These bases are commonly used to compute the factory overhead application rate: (1) units of production, (2) direct materials cost, (3) direct labor cost, (4) direct labor hours, and (5) machine hours.
UNITS OF PRODUCTION
This method is very simple, since data on the units produced are readily available for applying factory overhead. The formula is as follows:
Estimated factory overhead costs
Estimated units of production =
Factory overhead application
rate per unit of production
This method applies factory overhead equally to each unit produced and is appropriate when a company or department manufactures only one product.
DIRECT MATERIALS COST
This method is suitable when it can be determined that a direct relationship exists between factory overhead cost and direct materials cost. When direct materials are a very large part of total cost, it may be inferred that the factory overhead costs are directly related to direct materials. The formula is as follows:
Estimated factory overhead costs Estimated direct materials cost
x 100 =
Percentage of direct materials cost
One problem in using direct materials cost as a base where more than one product is manufactured is that different product require varying quantities and types of direct materials with different acquisition costs. Therefore, different factory overhead application rates should be determined for each product.
DIRECT LABOR COST
This is the most widely used base because labor costs are generally closely related to factory overhead cost, and payroll data are readily available. It therefore meets our objectives of having a direct relationship to factory overhead cost, being simple to compute and apply, and requiring little, if any, additional cost to compute. Thus this method is appropriate when a direct relationship exists between direct labor cost and factory overhead. (There are, however, situations where there is little relationship between direct labor costs and factory overhead and this method would not be appropriate. For example, factory overhead costs may be composed largely of depreciation and equipment-related costs). The formula is as follows
Estimated factory overhead costs x 100 = Percentage of
Estimated direct labor cost
direct labor cost
DIRECT LABOR HOURS
This method is appropriate when there is a direct relationship between factory overhead costs and direct labor hours, and when there is a significant disparity in hourly wage rates. Timekeeping records must be accumulated to provide the data necessary for applying this rate. The formula is as follows:
Estimated factory overhead costs =
Estimated direct labor hours
= Factory overhead application rate per direct labor hour
This method, like the direct labor cost method, would be inappropriate if factory overhead costs were composed of costs unrelated to labor activity.
This method uses the time required for machines to perform similar operations as a base in computer the factory overhead application rate. This method is appropriate when a direct relationship exists between factory overhead costs and machine hours. This generally occurs in companies or departments that are largely automated so that the majority of factory overhead costs consist of depreciation on factory equipment and other equipment-related costs. The formula is as follows:
Estimated factory overhead costs =
Estimated machine hours
= Factory overhead application rate per machine hour
The disadvantages of this method are the additional cost and time involved in summarizing total machine hours per unit. Since every company is different, the decision regarding which base is appropriate for a particular manufacturing operation must be made by management after careful analysis.