CHAPTER III FACTORY OVERHEAD CONCEPT AND ALLOCATION OF FACTORY OVERHEAD

Manufacturing companies should compute production costs and trace them to a cost object, a product or a service, correctly. They calculate production cost to evaluate inventory, to plan and control processes and to make proper decisions. The assignment of both direct material and direct labour costs can be performed easily since these costs are directly related to a cost object. Consumption of direct material and direct labour by a product is easily weighted, measured or computed so that the cost of which can be directly traced to the products or services.

However the third cost element, factory overhead, is difficult to handle. This is because the factory overhead includes any costs, other than direct material and direct labour, which incur in a factory floor. Unfortunately these costs have different characteristics and therefore, many of them have indirect relationships with a cost object. But companies still need them to find the cost of production. That is why these costs should be allocated to the products or services.

Some examples of the overhead costs Indirect material Indirect labour Internal transportation cost (forklifts etc.) Supplies Supervisor Electricity & Water charges Property taxes Factory rent Depreciation of buildings Heat & Light Cafeteria costs Depreciation of machinery and equipments Quality control Factory insurance Overtime premiums Telephone Stationary costs Repair & maintenance Factory security Employee insurance Employee transportation costs

Indirect materials: Any materials, other than the direct materials, that are used in the production process. Although these are not the basic materials, they are needed for production. In a carpenter workshop, for example, screws, nails and glue are in this category. Supplies: Any material that is used in a production process but not contained in a product produced. Examples are sand paper, lubricants, cleaning materials, gloves, etc. Indirect labour: The workers who do not make production but help those who make the production. All workers, except direct labour are known as indirect labour (including engineers, technicians etc.) if they work in the factory floor. From this perspective, employees working for quality control and repair & maintenance departments are classified in this category.

In short, the factory overhead cost includes everything—except the costs of direct labour and direct material, provided that they incur in the factory floor. We can divide factory overhead into three categories depending on their characteristics; variable, fixed and mixed costs. Variable Factory Overhead Costs: These are related to the level of production. Indirect material and the electricity for power are examples of variable overhead costs. Fixed Factory Overhead Costs: These are unrelated to the level of manufacturing so they always remain constant within the relevant range. Examples are factory rent, depreciation of factory buildings and equipments, factory insurance and property taxes.

Mixed Factory Overhead Costs: These are the costs that include the characteristics of both variable and fixed overhead costs. Indirect labour, telephone, supervision, internal transportation costs of the factory are given as examples of the mixed overhead costs. On the other hand, in order to determine the cost of a product or service, all overhead costs must be allocated to a cost object. The procedure to allocate overhead cost to products or services is divided into two different ways; by using single (blanket) or multiple allocation bases, or by considering departmental allocation base. These methods explained below are different from each other.

FOH Allocation: Blanket Overhead Rates The first cost allocation way is to use single or multiple bases. The basic way of calculating an overhead rate is simple: total planned overhead cost is divided by a total planned allocation base such as direct labour hours, machine hours, units produced, amount of direct materials used, etc. The calculation formula may be as follows: Total Planned FOH Cost FOH application rate = Total Planned Allocation Base

Total planned FOH cost belongs to a period (a year) during which the company makes its production. This planned overhead may include all characteristics of this type of cost. In other words, it includes fixed, variable, mixed types of overhead costs that are expected to incur in a factory floor. However, the identification of the planned OH may be a difficult process. An accountant should know about the total production amount because all variable and semi-variable overhead costs will depend on the production amount. Also total fixed costs, such as rent, depreciation, property taxes, etc., should be taken into account. This cost identification and planning process requires a thorough analysis of many items that are related to the overhead.

Total planned allocation base on the other hand, is a denominator value that is employed in order to allocate the planned OH to the production. This denominator value should be identified in advance depending on the planned production. Examples of these are direct labour hours, machine hours, etc. The logic behind this calculation is that the overhead (at the nominator level) incurs because of this base (at the denominator level) which represents the production amount. In other words, it is assumed that the more production, the higher the overhead cost. What increases the production? Direct labour hours or machine hours. If the production affects the factory overhead, and if, for example, direct labour hours identify the production amount, then the FOH can be, and must be, allocated to the production using the direct labour hours as an allocation base.

