Accounting: The Language of Business - Vol. 1 (Part 111)

"Count your blessings, name them one by one /  Count your blessings, see what God hath done /  Count your blessings, name them one by one / And it will surprise you what the Lord hath done!" - Johnson Oatman Jr. 

 Introduction to Managerial Accounting and Job Order Cost Systems (Part D)

by

Charles Lamson

Factory Labor

There are two primary objectives in accounting for factory labor. One objective is to determine the correct amount to be paid each employee for each payroll period. The second objective is to properly allocate factory labor costs to factory overhead and individual job orders.

The amount of time spent by an employee in the factory is usually recorded on clock cards or in-and-out cards. The amount of time spent by each employee and the labor cost incurred for each individual job are recorded on time tickets. Exhibit 6 shows typical time ticket forms and cost flows for direct labor for Goodwell Printers.

EXHIBIT 6 Labor Information and Cost Flows

A summary of the time tickets at the end of each month is the basis for recording the direct and indirect labor costs incurred in production. Direct labor is posted to each job cost sheet, while indirect labor is debited to the factory overhead. Goodwell Printers incurred 850 direct labor hours on Jobs 71 and 72 during December. The total direct labor costs were $11,000 divided into $3,500 for Job 71 and $7,500 for Job 72. The labor costs that flow into production are recorded by the following summary entry to the work in process controlling account:

As with recording direct materials, many organizations are automating the labor recording process. Employees may log their name directly into computer terminals at their work stations. Alternatively, employees may be issued magnetic cards, much like credit cards, to log in and out of work assignments that are spread across a wide geographical area. For example, Shell Oil Company uses a magnetic card system to track the work of maintenance crews and its refinery operations.

Factory Overhead Cost

Factory overhead includes all manufacturing costs except direct materials and direct labor. Debits to factory overhead come from various sources such as indirect materials [Indirect materials are goods that, while part of the overall manufacturing process, are not integrated into the final product. For example, disposable gloves, personal protective equipment, tape, etc., may be essential to a production line, but they are not part of the actual product created on that line (gep.com).] indirect labor (Indirect labor refers to employees who are not involved in planning or construction projects. However, they are involved in the day-to-day running of the business. This includes human resources, administration, accountants, customers relations, etc.)factory power, and factory depreciation. For example, the factory overhead of $4,000 incurred in December for Goodwell Printers would be recorded as follows:

Allocating Factory Overhead

Factory overhead is much different from direct labor and direct materials because it is indirectly related to the jobs. How, then, do the jobs get assigned a portion of overhead costs? The answer is through cost allocation, which is the process of assigning factory overhead cost to a cost object, such as a job. The factory overhead costs are assigned to the jobs on the basis of some known measure about each job. The measure used to allocate factory overhead is frequently called an activity base, allocation base, or activity driver. The estimated activity base should be a measure that reflects the consumption or use of factory overhead cost. For example, the direct labor is recorded for each job using time tickets. Thus, direct labor (hours or cost) could be used to allocate production-related factory overhead costs to each job. Likewise, direct materials costs are known about each job through the materials requisitions. Thus, materials-related factory overhead, such as Purchasing Department salaries, could logically be allocated to the job on the basis of direct materials cost.

Predetermined Factory Overhead Rate

To provide current job cost, factory overhead may be allocated or applied to production using a predetermined factory overhead rate. The predetermined factory overhead rate is calculated by dividing the estimated amount of factory overhead for the forthcoming year by the estimated activity base, such as machine hours, direct materials costs, direct labor costs, or direct labor hours.

To illustrate calculating a predetermined overhead rate, assume that Goodwell Printers estimates the total factory overhead cost to be $50,000 for the year and the activity base to be 10,000 direct labor hours. The predetermined factory overhead rate would be calculated as $5 per direct labor hour, as follows:

Why is the predetermined overhead rate calculated from estimated numbers at the beginning of the period? The answer is to ensure timely information. If a company waited until the end of an accounting period when all overhead costs are known, the allocated factory overhead would be accurate but not timely. If the cost system is to have maximum usefulness, cost data should be available as each job is completed, even though there may be a small sacrifice in accuracy. Only through timely reporting can management make needed adjustments in pricing or in manufacturing methods and achieve the best possible combination of revenue and cost on future jobs. 

A number of comparative companies are using a new product-costing approach [Product costing methods are used to assign a cost to a manufactured product (accountingtools.com).] called activity-based costing. Activity-based costing is a method of accumulating and allocating factory overhead costs to products, using many overhead rates. Each rate is related to separate factory activities, such as inspecting, moving, and machining.

Applying Factory Overhead to Work in Process

As factory overhead costs are incurred, they are debited to the factory overhead account, as shown previously in transaction (d). For Goodwell Printers, factory overhead costs are applied to production at the rate of $5 per direct labor hour. The amount of factory overhead applied to each job would be recorded in the job cost sheets as shown in Exhibit 7. For example, the 850 direct labor hours used in Goodwell's December operations would all be traced to individual jobs. Job 71 used 350 labor hours, so $1,750 (350 * $5) of factory overhead would be applied to job 71. Similarly, $2,500 (500 * $5) of factory overhead would be applied to job 72.

EXHIBIT 7 Assigning Factory Overhead to Jobs

The factory overhead costs applied to production are periodically debited to the work in process account and credited to the factory overhead account. The summary entry to apply the $4,250 ($1,750 + $2,500) of factory overhead is as follows:

The factory overhead costs applied and the actual factory overhead costs incurred during a period will usually differ. If the amount applied exceeds the actual costs incurred, the factory overhead account will have a credit balance. This credit is described as overapplied or overabsorbed factory overhead. If the amount applied is less than the actual costs incurred, the account will have a debit balance. This debt is described as underapplied or underabsorbed factory overhead. Both cases are Illustrated in the following account for Goodwell Printers:

if the underapplied or overapplied balance increases in only one direction and it becomes large, the balance and the overhead rate should be investigated. For example, if a large balance is caused by changes in manufacturing methods or in production goals, the factory overhead race should be revised. On the other hand, a large underapplied balance may indicate a serious control problem caused by inefficiencies in production methods, excessive costs, or a combination of factors.

Disposal of Factory Overhead Balance

The balance in the factory overhead account is carried forward from month to month. It is reported on interim balance sheets as a deferred debit or credit. This balance should not be carried over to the next year, however, since it applies to the operations of the year just ended.

One approach for disposing of the balance of factory overhead at the end of the year is to transfer the entire balance to the cost of goods sold account. To illustrate, the journal entry to eliminate Goodwill Printers' underapplied overhead balance of $150 at the end of the calendar year would be: 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 745-749*

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