Chapter 8: Accounting for Factory Overhead

Learning Objectives
Upon of this chapter, you should be able to:
● Compute a factory overhead rate using the different bases
● Apply the concept of actual factory overhead and applied factory overhead
● Identify the compute the different methods of allocating budgeted service department to
producing departments
● Compute the different factory overhead variances
● Apply the concept of activity-based costing

All costs incurred in the factory that are not direct materials or direct labor are generally termed
as factory overhead. One method to determine whether a factory expenditure is a factory
overhead item is to compare it to the classification standard established for direct materials and
direct labor costs. If the expenditure cannot be charged to either of these two "direct" factory
accounts, it is classified as factory overhead. Factory overhead refers to the cost pool used to
accumulate all indirect manufacturing costs. Examples of factory overhead include the following:

Indirect materials and indirect labor

Heat, light, and power for the factory
Rent on factory building
Depreciation on factory building and factory equipment
Maintenance of factory building and factory equipment

Factory overhead costs are divided into three categories on the basis of their behavior in
relation to production. The categories are (1) variable overhead (2) fixed overhead and (3)
mixed overhead.

Variable factory overhead costs - these are the factory overhead costs that vary in direct
proportion to the level of production, within the relevant range. Variable cost per unit remains
constant as production either increases or decreases. Total variable cost varies in direct
proportion to production, that is, the greater the number of units
produced, the higher the total variable costs.

Fixed factory overhead costs - these are the factory overhead costs that remain constant
within the relevant range regardless of the varying levels of production. The total remains
constant but the fixed cost per unit varies inversely with the production, that is, the greater the
number of units produced, the lower the fixed cost per unit (this is the advantage of mass
production - the more we produce the lesser the manufacturing cost per unit.

Mixed factory overhead costs - these factory overhead costs are neither wholly fixed nor
wholly variable in nature but have characteristics of both. Mixed factory overhead costs must
ultimately be separated into their fixed and variable components for purposes of planning and
control.
BUDGETING FACTORY OVERHEAD COSTS
Budgets are management's operating plans expressed in quantitative terms, such as units of
production and related costs. After factory overhead costs have been classified as either fixed,
or variable, budgets can be prepared for expected levels of production. The separation of fixed
and variable cost components permits the company to prepare a flexible budget.

FACTORS TO BE CONSIDERED IN THE COMPUTATION OF OVERHEAD RATE

1. BASE TO BE USED
a. Physical output
b. Direct materials cost
c. Direct labor cost
d. Direct labor hours
e. Machine hours
2. ACTIVITY LEVEL TO USE
a. Normal capacity
b. Expected actual capacity
3. INCLUSION OR EXCLUSION OF FIXED FACTORY OVERHEAD
a. Absorption costing - method used for cost accounting
b. Direct costing - method used for internal reporting (management services)
4. USE OF SINGLE RATE OR SEVERAL RATES
a. Plant-wide or blanket rate - one rate for all producing departments
b. Departmentalized rate - one rate for each producing department.

BASE TO BE USED
The base to be used should be related to functions represented by the overhead cost being
applied. If factory overhead is labor - oriented, the most appropriate base to use is direct labor
hours or direct labor cost. If the factory is investment-oriented, related to operation of machinery,
then the most appropriate base will be machine hours. On the other hand, if factory overhead is
material-oriented, then material cost might be considered as the most appropriate base. The
simplest of all bases is physical output or units of production.

1. Direct labor hours

This is the most commonly used base or denominator in the computation of the
predetermined factory overhead rate. The number of direct labor hours spent for a
particular is readily available on the payroll sheet. This base should be used if it can be
established that there is a direct relationship between factory overhead and direct labor
hours. It may be used if there is great disparity in hourly wage rates. The formula is
expressed as:
Factory overhead rate = Estimated factory overhead
Estimated direct labor hours

= Factory overhead rate/direct labor hour

2. Direct labor cost
This method is recommended if it can be established that there is a direct relationship
between labor cost and factory overhead. Just like direct labor hours, the direct labor
cost is readily available on the payroll sheet. Labor rates do not change as often as
material cost, so this base is more reliable than material cost. This base should not be
used if there is little relationship between labor cost and factory overhead. For example,
if overhead is composed largely of depreciation and equipment related cost. The formula
is:

