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

1. Cost Accounting Foundations and Evolutions Kinney, Prather, Raiborn Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing

2. 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

3. 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

4. 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

5. 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

6. 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

7. Predetermined Overhead Rate A budgeted, constant charge per unit of activity used to assign overhead to production or services

8. Total budgeted overhead Activity level (Volume) Predetermined Overhead Rate Predetermined Overhead Rate = $100,000 5,000 DL Hours = $20 per DL Hours

9. 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

10. Total budgeted variable overhead Total budgeted fixed overhead $375,000 $630,000 50,000 machine hours 50,000 machine hours Activity level (Volume) Activity level (Volume) Predetermined Overhead Rate $7.50 per machine hour = $12.60 per machine hour =

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

12. 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 54,180 Fixed Manufacturing Overhead 54,180

13. 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 86,430 Variable Manufacturing Overhead 32,250 Fixed Manufacturing Overhead 54,180

14. Recording Actual Overhead For one month Overhead Account (Combined/Fixed/Variable) Actual Overhead Applied Overhead Variable 31,385 Fixed 55,970 Variable 32,250 Fixed 54,180 Record actual overhead Variable Manufacturing Overhead 31,385 Fixed Manufacturing Overhead 55,970 Various accounts 87,355

15. Manufacturing Overhead For the entire year Overhead Account (Combined Fixed/Variable) Actual Overhead Applied Overhead Fixed 220,000 Fixed 260,000 Overhead is $40,000 overapplied $220,000 of actual overhead was incurred $260,000 was applied to Work in Process

17. 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

18. Disposing of Overhead Differences • Immaterial • Cost of Goods Sold • Material – Prorate to • Work in Process • Finished Goods • Cost of Goods Sold

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. Analyzing Mixed Costs A mixed cost contains both a variable and fixed component variable Mixed Cost $ fixed Units

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

27. 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

28. Separating Mixed Costs • Two Methods • High-Low Method • Least Squares Regression Analysis

29. High-Low Method • Actual cost observations • Considers only two data points • highest and lowest levels of activity

30. 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

31. 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

32. 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

33. Preparing a Flexible Budget • Separate mixed costs into variable and fixed elements • Determine the a + bX cost formula • Select several potential levels of activity within the relevant range • Determine total cost expected at each of the activity levels

34. Flexible Budgets

35. Income Statement Absorption Costing Product Costs Direct Material Direct Labor Fixed and Variable Mfg. Overhead Sales Less: Cost of Goods Sold Gross Profit Less: Operating Expenses Net Income Period Costs Selling, General, Administrative

36. Selling, General, Administration 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

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