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Chapter 3
Predetermined Overhead Rates, Flexible Budgets, and
Absorption/Variable Costing
Cost AccountingFoundations and Evolutions
Kinney, Prather, Raiborn
Learning Objectives (1 of 3)
• Explain why and how overhead costs are allocated to products and services
• Describe what causes underapplied or overapplied overhead and how is it treated at the end of the period
Learning Objectives (2 of 3)
• Explain how different capacity measures affect predetermined overhead rates
• Explain how managers use flexible budgets to set predetermined overhead rates
Learning Objectives (3 of 3)
• Contrast absorption and variable costing
• Describe how changes in sales or production levels affect net income under absorption and variable costing
Allocating OverheadActual vs. Normal
Product Cost
Direct Materials
Direct Labor
Overhead
Actual Cost System
Actual
Actual
Actual
Normal Cost System
Actual
Actual
Predetermined
Overhead Rate
Predetermined Overhead Rate
• Allows overhead to be assigned during the period, fulfilling the matching principle
• Allows managers to be aware of product, product line, customer, and vendor profitability
Predetermined Overhead Rate
A budgeted, constant charge per unit of activity used to assign overhead to
production or services
Predetermined Overhead Rate
Total budgeted overhead
Activity level(Volume)
=
PredeterminedOverhead
Rate
$100,0005,000
DL Hours
= $20 per DL Hours
The Activity Level(The Denominator)
• Relationship between the overhead cost and the activity– production volume– direct labor hours– direct labor cost– machine hours– number of purchase orders or parts– machine setups– material handling time
Predetermined Overhead Rate
Total budgeted variable overhead
Activity level(Volume)
$375,000
50,000machine hours
= $7.50 per machine
hour
Total budgeted fixed overheadActivity level
(Volume)
$630,000
50,000machine hours
= $12.60 per machine
hour
Applying Variable Overhead
Actual activity level times
Predetermined overhead rate
equalsoverhead applied
4,300 actual machines hours times
$7.50 Predetermined variable overhead rate
equals$32,250 overhead applied
Apply Variable OverheadWork in Process Inventory 32,250 Variable Manufacturing Overhead 32,250
For one month
Applying Fixed Overhead
Actual activity level times
Predetermined overhead rate
equalsoverhead applied
4,300 actual machines hours times
$12.60 Predetermined fixed overhead rate
equals$54,180 overhead applied
Apply Fixed OverheadWork in Process Inventory 54,180 Fixed Manufacturing Overhead 54,180
For one month
Overhead Account(Combined Fixed/Variable)
Actual Overhead Applied Overhead
Variable 32,250
Fixed 54,180
Recording and Applying Overhead
Apply Overhead (combined journal entry)Work in Process Inventory 86,430 Variable Manufacturing Overhead 32,250 Fixed Manufacturing Overhead 54,180
For one month
Overhead Account(Combined/Fixed/Variable)
Actual Overhead Applied OverheadVariable 31,385
Fixed 55,970
Recording Actual Overhead
Variable 32,250
Fixed 54,180
Record actual overheadVariable Manufacturing Overhead 31,385Fixed Manufacturing Overhead 55,970 Various accounts 87,355
For one month
Overhead Account(Combined Fixed/Variable)
Actual Overhead Applied Overhead
Fixed 220,000 Fixed 260,000
Manufacturing Overhead
Overhead is $40,000 overapplied$220,000 of actual overhead was incurred $260,000 was applied to Work in Process
For the entire year
Disposing of Overhead Differences
If overhead is underappliedCost of Goods Sold increases
Income decreases
If overhead is overappliedCost of Goods Sold decreases
Income increases
Disposing of Overhead Differences
• Immaterial– Cost of Goods Sold
• Material – Prorate to– Work in Process– Finished Goods– Cost of Goods Sold
Alternative Capacity Levels(The Denominator Level)
• Capacity measure of volume or some other activity base
• Alternative measures – Theoretical
– Practical
– Normal
– Expected
• Choice of capacity level affects product cost
• Theoretical capacity– All production factors are operating perfectly– Disregards
• Machinery breakdown
• Holiday downtime
– Results in • Significant underapplied overhead
• Lowest product cost
Alternative Capacity Levels(The Denominator Level)
• Practical capacity– Theoretical capacity reduced by ongoing,
regular operating interruptions (holidays, downtime, and start-up time)
– Usually results in • Underapplied overhead
• Low product cost
Alternative Capacity Levels(The Denominator Level)
Alternative Capacity Level
• Normal capacity– Considers
• Historical production level
• Estimated future production level
• Cyclical fluctuations
– Attainable level of activity– When normal capacity is greater than expected
capacity, may result in • Underapplied overhead
• Higher product cost
Alternative Capacity Levels(The Denominator Level)
Alternative Capacity Level
• Expected capacity– Anticipated activity level for the upcoming
period based on projected product demand– Determined during the budget process– Should closely reflect actual costs– Results in
• Immaterial overapplied or underapplied overhead
• Highest product cost
Alternative Capacity Levels(The Denominator Level)
Alternative Capacity Level
• Theoretical lowest product cost
• Practical low product cost
• Normal higher product cost *
• Expected highest product cost
*assuming normal exceeds expected capacity
Alternative Capacity Levels(The Denominator Level)
Mixed Cost
Analyzing Mixed Costs
$
Unitsfixed
variable
A mixed cost contains both
a variable and fixed component
Mixed Costs
To determine
variable and fixed
predetermined overhead rates,
separate mixed costs into
variable and fixed components
Separating Mixed Costs
y = a + bX
y = total costa = fixed portion of total costb = variable costX = activity base to which y is related
Use formula for a straight line
Separating Mixed Costs
• Two Methods
– High-Low Method
– Least Squares Regression Analysis
High-Low Method
• Actual cost observations
• Considers only two data points
– highest and lowest levels of activity
Least Squares Regression Analysis
• Statistical technique that analyzes the relationship between dependent and independent variables– Dependent variable – Cost– Independent variables – Activities
• Regression line provides line of best fit for the data
Flexible Budgets
Separate overhead costs into fixed and variable components in order to estimate
the amount of overhead at various levels of the denominator activity
Flexible Budget• Shows manufacturing overhead costs and
cost behavior
• Separates costs into fixed and variable elements
• Provides budgeted costs at various activity levels
• Shows impact of a change in the denominator level of activity
Preparing a Flexible Budget
1. Separate mixed costs into variable and fixed elements
2. Determine the a + bX cost formula
3. Select several potential levels of activity within the relevant range
4. Determine total cost expected at each of the activity levels
Flexible Budgets
Income Statement Absorption Costing
Sales
Less: Cost of Goods Sold
Gross Profit
Less: Operating Expenses
Net Income
Product CostsDirect MaterialDirect Labor
Fixed and Variable Mfg. Overhead
Period CostsSelling, General,
Administrative
Variable Costing or Contribution Margin Income Statement
Sales
Less: Variable Cost of Goods Sold
Product Contribution Margin
Less: Variable Operating Expenses
Contribution Margin
Less: Fixed Mfg. Overhead
Less: Fixed Operating Expenses
Net Income
Direct MaterialDirect Labor
Variable Mfg. Overhead
Selling, General,
Administration
Selling General
Administrative
Questions
• How does underapplied overhead affect cost of goods sold and net income?
• What is the difference between absorption and variable costing?