Chapter 3 Predetermined Overhead Rates Flexible Budgets and

Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing Cost Accounting: Foundations and Evolutions, 8 e Kinney ● Raiborn

Learning Objectives n n n n Why and how are overhead costs allocated to products and services? What causes underapplied or overapplied overhead, and how is it treated at the end of a period? What impact do different capacity measures have on setting predetermined overhead rates? How are the high-low method and least squares regression analysis used in analyzing mixed costs? How do managers use flexible budgets to set predetermined overhead rates? How do absorption and variable costing differ? How do changes in sales or production levels affect net income computed under absorption and variable costing?

Allocating Overhead Actual vs. Normal Product Cost Direct Materials Actual Cost System Actual Normal Cost System Actual Direct Labor Actual Overhead Actual Predetermined Overhead Rate

Predetermined Overhead Rate n n Allows overhead to be assigned during the period, fulfilling the matching principle Adjusts for variations not related to activity Compensates for fluctuations in activity level that do not affect fixed overhead 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 Total budgeted overhead Activity level (Volume) (usually for a year) $100, 000 5, 000 Direct Labor (DL) Hours = Predetermined Overhead Rate = $20 per DL Hour

The Activity Level: The Denominator n Relationship between the overhead cost and the activity q q q q 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 $630, 000 50, 000 machine hours = $7. 50 per machine hour $12. 60 per machine hour

Applying Variable Overhead For one month Actual activity level times Predetermined overhead rate equals overhead applied 4, 300 actual machine hours times $7. 50 Predetermined variable overhead rate equals $32, 250 overhead applied Apply Variable Overhead Work in Process Inventory Variable Manufacturing Overhead 32, 250

Applying Fixed Overhead For one month Actual activity level times Predetermined overhead rate equals overhead applied 4, 300 actual machines hours times $12. 60 Predetermined fixed overhead rate equals $54, 180 overhead applied Apply Fixed Overhead Work in Process Inventory Fixed Manufacturing Overhead 54, 180

Recording and Applying Overhead For one month Overhead Account (Combined Fixed/Variable) Actual Overhead Applied Overhead Variable 32, 250 Fixed 54, 180 Apply Overhead (combined journal entry) Work in Process Inventory Variable Manufacturing Overhead Fixed Manufacturing Overhead 86, 430 32, 250 54, 180

Recording Actual Overhead For one month Overhead Account (Combined/Fixed/Variable) Actual Overhead Applied Overhead Variable 31, 385 Variable 32, 250 Fixed 55, 970 Fixed 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

Manufacturing Overhead: Single Account, Variable, and Fixed

Disposing of Overhead Differences n If overhead is underapplied, the adjusting entry q q n increases Cost of Goods Sold decreases Net Income If overhead is overapplied, the adjusting entry q q decreases Cost of Goods Sold increases Net Income

Disposing of Overhead Differences n Immaterial n Material— q Cost of Goods Prorate to Sold q Work in Process q Finished Goods q Cost of Goods Sold

Disposing of Overhead Differences n Immaterial q Cost of Goods Sold n Material q Prorate to n Work in Process n Finished Goods n Cost of Goods Sold

Alternative Capacity Levels (The Denominator Level) n n n Capacity measure of volume or some other activity base Alternative measures q Theoretical q Practical q Normal q Expected Choice of capacity level affects product cost

Theoretical Capacity All production factors are operating perfectly n Disregards q Machinery breakdown q Holiday downtime n Results in q Significant underapplied overhead q Lowest product cost n

Practical Capacity n n Theoretical capacity reduced by ongoing, regular operating interruptions (holidays, downtime, and start-up time) Usually results in q q Underapplied overhead Low product cost

Normal Capacity n Considers q q q n n Historical production level Estimated future production level Cyclical fluctuations Attainable level of activity When normal capacity is greater than expected capacity, may result in q q Underapplied overhead Higher product cost

Expected Capacity n n Anticipated activity level for the upcoming period based on projected product demand Determined during the budget process Should closely reflect actual costs Results in q q Immaterial overapplied or underapplied overhead Highest product cost

Alternative Capacity Levels Alternative Capacity (The Denominator Level) Level n n 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 Mixed Cost variable $ fixed # of Units

Separating Mixed Costs n n To determine variable and fixed predetermined overhead rates, separate mixed costs into variable and fixed components Use formula for a straight line: y = a + b. X y = total cost a = fixed portion of total cost b = variable cost X = activity base to which y is related

Methods for Separating Mixed Costs n High-Low Method q q Actual cost observations Considers only two data points n q n Least Squares Regression Analysis q Highest and lowest levels of activity Disregard outliers when analyzing mixed costs Statistical technique that analyzes the relationship between dependent and independent variables n n q Dependent variable— Cost Independent variables— Activities Regression line provides line of best fit for the data

Using the High–Low Method High Low Difference $1, 320 Machine Hours Cost 9, 000 4, 600 4, 400 $3, 500 2, 180 $1, 320 = $0. 30/unit Variable cost per unit 4, 400 3, 500 = a + ($0. 30)(9, 000) Fixed cost a = 800 Y = $800 + $0. 30 X (X = machine hours)

Regression Analysis Assumptions Independent variable must be a valid predictor of the dependent variable q Coefficient of correlation n Reliable only within the relevant range n Useful only as long as circumstances existing at the time of its development remain constant n

Estimated Total Costs High—Low Method $800. 00 + $0. 30 X (X = machine hours) Regression Analysis $354. 62 + $0. 35 X More data points mean a better estimate of total costs

Flexible Budgets n Separate overhead costs into fixed and variable components in order to estimate the amount of overhead at various levels of the denominator activity q q 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 + b. X 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

Absorption vs. Variable Costing Absorption or Full Costing n External use n GAAP n Classify by Function q Cost of goods sold q Selling expense q Administrative expense Variable or Direct Costing n Internal use n Not GAAP n Classify by Behavior q Variable q Fixed

Absorption vs. Variable Costing Absorption or Full Variable or Direct n Product costs q Direct material q Direct labor q Variable mfg. overhead q Fixed mfg. overhead n Period costs q Fixed mfg. overhead q Selling q General q Administrative

Differences Between Absorption and Variable Costing Absorption Costing n Fixed manufacturing overhead is a product cost n n Fixed manufacturing overhead is a period cost Variable operating expenses are subtracted from product contribution margin to equal contribution margin

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

Difference in Income Absorption vs. Variable n No change in inventory level q n Increase in inventory level q q n Absorption Income = Variable Income Absorption Income > Variable Income Phantom Profits Decrease in inventory level q Absorption Income < Variable Income

Questions n n n How does underapplied overhead affect cost of goods sold and net income? What two methods are used to separate mixed costs into variable and fixed costs? What is the difference between absorption and variable costing?

Potential Ethical Issues n n n Using high activity level for overhead application rate resulting in lower overhead rate, lower product cost, and higher operating income Using high production estimate resulting in lower overhead rate, lower product cost, and higher operating income Treating period costs as product costs resulting in higher inventory and net income Manipulating sales reporting at the end of an accounting period Choosing overhead allocation methods that distort cost and profit of certain products or subunits