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ADVANCED FINANCIAL ACCOUNTING & REPORTING PROF. ROEL E. HERMOSILLA

WEEK 5

FACTORY OVERHEAD

A. Accounting for Overhead

Accounting for manufacturing overhead is an important part of job order costing and any other costing
system. Overhead consists of all manufacturing costs other than direct materials and direct labor. The
distinguishing feature of manufacturing overhead is that while it must be incurred in order to produce goods, it
cannot be directly traced to the final product as can direct materials and direct labor. Therefore, overhead must
be applied, rather than directly charged, to goods produced. The overhead application process is described
below:
a. Overhead items are grouped by cost behavior, such as fixed and variable.
b. The fixed and variable overhead costs are estimated for the forthcoming year (e.g., P5,000,000)
c. A denominator (activity) base is chosen. There are five (5) bases of overhead rate. These are units of
production, materials cost, direct labor costs, direct labor hours and machine hours. A common choice is
direct labor hours or machine hours.
d. The activity level is estimated for the forthcoming year (e.g., 80,000 direct labor hours).
e. A predetermined overhead rate is computed

Estimated overhead costs P5,000,000

---------------------------- = --------------- = P62.50/hour
Estimated activity level 80,000 hours

4. As actual overhead costs are incurred, they are debited to factory overhead control (e.g., P4,000). (Factory
overhead control is an account used to described actual manufacturing expenses incurred except direct
materials used and direct labor employed).

Factory overhead control (actual) 4,000

Various accounts 4,000

5. As jobs are completed the predetermined overhead rate is used to apply overhead to these jobs. For
example, if job 17 used 52 direct labor hours, P3,250 of overhead (52 x P62.50) would be charged to work
in process and entered on the job cost sheet.
Work in process 3,250
Factory overhead applied 3,250
To allocate the costs of overhead to units produced, an activity base must be chosen for use in the
computation of a predetermined overhead rate. This activity base should bear a causal relationship to the
incurrence of overhead costs. Examples of activity bases also called costs driver are:
1. Direct manufacturing labor hours
2. Direct manufacturing labor cost
3. Machine hours
4. Materials cost
5. Units of production

For example, overhead may result from (be a function of) hours regardless of who works, which would
mean that direct manufacturing labor hours should be the activity base. If, on the other hand, more
overhead costs were incurred because of heavily automated operations, machine hours might be a more
appropriate activity base.
As illustrated in the diagram below, a number of approaches can be used to determine the activity level.
(step “A.4” above).
Approach Definition
Theoretical capacity Output is produced efficiently 100% of the time.

Practical capacity ADJUSTED FOR: factors such as days off, down time, etc. Output is produced maximum
percentage of time practical (75-85%)
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Normal volume ADJUSTED FOR: long-run product demand. Average annual output necessary to meet
sales and inventory fluctuations over 4-5 year period.

Expected annual ADJUSTED FOR: current year fluctuations. Expected output for capacity current
year.

Note that theoretical capacity is larger than practical capacity, which is larger than normal volume. Expected
annual capacity fluctuates above and below normal volume. Most firms use expected annual capacity for their
predetermined overhead rate.
At year-end overhead may be
1. Overapplied - more is applied than incurred because
a. Overhead costs were overestimated.
b. More than expected activity took place, and/or
c. Actual overhead costs were less than expected.
2. Underapplied - less overhead is applied than incurred because
a. Overhead costs were underestimated.
b. Less than expected activity took place, and/or
c. Actual overhead costs were more than expected.

B. Disposition of Under- and Overapplied Overhead

1) If the under- or overapplied overhead is immaterial, it is frequently written off to cost of goods sold on
grounds of expediency. (This will be your general assumption if the problem is silent as to whether the
variance is material or immaterial). The entry below explains that Applied Factory Overhead which is a
credit balance must be closed to Factory Overhead Control account with a debit balance and the balancing
figure to cost of goods sold, debit or increase if underapplied, credit or decrease if overapplied.

Applied Factory Overhead xx

Cost of goods sold (debit or credit to balance entry) xx
Factory Overhead Control xx

2) If the balance is material, then an adjustment must be made to all goods which were costed using an
erroneous application rate during the current period. The goods with the incorrect costs will be in three
accounts. Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Proration may be
made based upon total ending balance (before proration) of the three accounts or based on their
corresponding applied factory overhead or on some other equitable basis. The problem will normally give
specific directions on what allocation base should be used.

C. Service Department Cost Allocation

A large firm will have several production departments, each of which may compute a separate predetermined
overhead rate. A problem arises when a service department (maintenance, receiving, general factory, etc.)
incurs costs and benefits multiple production departments.

Costs of these service departments must be allocated to production departments because all
manufacturing costs must ultimately be traced to products. For example, the costs of the materials-handling
cost center may need to be allocated to the production departments (and possibly other service departments).
Apportionment of service department costs should be based on meaningful criteria such as:

1) Services provided
2) Services available
3) Benefits received
4) Equity

Examples of apportionment bases are:

1) Area or square feet for building costs
2) Usage for electricity
3) Employees for cafeteria, personnel, and first aid
4) Usage for material handling, maintenance, etc.

