Accounting

Factory overhead includes direct materials, direct labour and factory overhead. Salaries paid to carpenters for making furniture is part of direct labor. Wood used to make chairs is part of direct materials. All other costs and expenses of the factory are lumped under factory overhead. Factory overhead should be included in product costs to determine if revenues are high enough to recover factory costs and expenses.

Question 1
Organisations normally charge indirect costs (overheads) to individual products in addition to the direct costs involved in making the products. By matching the direct and direct costs in producing a product to the corresponding revenues, management will know if the company was able to successfully generate profits. Standard accounting principle dictates that a strict matching of costs to generate the corresponding revenues should be adhered to without exception. Thus, the cost of indirect materials used to aid in the production of finished goods should be deducted from the revenues made from selling the finished products(Helfert, 1994 152).
 
Likewise, the indirect labour cost that includes the janitors and the supervisors salaries should be included in as part of product cost in order to determine the total manufacturing cost which will be recovered whenever the finished products are sold. Putting it another way, it would be unfair to deduct the indirect factory labor from the revenues generated by the marketing department for it would be violated generally accepting accounting principles of matching cost with the related revenues. The marketing department deducts commissions, advertising, other promotional expenses, and the sales personnels salaries and other benefits from its net revenues (Shim, 2007 17).
 
In a furniture manufacturing company, the direct materials cost is part of the direct cost. It includes the nails, wood, and furniture paints used to produce chairs or other furniture products. In addition, the direct labour is also part of the direct costs of producing the furniture. The direct labour is the amount paid to the workers who construct the chairs, tables, and other furniture (Lanen, 2008, 25). Another item under direct labour in a furniture-manufacturing environment is carpenter. The direct materials and the indirect materials form part of the total manufacturing cost. Further, the third segment of the total manufacturing cost is the factory overhead. The factory overhead includes other expenses that do not fall under direct materials and direct labour. Factory overhead includes the indirect materials and the indirect labour. Indirect costs are costs that cannot be directly corresponded to a cost object (Boer, F, 1999 45).
   
There are several stages involved in determining overhead absorption rates for each production department in a manufacturing company. First, the company collects the total amount spent in terms of indirect materials and indirect labour. The cost accounting department staff will divide the indirect amount by the predetermined rates. Generally, the indirect labour costs is divided by the estimated direct labour hours or machine hours used in one accounting period (Hilton, 200748). There are different bases that may be used for absorbing factory overheads. One very popular method is to use direct labour hours in the allocation of factory overhead.   Likewise, factory overhead can be machine hours used to allocate factory overhead.
   
For a company where most of the jobs are done by machines, the machine hour will offer the most as there are many advantages of using machine hours over direct labour hours in the allocation of factory overhead.  A very tenable reason for using machine hours here is that the depreciation expenses of the machines are included in the income statement as deduction from the gross profit.
   
Likewise, since electricity used by machines, repairs and maintenance of machines reduce revenues, it would be more advantageous to use machine hours in allocating factory overhead costs. On the other hand, direct human labour does most of the jobs in manufacturing plants. It would be better to use direct labour hours in allocating factory overhead together with the advantages and disadvantages of each method (Meigs, 1995305).
     
There are several reasons for charging overheads. One very good reason is for proper matching of costs and expenses to the related revenues. This is very important because deducting cost of goods sold from net revenues generates the net profit or loss figure. In the same light, the cost of goods sold is arrived at by adding the direct materials, costs, direct labor costs, and the factory overhead costs (Horngren, 200084).
     
Another reason for charging overheads is determining the cost of goods sold by the company. The cost of goods sold is the amount that is generated when the factory overhead, direct materials and direct labour, working in projects, are deducted from net revenues. Another reason for deducting revenue is determining the total manufacturing costs. The total manufacturing costs is the sum of the direct materials, direct labor and the factory overhead (Boer, F, 1999 45).  

Question 2
There are different stages in determining the overhead absorption rate. First, the management estimates the total factory overhead amount. Next, the total estimated factory overhead is divided by either estimated total direct labour cost, total estimated direct labour hours, or total estimated machine hours. The procedure for allocating factory overhead to cost centres objects and units covers cost allocation, cost apportionment, and overhead absorption. While the allotment of whole items of cost-to-cost centers or cost units is referred to as cost allocation, the allotment of common costs to two or more cost centres on the estimated basis of benefits received is known as cost apportionment.
     
In addition, overhead absorption represents the allotment of factory overheads to cost units objects by means of a predetermined factory overhead application rate. The factory overhead absorption rate can be either actual overheads rate or a predetermined overhead rate. Normally, a predetermined overhead rate is preferred the reason being is that it is useful in bidding cases to determine quotation prices. Another good reason is it allows easy costing of individual jobs manufactured.  A third reason is that the rate makes interpreting stock market charts. This may trigger by variation in actual factory overhead costs, and or actual level of activity.  One of the two key factors to determine the factory overhead application rate for a period is to select a volume level of production (also known as the factory capacity) that will serve as the bases for applying factory overheads to production (denominators). The second key is the budgeted factory overhead at the capacity being chosen for factory overhead allocation (Power, 1999, 45).
   
