1. www.paperhint.com Costing and Control of Factory (Manufacturing) Overheads

2. www.paperhint.com Factory Overhead Costs Factory overheads represent all indirect manufacturing costs. Unlike direct costs, these costs cannot be conveniently and wholly charged to product cost centres. Examples of factory overheads are as follows:  Indirect materials and indirect labour.  Factory rent, rates, lighting, power, and fuel.  Depreciation on factory plant and equipments and factory building.  Insurance, repairs and maintenance of factory plant and equipments and building.  Storekeeping, toolroom costs.

3. www.paperhint.com Therefore, cost allocation should be justified on the basis of cost-benefit considerations. Yet, cost allocation is necessary to determine the true cost of products, particularly in the case of multi-product firms. All factory overhead costs find their way into production costs through a somewhat difficult method of allocations and apportionments and reallocations and reapportionments. Allotment of common costs/factory overheads to cost centres/cost objects/cost units is often made on a somewhat arbitrary basis. Cost allocation procedures are costly as they use the time of cost accountants and decision-makers.

4. www.paperhint.com Costing and Control of Factory Overheads (i) Determination of Factory Overheads Application role (ii) Allocation of Overheads (iii) Absorption of Overheads (iv) Under/over Absorption of Overheads

5. www.paperhint.com 1. Factory Overhead Application Rate Factory overhead absorption rate can either be actual overhead rate or a predetermined overhead rate. Normally, a predetermined overhead rate is preferred, the reason being: (a) It is useful in ‘bidding’ cases to determine quotation prices; (b) It enables individual jobs to be costed immediately on their completion; and (c) Such a rate levels out the fluctuations which may be caused by variations in actual factory overhead costs and/or actual level of activity.

6. www.paperhint.com Predetermined overhead rate is determined dividing budgeted factory overhead costs for the coming period/year by capacity level. Two key factors to determine the factory overhead application rate for a period are: a)To select a volume/level of production (more commonly referred to as capacity) to be used as a base for applying factory overheads to production (denominator) and b) To budget factory overheads at the capacity selected (numerator).

7. www.paperhint.com Concept of Capacity It refers to the volume of production that a particular production department or factory is capable of producing if the plant were in continuous operation at peak efficiency at all times. Practical capacity is the maximum capacity expected when the plant operates at a planned level of efficiency. 1.Maximum or Theoretical Idle Capacity 2. Practical Capacity:

8. www.paperhint.com Among four capacity measures, normal capacity (based on long- run productive capacity) is considered as the best denominator measure. Normal capacity is equal to, or less than, practical capacity depending on the volume of expected sales. It is the volume of production required to meet the estimated/projected demand for the next period/year (that is in a single year only). Thus, expected actual capacity differs from normal capacity in the length of time to determine capacity base; this measure does not smoothen out cyclical variations in sales that are likely to occur over a period of time as it is guided by one year projections only. 4. Expected or Short-run Actual Capacity: 3. Normal or Long-run Productive Capacity:

9. www.paperhint.com Example 1 The Hypothetical Manufacturing Company Ltd wishes to determine various capacity levels both in terms of production units and machine-hours. One machine-hour produces 10 units of finished product. The production department in which the machine is located normally operates 6 days a week (except Sunday) on a single, eight-hour shift. The plant is closed for 10 working days each year for holidays. Plant is closed for 200 hours each year for its repairs and maintenance. Normal sales demand averages 20,000 units a year over a 5-year period (extensive product changes are made every five years). The expected sales volume for the next year is 19,000 units. Show the machine-hours and production capacity at the four levels.

10. www.paperhint.com Table 1: Capacity at Various Levels Capacity Details of computationMachine -hours Production units @ 10 units per hour 1.Maximum capacity (365 days ×8 hours per day) 2.Practical capacity Maximum capacity (in hours) Less idle capacity: Sundays (52 days ×8 hours) Holidays (10 days ×8 hours) Plant maintenance 3.Normal capacity 4.Expected capacity 2,920 416 80 200 2,920 2,224 2,000 1,900 29,200 22,240 20,000 19,000 Solution Machine-hours and production capacity at 4 levels of capacity are shown in Table 1.

