory overhead. This change in budgeted factory overhead is due to variable factory overhead. Therefore, Variable rate = Change in budgeted FOH

Change in activity level Rs 100,000/50,000 machine hours Rs. 2 per machine hour

(ii) Budgeted Fixed Factory Overhead:
Total FOH for 150,000 machine hours Budgeted variable FOH = 150,000 hrs Rs 2 Budgeted fixed FOH = Rs 800.000 less Rs. 300,000 OR Total FOH for 100.000 machine hours Budgeted variable FOH =100.000 hrs x Rs. 2 Budgeted fixed FOH = Rs, 700.000 less Rs. 200,000 = Rs. 800.000 = Rs. 300,000 = Rs. 500.000 = Rs 700.000 = Rs 200.000 =Rs. 500.000
(iii)Budgeted Activity Level
Budgeted activity level = Fixed FOH Fixed rate = Rs. 500.000/ (Rs. 6 less Rs. 2) =125,000 machine hours
(iv) Over or under absorbed Factory Overhead:
Actual factory overhead Absorbed factory overhead Actual volume x FOH absorption rate 120,000 hrs x Rs. 6 Over absorbed Rs. 710.000 720.000 10,000
(v) Volume Variance: Absorbed factory overhead Budgeted FOH for actual volume Fixed FOH + (Actual volume x Variable rate) Rs, 500.000 + (120.000 hrs, x Rs. 2) Unfavorable Rs. 720,000 740,000 20,000
(vi) Spending Variance: Budgeted FOH for actual volume Actual factory overhead Favorable Rs. 740,000 710,000 30,000
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