Accounting For Conversion Costs PDF

BM2404 ACCOUNTING FOR CONVERSION COSTS Accounting for Labor Labor is the physical or mental effort expended in manufacturing a product. Labor cost is the price paid for using human resources. The compensation paid to employees who engage in production-related activities re...

BM2404 ACCOUNTING FOR CONVERSION COSTS Accounting for Labor Labor is the physical or mental effort expended in manufacturing a product. Labor cost is the price paid for using human resources. The compensation paid to employees who engage in production-related activities represents factory labor. The principal labor cost is wages paid to production workers. Wages are payments made regularly for managerial or clerical services. However, in practice, the terms “wages” and “salaries” are often incorrectly used interchangeably. Factory payroll costs are divided into – a) direct labor and b) indirect labor. Direct labor represents payroll costs that are allocated directly to the product and are debited to the work-in-process account. Indirect labor cost of labor costs incurred for a variety of jobs that are related to the production process but are considered either too remote or too insignificant to be charged directly to production. Indirect labor costs are charged to the factory overhead control account. Included as indirect labor are salaries and wages of the factory superintendent, supervisors, janitors, clerks, factory accountants, and timekeepers. The accounting system of a manufacturer must include the following procedures for recording payroll costs. 1. Recording the number of hours used in total and by job. 2. Recording the quantity produced by the workers. 3. Analyzing the hours used by employees to determine how time is to be charged. 4. Allocation of payroll costs to jobs and factory overhead accounts. 5. Preparation of the payroll, including computation and recording of the employee's gross earnings, deduction, and net earnings. Wage Plans Companies use different wage plans. The union approves the plan established by management and should comply with government agency regulations. Some of these plans are hourly-rate plans, piece-rate plans, and modified wage plans. Hourly-Rate Plan Under this plan, a definite rate per hour is set for each employee. The employee's wages are calculated by multiplying the rate per hour by the number of hours worked. The hourly rate plan is simple to use but does not provide an incentive for the employee to achieve a high level of productivity. The employee is paid for merely "being on the job." Piece-Rate Plan Under a piece-rate plan, earnings are calculated by multiplying the employee's output by the rate per piece. The plan provides an incentive for the employee to produce more. However, the employee might sacrifice quality to maximize earnings. 03 Handout 1 *Property of STI Page 1 of 17  BM2404 Modified Wage Plan A modified wage plan combines the features of hourly-rate and piece-rate plans. An example of a modified wage plan would be to set a minimum hourly wage that the company will pay even if an employee does not attain an established quota of production. If the established quota is exceeded, an additional payment per piece would be added to the minimum wage level. Controlling Labor Cost The timekeeping and payroll departments are responsible for maintaining labor records. The timekeeping department accounts for the time employees spend in the factory. The payroll department computes each employee's gross earnings, the amount of withholdings and deductions, and the net earnings to be paid to the employee. The departmental responsibilities of timekeeping and payroll are carried out by completing and maintaining the following forms and records: Time-keeping Payroll Clock cards Payroll records Time ticket Employee’s earning records Production reports Payroll summaries Accounting for Labor Costs For all regular hourly employees, the hours worked should be recorded on a time ticket, and production reports are used instead of time tickets when labor costs are calculated daily. The pay rates and gross earnings are entered and sent to payroll daily. Cost accountants sort the time tickets and production reports and charge the labor cost to the appropriate jobs or departments and factory overhead. The accounting department records the earnings in the factory overhead ledger and on the labor cost summary. The labor cost summary is used as the source for making a general journal entry to distribute payroll to the appropriate accounts. The entry is then posted to the cost accounts, Work in Process, and Factory Overhead in the general ledger. In preparing the labor cost summary from the tickets, it is important to separate any employee's regular time because the accounting treatment may be different for each type of pay. Regular time worked is charged to job debiting Work in Process. Overtime may be charged to jobs, to factory overhead, or allocated partly to jobs and partly to overhead. Overtime distribution depends upon the conditions creating