Costing Control of Factory (Manufacturing) Overheads

Description
This is a PPT about costing control of factory overheads.

Costing and Control of Factory (Manufacturing) Overheads
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COSTING AND CONTROL OF FACTORY (MANUFACTURING) OVERHEADS
Factory Overhead Costs
Cost Allocation Absorption of Factory Overheads Underabsorption and Overabsorption of Factory Overheads

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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.

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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. Therefore, cost allocation should be justified on the basis of costbenefit considerations. Yet, cost allocation is necessary to determine the true cost of products, particularly in the case of multi-product firms.
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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

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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.
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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).

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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

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(1) Unit of Production According to units of production method, the factory overhead absorption rate = Estimated/budgeted factory overhead costs ÷ Estimated/budgeted units of production. (2) Direct Material Cost Method

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.
3. Direct Labour Costs Basis/Method The factory overhead rate according to direct labour cost method = (Estimated factory overhead cost/Estimated direct labour cost) x 100. 4. Prime Cost Method According to prime cost method the factory overhead rate = (Estimated factory overhead cost/Estimated prime cost) x 100. 5. Direct Labour-hours The factory overhead absorpation rate per direct labour hour = Estimated factory overhead costs ÷ Estimated direct labour-hours.
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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, machinehour rate is normally adopted to absorb factory overheads.

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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.
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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 decisionmaking 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 machinehour 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.

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Example 6
Compute the machine-hour rate from the following data: Cost of machine Rs 3,00,000 Estimated scrap value after the expiry of its useful life (5 years) 50,000 Rent and rates for the shop per month 2,000 General lighting for the shop per month 1,500 Insurance premium for the machine per annum 4,800 Repairs and maintenance expenses per annum 5,000 Power consumption — 10 units per hour @ Rs 2 per unit Estimated working hours per annum 2,200 (including settingup time of 200 hours; no power is required during setting-up time) 20 Shop supervisor’s salary per month 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.
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Solution Determination of Machine-hour Rate Particulars 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)hr Depreciation [(Rs 3 lakh – Rs 0.5 lakh)/5years] ÷ 2,000 Power consumption per hour Machine-hour rate per hour *are in the nature of mixed and variable costs. Rate per hour Rs 6,000 4,500 4,800 14,400 29,700

2,000

Rs 14.85

2.5 25.0 20.0

47.50 62.35

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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. 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. Under-absorption of factory overheads = Actual factory overheads – Overheads charged to production Overabsorption of factory overheads = Overheads charged to production – Production overheads
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Journal Entries: Overhead Variance Treated as a Period Cost

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) Journal Entries: Overhead Variance Considered as the Cost of Production 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)
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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?

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Solution Determination of Unabsorbed Factory Overheads Factory overhead expenses incurred Less factory overheads absorbed (1,50,000 mandays × Rs 25 per manday) Unabsorbed factory overheads 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 Rs 2,40,000 (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) Rs 1,20,000 — Finished goods inventory (Rs 1,60,000 × 1/4) 40,000 1,60,000 4,00,000
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Rs 41,50,000 37,50,000 4,00,000



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