11. www.paperhint.com Budgeted Factory Overhead Costs Budgeted Factory Overhead Costs Once the estimated level of production (capacity) has been decided, a manufacturing firm prepares a budget of expected production/factory overheads likely to be incurred in the next year. For estimating budgeted factory overheads, past historical cost data are normally taken as the base and adjustments are made for likely changes in prices/rates of various cost constituents of factory overheads. Total budgeted fixed factory overheads --———— Add variable factory overheads (Budgeted capacity level x Budgeted variable overhead rate) ————— Total _________ Format 1: Determination of Budgeted Factory Overhead Costs

12. www.paperhint.com Example 2 For Hypothetical Ltd in Example 1, assume further that the budgeted fixed overhead costs are estimated at Rs 6 lakh and variable overhead costs at Rs. 100 per unit as the basis of determining factory overhead application rate. Compute the factory overhead application rate. Solution Table 2: Determination of Factory Overhead Application Rate (a)Total budgeted fixed overheads Fixed overhead costs Variable overhead costs (2,000 hours × Rs. 100) (b)Normal capacity (machine-hours) (c)(i)Factory overhead application rate (Rs. 8,00,000/2,000) per hour (ii)Factory overhead application rate (Rs. 8,00,000/20,000 units) per unit Rs 6,00,000 2,00,000 8,00,000 2,000 400 40

13. www.paperhint.com Cost Allocation The cost allocation process is comprised of three basic activities. 1)Accumulating the costs on the basis of department or division or product. 2)Identifying the cost objects or recipients of the allocated costs, say, a unit of product or a department. 3)Selecting a method for relating the costs so accumulated to the cost objects. Cost common to more than one department are to be allocated among the production departments receiving benefits, and service department costs are to be distributed among producing departments.

14. www.paperhint.com (Say supervisor’s salaries, canteen expenses) are usually allocated on the basis of number of employees, direct labour-hours, wages paid or similar other labour related criteria. (Say insurance, maintenance, depreciation) are normally allocated on the basis of machine-hours, current book value of machinery, number of machines, or similar other machine-related criteria. (Say factory building rent and insurance, lighting, maintenance of building) are usually allocated on the basis of space occupied or similar other space- related criteria. (Say materials handling, utility) are normally allocated on the basis of value, quantity, time and similar other service related criteria. Labour-related Factory Overheads Machine-related Factory Overheads Space-related Factory Overheads Service-related Costs

15. www.paperhint.com Departmental Rates These are the costs which can be easily traced to specific departments. For instance, indirect materials used in production department (say X) can be traced through requisitions on store and can wholly be allocated to department X; likewise, indirect labour (foreman’s and supervisor’s salaries) wholly engaged in department X can be traced through payroll records; the same applies for depreciation on machines and plants exclusively used in the department X and annual maintenance contact payment for these machines. These are the costs which are common to more than one department and, hence, need to be shared/apportioned among the departments receiving benefits. Building occupancy costs (such as rent, maintenance and light); factory insurance premium, power charges for machine operations (where there are no separate metres for departments) are the major costs included in this category. (1) Direct Departmental Costs (2) Indirect Departmental Costs

16. www.paperhint.com Charging Cost of Service Department (i) Direct method (ii) Step method (iii) Repeated distribution method (iv) Algebraic method

17. www.paperhint.com Direct Method According to direct method, total budgeted costs of service departments are apportioned between/among production departments, ignoring any services provided by service departments to each other.

18. www.paperhint.com Example 3 A manufacturing company has 5 service departments and 2 production departments. The total budgeted costs for the period for each department were as follows: Service Departments: Building and grounds Personnel General factory and administration Cafeteria Storeroom Production Departments: Machinery Assembly Rs 1,00,000 10,000 2,60,900 16,400 26,700 3,47,000 4,89,000 The following schedule was prepared to assist in allocating service department costs: Direct labour-hours Number of employees Square feet Total labour- hours Number of requisitions Building and grounds Personnel General factory administration Cafeteria Storeroom Machinery Assembly — 5,000 15,000 20,000 — 35 10 5 50 100 200 — 2,000 7,000 4,000 7,000 30,000 50,000 1,00,000 — 1,000 8,000 17,000 27,000 — 2,000 1,000 3,000

19. www.paperhint.com The company management decided that the appropriate bases used by each service department would be the following: Building and grounds Personnel department General factory administration Cafeteria Storeroom Square feet Employees Total labour-hours Employees Requisitions Direct labour-hours are used as the basis for computing the production dapartment’s factory overhead application rates. You are required to allocate the total budgeted costs of the service departments by using direct method. Also, determine the factory overhead absorption rates for the production departments.