Factory overhead rate = Estimated factory overhead x100

Estimated direct labor cost

= Percentage of direct labor cost

3. Machine hours
This is appropriate when a direct relationship exists between factory overhead cost and
machine hours. This may occur in companies or departments that are largely automated
so that the majority of the factory overhead cost consists of depreciation on factory
equipment. Additional work will be required because each machine will have a time
record to summarize the total machine hours used for each job. The formula is:

Factory overhead rate = Estimated factory overhead

Estimated machine hours

= Factory overhead rate/machine hour

4. Direct material cost

This method is appropriate if it can be inferred that factory overhead costs are directly
related to direct material cost as in cases where direct materials are a very large part of
total cost. Direct material cost is not appropriate when more than one product is
manufactured by a company. Different products require different materials and different
quantities at that, so it will be very inconvenient to use materials cost as the base
because we will have to compute a factory overhead rate for each product. The formula
is:

Factory overhead rate = Estimated factory overhead x100

Estimated direct material cost

= Percentage of direct material cost

5. Units of production
This is the simplest method to use because units produced are readily available. This method is
appropriate when a company or department manufactures only one product. The formula is:

Factory overhead rate = Estimated factory overhead

Estimated units of production

= Factory overhead rate/unit of production

ILLUSTRATIVE PROBLEM 1
The Round Table Company estimates factory overhead at P450,000 for the next fiscal year. It is
estimated that 90,000 units will be produced at a material cost of P600,000. Conversion will
require an estimated 100,000 direct labor hours at a cost of P3.00 per hour, with 45,000
machine hours.

Required: Compute the predetermined factory rate based on:

a. Material cost
b. Units of production
c. Machine hours
d. Direct labor cost
e. Direct labor hours

SOLUTION TO ILLUSTRATIVE PROBLEM 1

a. Factory overhead rate = Est. factory overhead
Est. direct mat, cost
= P 450,000 x 100
= P 600,000
= 75% of direct mat. Cost

b. Factory overhead rate = Est. factory overhead

Est. units of production
= P 450,000
90,000 direct labor hours
= P 5.00/unit

c. Factory overhead rate = Est. factory overhead

Est. machine hours
= P 450,000
45,000 machine hours
= P 10.00/machine hour
 d. Factory overhead rate = Est. factory overhead
Est. direct labor cost
= P 450,000 x 100
P 300,000
= P 150% of direct labor cost

e. Factory overhead rate = Est. factory overhead

Est. direct labor hours
= P 450,000
100,000 direct labor hours
= P 4.50/direct labor hour

The rates computed above are known as the plant-wide or blanket rate. All departments in the
company will use the same application rate for factory overhead and also the same base. A
single plant wide factory application rate can be used when either a single product is being
manufactured or when the different products being manufactured pass through the same series
of productive departments and are charged similar amounts of applied factory overhead.
Multiple department factory overhead application rates are preferable when the different
products being manufactured either do not pass through the same series of productive
departments or, if they do, they should be charged dissimilar amounts of applied factory
overhead because of the differing amounts of attention each product receives.

STEPS IN COMPUTATION OF DEPARTMENTALIZED OVERHEAD RATE

1. Divide the company into segments, called departments, cost centers, to which expenses
are charged.
2. Estimate the factory overhead for each department (direct departmental charges +
indirect departmental charges).
3. Select and estimate the base to be used by each department.
4. Allocate the service department costs to the producing departments.
5. Compute the factory overhead rate (similar to computation using blanket rate).

In a departmentalized company, factory overhead should be budgeted for each department. The
procedures for distributing the budgeted departmental expenses are identical to those used to
allocate the actual factory overhead expenses. Prior to the computation of the departmentalized
factory overhead rate, management must make sure that the service department costs have
been allocated to the producing departments. Departmentalized overhead rates are for the
producing departments only. Producing departments, which include the production lines, are the
cost-accumulation centers in which work is performed directly on the goods being produced. On
the other hand, service departments, which include such activities as maintenance, personnel,
employee services, and the provision of heat, power, and light, are necessary for the entire
factory - including the producing departments - to remain in operation.
TYPICAL ALLOCATION BASES FOR COMMON COSTS
Most common costs can be grouped into four:
1. Labor-related common costs
2. Machine-related common costs
3. Space-related common costs
4. Service-related common costs

Common costs should be analyzed carefully to determine the most appropriate allocation base.
The typical allocation bases for common costs are shown below:

COMMON COST TYPICAL ALLOCATION BASE

Labor-related
1. Supervision No.of employees, payroll amount of DLHrs
2. Personnel services Number of employees
Machine-related
3. Insurance on equipment Value of equipment
4. Taxes on equipment Value of equipment
5. Equipment depreciation Machine-hours, equipment value
6. Equipment maintenance Number of machines, machine hours
Space-related
7. Building rental Space occupied
8. Building insurance Space occupied
9. Heat & air-conditioning Space occupied; volume occupied
10. Concession rental Space occupied & desirability of location
11. Interior bldg. Maintenance Space occupied
Service-related
12. Material handling Quantity or value of materials
13. Billing and accounting Number of documents
14. Indirect materials Value of direct materials

METHODS OF ALLOCATING SERVICE DEPARTMENT COST TO PRODUCING

DEPARTMENTS

1. Direct Method - the most widely used method. This method ignores any service
rendered by one service department to another, it allocates each service department’s
total cost directly to the producing departments.
 2. Step method - sometimes called sequential method of allocation. This method
recognizes services rendered by service departments to other service departments and
is more complicated because it requires a sequence of allocation. The sequence
typically starts with the department that renders service to the greatest number of other
service departments and ends with the department that renders service to the least
number of other departments. Once a service department's costs are allocated, no
subsequent service department costs are allocated to it.

3. Algebraic method - sometimes called reciprocal method. This method allocates costs
by explicitly including the mutual services rendered among all departments.

ILLUSTRATIVE PROBLEM 2
Kappa Gamma Company's factory is divided into four departments - producing departments;
Molding and Decorating, serviced by the Buildings and Grounds and the Factory Administration
departments. Buildings and Grounds cost will be allocated using square feet (floor area) and
Factory Administration cost will be allocated using direct labor hours. In computing
predetermined overhead rates, machine hours are used as the base in Molding and direct labor
hours as the base in Decorating.

Molding Decorating Bldgs. & Grounds Factory Adm.

Budgeted FO P 400,000 P 600,000 P 80,000 P 120,000

Direct labor hours 200,000 100,000

Floor area 100,000 60,000 2,000 4,000

Machine hours 200,000 100,000

Requirements: Allocate the cost of the service departments using:

1. Direct method
2. Step method - start with Bldgs. & Grounds
3. Algebraic method

SOLUTION TO ILLUSTRATIVE PROBLEM

1. Direct method

Bldgs. &
Molding Decorating Grounds Factory Adm.
Budgeted FO ₱400,000.00 ₱600,000.00 ₱80,000.00 ₱120,000.00
Allocated FO
B&G 50,000 30,000 -80,000
FA 80,000 40,000 -120,000
Total FO ₱530,000.00 ₱670,000.00

Base 200,000 MHrs. 100,000 DLHrs.

FO rate ₱2.65/MHr. ₱6.70/DLHr.

Allocation of B & G cost
Molding = 100 x 80,000
160 x 80,000
 Decorating = 60 x 80,000
160

Allocation of FA cost
Molding = 200 x 120,000
300
Decorating = 100 x 120,000
300
2. Step method
Bldgs. &
Molding Decorating Grounds Factory Adm.
Budgeted FO ₱400,000.00 ₱600,000.00 ₱80,000.00 ₱120,000.00
Allocated FO
B&G 48,781 29,268 -80,000 1,951
FA 81,301 40,650 -121,951
Total FO ₱530,082.00 ₱669,918.00

Base 200,000 MHrs. 100,000 DLHrs.

FO rate ₱2.65/MHr. ₱6.70/DLHr.

Allocation of B & G cost

Molding = 100 x 80,000
164
Decorating = 60 x 80,000
164
FA = 4 x 80,000
164

3. Algebraic method
Additional information for the illustrative problem:
Services provided by
B&G FA
50% 40%
30% 50%
- 10%
20% -
Algebraic equation:
B & G = 80,000 + 10% (FA)
FA = 120,000 + 20% (BG)
Substitution:
B & G = 80,000 + 10% (120,000 + .20BG)
 = 80,000 + 12,000 + .02BG
.98BG = 92,000
BG = 92,000
.98
= 93,878

FA = 120,000 + 20% (BG)

= 120,000 + 20% (93,878)
= 138,776

The allocation will be as follows:

Bldgs. &
Molding Decorating Grounds Factory Adm.
Budgeted FO ₱400,000.00 ₱600,000.00 ₱80,000.00 ₱120,000.00
Allocated FO
B&G 46,939 28,163 -93,878 18,776
FA 55,510 69,388 13,878 -138,7761
Total FO ₱502,449.00 ₱697,551.00

Base 200,000 MHrs. 100,000 DLHrs.