Service department costs can be allocated by:

1) Direct method
2) Step method
3) Algebraic or simultaneous or reciprocal method
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1. Direct Method
The direct method simply allocates the costs of each service department to each of the producing
departments based on a relative level of the apportionment base. For example, if a service department had
costs of P140,000, and departments X and Y used 80% and 20% of the apportionment base, X and Y would be
assigned P112,000 and P28,000 respectively. Note that the direct method ignores use of services by other
service departments. For example, the direct method would ignore the fact that service department A uses the
services of service department B. The essence of the direct method is shown in the following diagram

Service Service Service

Department Department Department
A B C

Production Production
Department Department
1 2

2. Step Method
The step method allocates service department costs to other service departments as well as
production departments. The allocation process is:
a. Select the service department serving the most other service departments.
1) When more than one service department services an equal number of service departments, select
the department with the highest costs.
b. Allocate the costs of the service department selected in step a. to the production departments and
other service departments based on a relative level of the apportionment base as in the direct method.
c. Costs of service departments are never allocated back to departments whose costs have already been
allocated.

Note that the step method ignores the fact that reciprocal services are used between some service
departments.

3. Algebraic or Simultaneous or Reciprocal Method

Under this method, the reciprocal services are considered to determine the total cost of a service
department. The total cost will be the amount allocated to all departments served by the service
department. The following steps under the method are:
a. Identify the equation to determine the total cost of a service department, e.i., the budgeted amount
plus the share on the cost of the other service department.
b. Compute the total cost by using either substitution or elimination method.
c. The total cost computed will be the amount allocated to all departments served.

EXAMPLE:
Producing Departments Service Departments
1 2 A B Total
Budgeted costs P380,000 P420,000 P40,000 P60,000 P900,000
Use of A 40% 50% 10% 100%
Use of B 40% 30% 30% 100%

Direct Method – Allocate A’s and B’s costs directly to production departments 1 and 2.
1 2 A B
Costs prior to allocation P380,000 P420,000 P40,000 P60,000
Allocation of A’s costs - 4:5 17.778 22,222 ( 40,000)
Allocation of B’s costs – 4:3 34,286 25,714 ( 60,000)
Total cost for OH rate computation P432,064 P467,936

P900,000
Step Method – Allocate B’s costs (B has more costs than A) to departments 1, 2 and A. Next allocate A’s costs to
departments 1 and 2; you cannot allocate A’s costs back to B, as B’s costs have already been allocated.

Departments 1 2 A B
Costs prior to allocation P380,000 P 420,000 P40,000 P60,000
Allocation of B’s costs– 4:3:3 24,000 18,000 18,000 ( 60,000)
Allocation of A’s costs – 4:5 25,778 32,222 ( 58,000)
Total cost for OH rate comp. P 429,778 P470,222

P900,000
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Algrebraic or Simultaneous or Reciprocal Method – Compute the total cost by considering the
reciprocal services rendered to other service departments using algebra. Develop the equation for total
cost computation. The equation for Department A’s cost must be: A = P40,000 + 30% of B; and
Department B’s cost must be: B = P60,000 + 10% of A. Using the substitution method the total cost of
Department A:

A = P40,000 + 30% (P60,000 + 10% of A)

= P40,000 + P18,000 + 3% of A
= P58,000/97%
= P59,794

B = P60,000 + 10% (P59,794)

= P65,979

Departments 1 2 A B
Costs prior to allocation P380,000 P420,000 P40,000 P60,000
Allocation of A’s costs – 4:5:1 23,918 29,897 ( 59,794) 5,979
Allocation of B’s costs – 4:3:3 26,392 19,794 19,794 ( 65,979)
Total cost for OH rate computation P430,309 P469,691

P900,000

D. Activity-Based Costing
Activity-based costing (ABC) is based upon two principles. First, activities consume resources. Second,
these resources are consumed by products, services, or other cost objectives (output). ABC allocates overhead
costs to products on the basis of the resources consumed by each activity involved in the design, production,
and distribution of a particular good. This is accomplished though the assignment of costs to homogeneous
cost pools that represent specific activities and then the allocation of these costs, using appropriate cost
drivers, to the product. Thus, product costs determined using ABC reflects the underlying behavior of the costs
allocated to the product. ABC may be used with both job order costing and process costing.

Central to ABC are the activities performed to fulfill organizational objectives (producing products or
services for customers). Activities may be value-added or non-value-added. Value-added activities are those
which customers perceive as increasing the worth of a product or service and for which customers are willing
to pay. They include only production activities. Non-value-added activities increase the cost of a product but do
not increase its value to customers. Examples include materials handling and rework. Packaging is required for
some products such as milk or potting soil, but it may be non-value-added for other products such as books.
Thus, these activities may be eliminated and/or restructured without customers perceiving a decline in the
value of the product/service. An activity (process) map is a flowchart which indicates all activities involved in
the production process and identifies both value-added and non-value-added activities.

Cost drivers are those activities, which have a direct cause and effect relationship to the incidence of a
particular cost. Traditional costing uses only variable and fixed or total overhead cost pools and views cost
drivers at the output unit level, wherein costs are allocated based on labor hours, machine hours, etc. Some
costs though, such as setup costs, vary at the batch level (batch-level costs) and should be spread over the
units in the batch to which they relate (not machine hours). Product-sustaining (process-level) costs such as
engineering change orders should be assigned to the products for which the orders were issued. Facility-
sustaining costs incurred at the organizational level support operations and can only be arbitrarily assigned to
products. As shown by the following table, ABC uses both transaction-related (e.g., purchase orders) and
volume-related (e.g., machine hours) cost drivers. Traditional product costing tends to use only volume-related
cost drivers.