20. www.paperhint.com Solution Table 3: Determination of Factory Overhead Absorption Rates for Production Departments (Machinery and Assembly) ItemsBasis of charge Service departmentsProduction departments Building and grounds (Rs) Personnel (Rs) General factory administratio n (Rs) Cafete ria (Rs) Store room (Rs) Machinery (Rs) Assembly (Rs) Budgeted costs Cost of service departments apportioned to production departments: Building and grounds Personnel General factory administration Cafeteria Storeroom Total cost Allocation Square feet ratio (3:5) Employees (1:2) Total labour- hours (8:17) Employees (1:2) Requisitions (2:1) 1,00,000 (1,00,000) — 10,000 (10,000) — 2,60,900 (2,60,900) — 16,400 (16,40 0) — 26,700 (26,700) — 3,47,000 37,500 3,333 83,488 5,467 17,800 4,94,588 4,89,000 62,500 6,667 1,77,412 10,933 8,900 7,55,412 Direct labour-hours Factory overhead absorption rate (Total cost/Direct labour-hours) 5,00015,000 98.92 50.36

21. www.paperhint.com Step Method In situations when one service department renders services to another (that is reciprocity exits), the step method is more appropriate than the direct method. This method takes into consideration the total/true cost of each service department (and not partial) in assigning them to production departments. The following is a list of steps used for the purpose of apportioning budgeted costs of service departments. (i)It is usual to apportion first the cost of that service department which renders services to the largest number of other service departments. (ii)The budgeted costs of the service department that renders services to the next largest number of service departments are then apportioned. (iii) This sequence is continued, step-by-step, until all the budgeted service department costs have been apportioned departments.

22. www.paperhint.com Using the facts given in Example 3, cost apportionment of service departments as per Step method is shown in Table 4. Table 4: Determination of Factory Overhead Absorption Rates for Production Departments (Machinery and Assembly) ItemsBasis of charge Service departmentsProduction departments Building and grounds (Rs) Personn el (Rs) General factory administra tion (Rs) Cafeteri a (Rs) Store room (Rs) Machin ery (Rs) Assemb ly (Rs) Budgeted costs Distribution of factory overheads of: Building and grounds Personnel General factory administration Cafeteria Storeroom Total cost Allocation Square feet ratio Employees Total labour- hours Employees Requisitions 1,00,000 (1,00,000) — 10,000 2,000 (12,000) — 2,60,900 7,000 2,100 (2,70,000) — 16,400 4,000 600 10,000 (31,000) — 26,700 7,000 300 10,000 1,000 (45,000) — 3,47,000 30,000 3,000 80,000 10,000 30,000 5,00,000 4,89,000 50,000 6,000 1,70,000 20,000 15,000 7,50,000 Direct labour-hours (DLH) Factory overhead absorption rate (Total cost/DLH) 5,000 100 15,000 50

23. www.paperhint.com Repeated Method The process of apportioning service departments overhead according to repeated distribution method is continued until the figures of unapportioned sum(s) of service department(s) become negligible. The following steps are involved in its application. (i) The first service department’s (to be identified on the basis of the order in which their names are stated) budgeted costs are to be apportioned. As a result, the balance of the first service department becomes nil; its costs are apportioned among other departments. (ii)The budgeted costs of the second service department (consisting of original amount plus the apportioned sum from the first service department) is to be apportioned among other departments including the first service department.

24. www.paperhint.com (iii) This process continues for all the remaining/other service departments. (iv)The second phase of cycle starts once again with the first service department; it will consist only of apportioned amounts from other service departments. As a result, the total costs of service departments becomes less and less with each phase of apportionment. (v)The process comes to an end when it is found that the residual sum (to be apportioned) has been either exhausted or has become virtually insignificant.

