Explain why a factory cost is not necessarily an office expense

A cost belongs in the factory only if it is spent on making the goods. A cost of the office, selling or delivery belongs in the income statement. When one cost serves both, it is split, and the split changes the profit.

This is the last skill in manufacturing accounts. It builds on direct and indirect costs and on transferring production cost, and it links to the ideas of capital and revenue treatment.

Why can the same type of cost sit in two places?

Rent, electricity, insurance and depreciation are costs, but not all of them are production costs. The test is what the cost is spent on, not what it is called.

• Rent of a building used for production is a factory overhead.
• Rent of a floor used for the office is an administration expense.
• If one rent bill covers both, apportion it using the fraction or ratio given.

The split matters because factory overheads end up inside the cost of unsold goods, while office expenses do not.

Worked example

Kilang Biskut Delima has these shared costs for the year, in RM: premises rent 24,000 (three quarters factory, one quarter office), electricity 7,200 (two thirds factory, one third office), machine depreciation 4,000 (all factory) and depreciation of office computers 900 (all office).

Step 1, rent: factory 24,000 × 3/4 = 18,000. Office 24,000 × 1/4 = 6,000.

Step 2, electricity: factory 7,200 × 2/3 = 4,800. Office 7,200 × 1/3 = 2,400.

Step 3, factory overheads: 18,000 + 4,800 + 4,000 = RM 26,800.

Step 4, office expenses: 6,000 + 2,400 + 900 = RM 9,300.

Check: 26,800 + 9,300 = 36,100, and the original costs total 24,000 + 7,200 + 4,000 + 900 = 36,100.

Now see why the split matters. Suppose the factory made 10,000 units, with materials and direct wages of RM 70,000 in total, no work in progress and no opening finished goods. It sold 9,000 units.

• Correct: factory cost = 70,000 + 26,800 = 96,800, which is RM 9.68 a unit. Closing 1,000 units = 9,680. Cost of sales = 96,800 − 9,680 = 87,120. Charged to profit: 87,120 + office 9,300 = 96,420.
• Wrong (all overheads treated as office): factory cost = 70,000, which is RM 7.00 a unit. Closing 1,000 units = 7,000. Cost of sales = 63,000. Charged to profit: 63,000 + 26,800 + 9,300 = 99,100.

The wrong treatment charges RM 2,680 too much against profit (99,100 − 96,420). That is the overhead of 2.68 a unit that should have been carried forward in the 1,000 unsold units.

The mistake to watch for

A common slip is to put all the rent into the factory, or all of it into the office.

Mistaken answer: factory overheads = 24,000 + 7,200 + 4,000 = 35,200.

The student put the whole rent and electricity in the factory because the bills say “premises”.

The correct factory overheads are 26,800. The office part of the rent and electricity, 8,400, is an administration expense. The correction is to read how the question says the cost is shared, then apply the fraction before placing the amounts.

Check yourself

Try these on paper first, then open each answer.

1. Rent of RM 15,000 is shared two thirds factory and one third office. Find each part.

2. Which of these are factory overheads: (a) depreciation of a delivery van, (b) depreciation of a lathe used in production, (c) salary of the accounts clerk, (d) wages of a factory cleaner?

3. In one sentence, explain why a factory overhead is not charged in full to profit in the year it is spent.

Where this leads next

You now have every step of the chain. Test it with the manufacturing accounts practice set, and use the double-entry and ledger trainer to check where each cost is posted.

Students sometimes find the explanation questions harder than the calculations. In online one-to-one Accounting tuition, a teacher can help you practise short written answers using your own working.