FO rate ₱2.51/MHr. ₱6.98/DLHr.

CAPACITY PRODUCTION
In the estimation of manufacturing overhead, as well as the estimation of the base to be used
for allocation, it is important to determine what capacity of production should be adopted.
a. Theoretical, maximum or ideal capacity - a capacity to produce at full speed without
interruptions. It gives no allowance for human capacity to achieve the maximum nor due
allowance for any circumstances that might result in a stoppage of production within or
not within the control of management. At this capacity level, the plant is assumed to
function 24 hours a day, 7 days a week; and 52 weeks a year without any interruptions in
order to yield the highest physical output possible.
b. Practical capacity - a capacity of production that provides allowance for circumstances
that might result in a stoppage of production.
c. Expected actual capacity - a capacity concept based on a short-range outlook which is
feasible only for firms whose products are seasonal or where the market and style
changes allow price adjustments according to competitive conditions and customer
demands.
 d. Normal capacity - a capacity of production taking into consideration the utilization of the
plant facilities to meet commercial demands served over a period long enough to level
out the peaks and valleys which come with seasonal and cyclical variations. This
capacity is commonly used in the computations of overhead rates.

METHOD OF ACCUMULATION OF FACTORY OVERHEAD COSTS

1. Non-controlling account system - an account for each kind of overhead expense according
to their nature is opened in the ledger and charges to such an account are made upon
incurrence of the expense.
2. Controlling account system - an Overhead Control account is opened in the general ledger
wherein the overhead incurred are charged and a subsidiary ledger is maintained to show in
detail the nature and account of the expense.

Actual overhead costs are usually incurred daily and recorded periodically in the general and
subsidiary ledgers. Subsidiary ledgers permit a greater degree of control over factory overhead
costs as related accounts can be grouped together and the various expenses incurred by
different departments can be described in detail.

Computation of overhead chargeable to individual cost sheets (factory overhead applied)

After the factory overhead application rate has been determined, it is used to apply (or match)
estimated factory overhead costs to production. The estimated factory overhead costs are
applied to production on an on-going basis as goods are manufactured, according to the base
used (i,e., as a percentage of direct material costs or direct labor cost or on the basis of direct
labor hours, machine hours, or units produced). Applied factory overhead can be computed by
multiplying the actual factor incurred per cost sheet x predetermined overhead rate.

Entry to charge production with applied overhead:

Work in process - overhead XXX

Factory overhead applied XXX

Factory overhead variance - the difference between the actual factory overhead as shown by
the factory overhead control account and the overhead charged to production as shown by the
factory overhead applied account.

Classification of manufacturing overhead variance

a. Underapplied overhead - the difference between actual overhead and applied
overhead when the actual is more than the applied.
b. Overapplied overhead - the difference between actual overhead and applied overhead
when the actual is less than the applied.

Causes of the manufacturing overhead variance:

a. Spending variance - the variance due to expense factors.
 b. Idle capacity or volume variance - the variance due to difference in volume and
activity factors.

Computation of manufacturing overhead variance

a. Spending variance
Actual factory overhead incurred P XXX
Less: Budget allowed based on capacity used
Fixed factory overhead P XXX
Variable factory overhead XXX XXX
Spending variance P XXX

b. Idle capacity variance

Budget allowed based on capacity used P XXX
Less: Factory overhead applied XXX
Idle capacity variance P XXX

Accounting for overhead variance

a. During the period prior to the closing of the books, the overhead variance is not recognized in
the account and the actual factory overhead account as well as the applied factory overhead
accounts are kept open. When interim financial statements are prepared and the variance is
expected to be absorbed prior to year-end, such variance should be deferred rather than
disposed of immediately.

b. At the end of the accounting period

1. If the amount of the overhead variance is immaterial or it is established to be the result of
inefficiency, it is close to the cost of goods sold.
2. If the amount of the overhead variance is material and found to be the result of an
erroneous computation of the predetermined overhead rate, such variance is distributed
to the cost of goods sold, finished goods inventory, and the work in process inventory.

ILLUSTRATIVE PROBLEM 3
The Davidson Corporation made the following data available from its accounting records and
reports.