the need for overtime hours. If an employee works beyond the regularly scheduled time but the employee is paid at the regular hourly rate, the extra pay is called overtime pay. If an additional rate is allowed for the extra hours worked, the additional rate earned is referred to as an overtime premium. The premium pay rate is added to the employee's regular rate for the additional hours worked. The premium rate will depend on the collective bargaining agreement (CBA) between management and the union. To illustrate how payroll is calculated where overtime premium is a factor, assume an employee regularly earns P 30 per hour for an 8-hour day. If called upon to work more than eight (8) hours in a working day, the company will have to pay an overtime premium for hours worked in excess of eight (8) hours. Assuming the 03 Handout 1 *Property of STI Page 2 of 17  BM2404 employee works 12 hours on Monday and is paid a 50% overtime premium (time-and-half), the earnings would be calculated as follows: Direct labor - 8 hours at P 30 P240 Direct labor - 4 hours at P 30 P 120 Factory overhead (overtime premium - 4 x 15) 60 180 Total earnings P420 If the previously mentioned employee is paid a premium of 100% (double-time), the earnings would be: Direct labor – 8 hours at P 30 P 240 Direct labor – 4 hours at P 30 P 120 Factory overhead (overtime premium-4 x 30) 120 240 Total earnings P 480 With the preceding illustration, the regular rate (240 + 120) will be charged to Work in Process. In contrast, the overtime premium (60 in the first illustration and 120 in the second illustration) will be charged to Factory Overhead Control. By charging the overtime premium to the factory overhead account, all jobs worked during the period share the cost of overtime premiums paid. If the job contract stipulated that it was a rush contract, it would be appropriate to charge the premium pay to the job (Work in Process) instead of to a factory overhead account. Employer’s Payroll Taxes Payroll taxes imposed on employers include Social Security premiums, Pag-ibig fund contributions, and PhilHealth premiums. Employers are responsible for periodically reporting and paying the taxes to the appropriate government agencies. Employers who fail to file required reports or pay taxes due are subject to civil and, in some cases, criminal penalties. Social Security System (SSS) Contribution The Social Security System requires employers to pay social security taxes on wages and salaries equivalent to approximately 55% of the total contribution credited to the employee. Let us consider the SSS contribution of an employee with a salary of P10,000/month. Note: Always refer to the recent SSS Contribution Table (https://www.sss.gov.ph/) Per the SSS contribution table, the total contribution is P925 - P506.70 being contributed by the employer and P333.30 deducted from the employee's salary. Of the total amount credited to the employee's name, approximately 68% (706.70/1,040) is paid by the employer, and approx. 32% only is deducted from the employee's salary. The benefits, to name a few, are pension upon retirement (lump sum equivalent to 18 months x the computed monthly pension and on the 19th month and up to the death of the retiree, the monthly pension will be credited to the retiree's banks account) salary, educational loan, maternity leave (with pay), housing loan and sometimes calamity loan. 03 Handout 1 *Property of STI Page 3 of 17  BM2404 PhilHealth contributions The amount contributed by the employer is equal to the amount deducted from the employee's salary or wage. The maximum deduction per the PhilHealth table is P375.00 for salaries of P30,000 and over. The employer's contribution, maximum, is also P375.00. Benefits are enjoyed when the employee is hospitalized. The amounts reimbursable, allowed by law, are professional fees, room, medicine, and other expenses (the amount is paid directly to the hospital). In our example, for an employee with a salary of P10,000, the deduction is P125.00 from the employee's salary, and the employer contributes the same amount. The total amount of P250.00 is credited to the employee's name. Note: Always refer to the recent PhilHealth Contribution Table (https://www.philhealth.gov.ph/) Pag-Ibig Funds Contribution The amount deducted from the employee's salary is equivalent to 3% of basic or P100, whichever is lower. The employer's contribution is also equal to the amount deducted from the employee. Some of the benefits are educational loans, salary loans, and housing loans. Upon retirement, the total amount deducted from the employee's salary plus the contribution of the employer plus dividends earned will be returned to the employee. Reference: https://www.pagibigfund.gov.ph/Membership_RegularSavings.html ILLUSTRATIVE PROBLEM 1 The Ingrid Manufacturing Company pays employees every two (2) weeks. Monday, May 1, is the beginning of a new payroll period. The following payroll summary is prepared by the payroll department and forwarded to accounting for recording: Payroll Summary For