Activity Cost driver

Purchase of materials Number of purchase transactions
Receiving Number of shipments received
Disbursing Number of checks issued
Setup costs Number of setups or setup hours
Machining Number of machine hours
Repair costs Number of machine hours
Engineering changes to products Number of engineering change notices

The activities listed above are all examples of direct activities, which can be traced, to an output or
service. In contrast, indirect activities such as human resources are not directly attributable to output. The cost
of indirect activities may be allocated or simply labeled as nontraceable.

To illustrate, ABC traces the costs of setup activities to the production batch that caused the setup costs to
be incurred. The cost of each setup is then spread over the units in that batch. On the other hand, a traditional
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costing system would typically allocate setup costs as overhead on the basis of a volume-related cost driver
such as direct manufacturing labor hours. Assume that product A and B incur setup costs as follows:

A B Total
Production volume 7,500 10,000
Batch size 250 1,000
Number of setups 30 10
Total setup costs incurred P60,000 P 20,000 P 80,000
Total cost per setup P 2,000 P 2,000
Direct manufacturing labor hours/unit 3 3
Total direct manufacturing labor hours 22,50 30,000 52,500
Setup cost per DMLH (P80,000/52,500) P1.52
Traditional setup cost/unit
A (P1.52 x 3 DMLH required) P 4.56
B (P1.52 x 3 DMLH required) P 4.56
ABC setup cost/unit
A (P2,000/setup  250 units/batch) P8.00
B (P2,000/setup  1,000 units/batch P2.00

In this case, products A and B are assigned different total setup costs. However, because they require the
same number of direct manufacturing labor hours per unit, traditional costing allocates equal setup costs per
unit to both products. In effect, one product picks up cost that was caused by another product (cross-
subsidization), which distorts product-costing information. ABC assigns different setup costs per unit to each
product because each unit of product A demand more resources for setup activity than does each unit of
product B. Note that the total setup cost remains the same under either method.

Additional explanations about activity-based costing:

A. Definition of Terms
1. Activity-based costing – identifies the causal relationship between the incurrence of cost and activities,
determines the underlying driver of the activities, establishes cost pools related to individual drivers,
develops costing rates, and applies cost to product on the basis of resources consumed (drivers).
2. Cost driver – is a measure of activity, such as direct labor hours, machine hours, beds occupied,
computer time used, flight hours, miles driven, or contracts, that is causal factor in the incurrence of cost
to an entity.
3. Cost objects – are the intermediate and final dispositions of cost pools. Intermediate cost objects receive
temporary accumulations of costs as the cost pools move from their originating points to the final cost
objects. Final cost objects, such as a job, product, or process, should be logically linked with the cost pool
based on a cause-and-effect relationship.
4. Cost pools – are accounts in which a variety of similar cost elements with a common cause are
accumulated prior to allocation to cost objects on some common basis. The overhead account is a cost
pool into which various types of overhead are accumulated prior to their allocation. In activity-based
accounting, a cost pool is established for each activity.
5. Value-adding costs – are the costs of activities that cannot be eliminated without reducing the quality,
responsiveness, or quantity of the output required by a customer or the organization.

B. Activity-Based Costing (ABC)

1. ABC may be used by manufacturing, service, or retailing entities and in job-order or process costing
systems. It has been popularised because of the rapid advance of technology, which has led to a
significant increase in the incurrence of indirect costs and a consequent need for more accurate cost
assignment. Furthermore, developments in computer and related technology (such as bar coding) also
allow management to obtain better and more timely information at decreased cost.
a. ABC is one means of improving a cost system to avoid what has been called peanut-butter
costing. Inaccurately averaging or spreading costs like peanut butter over products or service
units that use different amounts of resources results in product-cost cross-subsidization. This
term describes the condition in which the miscasting of one product causes the miscasting of other
products.
1) In a traditional system, direct labor and direct materials are traced to products or service
units, a single pool of costs (overhead) is accumulated for a given organizational unit,
and these costs are then assigned using an allocative rather than a tracing procedure.
The effect is an averaging of costs that may result in significant inaccuracy when
products or service units do not use similar amounts of resources.

2. To improve its costing system, an organization can attempt to identify as many direct costs as economically
feasible. It can also increase the number of separate cost pools not directly attributable to cost objects.
A cost pool contains cost elements, which are amounts paid for resources used by an activity. An
activity is a set of work actions undertaken within the entity. Cost objects are the intermediate and final
dispositions of cost pools. Intermediate costs objects receive temporary accumulations of costs as the cost
pools move from their originating points to the final cost objects. A cost object may be a job, product,
 Page 6

process, activity, service, or anything else for which a cost measure is desired. For example, work in
process is an intermediate cost object, and finished salable goods are final cost objects.
a. Each cost pool should be homogeneous; that is, each should consist of costs that have
substantially similar relationships with the driver or other base used for assignment to cost objects.
A cost driver is a factor or event that changes an activity’s cost; it is also the means used to
assign cost to activities and to reassign those costs to other activities, products, or services.
b. Thus, choosing the appropriate base, preferably one with a driver or cause-and-effect relationship
( a high correlation) between the demands of the cost object and the costs in the pool, is another
way to improve a costing system.

