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Chapter 13 Accounting for Overhead Costs Copyright © 2014 Pearson Education, Inc. publishing as

Chapter 13 Learning Objectives 1. Compute budgeted factory-overhead rates and apply factory overhead to production. 2. Determine and use appropriate costallocation bases for overhead application to products and services. 3. Use normalized variable- and fixed-overhead application rates and explain the disposition of overhead variances. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 3

Chapter 13 Learning Objectives 4. Compare variable- and absorption-costing systems. 5. Construct an income statement using the variable-costing approach. 6. Construct an income statement using the absorption-costing approach. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 4

Chapter 13 Learning Objectives 7. Distinguish between product-costing and planning-and-control purposes in accounting for variable and fixed costs. 8. Compute the production-volume variance and show it should appear in the income statement. 9. Reconcile variable- and absorption-costing operating income and explain why a company might prefer to use a variable-costing approach. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 5

Learning Objective 1 Accounting for Factory Overhead Years ago, direct materials and direct labor were the largest costs for most companies. Today, automated companies have lower direct labor costs but much larger overhead costs. Methods for assigning overhead costs to the products are an important part of accurately measuring product costs. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 6

Budgeted Overhead Application Rates 1. 2. 3. 4. 5. Select one or more cost-allocation bases. Prepare a factory overhead budget. Compute the factory overhead rate. Obtain actual cost-allocation base data. Apply the budgeted overhead to the products or services. 6. Account for any differences between the amount of overhead actually incurred and overhead applied. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 7

Budgeted Overhead Application Rates Overhead rates are budgeted; they are estimates. The budgeted rates are used to apply overhead based on actual events. Budgeted Total budgeted overhead = Factory overhead application Total budgeted rate Amount of cost driver Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 8

Illustration of Overhead Application Enriquez Machine Parts Company selects a single cost-allocation in each department for applying overhead, machine hours in machining and direct-labor in assembly. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 9

Illustration of Overhead Application Total overhead applied to a particular product equals budgeted overhead rates multiplied by actual machine hours (MH) or labor cost (LC) used by that product. Thus, we would apply $44 of overhead to a product that uses 6 MH in machining and incurs direct-labor cost of $40 in assembly. Machining: 6 actual MH X $4 per MH= $24 Assembly: $40 of DL cost X 50% = 20 Total overhead $44 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 10

Illustration of Overhead Application Suppose that at the end of the year Enriquez had used 70, 000 machine hours in Machining. How much overhead was applied to Machining? Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 11

Illustration of Overhead Application Suppose that at the end of the year Enriquez had incurred $190, 000 in direct labor cost. How much overhead was applied to Assembly? Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 12

Illustration of Overhead Application Total factory overhead applied: Machining: $280, 000 Assembly: 95, 000 Total Factory Overhead Applied $375, 000 The $375, 000 is an estimate of Enriquez’s overhead for the year, and it will become part of the cost of goods sold expense on Enriquez’s income statement when the units produced are subsequently sold. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 13

Learning Objective 2 Choice of Cost-Allocation Bases The accountant’s goal is to find the costallocation base that best links cause and effect. No one cost-allocation base is right for all situations. A separate cost pool should be identified for each cost-allocation base. Pool 1 Base 2 Pool 2 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 14

Learning Objective 3 Normalized Overhead Rates “Normal” product costs include an average or normalized chunk of overhead. Actual direct material + Actual direct labor + Normal applied overhead = Cost of manufactured product Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 15

Disposing of Underapplied or Overapplied Overhead Recall that Enriquez applied $375, 000 to its products, but. . . it incurred $392, 000 of actual manufacturing overhead during the year. $392, 000 actual overhead – 375, 000 applied overhead $ 17, 000 underapplied overhead The $375, 000 becomes part of Cost of Goods Sold when the product is sold, however. . . Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 16

Disposing of Underapplied or Overapplied Overhead The applied overhead is $17, 000 less than the amount incurred. It is: Overapplied overhead occurs when the amount applied exceeds the amount incurred. A company must report actual costs incurred in its financial statements. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 17

Disposing of Underapplied or Overapplied Overhead Accountants uses two methods for the adjustment: 1) Write-off to cost of goods sold 2) Proration, apportioning over- or underapplied overhead to cost of goods sold, work-in-process inventory, and finished-goods inventory in proportion to the ending balances of each account. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 18

Immediate Write-Off This method regards the $17, 000 as a reduction in current income and adds it to Cost of Goods Sold. Applied Overhead (Budgeted) Cost of Goods Sold Incurred Overhead (Actual) Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 19

