Chapter 3

Predetermined Overhead Rates, Flexible Budgets, and

Absorption/Variable Costing

Cost AccountingFoundations and Evolutions

Kinney, Prather, Raiborn

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 OverheadActual vs. Normal

Product Cost

Direct Materials

Direct Labor

Overhead

Actual Cost System

Actual

Actual

Actual

Normal Cost System

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)

=

PredeterminedOverhead

Rate

$100,0005,000

DL Hours

= $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)

$375,000

50,000machine hours

= $7.50 per machine

hour

Total budgeted fixed overheadActivity level

(Volume)

$630,000

50,000machine hours

= $12.60 per machine

hour

Applying Variable Overhead

Actual activity level times

Predetermined overhead rate

equalsoverhead applied

4,300 actual machines hours times

$7.50 Predetermined variable overhead rate

equals$32,250 overhead applied

Apply Variable OverheadWork in Process Inventory 32,250 Variable Manufacturing Overhead 32,250

For one month

Applying Fixed Overhead

Actual activity level times

Predetermined overhead rate

equalsoverhead applied

4,300 actual machines hours times

$12.60 Predetermined fixed overhead rate

equals$54,180 overhead applied

Apply Fixed OverheadWork in Process Inventory 54,180 Fixed Manufacturing Overhead 54,180

For one month

Overhead Account(Combined Fixed/Variable)

Actual Overhead Applied Overhead

Variable 32,250

Fixed 54,180

Recording and Applying Overhead

Apply Overhead (combined journal entry)Work in Process Inventory 86,430 Variable Manufacturing Overhead 32,250 Fixed Manufacturing Overhead 54,180

For one month

Overhead Account(Combined/Fixed/Variable)

Actual Overhead Applied OverheadVariable 31,385

Fixed 55,970

Recording Actual Overhead

Variable 32,250

Fixed 54,180

Record actual overheadVariable Manufacturing Overhead 31,385Fixed Manufacturing Overhead 55,970 Various accounts 87,355

For one month

Overhead Account(Combined Fixed/Variable)

Actual Overhead Applied Overhead

Fixed 220,000 Fixed 260,000

Manufacturing Overhead

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

For the entire year

Disposing of Overhead Differences

If overhead is underappliedCost of Goods Sold increases

Income decreases

If overhead is overappliedCost 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

• 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(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

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

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

Alternative Capacity Levels(The Denominator Level)

Mixed Cost

Analyzing Mixed Costs

$

Unitsfixed

variable

A mixed cost contains both

a variable and fixed component

Mixed Costs

To determine

variable and fixed

predetermined overhead rates,

separate mixed costs into

variable and fixed components

Separating Mixed Costs

y = a + bX

y = total costa = fixed portion of total costb = variable costX = activity base to which y is related

Use formula for a straight line

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 CostsDirect MaterialDirect Labor

Fixed and Variable Mfg. Overhead

Period CostsSelling, 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 MaterialDirect Labor

Variable Mfg. Overhead

Selling, General,

Administration

Selling General

Administrative

Questions

• How does underapplied overhead affect cost of goods sold and net income?

• What is the difference between absorption and variable costing?