3. ABC attempts to improve costing by assigning costs to activities rather than to an organizational unit.
Accordingly, ABC requires identification of the activities that consume resources and that are subject to
demands by ultimate cost objects.
a. Design of an ABC system starts with process value analysis, a comprehensive understanding of
how an organization generates its output. It involves a determination of which activities that use
resources are value-adding or nonvalue-adding and how the latter may be reduced or
eliminated. A value-added activity contributes to customer value or satisfies a need of the
entity. The perception is that it cannot be omitted without a loss of the quantity, quality, or
responsiveness of output demanded by the entity or its customers.
b. The linkage of product costing and continuous improvement of processes is activity-based
management (ABM). It encompasses driver analysis, activity analysis, and performance
measurement.

4. Once an ABC system has been designed, costs may be assigned to the identified activities, costs of related
activities that can be reassigned using the same driver or other base are combined in homogeneous cost
pools, and an overhead rate is calculated to each pool.
a. The next step, as in traditional methods, is to assign costs to next-stage cost objects. In other
words, cost assignment is a two-step process. First, costs are accumulated for an activity based on
the resources it can be directly observed to use and on the resources it can be assumed to use
based on its consumption of resources drives (the cost drivers that reflect the use of resources
by an activity), second, costs are reassigned to next-stage cost objects on the basis of activity
drivers (the cost drivers that measure the demands made on activities by next-stage cost
objects).

5. An essential element of ABC is driver analysis that emphasizes the search for the cause-and-effect
relationship between activity and its consumption of resources and an activity and the demands made on it
by a cost object. For this purpose, activities and their drivers have been classified in accounting literature
as follows:
a. Unit-level (volume-related) activities occur when a unit is produced, e.g., direct labor and direct
materials activities. Drivers are direct labor hours or pesos/dollars, machine hours, and units of
output.
b. Batch-level activities occur when a batch of units is produced, e.g., ordering setup, or materials
handling. Drivers may include number or duration of setups, orders processed, number of receipts,
weight of materials handled, or number of inspections.
c. Product-or service-level (product- or service-sustaining) activities provide support of different
kinds to different types of output, e.g., engineering changes, inventory management, or testing.
Drivers may include design time, testing time, number of engineering change orders, or number of
categories of parts.
d. Facility- or plant-level (facility-sustaining) activities concern overall operations, e.g.,
management of the physical plant, personnel administration, or security arrangements. Drivers
may include any of those used at the first three levels.

6. Using this model, activities are grouped by level, and drivers are determined for the activities.
a. Within each grouping of activities, the cost pools for activities that can use the same driver are
combined into homogeneous cost pools. In contrast, traditional systems assign costs largely on the
basis of unit-level drivers.
b. A difficulty in applying ABC is that, whereas the first three levels of activities pertain to specific
products or services, facility-level activities do not. Thus, facility-level costs are not accurately
assignable to products or services. The theoretically sound solution may be to treat these costs are
period costs. Nevertheless, organizations that apply ABC ordinarily assign them to products or
services to obtain a full-absorption cost suitable for external financial reporting in accordance with
GAAP.
 Page 7

7. As the foregoing discussion indicates, an advantage of ABC is that overhead costs are accumulated in
multiple cost pools related to activities instead of in a single pool for a department, process, plant, or
company. ABC also is more likely than a traditional system to assign costs to activities and reassign them
to next stage cost objects using a base that is highly correlated with the resources consumed by activities
or with the demands placed on activities by cost objects. Furthermore, process value analysis provides
information for eliminating or reducing nonvalue-adding activities (e.g., scheduling production, moving
components, waiting for the next operating step, inspecting output, or storing inventories). The result is
therefore not only more accurate cost assignments, especially of overhead, but also better cost control and
more efficient operations.
a. A disadvantage of ABC is that it may still be relatively more costly to implement because of the
more detailed information required. Another disadvantage is that ABC-based costs of products or
services may not conform with GAAP; for example, ABC may assign research costs to products but
not such traditional product costs as plant depreciation, insurance, or taxes.

8. Organizations most likely to benefit from using ABC are those with products or services that vary
significantly in volume, diversity of activities, and complexity of operations; relatively high overhead costs;
or operations that have undergone major technological or design changes.
a. However, service organizations may have some difficulty in implementing ABC because they tend
to have relatively high levels of facility-level costs that are difficult to assign to specific service
units. They also engage in many nonuniform human activities for which information is not readily
accumulated. Moreover, output measurement is more problematic in service than in manufacturing
entities. Nevertheless, ABC has been adopted by various insurers, banks, railroads, and health care
providers.

9. Overhead. Direct labor (hours or pesos/dollars) has long been the most common base for allocating
overhead because of its simplicity of use, but it is not always relevant. Companies now use dozens of
different allocation base depending upon how activity affects overhead costs. One company reported that it
used 37 different bases to allocate overhead , some of which were averages of several activities.
a. In principle, a separate overhead account or subsidiary ledger account should be used for each
type of overhead.
b. In the past, direct labor was ordinarily a larger component of total production cost than overhead
and was the activity that drove (caused) overhead costs. Due to the increased use of computers
and robotics, overhead is more likely to be a large component of total production cost, with direct
labor often a small percentage.
1) Most overhead costs vary in proportion to product diversity and the complexity of an
operation. Direct labor is not a cost driver for most overhead costs.
2) Allocating a very large cost (overhead) using a very small cost (direct labor) as a base is
irrational. A small change in direct labor on a product can make a significant difference
in total production cost, an effect that may rest on an invalid assumption about the
relationship of the cost and the allocation base.
c. As previously note, ABC is more useful when overhead costs are relatively high. Also, the more
diverse a company’s line of products or services or the more significant the volume differences
among its products or services, the more beneficial ABC will be.
1) Simple averaging procedures such as direct-labor based costing are valid only when all
products or services are absolutely uniform. For example, a simple allocation basis in a
factory with large and small machines and high-priced and low-cost labor that work
together would not be very exact.

