Determination of Factory Overhead Application Rates

Once level of production and total factory overhead costs for the next period of a manufacturer have been estimated, the predetermined factory overhead application rate for the next period can be computed. Factory overhead application rates are generally stated in terms of dollars per unit of estimated activity of some base (called denominator activity). This post provides procedures and computation of factory overhead application rates. But before that, let’s recall out memory about factory overhead first. Read on…

 

Factory Overheads

Factory overhead refers to the cost pool used to accumulate all indirect manufacturing costs (excluding selling, general, and administrative expenses because they are nonmanufacturing costs). Examples of factory overhead include the following:

  • Indirect labor and indirect materials
  • Heat, light, and power for the factory
  • Rent on factory building
  • Depreciation on factory building and factory equipment
  • Maintenance of factory building and factory equipment
  • Property taxes on factory building

 

Factory overhead costs are divided into three categories on the basis of their behavior in relation to production. The categories are (1) variable costs, (2) fixed costs, and (3) mixed costs and are described below:

Variable factory overhead costs – Total variable factory overhead costs vary in direct proportion to the level of production, within the relevant range, which was previously defined as that interval of activity within which total fixed costs and per-unit variable costs remain constant; that is, the greater the number of units produced, the higher the total variable factory overhead cost. However, variable factory overhead cost per unit remains constant as production either increases or decreases. Examples of variable factory overhead costs are indirect materials and indirect labor.

Fixed factory overhead costs – Total fixed factory overhead costs remain constant within the relevant range regardless of the varying levels of production within that range. Examples of fixed factory overhead costs are property taxes, depreciation, and rent on the factory building.

Mixed factory overhead costs – Mixed factory overhead costs are neither wholly fixed nor wholly variable in nature but have characteristics of both. Mixed factory overhead costs must ultimately be separated into their fixed and variable components for purposes of planning and control. Examples of mixed factory overhead costs are factory truck rentals and factory telephone service (semi variable factory overhead costs) and factory supervisors’ salaries and factory inspector salaries (step factory overhead costs).

 

Actual versus Normal Costing of Factory Overhead

In an actual cost system, product costs are recorded only when they are incurred. This technique is usually acceptable for the recording of direct materials and direct labor because they can be easily traced to specific jobs [job order costing] or departments [process costing]. Factory overhead, because it is an indirect element of product cost, usually cannot be easily or conveniently traced to a specific job or department. As a consequence, a modification of an actual cost system, called normal costing, is commonly used.

Under normal costing, costs are accumulated as they are incurred, with one exception: Factory overhead is applied to production on the basis of actual inputs (hours, units) multiplied by a predetermined factory overhead application rate. This procedure is necessary because factory overhead costs are not incurred evenly throughout a period; therefore, estimates must be made and a rate developed to apply factory overhead costs to jobs or departments as units are produced. The classification of a factory overhead cost as variable, fixed, or mixed becomes important when the predetermined factory overhead application rate is computed.

 

Computing Factory Overhead Application Rates

There are no definitive rules for determining the base to use as the denominator activity. However, there must be a direct relationship between the base and factory overhead costs. Also the method used to determine the factory overhead application rate should be the simplest and least costly to compute and apply.

Once total factory overhead costs have been estimated and the base chosen, the normal capacity activity level must be estimated in order to compute the factory overhead application rate.

The formula for computing the factory overhead application rate, which is the same regardless of the base chosen, is as follows:

Factory overhead application rate per unit, hour, dollar, etc. = Estimated factory overhead costs [:] Estimated base at denominator activity

 

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

 

The data for the following illustrations is based on the Lie Dharma Corporation’s static factory overhead budget at the normal productive capacity level. The estimated factory overhead costs for the period are $1,000,000 and normal productive capacity is 250,000 units. The factory overhead application rate using the units of production method would be computed as follows:

1,000,000 / 250,000 = $4.00 per unit 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

For example, Lie Dharma Corporation’s estimated factory overhead cost for the period is $1,000,000; assume that the estimated direct materials cost is $500,000. Using direct materials cost as the base, the factory overhead application rate is computed as follows:

$1,000,000 / $500,000 = 200% 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 estimated factory overhead costs are $1,000,000 and estimated direct labor costs are $2,000,000 [500,000 direct labor hours at an assumed $4 per direct labor hour at their overseas plant], the Lie Dharma Corporation’s factory overhead application rate would be computed as follows:

$1,000,000 / $2,000,000 = 50% 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

Assume that the Lie Dharma Corporation’s estimated factory overhead for the period is $ 1,000,000 and estimated direct labor hours are 500,000 (250,000 units at 2 direct labor hours per unit). The factory overhead application rate, based on direct labor hours, would be computed as follows:

$1,000,000 / 500,000 direct labor hours = $2 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

Assume that the Lie Dharma Corporation’s estimated factory overhead costs for the period are $1,000,000 and estimated machine hours are 15,000. The factory overhead application rate would be computed as follows:

$1,000,000 / 15,000 machine hours = $66.70 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.

 

Single Plant-wide versus Multiple Departmental Factory Overhead Application Rates

A single plant-wide factory overhead application rate can be used either when a single product is being manufactured or when the different products being manufactured pass through the same series of productive departments and are charged similar amounts of applied factory overhead. Multiple departmental factory overhead application rates are preferable when the different products being manufactured either do not pass through the same series of productive departments or, if they do, they should be charged dissimilar amounts of applied factory overhead because of the differing amounts of attention each product receives.

 

Separate Variable and Fixed Factory Overhead Application Rates

Some companies prefer to apply factory overhead to production using separate application rates for variable and fixed factory overhead because, as we have shown, variable costs and fixed costs do not behave the same as activity changes. Separate application rates are especially useful for control purposes via the analysis of applied factory overhead costs versus actual factory overhead costs.

If direct labor hours are used as the base to apply factory overhead for the Lie Dharma Corporation, the factory overhead application rate for 20X9 can be easily divided into separate variable and fixed factory overhead application rates as follows:

Variable factory overhead application rate = $650,000 / 500,000 direct labor hours = $1.30 per direct labor hours

Fixed factory overhead application rate = $350,000 / 500,000 direct labor hours = $0.70 per direct labor hours

Factory overhead application rate = $1,000,000 / 500,000 direct labor hours = $2.00 per direct labor hours

 

Applied Factory Overhead Cost

After the factory overhead application rate has been determined, it is used to apply (or match) estimated factory overhead costs to production. The estimated factory overhead costs are applied to production on an ongoing basis as goods are manufactured, according to the base used [i.e., as a percentage of direct materials costs or direct labor cost or on the basis of direct labor hours, machine hours, or units produced]. For example: assume that the factory overhead application rate was determined to be $2.00 per direct labor hour, using direct labor hours as a base, and that 00,000 actual direct labor hours were worked. Then $200,000 (=100,000 × $2.00) of estimated factory overhead would have been applied to production during the period in relation to the direct labor hours that were actually worked.

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

8 thoughts on “Determination of Factory Overhead Application Rates”

  1. I would like to know the reference materials regarding requirement(s) in the IFRS that concern the recognition and measurement of items ( particularly *grants)typically shown in the financial statements of not-for-profit entities.

    ? E.g. A grant given by a professional association to one of its local chapters is held by the association as a credit for the chapter and will only be remitted to the chapter upon request. How will this be reflected in the local chapter’s year-end financial statements for the financial year in which the grant is given and in subsequent years ? Will IAS 21 be applicable to this case if the functional currency of the association is different from that of the local chapter. ( e.g. the grant is denominated in the functional currency of the association.)

    Thanks for your kind support in advance !

    With warm regards,

    Angela

  2. Thanks Mr.Putra,

    i have a doubt.when applying the overheads which input quantity we have to use- whether we have to use the actual quantity of input used (or) the standard quantity allowed for the actual output?
    PLEASE CLARIFY

  3. Hello there! just couple of questions that I have, I work for a manufacturing firm in Harbor City and we are currently using standard costing, determining cost is based on direct labor however we feel that our operations is more driven by machines we manufacture various parts for customers and its is basically 24/7 there are machines that is being used more than the others some of them requires a person to run and other machines just a set up and has a part time operators.
    Question is how can I do a better analysis to see if we should move to machine hours?

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