the period May 1-14 Factory Sales and Worker Adm. Employee Total Gross Earnings P 10,000,00 P 20,000,00 P30,000,00 Withholdings & deductions: Income tax P 1,979.25 P 2,833.33 P 4,812.58 SSS Premiums 333.30 500.00 833.30 PhilHealth contributions 125.00 250.00 375.00 Pag-Ibig contributions 100.00 100.00 200.00 Total deductions P 2,537.55 P 3,683.33 P6,220.88 Net earnings P 7,462.45 P 16,316.67 P23,779.12 After the data are verified, a payroll voucher is authorized and recorded as follows: May 14 Payroll P 30,000 Withholding Tax payable P 4,812.58 SSS Premium Payable 833.30 PhilHealth Contributions Payable 375.00 Pag-Ibig Funds Contribution Payable 200.00 Vouchers Payable 23,779.12 03 Handout 1 *Property of STI Page 4 of 17  BM2404 To record the payment of the net earnings to employees, the following entry is required: May 14 Vouchers Payable 23, 779.12 Cash 23,779.12 Assuming that the total factory payroll of P10,000- P3,000 is indirect labor, the entry to record the distribution of the payroll is: Work in Process 7,000 Factory Overhead Control 3,000 Selling & Adm. Expense Control 20,000 Payroll 30,000 The following schedule provides the information necessary to record the employer’s payroll taxes for the period. SSS Premiums PhilHealth Pagibig Total Factory payroll 706.70 125 100 931.70 Selling & Adm. 1,060.00 125 100 1,285.00 Total 1,766.70 250 200 2,216.70 The entry to record the employer’s payroll taxes is as follows: Factory Overhead Control 931.70 Selling & Adm. Expense Control 1,285.00 SSS Premiums Payable 1,766.70 PhilHealth Contributions Payable 250.00 Pag-ibig Funds Contributions Payable 200.00 Classification for Labor 1. Direct Labor - Labor identified with products that are considered feasible to be measured and charged to specific production order cost sheet 2. Indirect labor a. Labor identified with particular products but which is not considered feasible to measure and charge to a specific production order. b. Labor expected for the benefit of production in general and not identified with particular products. 3. Labor Overhead a. Waiting time or idle time – Cost of non-productive hours of direct labor caused by lack of work, waiting for material delays from scheduling, machine breakdown, and machine setup. For example, when a job is being “set up” for production, some workers may temporarily have nothing to do. If their idleness is normal for production and cannot be avoided, the cost of idle time should be charged to factory control. Let us assume Maxine Garcia’s rate is P50.00 per hour for a 40-hour week, as per the union contract. The following entry should be made to record Maxine’s total wages. 03 Handout 1 *Property of STI Page 5 of 17  BM2404 Work in process Job 101 (36 hrs. x P50) 1,800 Factory overhead control – Idle time (4hrs. x P50) 200 Accrued payroll 2,000 b. Make-up pay – When payments to an employee are based solely on the number of units produced, the employee is said to be paid at a "piecework" rate. Many companies will pay employees a minimum wage, but they could earn more if they produced more. This labor payment system benefits new employees because it guarantees them a minimum salary while they are learning their new job (during which time they usually do not produce enough units). If the output multiplied by the piece rate results in an amount less than the guaranteed wage, the difference is charged to factory overhead control. If the output multiplied by the piece rate results in an amount greater than the guaranteed wage, the employee is paid the amount earned. Let us assume Maxine Garcia is paid P15.00 per piece produced, and during the week, she produced 80 pieces. If the guaranteed weekly pay is P1,500, then the difference between P1,500 (guaranteed pay) and P1,200 (actual pay) is charged to factory overhead control. The entry to record Maxine's pay is: Work in process – Job 101 1,200 Factory overhead control. – Make-up pay 300 Accrued payroll 1,500 If Maxine, in the previous illustration, is guaranteed a weekly pay of P1,000, then the entry will be Work in process – Job 101 (80x P15) 1,200 Accrued payroll 1,200 c. Overtime premium - Represents the amount paid in excess of the regular rate to employees working in excess of 8 hours in a day or working during holidays or their rest days. Regular earnings represent the total hours worked, including overtime hours, multiplied by the regular rate. The premium rate for overtime hours is usually some fraction of the regular rate. For example, if Maxine worked for 45 hours during the week and she paid time and a half, then the entry would be Work in process (45 hours x P 50) 2,250 Factory overhead control (5 hours x P 25) 125 Accrued payroll 2,375 If overtime results from the requirements of a specific job and not from random scheduling, the overtime premium should be charged to the particular job that caused the overtime. For example, suppose a rush order caused Maxine's overtime, and the customer has agreed to pay for the special service. In that case, the premium will be debited to work in process instead of factory overhead control. 