10. Comprehensive Example. Assume that a company produces two similar products. Raw materials costs
are P20 per unit, direct labor is P70 per unit, and factory overhead totals P20,000. The company produces
1,000 units of Product 1 and 100 units of Product 2. Using the direct labor as the allocation base, costs are
as follows:

Product 1 Product 2
Raw materials P 20,000 P 2,000
Direct labor 70,000 7,000
Overhead 18,182 * 1,818 **
Total cost P108,182 P10,818
Cost per unit P 108.18 P108.18
* {[P70,000 + (P70,000 + P7,000)] x P20,000}
** {[P7,000 + (P70,000 + P7,000)] x P20,000}
Alternatively, assume that the overhead represents setup costs, with equal setup times required for the
products. Thus, the P20,000 would be allocated equally under an ABC system. The ABC costs would be as
follows:
Product 1 Product 2
Raw materials P 20,000 P 2,000
Direct labor 70,000 7,000
 Page 8

Overhead 10,000 10,000

Total cost P100,000 P19,000
Cost per unit P 100.00 P190.00

Because of the low volume of Product 2, the difference between the traditional allocation base and ABC is
significant. If the company were selling Product 2 at P150 each (resulting in an apparent unit profit of P41.82
based on the P108.18 direct-labor-based cost), it would be losing money on every sale.
a. As the example above illustrates, differences in volume can distort cost allocations even when
overhead is relatively low. The distortion is worse when overhead is a higher proportion of total
costs. Assume that direct labor costs are only P10 per unit and that overhead totals P140,000.

b. The traditional allocation results in the following costs:

Product 1 Product 2
Raw materials P 20,000 P 2,000
Direct labor 10,000 1,000
Overhead 127,273 * 12,727 **
Total cost P157,273 P15,727
Cost per unit P 157.27 P157.27
* {[P10,000 + (P10,000 + P1,000)] x P140,000}
** {[P1,000 + (P10,000 + P1,000)] x P140,000}
Using the ABC system, the allocation of overhead setup costs based on equal setup times would result in
the following production costs:
Product 1 Product 2
Raw materials P 20,000 P 2,000
Direct labor 10,000 1,000
Overhead 70,000 70,000
Total cost P100,000 P73,000
Cost per unit P 100.00 P730.00
Thus, the combination of relatively high overhead and a substantial difference in product volume
results in unit costs for Product 1 and Product 2 that are 36.4% lower and 364% higher, respectively, than
those computed using the traditional method.
1) The practical effect of this difference can be illustrated in a competitive bid situation for Product
1. A manager using direct-labor based cost would bid some amount slightly greater than P157.27
and, after losing, would then wonder how a competitor could made a profit with a bid just over
P100. The ABC system provides more relevant costing figures.

11. Companies have begun adopting ABC because of its ability to solve costing problems that conventional cost
accounting either creates or fails to address. These problems include suboptimal pricing, poor allocation of
costs, and incorrect direction by management. For example, if overhead is allocated at 700% of direct
labor, managers may try to reduce direct labor costs by P1 to reduce the amount of overhead allocated by
P7. But the better decision may be to ignore direct labor and concentrate on such cost-cutting efforts as
eliminating setups, engineering changes, and movement of materials.

PROBLEMS
1. B Company Inc. records incoming materials at invoice price less cash discounts plus applied receiving and
handling cost. For product G, the following data are available:
Budgeted for Actual Cost
the Month for the Month
Freight-in and cartage-in P 25,000 P 25,800
Purchasing department cost 48,000 45,000
Receiving department cost 39,000 42,000
Storage and handling 42,000 38,000
Testing, spoilage, and rejects 26,000 31,200
P180,000 P182,000
The purchasing budget shows estimated net purchases of P1,440,000 for the month. Actual invoices net of
discounts total P1,485,000 for the month.
Required:
1. Determine the applied acquisition costing rate for the month.
2. Determine the amount of applied cost added to materials purchased during the month.
3. Indicate the possible disposition of the variance.
 Page 9

2. Kaleidoscope Cutlery manufactures kitchen knives. One of the employees, whose job is to cut out wooden knife
handles, worked 48 hours during a week in January. The employee earns P12 per hour for a 40-hour week. For
additional hours the employee is paid an overtime rate of P16 per hour. The employee’s time was spent as
follows:
Regular duties involving cutting out knife handles 38 hours
General shop cleanup duties 9 hours
Idle time due to power outage 1 hour

Required:
1. Calculate the total cost of the employee’s wages during the week described above.
2. Determine the portion of this cost to be classified in each of the following categories:
a. Direct labor.
b. Manufacturing overhead (idle time).
c. Manufacturing overhead (overtime premium).
d. Manufacturing overhead (indirect labor).

3. C Corporation estimates factory overhead of P207,000 for the next fiscal year. It is estimated that 52,100 units
will be produced at a materials cost of P500,000. Conversion will require an estimated 85,000 labor hours at a
cost of P9 per hour, with 69,000 machine hours.
Required:
Calculate the predetermined factory overhead rate based on:
1. Materials costs. 4. Direct labor cost.
2. Units of production. 5. Direct labor hours.
3. Machine hours.