Prorating Among Inventories This method prorates the $17, 000 of underapplied overhead to Work-In-Process (WIP), Finished Goods, and Cost of Goods Sold accounts. Companies generally prorate overhead variances only when material. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 20

Variable and Fixed Application Rates The presence of fixed costs is a major reason of costing difficulties. Some companies distinguish between variable overhead and fixed overhead for product costing. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 21

Learning Objective 4 Variable Versus Absorption Costing Variable costing excludes fixed manufacturing overhead from the cost of products. Variable costing Absorption costing includes fixed manufacturing overhead in the cost of products. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 22

Variable Versus Absorption Costing Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall

Facts for Illustration Basic Production Data at Standard Cost Direct material $205 Direct labor 75 Variable manufacturing overhead 20 Standard variable costs per unit $300 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 24

Facts for Illustration The annual budget for fixed manufacturing overhead is $1, 500, 000 Budgeted production is 15, 000 computers. Sales price = $500 per unit $20 per computer is variable overhead. Fixed S&A expenses = $650, 000 Sales commissions = 5% of dollar sales Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 25

Facts for Illustration Actual product quantities are: There are no variances from the standard variable manufacturing or selling and administrative costs, the actual fixed manufacturing overhead incurred is $1, 500, 000 each year, and the actual fixed selling and administrative cost is $650, 000 each year. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 26

Learning Objective 5 Comparative Income Statement Using Variable-Costing Desk PC Division: Comparative Income Statements

Fixed-Overhead Rate The fixed-overhead rate is the amount of fixed manufacturing overhead applied to each unit of production. Fixed overhead rate = budgeted fixed manufacturing overhead expected volume of production $1, 500, 000 ÷ 15, 000 = $100 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 28

Learning Objective 6 Absorption-Costing Method Comparative Income Statement Desk PC Division: Comparative Income Statements

Variable Costing vs. Absorption Costing On a variable-costing income statement, costs Are separated into the Major categories of fixed and variable. Revenue less all variable costs (both manufacturing and nonmanufacturing) is the contribution margin. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 30

Variable Costing and Absorption Costing On an absorption-costing income statement, costs are separated into the major categories of manufacturing and non-manufacturing. Revenue less manufacturing costs (both fixed and variable) is gross profit or gross margin. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 31

Learning Objective 7 Product-costing and planning-andcontrol purposes in accounting for variable and fixed costs. The differences between variable- and absorption-costing formats arise because the two formats treat fixed manufacturing overhead differently. Variable and Fixed Unit Costs: To stress the basic assumptions behind absorption costing, split manufacturing overhead into variable and fixed components. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 32

Fixed Overhead and Absorption Costs of Product Compare (1) the manufacturing overhead costs in the flexible budget used for departmental budgeting and control purposes With (2) the manufacturing overhead costs applied to products under an absorption-costing system Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 33

Variable Overhead Costs The expected variable-overhead costs from the flexible budget are the same as the variableoverhead costs applied to the products. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 34

Fixed Overhead Costs The graph for applied fixed-overhead costs differs from that for the

Learning Objective 8 Production-Volume Variance The difference between applied and budgeted fixed overhead is the production-volume variance. In practice, accountants often call the production-volume variance simply the volume variance. Production-volume variance = (actual volume – expected volume) X fixed overhead rate Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 36

Production-Volume Variance A production-volume variance arises when the actual production volume achieved does not coincide with the expected volume of production used as a denominator for computing the fixedoverhead rate for product-costing purposes: 1. When expected production volume and actual production volume are identical, there is no production-volume variance. 2. When actual volume is less than expected volume, the production-volume variance is unfavorable because usage of facilities is less than expected and fixed overhead is underapplied. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 37

Learning Objective 9 Reconciliation of Absorption. Costing and Variable-Costing The difference in variable-costing and absorption-costing operating income can be explained by multiplying the fixed-overhead product-costing rate by the change in the total units in the beginning and ending inventories. Consider 20 X 1: The change in inventory was 2, 000 units, so the difference in net income would be 2, 000 units × $100 = $200, 000. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 38

Effects of Sales and Production on Reported Income The relationship between sales and production determines the difference between variable-costing and absorption-costing income. Whenever units sold are greater than (less than) units produced, variable-costing income is greater than (less than) absorption costing income. This means that when inventories decrease (increase), variable-costing income is greater than (less than) absorption-costing income. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 39

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 13 - 40