03 Handout 1 *Property of STI Page 6 of 17  BM2404 d. Shift Premium - extra pay to work during less desirable evening shift (2 pm to 10 pm) or night shift (10 pm to 6 am). This shift premium, or shift differential, should be charged to factory overhead control rather than work in process. Assume that Maxine is assigned to the night shift and is paid a shift premium of P20 per hour; the entry for her pay will be: Work in process (40 hours x P 50) 2,000 Factory overhead control (5 hours x P 25) 800 Accrued payroll 2,800 e. Employer’s payroll taxes - amounts remitted to different government agencies for SSS premiums, PhilHealth contributions, and Pag-ibig contributions. GROSS EARNINGS OF EMPLOYEES 1. Wages - Gross earnings of an employee who is paid by the hour for only the actual hours worked. 2. Salaries - Gross earnings of an employee who is paid a flat amount per week or month regardless of the hours worked in a period. 3. Gross earnings - The compensation of an employee and includes regular pay and overtime premiums. Payroll Deduction 1. Employee's income tax - The amount of tax to be withheld each period depends on the following: a. Amount of the employee's earnings, b. Frequency of the payroll period and; c. Classification of the taxpayer and number of qualified dependents. 2. Social Security System premiums—These are levied against both the employer and the employee (based on the table provided). 3. PhilHealth Contributions—These are levied against both the employer and the employee in equal amounts (based on the table provided). 4. Pag-ibig Contributions—These are levied against both the employer and the employee in equal amounts (based on the table provided). ACCOUNTING FOR FACTORY OVERHEAD All costs incurred in the factory that are not direct materials or direct labor are generally termed factory overhead. One method to determine whether a factory expenditure is a factory overhead item is to compare it to the classification standard established for direct materials and direct labor costs. If the expenditure cannot be charged to either of these two (2) “direct” factory accounts, it is classified as factory overhead. Factory overhead refers to the cost pool used to accumulate all indirect manufacturing costs. Examples of factory overhead include the following: Indirect materials and indirect labor 03 Handout 1 *Property of STI Page 7 of 17  BM2404 Heat, light, and power for the factory Rent on factory building. Depreciation of factory building and factory equipment Maintenance of factory building and factory equipment Factory overhead costs are divided into three (3) categories based on their behavior in relation to production: (1) variable overhead, (2) fixed overhead, and (3) mixed overhead. Variable factory overhead costs – These are the factory overhead costs that vary in direct proportion to the level of production within the relevant range. Variable cost per unit remains constant as production either increases or decreases. Total variable cost varies in direct proportion to production; that is, the greater the number of units produced, the higher the total variable costs. Fixed factory overhead costs—These are the factory overhead costs that remain constant within the relevant range regardless of the varying levels of production. The total remains constant, but the fixed cost per unit varies inversely with the production. That is, the greater the number of units produced, the lower the fixed cost per unit (this is the advantage of mass production—the more we produce, the lesser the manufacturing cost per unit). Mixed factory overhead costs—These factory overhead costs are neither wholly fixed nor wholly variable but have characteristics of both. For purposes of planning and control, mixed factory overhead costs must ultimately be separated into their fixed and variable components. Budget Factory Overhead Costs Budgets are management’s operating plans expressed in quantitative terms, such as units of production and related costs. After factory overhead costs have been classified as either fixed or variable, budgets can be prepared for expected levels of production. The separation of fixed and variable cost components permits the company to prepare a flexible budget. Factors to be Considered in the Computation of Overhead Rate 1. Base to be Used a. Physical output b. Direct materials cost c. Direct labor cost d. Direct labor hours e. Machine hours 2. Activity Level to Use a. Normal capacity b. Expected actual capacity 3. Inclusion or Exclusion of Fixed Factory Overhead a. Absorption costing – the method used for cost accounting b. Direct costing – the method used for internal reporting (management services) 03 Handout 1 *Property of STI Page 8 of 17  BM2404 4. Use of Single Rate or Several Rates a. Plant-wide or blanket rate – one rate for all producing departments b. Departmentalized rate – one rate for each producing department. Base to be Used The base to be used should be related to functions represented by the overhead cost being applied. If factory overhead is labor - oriented, the most appropriate base to use. The base to be used should be related to functions represented by the overhead cost, direct labor hours, or direct labor cost. If the factory is investment-oriented and associated with the operation of machinery, then the most appropriate base will be machine hours. On the other hand, if factory overhead is material-oriented, then material cost might be considered as the most suitable base. The simplest of all bases is physical output or units or production. 