4. Madison Corporation is developing departmental overhead rates based on direct labor hours for its two
production departments, Molding and Assembly. The Molding Department employs 20 people, and the
Assembly Department employs 80 people. Each person in these two department work 2,000 hours per year.
The production-related overhead costs for the Molding department are budgeted at P204,000, and the
Assembly Department costs are budgeted at P320,000. Two service departments, Repair and Power, support
the two production departments and have budgeted costs of P48,000 and P250,000, respectively. The
production department’s overhead rates cannot be determined until service departments’ costs are distributed.
The following schedule reflects the use of the Repair Department and Power Department’s output by the
various departments.

Services Provided
Department Repair Hours KWH
Molding 1,000 840,000
Assembly 8,000 120,000
Repair - 240,000
Power 1,000 -
10,000 1,200,000
Required:
1. Calculate the overhead rate per direct labor hour for Molding Department, distributing service
department costs to producing departments only.
2. Calculate the overhead rate per direct labor hour for Assembly Department, using the simultaneous
method to distribute service department costs.

5. Globe Telecommunications Corporation manufactures two different fax machines for the business market. Cost
estimates for the two models for the year 2018 are as follows:
Basic System Advanced System
Direct material P 400 P 800
Direct labor (20 hours at P15 per hour) 300 300
Manufacturing overhead * 400 400
Total P1,100 P1,500

* The predetermined overhead rate is P20 per direct labor hour.

Each model of fac machine requires 20 hours of direct labor. The basic system requires 5 hours in department
A and 15 hours in department B. The advanced system requires 15 hours in department A and 5 hours in
department B. The overhead costs budgeted in these two production departments are as follows:

Department A Department B
Variable cost P16 per direct labor hour P4 per direct labor hour Fixed cost P200,000
P200,000
The firm’s management expects to operate at a level of 20,000 direct labor hours in each production
department during 2018.
 Page 10

Required:
1. If the firm prices each model of fax machine at 10 percent over its cost, what will be the price of each
model?
2. Suppose the company were to use departmental predetermined overhead rates. Calculate the rate for each
of the two production departments.
3. Compute the product cost of each model using the departmental overhead rates calculated in requirement
(2).
4. Compute the price to be charged for each model, assuming the company continues to price each product
at 10 percent above cost. Use the revised product costs calculated in requirement (3).
5. Using the information of the main problem, assuming the company has implemented an activity-based
system with the following activity cost pools and cost drivers:

Activity Activity Cost Cost Driver Basic System Advanced System

Machine setup P100,000 200 setups 50 setups 150 setups
Material receiving 60,000 80,000 lbs 30,000 lbs. 50,000 lbs.
Inspection 80,000 1,600 inspections 700 inspections 900 inspections
Machinery-related 420,000 60,000 machine hrs. 20,000 mach. hrs. 40,000 mach. hrs.
Engineering 140,000 7,000 engineering hrs. 3,000 eng. hrs. 4,000 eng. hrs.
Total Overhead P800,000

Globe plans to produce 1,000 units of each model of fax machine.

Required:
a. Compute the cost rate per unit of each cost driver (e.g., the cost per setup).
b. Determine the total overhead to be assigned to each product line under activity-based costing.
c. Calculate the overhead assigned per unit of each type of fax machine under ABC.
d. Prepare a table comparing the total product cost assigned to each type of fax machine using a plant
wide overhead rate, departmental overhead rates, and activity-based costing.

6. Edgeworth Box Corporation manufactures a variety of special packaging boxes used in the pharmaceutical
industry. The company’s Canlubang plant is semiautomated, but the special nature of the boxes requires some
manual labor. The controller has chosen the following activity cost pools, cost drivers, and pool rates for the
Canlubang plant’s product-costing system.
Budgeted
Overhead Level for Cost
Activity Cost Pool Cost Cost Driver Driver Pool Rate
Purchasing, store and Raw material
material handling P 200,000 cost P1,000,000 20% of material cost
Engineering and product Hours in design
design 100,000 department 5,000 hours P20 per hour
Machine setup costs 70,000 Production runs 1,000 runs P70 per run
Machine depreciation
and maintenance 300,000 Machine hours 100,000 hours P3 per hour
Factory depreciation, taxes,
insurance, utilities 200,000 Machine hours 100,000 hours P2 per hour
Other manufacturing
overhead costs 150,000 Machine hours 100,000 hours P1.50 per hour
Total P 1,020,000

Two recent production orders had the following requirements.

20,000 units of 10, 000 units of
Box C52 Box W29
Direct labor hours 42 hours 21 hours
Raw materials cost P40,000 P35,000
Hours in design department 10 25
Production runs 2 4
Machine hours 24 20

Required:
a. Calculate the total overhead cost that should be assigned to Box C52 and Box W29.
b. Calculate the overhead cost per box for Box C52 and Box W29.

7. Thom Co. manufactures a variety of high- and low-volume products, including Product 456, in its San Pedro
Plant. The following information pertains to the most recent year:
Total for Total for
Product 456 San Pedro
Unit-level overhead P 200,000
 Page 11

Batch-level overhead 300,000

Product-level overhead 500,000
Plant-level overhead 400,000
P1,400,000
Units produced 100 5,000
Direct labour hours 200 20,000
Machine hours 90 10,000
Setups 6 120
Setup hours 30 500
Design changes 4 40
Design hours 280 4,000

Required: Determine:
a. If the San Pedro Plant accumulates all overhead in a single cost pool and allocates it on the basis of machine
hours, how much overhead cost will be allocated to a unit of Product 456?
b. In relation to the above information, if the San Pedro Plant uses ABC with setups as the driver for all batch-
level overhead, design hours as the driver for all product-level overhead, and machine hours as the driver for
all unit- and plant-level overhead, how much overhead cost will be allocated to a unit of Product 456?