Blanket overhead rate Blanket overhead rate is the basic way of calculating single factory overhead application rate. To find a blanket overhead rate, a total planned overhead cost is simply divided by the total planned allocation base, for example direct labour hours for the whole year. The above formula is used to find the blanket overhead rate. For example, let us assume that the total planned overhead cost for the company X is ¨ 150,000 and the total allocation base is 25,000 direct labour hours. Then FOH application rate is: ¨ 150,000/25,000 DL hrs = ¨ 6 per DL hour. This is an average rate that will be applied to the production depending on the DL hours realised.

Multiple overhead rates Multiple overhead rates: Although the same formula is used to calculate multiple overhead cost rates, more than one type of bases are used depending on the overhead cost they represent. In this respect, first the total planned overhead is divided into portions, each of which will be represented by a base selected, such as machine hour (M hr) or direct labour hour (DL hr). An accountant may find relationships between overhead costs portioned and the bases selected. Let us say that these bases are DL hours (25,000 hours planned for the whole year) and machine hours (10,000 hours planned for the whole year). Then each different overhead portion is divided by the rate which is appropriate and represents the overhead cost incurrence.

Example For example, total planned overhead costs is analysed and found that 70% is represented by direct labour hours, and the rest is represented by machine hours. Therefore, two overhead application rates should be computed using the above formula: OH Rate (DL hrs) = ( ¨ 150,000 * 70%)/25,000 DL hrs = ¨ 4.2 per DL hr. OH Rate (M hrs) = ( ¨ 150,000 * 30%)/10,000 M hr = ¨ 4.5 per M hr.

A manager may prefer a blanket rate if she/he wants to keep cost system simple. Moreover, the blanket rate may also be preferred when the same amount of time is required by the multiple products produced in a factory. Although the determination of single overhead application rate is very easy, it is not sensitive and it may not produce accurate results especially in a factory in which many departments exist and/or multiple products are being produced in each of these departments. Therefore, different application rates instead of the blanket overhead rate should be used for each department.

The difference between the blanket and the multiple overhead application rates Let us assume that Company W produces two different types of products, X and Y. It is estimated that factory overhead costs will be ¨ 200,000. Managers consider that 60% of the FOH cost could be associated with direct labour hours and 40% with machine hours. The total direct labour and machine hours will be equal to 40,000 and 20,000 respectively. The managers want to calculate the cost of Product X and Product Y separately. Product X requires two direct labour hours and Product Y requires 1 direct labour hour. Moreover, these products need 1 machine hour and 3 machine hours in the machining processes respectively. Direct Labour hour rate is equal to ¨ 25 for all products. Finally, Product X requires ¨ 35 as a material cost and Product Y needs a material cost of ¨ 15.

Solution FOH app. rate DL hrs = (200,000*60%)/40,000 = ¨ 3 per DL hr FOH app. rate Machine hrs = (200,000*40%)/20,000 = ¨ 4 per DL hr THE TOTAL UNIT COST = DM + DL + FOH Cost of Product X = 35 + (25*2) + (3*2+4*1) Cost of Product X = ¨ 95 Cost of Product Y = 15 + (25*1) + (3*1+4*3) Cost of Product Y = ¨ 55

If the blanket rate is used FOH application rate =200,000/40,000 = ¨ 5 per DL hr. Cost of Product X = 35 + (25*2) + (5*2) = ¨ 95 Cost of Product Y = 15 + (25*1) + (5*1) = ¨ 50

MANAGEMENT AND COST ACCOUNTING

Material Cost Direct Materials are the basic materials that can be directly identified with a final product. They are easily measured, weighted and assigned to a product. Since these materials can conveniently be allocated to the final product, their costs can be defined as Direct Material Costs. On the other hand, Indirect Materials are those that cannot be directly identified with a cost object. In the production of a desk, for example, direct materials are wood and iron bars. However, the costs of glue or nail are examples of indirect materials. It is important to note that indirect materials are accumulated into overhead cost.