1. Direct labor hours It is the most used base or denominator in the computation of the predetermined factory overhead rate. The number of direct labor hours spent for a particular is readily available on the payroll sheet. This base should be used if it can establish that there is a direct relationship between factory overhead and direct labor hours. It may be used also if there is a great disparity in hourly wage rates. The formula is expressed as: Factory overhead rate = Estimated factory overhead Estimated direct labor hours = Percentage of direct labor cost 2. Direct labor cost This method is recommended if it can establish that there is a direct relationship between labor cost and factory overhead. Just like direct labor hours, the direct labor cost is readily available on the payroll sheet. Labor rates do not change as often as material costs, so this base is more reliable than material costs. This base should not be used if there is little relationship between labor cost and factory overhead. For example, if overhead is composed largely of depreciation and equipment-related costs. The formula is: Factory overhead rate = Estimated factory overhead x 100 Estimated direct labor cost = Percentage of direct labor cost 3. Machine hours It is appropriate when a direct relationship exists between factory overhead cost and machine hours. It may occur in companies or departments that are largely automated, so the majority of the factory overhead cost consists of depreciation on factory equipment. Additional work will be required because each machine will have a time record to summarize the total machine hours used for each job. The formula is: Factory overhead rate = Estimated factory overhead Estimated machine hours. = Factory overhead rate/machine hour 4. Direct material cost This method is appropriate if it can be inferred that factory overhead costs are directly related to direct material cost, as in cases where direct materials are a very large part of the total cost. Direct material cost is not an appropriate base for when a company manufactures more than one product. Different products require 03 Handout 1 *Property of STI Page 9 of 17  BM2404 different materials and different quantities, so it will be very inconvenient to use materials cost as the base because we will have to compute a factory overhead rate for each product. Formula is: Factory overhead rate = Estimated factory overhead x 100 Estimated direct material cost = Percentage of direct material cost 5. Units of production It is the simplest method to use because the units produced are readily available. This method is appropriate when a company or department manufactures only one product. The formula is: Factory overhead rate = Estimated factory overhead Estimated units of production = Factory overhead rate/unit of production Illustrative Problem 1 The Round Table Company estimates factory overhead at P450,000 for the next fiscal year. It is estimated that 90,000 units will be produced at a material cost of P600,000. Conversion will require an estimated 100,000 direct labor hours at a cost of P3.00 per hour, with 45,000 machine hours. Required: Compute the predetermined factory rate based on: a. Material cost b. Units of production c. Machine hours d. Direct labor cost e. Direct labor hours Solution to Illustrative Problem 1 a. Factory overhead rate 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑑𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 𝑃450,000 𝑥 100 = 600,000 = 75% 𝑜𝑓 𝑑𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠 𝑐𝑜𝑠𝑡 b. Factory overhead rate 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑃450,000 = 90,000 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑟 ℎ𝑜𝑢𝑟𝑠 = 𝑃5.00 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 03 Handout 1 *Property of STI Page 10 of 17  BM2404 c. Factory overhead rate 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠 𝑃 450,000 = 45,000 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠 = 𝑃10.00 𝑝𝑒𝑟 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟 d. Factory overhead rate 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑟 𝑐𝑜𝑠𝑡 𝑃450,000 𝑥 100 = 𝑃300,000 = 150% 𝑜𝑓 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑟 𝑐𝑜𝑠𝑡 e. Factory overhead rate 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑟 ℎ𝑜𝑢𝑟𝑠 𝑃450,000 = 100,000 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑟 ℎ𝑜𝑢𝑟𝑠 = 𝑃4.50 𝑝𝑒𝑟 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑟 ℎ𝑜𝑢𝑟 The rates computed above are known as the plant-wide or blanket rate. All departments in the company, will use the same application rate for factory overhead and also the same base. A single plant-wide factory application rate can be used when either 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. Steps in Computation of Departmentalized Overhead Rate 1. Divide the company into segments, called departments and cost centers, to which expenses are charged. 