1. Foundations and Evolutions
Cost Accounting
Foundations and Evolutions
Kinney and Raiborn
Seventh Edition
Chapter 3
Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing
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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
Describe two methods of analyzing mixed costs – high-low method and least squares regression analysis

4. Learning Objectives (3 of 3)
Explain how managers use flexible budgets to set predetermined overhead rates
Contrast absorption and variable costing
Describe how changes in sales or production levels affect net income under absorption and variable costing

5. 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

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

7. 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

8. 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

9. 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

10. Alternative Capacity Levels (The Denominator 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

11. Alternative Capacity Levels (The Denominator 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

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

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

14. 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

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

16. 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

17. 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

18. Plantwide vs. Departmental Predetermined Overhead Rates
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

19. Differences 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

20. 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

21. 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?

22. 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

23. Potential Ethical Issues
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