Question

What are the four (4) steps in determining the standard fixed factory overhead application rate? Does the procedure differ for product-costing versus cost-control purposes? Explain.

Answer 1

Computing Factory Overhead Application Rates

Bases commonly used to compute the factory overhead application rate are: (1) units of production, (2) direct materials cost, (3) direct labor cost, (4) direct labor hours, and (5) machine hours. Let’s go to the details. Read on…

Units of Production:

This method is very simple because data on the units produced is readily available for applying factory overhead. The formula is as follows:

Factory overhead application rate per unit of production = Estimated factory overhead cost [:] Estimated units of production

This method applies factory overhead equally to each unit produced and is appropriate when a company or department manufactures only one product.

Direct Materials Cost:

This method is suitable when it can be determined that a direct relationship exists between factory overhead cost and direct materials cost. When direct materials are a very large part of total cost, it may be inferred that the factory overhead costs are directly related to direct materials. The formula is as follows:

Estimated factory overhead costs [:] Estimated direct materials cost = Percentage of direct materials cost

One problem in using direct materials cost as a base where more than one product is manufactured is that different products require varying quantities and types of direct materials with different acquisition costs. Therefore, different factory overhead application rates should be determined for each product. As can be seen, we are beginning to move away from one of our objectives—simplicity with the use of multiple rates. This should indicate to management that perhaps another base would be more appropriate.

Direct Labor Cost:

This is the most widely used base because direct labor costs are generally closely related to factory overhead cost, and payroll data is readily available. It therefore meets our objectives of having a direct relationship to factory overhead cost, being simple to compute and apply, and requiring little, if any, additional cost to compute. Thus this method is appropriate when a direct relationship exists between direct labor cost and factory overhead. [There are, however, situations where there is little relationship between direct labor costs and factory overhead and this method would not be appropriate. For example, factory overhead costs may be composed largely of depreciation and equipment-related costs]. The formula is as follows:

Estimated factory overhead costs [:] Estimated direct labor cost = Percentage of direct labor cost

If there is a direct relationship between factory overhead cost and direct labor cost, but wage rates vary greatly within departments, the following base may be more preferable.

Direct Labor Hours:

This method is appropriate when there is a direct relationship between factory overhead costs and direct labor hours, and when there is a significant disparity in hourly wage rates. Timekeeping records must be accumulated to provide the data necessary for applying this rate. The formula is as follows:

Estimated factory overhead costs [:] Estimated direct labor hours = Factory overhead application rate per direct labor hour

This method, like the direct labor cost method, would be inappropriate if factory overhead costs were composed of costs unrelated to labor activity.

Machine Hours:

This method uses the time required for machines to perform similar operations as a base in computing the factory overhead application rate. This method is appropriate when a direct relationship exists between factory overhead costs and machine hours. This generally occurs in companies or departments that are largely automated so that the majority of factory overhead costs consist of depreciation on factory equipment and other equipment-related costs. The formula is as follows:

Estimated factory overhead costs [:] Estimated machine hour = Factory overhead application rate per machine hour

The disadvantages of this method are the additional cost and time involved in summarizing total machine hours per unit. Because every company is different, the decision regarding which base is appropriate for a particular manufacturing operation must be made by management after careful analysis.

Product Costing

The costs involved in creating a product are called Product Costs. These costs include materials, labor, production supplies and factory overhead. The cost of the labor required to deliver a service to a customer is also considered a product cost. Product costs related to services should include things like compensation, payroll taxes and employee benefits.

Since product costs include manufacturing overhead that is required by both GAAP and IFRS, product costs should appear on financial statements. To eliminate overhead costs, a manager may modify product cost when making short-term product and unit pricing decisions. Alternatively, managers might decide to focus on the impact of a product on a bottleneck operation with their main focus being on the direct materials cost of a product and the time it spends in the bottleneck operations.

Product cost appears in the financial statements since it includes the manufacturing overhead that is required by both GAAP and IFRS. However, managers may modify product cost to strip out the overhead component when making short-term production and sale-price decisions. Managers may also prefer to focus on the impact of a product on a bottleneck operation, which means that their main focus is on the direct materials cost of a product and the time it spends in the bottleneck operation.

Types of Product Costs

Costs incurred to produce a product intended to sell to a customer is called Product Costs.

Product cost includes:

Direct material: raw materials bought that go directly into producing the products. For example, the metal to make a car is a direct material cost for a car manufacturer.

Direct labor: the wages, benefits, and insurance that are paid to employees directly involved in manufacturing and producing the goods. For example, workers on the assembly line or those who use the machinery to make the products.

Manufacturing overhead: indirect factory-related costs that are incurred when producing a product. Manufacturing overhead costs include:

• Indirect material: materials used in the production process but are not directly traceable to the product. Examples include glue, oil, tape, cleaning supplies, etc. are classified as indirect materials because it would be difficult to determine the exact cost of the materials that go into the production.
• Indirect labor: the cost of wages for the labor of those who are not directly involved in the production like security guards, supervisors, and quality assurance workers in the factory.
• Other costs such as factory lease, utilities and insurance.

Example of a Product Cost

Let’s look at an example of Product Cost. Company XYZ is a manufacturer of tables.

Its product costs can include:

Direct material: wood used to create tables

Direct labor: wages and benefits for the carpenters

Manufacturing overhead (indirect material): nails used to hold the tables together

Manufacturing overhead (indirect labor): wages and benefits for the security guards to overlook the manufacturing facility

Manufacturing overhead (other): factory rent and cost of factory utilities

Determine Product Cost

Typically, the cost of a product on a unit basis is derived by accumulating the costs associated with a batch of units that were produced as a group and dividing by the number of units manufactured.

The formula for Product Cost is:

Product unit cost = (Total direct labor + Total direct materials + Consumable supplies + Total allocated overhead) ÷ Total number of units

Cost Control

Factory overhead is the costs incurred during the manufacturing process, not including the costs of direct labor and direct materials. Factory overhead is normally aggregated into cost pools and allocated to units produced during the period. It is charged to expense when the produced units are later sold as finished goods or written off. The allocation of factory overhead to units produced is avoided under the direct costing methodology, but is mandated under absorption costing. The allocation of factory overhead is required when producing financial statements under the dictates of the major accounting frameworks. Examples of factory overhead costs are:

• Production supervisor salaries

• Quality assurance salaries

• Materials management salaries

• Factory rent

• Factory utilities

• Factory building insurance

• Fringe benefits

• Depreciation

• Equipment setup costs

• Equipment maintenance

• Factory supplies

• Factory small tools charged to expense

• Insurance on production facilities and equipment

• Property taxes on production facilities

The range of possible factory overhead costs can be quite extensive, depending upon the size and complexity of a factory operation and the level of detail at which costs are recorded.

After factory overhead is allocated to inventory, the amount actually allocated will vary from the standard amount that had been budgeted to be allocated. This difference is caused by either a spending variance or an efficiency variance. The spending variance occurs because the actual amount of factory overhead expenditure incurred in the period was different from the standard amount that had been budgeted at some point in the past. The efficiency variance occurs because the the amount of units to which the factory overhead was allocated varied from the standard amount of production that had been expected when the allocation rate was set up.

The use of factory overhead is mandated by accounting standards, but does not bring real value to the understanding of overhead costs, so a best practice is to minimize the complexity of the factory overhead allocation methodology. Ideally, there should be a small number of highly aggregated factory overhead accounts that are pooled into a single cost pool, and then allocated using a simple methodology. Also, the amount of factory overhead analysis and recordation work can be mitigated by charging all immaterial factory costs to expense as incurred.