25. www.paperhint.com Example 4 A company has three production departments and two service departments. Distribution summary of overheads is as follows: Production departments: A B C Service departments: X Y Rs 13,600 14,700 12,800 9,000 3,000 The expenses of service departments are charged on a percentage basis, which is as follows: DepartmentABCXY X403020—10 Y30 20 — Apportion the cost of service departments by using the repeated distribution method.

26. www.paperhint.com Solution Table 5: Apportionment of Cost of Service Departments to Production Departments particularsProduction departmentsService departments ABCXY Primary apportionment Department X overheads apportioned in ratio of (4:3:2:1) Department Y overheads (Rs 3,900) apportioned in the ratio of (3:3:2:2) Department X overheads (Rs 780) apportioned in the ratio of 4:3:2:1 Department Y overheads (Rs 78) apportioned in the ratio of 3:3:2:2 Department X overheads (Rs 16) apportioned in the ratio of 4:3:2:1 Department Y overheads (Rs 2) apportioned in the ratio of 3:3:2:2 Total Rs 13,600 3,600 1,170 312 23 6 1 18,712 Rs 14,700 2,700 1,170 234 23 5 1 18,833 Rs 12,800 1,800 780 156 16 3 — 15,555 Rs 9,000 (9,000) 780 (780) 16 (16) — Rs 3,000 900 (3,900) 78 (78) 2 (2) —

27. www.paperhint.com Algebraic Method The algebraic method is the most appropriate of all the four methods when reciprocal services exist between service departments. This method is also called the reciprocal services method as it takes into account cost flows in both directions between service departments that render services to each other. This is typical for the service departments to provide services to each other in most of the manufacturing firms in practice. This method provides conceptually the most correct budget cost estimates of service departments and their subsequent apportionment.

28. www.paperhint.com Example 5 Royal Industries Ltd has 2 service (SD) and 2 production departments (PD). It employs the algebraic method to allocate budgeted service department costs. The following information is available: Services provided by DepartmentBudgeted costsDepartment ADepartment B Total costs: SD A SD B Factory overhead costs: PD1 PD2 Direct labour-hours (DLH): PD1 PD2 Rs 1,00,000 2,00,000 1,40,000 60,000 5,00,000 20,000 10,000 — 35 % 15 50 100 % 20 % — 45 35 100 % From the above information, you are required to: (a) Allocate the service departments costs to production departments. Use algebraic equation method, (b) Compute factory overhead absorption rate, based on direct labour-hours.

29. www.paperhint.com Solution (a) Let X be the total overhead costs of SD A and Y be of SD B X = Rs 1,00,000 + 0.20Y Y = Rs 2,00,000 + 0.35X Substituting, X = Rs 1,00,000 + 0.20 × (Rs 2,00,000 + 0.35X) = Rs 1,00,000 + Rs 40,000 + 0.07X = Rs 1,40,000/0.93 = Rs 1,50,538 Y = Rs 2,00,000 + 0.35 × (Rs 1,50,538) = Rs 2,52,688 Allocation of Overheads Among Production Departments ItemsProduction DepartmentsTotal P1P1 P2P2 Direct overheads SD A (15:50) SD B (45:35) Total Rs 1,40,000 22,581 1,13,709 2,76,290 Rs 60,000 75,269 88,441 2,23,710 Rs 2,00,000 97,850 2,02,150 5,00,000

30. www.paperhint.com Working Notes 1.Total expenses of SD A Less share of SD B (0.35 × Rs 1,50,538) Amount to be divided between production departments 2.Total expenses of SD B Less share of SD A (0.20 × Rs 2,52,688) Amount to be divided between production departments Rs 1,50,538 52,688 97,850 2,52,688 50,538 2,02,150 (b) Factory Overhead Absorption Rate (based on DLH) for Production Departments For P 1 (Rs 2,76,290/20,000, DLH) For P 2 (Rs 2,23,710/10,000, DLH) Rs 13.8145 22.3710

31. www.paperhint.com Absorption of Factory Overheads Factory overheads of production departments (inclusive of appropriate apportioned share from other services departments) are to be applied to production/jobs. Some common bases of absorption of factory overheads are: 1)Units of production 2)Direct materials cost 3)Direct labour cost, 4)Prime cost method 5)Direct labour-hours 6)Machine-hours