In terms of capacity theories, the choice of capacity to be used as a base in applying factory overhead often raises difficult questions. The reason is that there is more than one basis of determining capacity. For instance, capacity can be based on the physical facilities that have been put into place in the factory site. Capacity can also mean productive capacity that can be utilized by giving due allowance for unavoidable lost hours both in respect of machines and number of hours worked by the factory workers. Another capacity issue is the actual capacity used in relation to the expected number of units sold. While one capacity level relates to the level of production determined by engineers, with no thought to the expected sales volume, the other is the expected production revenues. The choice is to be made from one of the following maximum or theoretical idle capacity, practical capacity, normal long-term capacity, and expected short-term actual capacity (Power, 1999, 45).
     
The maximum or theoretical capacity represents the volume of production that a particular production department or unit is capable of producing if the plant were in continuous operation at peak levels at all production periods or hours.  This capacity base does not have any provision for either lack of sales volume or interruptions in factory product output due to machine breakdown, machine downtime, for repairs and maintenance, set up time, holidays, weekends, and other factors. At this capacity, the plant is presumed to work for 24 straight hours a day for 7 days a week, for 52 weeks a year without any stoppage or recess. In addition, the factory is presumed to work at 100 percent of factory site capacity. On the other hand, the practical capacity does not expect full utilization of the factory site. This type of capacity makes due allowance for unavoidable idleness of workers and machinery brought about by repairs and maintenance incidents during production of the companys products. Delays may also be caused by machine set -ups, fatigue, and time lost because of vacations and holidays. However, this measure does not take into consideration plant and personnel made idle due to the lack of sales order. In operational terms, it is the maximum capacity expected when the plant operates at a planned level of production efficiency (Power, 1999, 45).
   
In the same light, the normal or long run production capacity differs from practical capacity. This new capacity permits idleness both of the plant as well as the personnel caused due to a lack of sales orders. Normally, capacity is equal to, or less than, practical production capacity depending upon the volume of expected sales. More often, normal capacity is less than practical capacity. Further, revenue is generally not the basis for the accounting period revenues... It is the average annual finished goods produced over several accounting periods to meet the demands of ordinary and usual sales demand over a cycle of years long enough to be considered as a trend, usually five years (Khan  Jain, 200610).

The expected or short run actual capacity. It is defined as the volume of production needed to fill the estimated or projected demand for the next accounting period, usually one year. Therefore, expected actual capacity differs from normal capacity in the length of time to determine the capacity base used for factory overhead absorption. This measurement estimate will surely not smooth out cyclical variations the terms of quantity sold that are likely to happen over a long period of time as it is guided by an average of only one year projection. This type of measurement may appeal to some entities that are that interested more in short tern plans and control (Khan   Jain, 2006 10).

Question 3   
There are generally three major bases that may be used for absorbing factory overheads. They are direct labor costs, direct labor hours used, and machine hours used. The traditional standard cost system has been highly criticized by engineers and production managers as well as writers in the new manufacturing environment. The criticism in terms of direct labour focuses on the use of variances for control purposes -- primarily the material price variance, the labor efficiency variance, and the volume variance. To a lesser degree, standard cost systems have been disparaged for not promoting continuous improvement for allowing adherence to static standards. Labour variance is the change in direct labours when the numbers of hours worked are computed based on the budgeted and actual amounts gathered in the areas of actual and budgeted hours worked and labor fees actually paid.   Here, the factory overhead is allocated based on the actual direct labor amount for the same accounting period. For example, the actual labour cost is 1,000. If the budgeted factory overhead is twice the direct labor cost, the factory overhead applied is 2,000 (Cheatham, 1993 45).     On the other hand, direct labour hours are the basis for allocating factory overhead. A factory overhead rate hour is then arrived bat (Lewis, 1993 35).
     
In addition, the projected number of machine hours used during the entire accounting period to produce the finished goods of the total estimated factory overhead is important in allocating factory overhead.  This generates an overhead rate hour. This rate is multiplied by the actual number of machine hours spent by the workers to produce the finished goods. The result forms part of the factory overhead for one accounting period (Lewis, 1993 35).
     
Further, standard cost systems did not evolve until the 1900s.   Clearly, standard cost systems are distinguished from earlier cost systems in that they prescribed what factory overhead costs and expenses would be recording in the accounting books. This is different from the traditional way of just simply recording business attractions in the past. Estimates or standards for future costs established, and actual costs compares well with the officers pondering compared well to these predetermined benchmarks in determining the effectiveness of performance (Cheatham, 1993 45).
   
There are advantages and disadvantages in choosing machine hours or labour hours in the allocation of factory overhead. The advantages of using machine hours include determining if the machines were fully maximized or used to full capacity in producing the finished goods. Another advantage is that management will know if the machines were idle or used in contributing to the production of the finished goods.   The disadvantages include not knowing if labour was contributing to the failure of the machine to work at maximum capacity. Another disadvantage is that management may not know if the there are lazy workers contributing to the idleness of the machines.
     
There are advantages of using labour hours in the allocation of factory overhead. They include knowing if labour is skilled enough to produce more goods, and determining if one worker overshoots benchmarks. The disadvantages include not knowing if machines used were contributing to the failure to meet benchmarks. Another disadvantage is that management may not know if there are any machines damaged, causing decline in production output.

Computation in Excel
Briefly, total manufacturing cost is composed of direct materials, direct labour, and factory overhead. All factory costs not classified as direct materials and direct labor are lumped under the account title factory overhead. Direct labour cost, direct labour hours, or machine hours are used to allocate factory overhead. Indeed, factory overhead should form part of product costs to determine if revenues are high enough to recover factory costs and expenses.