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

1. Chapter 3:Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2. Learning Objectives • 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? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. Predetermined Overhead Rate • Allows overhead to be assigned duringthe 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. Total budgeted overhead Activity level (Volume) (usually for a year) Predetermined Overhead Rate A budgeted, constant charge per unit of activity used to assign overhead to production or services Predetermined Overhead Rate = $100,000 5,000 Direct Labor (DL) Hours $20 per DL Hour = © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. 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 = © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. 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 32,250 Variable Manufacturing Overhead 32,250 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. Recording and Applying Overhead For one month Overhead Account (Combined Fixed/Variable) Actual Overhead Applied Overhead Variable32,250 Fixed 54,180 Apply Overhead (combined journal entry) Work in Process Inventory 86,430 Variable Manufacturing Overhead 32,250 Fixed Manufacturing Overhead 54,180 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. Manufacturing Overhead: Single Account, Variable, and Fixed © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. Disposing of Overhead Differences • If overhead is underapplied,the adjusting entry • increases Cost of Goods Sold • decreases Net Income • If overhead is overapplied,the adjusting entry • decreases Cost of Goods Sold • increases Net Income © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. Disposing of Overhead Differences • Immaterial • Cost of Goods Sold • Material— Prorate to • Work in Process • Finished Goods • Cost of Goods Sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Disposing of Overhead Differences • Immaterial • Cost of Goods Sold • Material • Prorate to • Work in Process • Finished Goods • Cost of Goods Sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. Theoretical Capacity • All production factors are operating perfectly • Disregards • Machinery breakdown • Holiday downtime • Results in • Significant underapplied overhead • Lowest product cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. Practical Capacity • Theoretical capacity reduced by ongoing, regular operating interruptions (holidays, downtime, and start-up time) • Usually results in • Underapplied overhead • Low product cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. Analyzing Mixed Costs A mixed cost contains both a variable and fixed component Mixed Cost variable $ fixed # of Units © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. Separating Mixed Costs • To determine variable and fixed predetermined overhead rates, separate mixed costs into variable and fixed components • 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25. High-Low Method Actual cost observations Considers only two data points Highest and lowest levels of activity Disregard outliers when analyzing mixed costs 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 Methods for Separating Mixed Costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. $1,320 4,400 Using the High–Low Method Machine Hours Cost High 9,000 $3,500 4,600 2,180 Low Difference 4,400 $1,320 Variable cost per unit = $0.30/unit 3,500 = a + ($0.30)(9,000) a = 800 Fixed cost Y = $800 + $0.30X(X = machine hours) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27. Regression Analysis Assumptions • Independent variable must be a valid predictor of the dependent variable • Coefficient of correlation • Reliable only within the relevant range • Useful only as long as circumstances existing at the time of its development remain constant © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. High—Low Method $800.00 + $0.30X Regression Analysis $354.62 + $0.35X Estimated Total Costs More data points mean a better estimate of total costs (X = machine hours) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. 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 • 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31. Flexible Budgets © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. Absorption or Full Costing External use GAAP Classify by Function Cost of goods sold Selling expense Administrative expense Variable or Direct Costing Internal use Not GAAP Classify by Behavior Variable Fixed Absorption vs. Variable Costing © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33. Absorption vs. Variable Costing Absorption or Full • Product costs • Direct material • Direct labor • Variable mfg. overhead • Fixed mfg. overhead • Period costs • Selling • General • Administrative Variable or Direct • Product costs • Direct material • Direct labor • Variable mfg. overhead • Period costs • Fixed mfg. overhead • Selling • General • Administrative © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34. Absorption Costing Fixed manufacturing overhead is a product cost Variable Costing Fixed manufacturing overhead is a period cost Variable operating expenses are subtracted from product contribution margin to equal contribution margin Differences Between Absorption and Variable Costing © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35. 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

37. Difference in Income Absorption vs. Variable • No change in inventory level • Absorption Income = Variable Income • Increase in inventory level • Absorption Income > Variable Income • Phantom Profits • Decrease in inventory level • Absorption Income < Variable Income © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

38. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

39. Questions • 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? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

40. Potential Ethical Issues • 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 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.