Budgeted factory overhead P300,000

Budgeted direct labor hours 100,000 hrs.
Variable factory overhead rate P 1.00/DLHr.
Actual factory overhead P350,000
Actual direct labor hours used 110,000 hrs.

Solution:
Spending variance:
Actual factory overhead P350,000
Budget allowed on actual hours
Fixed P200,000
Variable 110,000 310,000
Spending variance - unfavorable P 40,000
Spending variance - unfavorable

Idle capacity variance:

Budget allowed on actual hours P310,000
Applied factory OH (1 10,000 x P3.00) 330,000
Idle capacity variance - favorable P (20,000)

To understand fully the computation of the variance, the following table may be prepared:

Total Per Hour

Fixed overhead P 200,000 P 2.00

Variable overhead 100,000 1.00

Total P 300,000 P 3.00

Factory overhead rate = 300,000/100,000 hrs.

= P 3.00/DLHr.

Variable overhead cost = 100,000 Hrs. x P 1.00

= 100,000

ACTIVITY BASED COSTING

The growth in the automation of manufacturing has brought many challenges to product costing.
Increased use of robotics, specialized machinery, and other computer-driven processes has
changed the nature of manufacturing and the composition of total product cost. In many
highly-automated manufacturing businesses the significance of direct labor cost has diminished
and overhead costs have increased. The cost of acquiring, installing, maintaining, and operating
state-of-art manufacturing technologies has greatly increased overhead costs. In addition, costs
that used to be classified as indirect such as quality control, computer programming,
troubleshooting, and middle level management costs have become major components of total
production cost.

In highly automated manufacturing environments, overhead application rates based on direct

labor may not provide accurate overhead charges because they no longer represent cause and
effect relationship between output and overhead costs. The need for more representative
overhead application bases has led to activity-based costing (ABC) which is also known as
transaction costing. Those activities (transactions) that consume overhead resources are
identified and related to the costs incurred. The basic premise in activity-based costing is that
overhead costs that are caused by activities are traced to individual product units on the basis of
frequency of consumption of overhead resources by each product.

Traditional overhead is applied to production using one of the application bases which were
previously discussed such as direct labor hours, machine hours, direct labor cost, direct material
cost and units of production. Direct labor hours, direct labor costs, machine hours, machine
hours, or units produced are volume-based application bases. Volume-based production means
that the more units estimated to be produced, the larger the denominator in the equation used to
determine the overhead rate, thus the smaller the overhead application rate and it follows that
the amount of overhead assigned to each unit will be lesser so overhead will be underapplied
which is unfavorable.

Activity-based costing is a simple concept which can provide accurate information about a
particular product's consumption of overhead resources. ABC is an approximation of a user's
fee. A user's fee refers to the process of charging for services consumed by users of the
service. ABC is based on the premise that if a product consumes many resources (activities)
that comprise overhead, it should bear a greater share of overhead costs than other products
that do not consume as many activity units. In other words, activity costing is also like riding the
LRT, the more you ride, the more cards you need to buy.

FIVE BASIC STEPS IN APPLYING ABC

1. Assemble similar actions into activity centers
2. Classify costs by activity center and by type of expense
3. Select cost drivers
4. Compute a cost function to associate costs and cost-drivers with resource use
5. Assign cost to the cost objective

Assemble similar activities into activity centers

There are several actions performed in any organization so it will be difficult to relate the cost of
every action to a cost driver and then to the product. Therefore, it will be best to combine
actions into activity centers. One way of grouping actions is to classify them with different levels
of activities; namely, unit level activities, batch-level activities, product-level activities, and
facilities-level activities. Unit-level activities are performed each time a unit is produced.
Example: assembly, stamping, and machining. Costs of these activities vary with the number of
units produced. Batch- level activities are performed each time a batch of units is produced. The
costs of these activities vary according to the number of batches but remain fixed for all units in
the batch. Examples - machine set-ups, order processing, and materials handling. Product-level
activities are those performed as needed to support the production of each different type of
product. Examples: production scheduling, product designing, and parts and products testing,
Facility-level activities are those which sustain a facility's general manufacturing process.
Examples: plant supervision, building occupancy, and personnel administration.
Classify costs by activity center and by type of expense.
Assign costs to the activity centers where they are accumulated while waiting to be applied to
products. Costs that are traceable to the activity center should be assigned directly to activity
centers. Other costs shared by two or more activity centers should be assigned according to
some cost driver that controls the utilization of the costs involved.