32. www.paperhint.com According to units of production method, the factory overhead absorption rate = Estimated/budgeted factory overhead costs ÷ Estimated/budgeted units of production. Direct material cost method, the overhead recovery rate in terms of percentage of direct material cost = (Estimated/budgeted factory overhead cost/Estimated direct material cost) x 100. (1) Unit of Production (2) Direct Material Cost Method The factory overhead rate according to direct labour cost method = (Estimated factory overhead cost/Estimated direct labour cost) x 100. According to prime cost method the factory overhead rate = (Estimated factory overhead cost/Estimated prime cost) x 100. The factory overhead absorpation rate per direct labour hour = Estimated factory overhead costs ÷ Estimated direct labour-hours. 5. Direct Labour-hours 3. Direct Labour Costs Basis/Method 4. Prime Cost Method

33. www.paperhint.com Machine-hour Rate According to the machine-hour rate, the factory overhead absorption rate per machine-hour (MHR) = Estimated factory overhead costs ÷ Estimated machine-hours. Since most of the work is done through machines, machine-hour rate is normally adopted to absorb factory overheads.

34. www.paperhint.com In case where production department has several machine (serving different needs), the factory overheads among different machines (each machine/block of machine constitutes a cost centre) should be apportioned on equitable basis. For instance 1)rent and rates, lighting and heating costs can be apportioned on the basis of effective floor space occupied (that is, allowing for reasonable space to operate the machine); 2)insurance may be apportioned on the basis of book value of machines; 3)depreciation may be computed on the basis of effective cost of the machine and its effective useful life in hours; 4)power costs should be charged on the basis of actual units consumed; 5)supervision costs are to be apportioned on the basis of the degree of supervision required by each machine. Similarly, other production departments costs are to be apportioned on the most equitable basis. The estimated productive machine-hours should be based on effective hours for which the machine works. It should exclude time lost due to setting-up of the machine and its maintenance.

35. www.paperhint.com Further, total overheads related to machine should be normally segregated in two categories: fixed costs (commonly called standing charges), and variable costs (referred to as machine expenses) for cost control purposes, as also for decision-making purposes. Included in machine expenses are depreciation, power, repairs and maintenance; standing charges include rent and rates, general lighting, insurance, and supervisor’s salary. Where the work performed by direct labour personnel is identifiable with a particular machine group, their direct wages should be included as part of the machine group cost. Thus production/job will be charged with a machine-hour rate which is inclusive of direct wages. Such a rate is known as comprehensive machine-hour rate. Direct labour-hour rate (where factory overhead costs consist primarily of labour activity) and machine-hour rate (where indirect manufacturing costs predominantly comprise of machine-related activity) are the two suitable methods. Further, for cost control and decision-making purposes, factory overhead absorption rate should be computed separately both for fixed costs and variable costs.

36. www.paperhint.com Example 6 Compute the machine-hour rate from the following data: Cost of machine Estimated scrap value after the expiry of its useful life (5 years) Rent and rates for the shop per month General lighting for the shop per month Insurance premium for the machine per annum Repairs and maintenance expenses per annum Power consumption — 10 units per hour @ Rs 2 per unit Estimated working hours per annum 2,200 (including setting- up time of 200 hours; no power is required during setting-up time) Shop supervisor’s salary per month Rs 3,00,000 50,000 2,000 1,500 4,800 5,000 20 6,000 The machine occupies one-fourth of the total area of the shop. The supervisor is expected to devote one-fifth of his time for supervising the machine. Determine machine-hour rate.

37. www.paperhint.com Solution Determination of Machine-hour Rate ParticularsRate per hour Standing charges: Rent and rates (Rs 2,000 per month × 12)/4 General lighting (Rs 1,500 per month × 12)/4 Insurance premium per annum Shop supervisor’s salary (Rs 6,000 per month × 12)/5 Total standing charges Productive working machine-hours (2,200 – 200, setting-up time) Standing charges per hour (Rs 29,700/2,000) Machine expenses*: Repairs and maintenance expenses (Rs 5,000/2,000 hours) Depreciation [(Rs 3 lakh – Rs 0.5 lakh)/5years] ÷ 2,000 hours Power consumption per hour Machine-hour rate per hour Rs 6,000 4,500 4,800 14,400 29,700 2,000 2.5 25.0 20.0 Rs 14.85 47.50 62.35 *are in the nature of mixed and variable costs.