8. The controller for Bagani Supply Company has established the following activity cost pools and cost drivers.
Budgeted Budgeted
Overhead Level for Cost
Activity Cost Pool Cost Cost Driver Driver Pool Rate
Machine setups P200,000 Number of setups 100 P 2,000/setup
Material handling 100,000 Weight of raw
material 50,000 pounds P2/pound
Hazardous waste control 50,000 Weight of hazardous 10,000 pounds 5/pound
chemical used
Quality control 75,000 Number of inspections 1,000 P75/inspection
Other overhead costs 200,000 Machine hours 20,000 10/machine hr.
Total P625,000

An order for 2,000 boxes of film development chemicals has the following production requirements:
Machine setups 4 setups
Raw materials 10,000 pounds
Hazardous materials 2,000 pounds
Inspections 10 inspections
Machine hours 500 machine hours

Under the activity based cost system, how much is the overhead cost per box of chemicals?
A. P 21.875 B. P43.75 C. P15.625 D. P7.8125

Using a single predetermined overhead rate based on machine hours, compute the rate per box of
chemicals.
A. P 21.875 B. P 43.75 C. P 15.625 D. P 7.8125

STANDARD AND BACKFLUSH COSTING

A. Standard Costing
Standard costs are predetermined target costs which should be attainable under efficient conditions.
The tightness, or attainment difficulty, of standard costs should be determined by the principles of motivation
(e.g., excessively tight standards may result in employees feeling that the standards are impossible to achieve;
consequently, they may ignore them). Standard costs are used to aid in the budget process, pinpoint trouble
areas, and evaluate performance. Standard costing will often result in lower bookkeeping costs than actual
costing, because standard costing does not require actual department costs to be allocated to each unit
produced in that department.

The tightness of standards is generally described by one of two terms. Ideal standards reflect the
absolute minimum costs which could be achieved under perfect operating conditions. Currently attainable
standards should be achieved under efficient operating conditions. Generally, currently attainable standards are
most often used since they are more realistic for budgeting purposes and are a better motivational tool than
ideal standards.
 Page 12

Variances are differences between actual and standard costs. The total variance is generally broken
down into sub-variances to further pinpoint the causes of the variance.

1. Journal Entries for Variances

Variances are often computed and analyzed, but not entered into the accounts. If incorporated into the
accounts, the standard amounts are entered into the inventory account. For example, when materials are
purchased, standard price is known but standard quantity is not known. Therefore, the materials account is
debited for actual quantity at standard price. When materials are used, standard quantity is also known, so
work in process is debited for standard quantity at standard price. Pro-forma entries for materials, labor
and overhead are presented below.

a. To record material purchases.

Materials AQ x SP
Price variance XXX(U) or XXX(F)
Accounts payable AQ x AP

b. To record materials used.

WIP inventory SQ x SP
Quantity variance XXX(U) or XXX(F)
Materials AQ x SP

c. To record accrued payroll or distribution of payroll.

WIP inventory SH x SR
Rate variance XXX(U) or XXX(F)
Efficiency variance XXX(U) or XXX(F)
Accrued payroll or Payroll AH x SR

d. To record actual factory overhead.

Factory overhead control XXX
Various credits XXX

e. To record applied overhead.

WIP inventory AH(Units) x SOHR
Applied factory overhead AH(units)x SOHR

f. To record factory overhead variances

Applied factory overhead XXX
Controllable variance AOH-BASH(U) or AOH-BASH(F)
Volume variance BASH-SOH(U) or BASH-SOH(F)
Factory overhead control XXX

A(n) unfavorable (favorable) variance is recorded as a debit (credit) to the variance account. Overhead
variances, while computed and analyzed monthly, would normally be entered in the accounts. The total
overhead variance, of course, is the difference between the balances in the Control and Applied accounts.

2. Disposition of Variances
If immaterial, variances are frequently written off to cost of goods sold on grounds of expediency. If
material, the variances must be allocated among the inventories and cost of goods sold, usually in
proportion to EUP or ending balances.

B. Backflush Costing
The term backflush costing (also called delayed costing, endpoint costing, or post-deduct costing ) describes
a costing system that delays recording changes in the status of a product being produced until good finished units
appear; it then uses budgeted or standard costs to work backward to flush out manufacturing costs for the units
produced. An extreme form of such delay is to wait until sale of finished units has occurred. Typically, no record of
work in process appears in backflush costing.

In companies that adopt backflush costing, the following occurs:

1. Management wants a simple accounting system. Detailed tracking of direct costs through each step of
the production system to the point of completion is deemed unnecessary.
2. Each product has a set of budgeted or standard costs.
3. Backflush costing reports approximately the same financial results as sequential tracking would
generate.

If inventories are low, managers may not believe it worthwhile to spend resources tracking costs through
Work in Process, Finished Goods, and Cost of Goods Sold. Backflush costing, therefore, is especially attractive in
companies that have low inventories resulting from Just-In Time (JIT). Backflush costing and sequential tracking
 Page 13

(traditional approach) will also produce approximately the same results, however, when inventory is present,
provided inventories maintain stable values. Constant amounts of costs will be deferred in inventory each period.

