© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption/ Variable Costing Cost Accounting Principles, 9e Raiborn ● Kinney

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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 is the high-low method 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? (Appendix) How is least squares regression used in analyzing mixed costs?

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Predetermined Overhead Rate 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Applying Overhead to Production Applied overhead is the dollar amount of overhead assigned to WIP Inventory using the activity measure that was selected to develop the OH rate. Applied overhead is calculated as the predetermined OH rate multiplied by the actual activity volume.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Disposing of Overhead Differences Underapplied overhead occurs when the OH applied to WIP Inventory is less than the actual OH cost. If overhead is underapplied, the adjusting entry  increases Cost of Goods Sold  decreases Net Income Overapplied overhead occurs when the OH applied to WIP Inventory is more than actual OH cost. If overhead is overapplied, the adjusting entry  decreases Cost of Goods Sold  increases Net Income

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Theoretical capacity  All production factors are operating perfectly  Disregards Machinery breakdown Holiday downtime  Results in Significant underapplied overhead Lowest product cost Alternative Capacity Levels: Theoretical Capacity

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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: Practical Capacity

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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: Normal Capacity

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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: Expected Capacity

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Mixed Cost Analyzing Mixed Costs $ Units fixed variable A mixed cost contains both a variable and fixed component

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Separating Mixed Costs y = a + bX y = total cost a = fixed portion of total cost b = variable cost X = activity base to which y is related Use formula for a straight line

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Separating Mixed Costs Two Methods  High-Low Method  Change in total cost divided by change in activity level equals the unit variable cost per measure of activity  Considers only two data points of activity (highest and lowest)  Disregard outliers when analyzing mixed cost  Least Squares Regression Analysis  Statistical technique that is used to develop an equation that predicts an unknown value of a dependent variable (cost) from the known values of one or more independent variables (activities that create costs). (Appendix)

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Plantwide Overhead Rate  Homogeneous activities throughout plant Departmental Overhead Rate  Different types of work effort in departments  Diverse material requiring different times in departments  Usually provides better information for planning, control, and decision making Plantwide vs. Departmental Predetermined Overhead Rates

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. Differences Absorption costing Fixed manufacturing overhead is a product cost Also known as full costing Variable costing Fixed manufacturing overhead is a period cost Variable operating expenses are subtracted from product contribution margin to equal contribution margin Also known as direct costing

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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?

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part. 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