38. www.paperhint.com UNDERABSORPTION AND OVERABSORPTION OF FACTORY OVERHEADS When predetermined factory overhead applied rate is used as the basis of absorption of indirect manufacturing costs, it is seldom that the total factory overhead costs applied to production (or jobs) in a given period are equal to the total factory overhead costs incurred in that period. Under-absorption of factory overheads = Actual factory overheads – Overheads charged to production When the absorbed factory overheads exceed the actual, it is a situation of overabsorption; under-absorption results when the actual factory overhead costs exceed the factory overheads charged to production. Overabsorption of factory overheads = Overheads charged to production – Production overheads

39. www.paperhint.com Cost of Goods Sold A/c..... ……….. Dr To Factory Overhead Control A/c (For charging under-absorbed factory overheads) Factory Overhead Control A/c....... Dr To Cost of Goods Sold A/c (For adjusting over-absorbed factory overheads) Work-in-process Inventory A/c.......Dr Finished Goods Inventory A/c.......Dr Cost of Goods Sold A/c.......Dr To Factory Overhead Control A/c (For charging under-applied factory overheads) Factory Overhead Control A/c.......Dr To Work-in-process Inventory A/c To Finished Goods Inventory A/c To Cost of Goods Sold A/c (For adjusting over-applied factory overheads) Journal Entries: Overhead Variance Treated as a Period Cost Journal Entries: Overhead Variance Considered as the Cost of Production

40. www.paperhint.com Example 7 In a manufacturing unit, factory overhead was recovered at a predetermined rate of Rs 25 per manday. The total factory overhead expenses incurred and the mandays actually worked were Rs 41.50 lakh and 1.5 lakh, respectively. Out of the 40,000 units produced during a period, 30,000 were sold. On analysing the reasons, it was found that 60 per cent of the unabsorbed overheads were due to defective planning and the rest were attributable to increase in overhead costs. How would unabsorbed overheads be treated in cost accounts?

41. www.paperhint.com Solution Determination of Unabsorbed Factory Overheads Factory overhead expenses incurredRs 41,50,000 Less factory overheads absorbed (1,50,000 mandays × Rs 25 per manday) 37,50,000 Unabsorbed factory overheads4,00,000 Treatment of Unabsorbed Factory Overheads: (1) 60 per cent of unabsorbed overheads are attributed to defective planning. Being abnormal in nature, Rs 2,40,000 (0.60 × Rs 4 lakh) is charged to costing profit and loss account (2) Rs 1,60,000 is to be pro-rated between cost of goods sold (30,000 units) and finished goods inventory (10,000 units): — Cost of goods sold (Rs 1,60,000 × 3/4) — Finished goods inventory (Rs 1,60,000 × 1/4) Rs 1,20,000 40,000 Rs 2,40,000 1,60,000 4,00,000

42. www.paperhint.com Example 8 The XYZ Ltd has the following information relating to applied and actual factory overheads for the current month: Factory overheads, incurred Applied factory overheads Applied factory overhead costs are in the following accounts: Cost of goods sold Ending work-in-process inventory Ending finished goods inventory Rs 1,52,500 1,98,500 1,60,000 17,500 21,000 You are required to allocate the under or overapplied factory overheads to relevant accounts and pass necessary journal entries at the month-end.

43. www.paperhint.com Solution: Overapplied/Overabsorbed Factory Overheads: Applied factory overheads Less factory overheads incurred Over-absorbed factory overheads will be pro-rated in the following accounts: Cost of goods sold (Rs 1,60,000/Rs 1,98,500) × Rs 46,000 Ending work-in-process inventory (Rs 17,500/Rs1,98,500) × Rs 46,000 Ending finished goods inventory (Rs 21,000/Rs 1,98,500) × Rs 46,000 Rs 1,98,500 1,52,500 46,000 37,078 4,055 4,867 46,000 Journal Entries: Factory Overhead Applied A/c.......Dr To Over-applied Factory Overhead A/c To Factory Overhead Control A/c Rs 1,98,500 Rs 46,000 1,52,500 Overapplied Factory Overhead A/c.......Dr To Cost of Goods Sold A/c To Ending Work-in-process Inventory A/c To Ending Finished Goods Inventory A/c 46,000 37,078 4,055 4,867