# Manufacturing Overhead Cost Standards:

Learning Objective of the article:

1. How manufacturing overhead standards are set?

Procedures for establishing and using standard factory overhead rates are similar to the methods of dealing with the estimated direct and indirect factory overhead and its application to jobs and products. An overhead budget for the rate calculation provides a budget allowance for a specific, predetermined level of activity, while a flexible budget provides allowance for various levels of activity. Both type of budgets aim for the control of factory overhead. Control is achieved by keeping actual expenses within ranges established by the budget. The maximum limit of a range is the amount set up in the flexible budget. However for costing jobs or products it is necessary to establish a normal overhead rate based on total estimated overhead rate at normal capacity volume.

An example of the effect of volume on overhead cost per unit is as follows:

 Production volume (units) 80,000 90,000 100,000 110,000 ———- ———- ———- ———- Factory overhead: Variable \$112,000 \$126,000 \$140,000 \$154,000 Fixed 60,000 60,000 60,000 60,000 ———- ———- ———- ———- Total \$172,000 \$186,000 \$200,000 \$214,000 ====== ====== ====== ====== Factory overhead per unit: Variable \$1.40 \$1.400 \$1.40 \$1.400 Fixed 0.75 0.667 0.6 0.545 ———- ———- ———- ———- Total unit overhead cost \$2.15 \$2.067 \$2.00 \$1.945 ====== ====== ====== ======

The example indicates the basic pattern of overhead behavior. Fixed expenses remain fixed, within a normal range of activity, as volume (output) changes, but they vary per unit. The greater the number of units, the smaller the amount of fixed overhead per unit. Variable expenses, on the other hand, increase proportionately with each increase of volume (output) and remain fixed per unit.

This characteristics of overhead behavior is important in establishing a standard factory overhead rate. Overhead absorption is accomplished by selecting a plant capacity as the base for charging variable and fixed overhead to jobs or products.

Variable expenses should be measured and controlled at any volume by the supervisors with the help of a flexible budget. The variable expenses in the flexible budget correspond to applied variable overhead, and variable overhead variances result from a comparison of actual variable costs with the flexible budget (applied) variable factory overhead.

Fixed expenses can be absorbed fully only by operating at the volume on which the rate is based. If the base set for overhead absorption is reached, budgeted and absorbed cost figures will be identical. Since this is highly improbable, a difference occurs between budgeted fixed expenses and absorbed fixed overhead, and fixed overhead variances from an analysis of this difference. For purposes of analysis, budgeted fixed overhead is used. Any difference that might occur between budgeted and fixed overhead becomes a part of the variable overhead variances in the methods of analysis presented in this section of the website. Alternatively this difference can be identified as a separate variance, called the fixed spending variance.

## Standard Factory Overhead Rate:

The standard factory overhead rate is a predetermined rate that is usually based on the direct labor hours. Other bases may also be used, e.g., direct labor dollars or machine hours. The use of direct labor dollars, however, may cause some distortion in the variance calculation. because the actual direct labor dollar figure includes any labor rate variations from the standard rate. The data from the following flexible budget for department is used to illustrate the calculation of standard overhead rate and overhead variances.

 Department 3 Monthly Flexible Budget Capacity 80% 90% 100% Standard production 800 1,000 1,200 Direct labor hours 3,200 4,000 4,800 Variable factory overhead: Indirect labor \$1,600 \$2,000 \$2,400 \$0.50 / dlh Indirect materials 960 1,200 1,440 \$0.30 Supplies 640 800 960 \$0.20 Repairs 480 600 720 \$0.15 Power and light 160 200 240 \$0.05 ———– ———– ———– ———– Total variable factory overhead \$3,840 \$4,800 \$5,760 \$1.20 per dlh ====== ====== ====== ====== Fixed factory overhead: Supervisor \$1,200 \$1,200 \$1,200 Depreciation on machinery 700 700 700 Insurance 250 250 250 Property tax 250 250 250 Power and light 400 400 400 Maintenance 400 400 400 ———– ———– ———– Total fixed factory overhead \$3,200 \$3,200 \$3,200 \$3,200 per month ———– ———– ———– ====== Total factory overhead \$7,040 \$8,000 \$8,960 \$3,200 per month + \$1.20 per dlh ====== ====== ====== ======

Assuming that 90% column represents normal capacity, the standard overhead rate is computed as follows:

Total factory overhead / Direct labor hours = \$8,000 / 4,000 = \$2 per standard direct labor hour

At 90% capacity level, the rate consists of:

Total variable factory overhead / Direct labor hours = \$4,800 / 4,000 = \$1.20 variable factory overhead rate

Total fixed factory overhead / Direct labor hours = \$8,000 / 4,000 = \$0.80 fixed factory overhead rate

Total factory overhead rate at normal capacity:

(\$1.20 + \$0.80) = \$2.00

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