Week 5 – Chapter 5 FACTORY OVERHEAD

FNSACC507A Provide Management Accounting Information

By the end of this part of the lesson you should be able to…

�  Define factory overhead �  Discuss what a cost driver is and what it is used for

in the context of factory overhead costs �  Use the high-low method of cost analysis and

estimation (this is revision from LESSON 1)

The Manufacturing Process

Is about converting raw materials into finished goods with the use of

direct labour and factory overhead.

The Manufacturing Process

WORK IN PROGRESS

MATERIALS

LABOUR

OVERHEADS

FINISHED GOODS

1. What is factory overhead? � Includes all factory costs other than direct

materials and direct labour. � Is also referred to as indirect manufacturing

cost. � Cannot be traced or is not worthwhile

tracing (cost vs. benefit) to individual units of production.

� Examples: * Factory insurance * Factory supervisor’s salary * Factory light & power

1. What is factory overhead? These indirect manufacturing costs are a necessary cost that must be

accounted for as a cost of production.

2. What is a cost driver? � The activity that causes overhead costs to be

incurred is called the cost driver.

�  In the following example, it is assumed that production level is the cost driver which causes total costs to change.

2. What is a cost driver? � We use the cost driver as our basis for the

allocation of overheads.

� For example, the cost of running a cafeteria may be allocated to the different departments within a company based on the number of employees working in each department.

2. Cost drivers (examples)

Overhead cost incurred Cost driver

Lubricant for machines Machine hours

Repair personnel Machine hours

Factory building depreciation Square metres occupied

Store personnel Material requisitions

If your answer to this question was yes, then you will know what it costs to own and maintain your car. How much you use your car around will determine how often you have to take your care for a service e.g. to get new spark plugs fitted. In this case, the number of kilometres you drive is the cost driver for your car’s maintenance costs i.e. the more kilometres you drive, the sooner you have to take your car in for a service.

Here is another example for you to think about…? Do you have a car?

3. Factory overhead analysis

FACTORY OVERHEAD COST ESTIMATION is revision from some of the work we did in WEEK 9

where we learnt how to use the HIGH-LOW METHOD OF

COST ANALYSIS & ESTIMATION

3. Cost Estimation High Low Analysis

Understanding the basics about cost estimation � Mixed costs have both a fixed portion and a variable portion. � Various methods are used to separate mixed costs out into these two manageable groups – this is what is referred to as cost estimation. � By separating mixed costs out into these two manageable groups, we can then use these cost groups to prepare budgets (planning) and predict and control costs (control) because we understand how these costs behave at various activity levels within the relevant range.

3. Cost Estimation High Low Analysis

This is achieved by taking the fixed cost component and the variable cost component and plugging these values into a cost equation (cost estimation formula) which is used

to predict future costs.

3. Cost Estimation High Low Analysis

Understanding how the high-low method of cost estimation works

The high-low method uses the highest and lowest activity levels over a period of time and within the relevant range to estimate the portion of a mixed cost that is variable and the portion that is fixed.

3. Cost Estimation High Low Analysis

What do we mean by the term ‘relevant range’? This is the range of activity over which the firm expects a set of cost behaviour patterns to hold. e.g. a relevant range of activity may be between 10,000 and 20,000 units. Within this range, certain costs are expected to remain fixed while others will vary.

3. Cost Estimation High Low Analysis

Estimates of fixed and variables costs apply only if the desired level of activity is within the relevant range. If the firm considers an alternative at level of activity outside the relevant range, then the breakdown of overhead cost into its fixed and variables components needs to be worked out again.

Worked Example

HIGH-LOW METHOD OF COST ESTIMATION Sunshine Ltd

Worked Examples  NOTE TO STUDENTS:

Before moving on to the next slide, please open and work through the following document now:

WEEK 5_FNSACC507A_Management

Accounting_WORKED EXAMPLES_Factory Overhead Analysis

This week’s homework � Read chapter 5 à Factory overhead

(p.240 to p.250) � Complete homework questions (chapter 5)

(ref. STUDENT ONLINE STUDY GUIDE)

You are now ready to start the next lesson on:

The rest of CHAPTER 5

Overhead Allocation and CHAPTER 7

Overhead Variance Analysis