2. Estimate the factory overhead for each department (direct departmental charges + indirect departmental charges). 3. Select and estimate the base to be used by each department. 4. Allocate the service department costs to the producing departments, 5. Compute the factory overhead rate (similar to computation using blanket rate). In a departmentalized company, factory overhead should be budgeted for each department. The procedures for distributing the budgeted departmental expenses are identical to those used to allocate the actual factory overhead expenses. Prior to the computation of the departmentalized factory overhead rate, management must make sure that the service department costs have been allocated to the producing departments. Departmentalized overhead rates are for the producing departments only. Producing departments, which 03 Handout 1 *Property of STI Page 11 of 17  BM2404 include the production lines, are the cost-accumulation centers in which work is performed directly on the goods being produced. On the other hand, service departments, which include such activities as maintenance, personnel, employee services, and the provision of heat, power, and light, are necessary for the entire factory – including the producing departments – to remain in operation. Typical Allocation Bases for Common Costs Most common costs can be grouped into four: 1. Labor-related common costs 2. Machine-related common costs 3. Space-related common costs 4. Service-related common costs Common costs should be analyzed carefully to determine the most appropriate allocation base. The typical allocation bases for common costs are shown below. COMMON COST Labor-related TYPICAL ALLOCATION BASE 1. Supervision No. of employees, payroll amount of DLHrs 2. Personnel services Number of employees Machine-related 3. Insurance on equipment Value of equipment 4. Taxes on equipment Value of equipment 5. Equipment depreciation Machine-hours, equipment value 6. Equipment maintenance Numbers of machines, machine hours Space-related 7. Building rental Space occupied 8. Building insurance Space occupied 9. Heat & air-conditioning Space occupied & volume occupied 10. Concession rental Space occupied & desirability of location 11. Interior bldg. maintenance Space occupied Service-related 12. Material handling Quantity or value of materials 13. Billing and accounting Number of documents 14. Indirect materials Value of direct materials Methods of Allocating Service Costs to Producing Departments 1. Direct method - the most widely used method. This method ignores any service directed by one service department to another. It allocates each service department's total cost directly to the producing departments. 03 Handout 1 *Property of STI Page 12 of 17  BM2404 Service Department Producing Department Human Production and Resource Manufacturing Security Manufacturing and Assembly 2. Step method - sometimes called sequential method of allocation. This method recognizes services rendered by service departments to other service departments and is more complicated because it requires a sequence of allocation. The sequence typically starts with the department that renders service to the greatest number of other service departments and ends with the department that renders service to the least number of different departments. Service Department Producing Department Human Resource Production and Manufacturing Security Manufacturing and Assembly 3. Algebraic method - sometimes called reciprocal method. This method allocates costs by explicitly including the mutual services rendered among all departments. Service Department Producing Department Human Production and Resource Manufacturing Manufacturing and Security Assembly 03 Handout 1 *Property of STI Page 13 of 17  BM2404 Illustrative Problem 2 Kappa Gamma Company's factory is divided into four departments - producing departments, Molding and Decorating, serviced by the Buildings and Grounds, and the Factory Administration departments. Buildings and Grounds costs will be allocated using square feet (floor area), and Factory Administration costs will be allocated using direct labor hours. In computing predetermined overhead rates, machine hours are used as the base for Molding, and direct labor hours as the base for Decorating. Bldgs. & Factory Molding Decorating Grounds Adm. Budgeted FO P400,000 P600,000 P80,000 P120,000 Direct labor hours 200,000 100,000 Floor area 100,000 60,000 2,000 4,000 Machine hours 200,000 100,000 Requirements: Allocate the cost of the service departments using: 1. Direct method 2. Step method - start with Bldgs. & Grounds 