Cost Accounting Foundations and Evolutions

Kinney, Prather, Raiborn

Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing

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 Overhead Actual vs. Normal

Product Cost
Direct Materials Direct Labor Overhead

Actual Cost System Actual

Actual

Normal Cost System Actual

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)
$100,000 5,000 DL Hours

Predetermined Overhead Rate

$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) Total budgeted fixed overhead Activity level (Volume)

$375,000 50,000
machine hours

$7.50
per machine hour

$630,000 50,000
machine hours

$12.60
per machine hour

Applying Variable Overhead

For one month Actual activity level 4,300 actual machines hours times times Predetermined $7.50 Predetermined overhead rate variable overhead rate equals equals overhead applied $32,250 overhead applied
Apply Variable Overhead Work in Process Inventory Variable Manufacturing Overhead 32,250 32,250

Applying Fixed Overhead

For one month Actual activity level 4,300 actual machines times hours Predetermined times overhead rate $12.60 Predetermined fixed overhead rate equals equals overhead applied $54,180 overhead applied
Apply Fixed Overhead Work in Process Inventory Fixed Manufacturing Overhead 54,180 54,180

Recording and Applying Overhead

For one month

Overhead Account (Combined Fixed/Variable)

Actual Overhead
Applied Overhead
Variable Fixed 32,250 54,180

Apply Overhead (combined journal entry) Work in Process Inventory 86,430 Variable Manufacturing Overhead Fixed Manufacturing Overhead

32,250 54,180

Recording Actual Overhead

For one month

Overhead Account (Combined/Fixed/Variable)

Actual Overhead
Variable
Fixed

Applied Overhead
Variable
Fixed

31,385
55,970

32,250
54,180

Record actual overhead Variable Manufacturing Overhead Fixed Manufacturing Overhead Various accounts

31,385 55,970 87,355

Manufacturing Overhead
For the entire year

Overhead Account (Combined Fixed/Variable)

Actual Overhead Fixed 220,000 Applied Overhead Fixed 260,000

Overhead is $40,000 overapplied $220,000 of actual overhead was incurred $260,000 was applied to Work in Process

Disposing of Overhead Differences

If overhead is underapplied
Cost of Goods Sold increases Income decreases

If overhead is overapplied
Cost 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

Alternative Capacity Levels

(The Denominator Level)
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 Alternative Capacity Level (The Denominator 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 Alternative Capacity Level (The Denominator 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 Alternative Capacity Level (The Denominator Level)

Theoretical Practical Normal Expected lowest product cost low product cost higher product cost * highest product cost

*assuming normal exceeds expected capacity

Analyzing Mixed Costs

A mixed cost contains both

a variable and fixed component

variable

Mixed Cost

$
fixed

Units

Mixed Costs
To determine variable and fixed predetermined overhead rates, separate mixed costs into variable and fixed components

Separating Mixed Costs

Use formula for a straight line

y = a + bX
y = total cost a = fixed portion of total cost b = variable cost X = activity base to which y is related

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 Costs Direct Material Direct Labor Fixed and Variable Mfg. Overhead
Period Costs Selling, 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 Material Direct Labor Variable Mfg. Overhead Selling, Selling General, General Administration Administrative

Questions
How does underapplied overhead affect cost of goods sold and net income? What is the difference between absorption and variable costing?