Select the cost drivers

The cost drivers are the links between cost, activity, and product. Cost drivers are not needed
for direct costs because these can be traced immediately to a product. However, indirect costs,
such as factory overhead, need links or drivers to link a pool of costs in an activity center to the
product.

Calculate a cost function

A cost function is used to translate the pool of costs and cost driver data into a rate per cost
driver unit or a percentage of other cost amounts, just like the plant-wide or departmentalized
factory overhead rate. For example, if the cost of the setup activity center is P25,000 and the
selected cost driver is 500 hours, then the cost function will be P50 per setup hour (P25,000/500
hours).

Assign cost to the cost objective

The last step is to allocate the costs to the different users of the resource. This is done by
multiplying the rate determined in the preceding paragraph by the actual data of the cost driver.
If actual setup hours used is 40, then the allocated cost will be P2,000 (40 hours × P50).

We now illustrate ABC by comparing it to one of the volume-based overhead allocation

procedures, namely direct labor hours. For instance, NDL Company has three products, namely:
C, D, and E and three related overhead activities: product-line setups, number of handles and
number of parts. The number of setups refer to the number of times each product line is readied
for production. The number of handles refers to the number of times each product is moved
from one workstation to another. The number of parts refers to the number of parts that is used
in making each product. The production, overhead activities and their corresponding costs are
shown on the table below:
 Units Total DL Total DL Total DM No. of Times No. of
Product Produced Hrs. Cost Cost Setups Handled Parts

C 20 30 P 300 P 600 2 2 1

D 100 150 1,500 3,000 4 2 2

E 100 70 700 3,000 2 2 2

Budgeted cost of each cost driver

Setups P 6,200
Times handled 3,300
No of parts 3,000
Total budgeted overhead cost P 12,500
The overhead application rate using direct labor hours, as base, would be computed as
Factory overhead rate = P 12,500/ 250 direct labor hours
= P 50.00 per direct labor hour

Using direct labor hours as the base, factory overhead will be applied to the three products as
follows:

Product Total Overhead Applied No. of Units OH Cost/unit

C 30 hrs. x P 50 P 1,500 20 P 75

D 150 hrs. x P 50 7,500 100 75

E 70 hrs. x P 50 3,500 100 75

The applied factory overhead when combined with the prime cost of each product will show the
following

Product C Product D Product E

Direct Materials P 600 P 3,000 P 3,000

Direct Labor 300 1,500 700

Factory Overhead Applied 1,500 7,500 3,500

Total Cost P 2,400 P 12,000 P 7,200

Cost per unit P 120/unit P 120/unit P 72/unit

Under activity-based costing the factory overhead rate is determined by dividing the total costs
of each overhead activity by the total frequency for each activity,
 Setup (P6,200/8) = P 775.00 per setup
Handling (P3,300/6) = 550.00 per handling
No. of parts (P3,000/5) = 600,00 per part

Product C Product D Product E

Direct Materials P 600 P 3,000 P 3,000

Direct Labor 300 1,500 700

Factory Overhead Applied 3,250 5,400 3,850

Total Cost P 4,150 P 9,900 P 7,550

Cost per unit P 207.60 P 99.00 P 75.50

The applied overhead cost of the products was determined as follows:

Product C
Setups 2 at P 775.00 P 1,550.00
Handling 2 at P 550.00 1,100.00
No. of parts 1 at P 600.00 600.00
Total overhead P 3,250.00

Product D
Setups 4 at P 775.00 P 3,100.00
Handling 2 at P 550.00 1,100.00
No. of parts 2 at P 600.00 1,200.00
Total overhead P 5,400.00

Product E
Setups 2 at P 775.00 P 1,550.00
Handling 2 at P 550.00 1,100.00
No. of parts 2 at P 600.00 1,200.00
Total overhead P 3,850.00
Under the traditional method, direct labor does not explain the cause-effect relationship between
the products and incurring overhead costs. On the table above, it can be seen that Product D
has the highest cost followed by Product E. Product C has the lowest allocated overhead
because C consumes less overhead activities than the other two products. By concentrating on
each product's consumption of the major cost component (overhead), activity costing avoids the
problem of overstating costs of products that are low level consumers of overhead activities and
understating costs of products that are high level consumers.