3. Algebraic method Solution to Illustrative Problem 1. Direct method Molding Decorating B&G FA Budgeted FO P400,000 P600,000 P80,000 P120,000 Allocated FO B&G 50,000 30,000 (80,000) FA 80,000 40,000 (120,000) Total FO P530,000 P670,000 Base 200,000 MHrs 100,000 DLHrs FO Rate P 2.65/MHr P6.70/DLHr Allocation of B & G Cost: Molding = 100/160 x 80,000 Decorating= 60/160 x 80,000 Allocation of FA cost Molding= 200/300 x 120,000 Decorating= 100/300 x 120,000 2. Step Method Molding Decorating B& G FA Budgeted FO 400,000 600,000 80,000 120,000 Allocated FO B&G 48,781 29,268 (80,000) 1,951 FA 81,301 40,650 (121,951) Total FO 530,082 669,918 Base 200,000 MHrs 100,000 DLHrs FO rate P2.65 P6.70 03 Handout 1 *Property of STI Page 14 of 17  BM2404 3. Algebraic Method Additional information for the illustrative problem Services provided by B and G FA Molding 50% 40% Decorating 30% 50% B&G - 10% FA 20% - Algebraic Equation: B&G = 80,000 + 10% (FA) FA = 120,000 + 20% ( BG) Substitution: B&G = 80,000 + 10% ( 120,000 +.20 BG) = 80,000 +12,000 + 0.02 BG 0.98 BG= 92,000 BG = 92,000/ 0.98 = 93,878 FA = 120,000 + 20% ( BG) = 120,000 + 20% (93,878) = 120,000 + 18,776 = 138,776 The Allocation will be as follows. Molding Decorating B&G FA Budgeted FO 400,000 600,000 80,000 120,000 Allocated FO B&G 46, 939 28,163 (93,878) 18,776 FA 55, 510 69,388 13, 878 (138,776) Total FO 502,449 697,551 Base 200,000 MHrs 100,000 DLHrs FO rate 2.51/MHr P 6.98/DLHr CAPACITY PRODUCTION It is important to determine what production capacity should be adopted in estimating manufacturing overhead and the vase to be used for allocation. a. Theoretical, maximum, or ideal capacity - Capacity to produce at full speed without interruptions. It gives no allowance for human capacity to achieve the maximum nor due allowance for any circumstances that might result in a Stoppage of production within or not within the control of management. At this capacity level, the plant is assumed to function 24 hours a day, 7 days a week, and 52 weeks a year without any interruptions in order to yield the highest physical output possible. 03 Handout 1 *Property of STI Page 15 of 17  BM2404 b. Practical capacity - Capacity of production that provides an allowance for the circumstances that might result in the stoppage of production. c. Expected actual capacity—This capacity concept is based on a short-range outlook, which is feasible only for firms whose products are seasonal or whose market and style changes allow price adjustments according to competitive conditions and customer demands. d. Normal capacity—A production capacity that considers the utilization of the plant facilities to meet the commercial demands served over a period long enough to level out the peaks and valleys that come with season and cyclical variations. This capacity is commonly used in the computations of overhead rates. METHOD OF ACCUMULATION OF FACTORY OVERHEAD COSTS 1. Non-controlling account system—The ledger opens an account for each kind of overhead expense according to its nature, and charges to such account are made upon incurrence of the expense. 2. Controlling account system—An Overhead Control account is opened in the general ledger, wherein the overhead incurred is charged, and a subsidiary ledger is maintained to show in detail the nature and account of the expense. Actual overhead costs are usually incurred daily and recorded periodically in the general and subsidiary ledgers. Subsidiary ledgers permit a greater degree of control over factory overhead costs, as related accounts can be grouped together, and the various expenses incurred by different departments can be described in detail. Computation of overhead chargeable to individual cost sheets - (factory overhead applied) 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 material costs or direct labor cost or on the basis of direct labor hours, machine hours, or units produced). Applied factory overhead can be computed by multiplying the actual factor incurred per cost sheet x predetermined overhead rate. Entry to charge production with applied overhead: Work in process - overhead xxx Factory overhead applied xxx Factory overhead variance - The difference between the actual factory overhead, as shown by the factory overhead control account, and the overhead charged to production, as demonstrated by the factory overhead applied account. Classifications of manufacturing overhead variance a. Underapplied overhead - The difference between actual overhead and applied overhead when the actual is more than applied. b. Overapplied overhead - The difference between actual overhead and applied overhead when the actual is less than the applied. 03 Handout 1 *Property of STI Page 16 of 17  BM2404 References Cabrera, E. (2021). Cost Accounting and Control. EESM Bookstore. DeLeon, N. (2022). Cost Accounting and Control. Readers Knowledge Bookstore. Piper, M. (2022). Cost Accounting Made Simple. Simple Subjects LLC. Raiborn, C. (2021). Cost Accounting and Control. Cengage Learning. 03 Handout 1 *Property of STI Page 17 of 17