1. Manufacturing Cost Flows in a JIT Setting

Backflush system Traditional system

1. Purchase of raw materials, P200,000.

Raw and In-process inventory 200,000 Raw materials inventory 200,000
Accounts payable 200,000 Accounts payable 200,000

2. Raw material requisitioned for production.

No entry Work-in-process inventory 200,000
Raw materials inventory 200,000
3. Direct-labor cost incurred, P50,000.
4. Actual manufacturing overhead cost incurred, P95,000.

Conversion costs 145,000 Work-in-process inventory 50,000

Wages payable 50,000 Wages payable 50,000
Accounts payable 95,000 Manufacturing overhead 95,000
Accounts payable 95,000

5. Application of manufacturing overhead to work-in-process inventory (predetermined overhead rate is 200% of

direct-labor cost).
No entry Work-in-process inventory 100,000
Manufacturing overhead 100,000
Products are completed, P350,000.
Finished goods inventory 350,000 Finished goods inventory 350,000
Raw and in-process inventory 200,000 Work-in-process inventory 350,000
Conversion costs * 150,000

6. Goods are sold, P350,000

Cost of goods sold 350,000 Cost of goods sold 350,000
Finished goods inventory 350,000 Finished goods inventory 350,000

* Applied conversion costs include direct labor of P50,000 and applied manufacturing overhead of P100,000.

Notice that overhead is overapplied by P5,000 under both systems. Under the traditional system, we have
actual overhead of P95,000 and applied overhead of P100,000. Under the backflush system, we have actual
conversion costs of P145,000 and applied conversion costs of P150,000. Under both approaches, the P5,000
of overapplied costs will be closed into Cost of Goods Sold (deduct) at the end of the period.

PROBLEMS
Standard Costing
1. M Manufacturing Company manufactures a product, which has the following standard costs:
Materials 6 units at P2.00 P12.00
Labor 1/4 hour at P8.00 2.00
Variable factory overhead 3/4 hour at P4.00 3.00
Fixed factory overhead (normal capacity
is 4,000 hours of processing time) 3/4 hour at P12.00 9.00
Total standard cost P26.00

The following information pertains to actual production activity for August:

a) 6,000 equivalent units were produced with respect to materials, 5,800 equivalent units with respect to
labor, and 5,500 equivalent units with respect to factory overhead.
b) 33,000 units of materials were purchased on account at a total cost of P64,350. The materials price
variance is recorded when the materials are purchased.
c) 40,000 units of materials were issued to production and used during the period.
d) Direct labor cost was P12,300 for 1,500 actual hours. Assume that the liability has already been
recorded but not yet distributed.
e) Actual processing required during August totalled 4,300 hours.
f) Actual factory overhead was P65,000.
g) 5,200 units were completed and transferred to finished goods inventory during the month.
h) 5,500 units were sold during the month for P40 each.
 Page 14

Required: Prepare the journal entries to record the information provided, including two variances for each
element of cost.

Back Flush Costing

2. The Lee Company has a plant that manufactures transistor radios. The production time is only a few minutes
per unit. The company uses a just-in-time production system and a backflush costing system with two trigger
points for journal entries:
• Purchase of direct (raw) materials.
• Completion of good finished units of product.
There are no beginning inventories. The following data pertain to April manufacturing:
Direct (raw) materials purchased P 8,800,000
Direct (raw) materials used 8,500,000
Conversion costs incurred 4,220,000
Allocation of conversion costs 4,000,000
Costs transferred to finished goods 12,500,000
Cost of goods sold 11,900,000

Prepare summary journal entries for April (without disposing of under or overallocated conversion costs).
Assume no direct materials variances.

3. The Action Corporation manufactures electric meters. For August, there were no beginning inventories of direct
(raw) materials and no beginning and ending work in process. Action uses a JIT production system and
backflush costing with two trigger points for making entries in the accounting system.
• Purchase of direct materials debited to Inventory: Raw and In-Process Control.
• Completion of good finished units of product debited to Finished Goods Control at standard costs.
Action’s August standard costs per unit are: direct materials, P25; conversion costs, P20.
The following data apply to August manufacturing:
Direct (raw) materials purchased P550,000
Conversion costs incurred 440,000
Number of finished units manufactured 21,000
Number of finished units sold 20,000

1. Prepare summary journal entries for August (without disposing of under-or overallocated conversion
costs). Assume no direct materials variances.

2. Assume the same facts as in 1 above. Assume that the second trigger point for the Acton Corporation
is the sale – rather than the production – of finished units. Also, the Inventory Control account is
confined solely to direct materials, whether these materials are in a storeroom, in work in process, or
in finished goods. No conversion costs are inventoried. They are allocated at standard cost to the units
sold. Any under- or overallocated conversion costs are written off monthly to Cost of Goods Sold.
Prepare the summary journal entries for August, including the disposition of under- or overallocated
conversion costs. Assume no direct materials variances.

3. Assume the same facts as in 2 above. Now assume that there is only one trigger point, the completion
of goods finished units of product, which are debited to Finished Goods Control at standard costs. Any
under- or overallocated conversion costs are written off monthly to cost of goods sold. Prepare
summary journal entries for August, including the disposition of under- or overallocated conversion
costs. Assume no direct materials variances.

reh/cde