2. Absorption Costing and Variable Costing
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Absorption Costing and Variable Costing
Chapter 5: Variable Costing: A Tool for Management.
Two general approaches are used for valuing inventories and cost of goods sold. One approach, called absorption costing, is generally used for external reporting purposes. The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format. This chapter shows how these two methods differ from each other.
Chapter 5

3. 7-2
Learning Objective 1
Explain how variable costing differs from absorption costing and compute unit product costs under each method.
Learning objective number 1 is to explain how variable costing differs from absorption costing and compute unit product costs under each method.

4. Overview of Absorption and Variable Costing
Absorption costing (also called the full cost method) treats all costs of production as product costs, regardless of whether they are variable or fixed. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for CVP computations. Under absorption costing, the cost of a unit of product consists of direct materials, direct labor, and both variable and fixed overhead. Variable and fixed selling and administrative expenses are treated as period costs and are deducted from revenue as incurred.
Variable costing (also called direct costing or marginal costing) treats only those costs of production that vary with output as product costs. This approach dovetails with the contribution approach income statement and supports CVP analysis because of its emphasis on separating variable and fixed costs. The cost of a unit of product consists of direct materials, direct labor, and variable overhead. Fixed manufacturing overhead, and both variable and fixed selling and administrative expenses are treated as period costs and deducted from revenue as incurred.
Think about the impact of each method on inventory values, and then answer the following question.

5. 7-4
Quick Check 
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
To answer this question correctly, recall which method includes more manufacturing costs in the unit product cost.

6. 7-5
Quick Check 
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
Unit product costs are in both work in process and finished goods inventories. Absorption costing results in the highest inventory values because it treats fixed manufacturing overhead as a product cost. Using variable costing, fixed manufacturing overhead is expensed as incurred and never becomes a part of the product cost.

7. Unit Cost Computations
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Unit Cost Computations
Harvey Company produces a single product with the following information available:
Harvey Company produces 25,000 units of a single product. Variable manufacturing costs total $10 per unit. Variable selling and administrative expenses are $3 per unit. Fixed manufacturing overhead for the year is $150,000 and fixed selling and administrative expenses for the year are $100,000.

8. Unit Cost Computations
7-7
Unit Cost Computations
Unit product cost is determined as follows:
The unit product costs under absorption and variable costing would be $16 and $10, respectively. Under absorption costing, all production costs, variable and fixed, are included when determining unit product cost. Under variable costing, only the variable production costs are included in product costs.
Under absorption costing, all production costs, variable and fixed, are included when determining unit product cost. Under variable costing, only the variable production costs are included in product costs.

9. Prepare income statements using both variable and absorption costing.
7-8
Learning Objective 2
Prepare income statements using both variable and absorption costing.
Learning objective number 2 is to prepare income statements using both variable and absorption costing.

10. Income Comparison of Absorption and Variable Costing
7-9
Income Comparison of Absorption and Variable Costing
Let’s assume the following additional information for Harvey Company.
20,000 units were sold during the year at a price of $30 each.
There is no beginning inventory.
Now, let’s compute net operating income using both absorption and variable costing.
We need some additional information to allow us to prepare income statements for Harvey Company:
20,000 units were sold during the year.
The selling price per unit is $30.
There is no beginning inventory.
Now let’s prepare income statements for Harvey Company. We will start with an absorption income statement.

11. 7-10
Absorption Costing
Part I.
Harvey sold only 20,000 of the 25,000 units produced, leaving 5,000 units in ending inventory. At a sales price of $30 per unit, sales revenue for the 20,000 units sold is $600,000. At a unit product cost of $16, cost of goods sold for the 20,000 units sold is $320,000. Subtracting cost of goods sold from sales, we find the gross margin of $280,000. After subtracting selling and administrative expenses from the gross margin, we see that net operating income is $120,000.
Part II.
Fixed manufacturing overhead deferred in inventory, as a result of the 5,000 unsold units at $6 of fixed overhead per unit, is $30,000.
Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000.

12. Variable Costing Variable manufacturing costs only.
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Variable Costing
Variable manufacturing costs only.
All fixed manufacturing overhead is expensed.
Now let’s examine a variable cost income statement. Notice that this is a contribution format statement. First, we subtract all variable expenses from sales to get contribution margin. At a product cost of $10 per unit, the variable cost of goods sold for 20,000 units is $200,000. The next variable expense is the variable selling and administrative expense. After computing contribution margin, we subtract fixed expenses to get the $90,000 net operating income. Note that all $150,000 of fixed manufacturing overhead is expensed in the current period.

13. 7-12
Learning Objective 3
Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.
Learning objective number 3 is to reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.

14. Comparing the Two Methods
7-13
Comparing the Two Methods
Under absorption costing, $120,000 of fixed manufacturing overhead is included in cost of goods sold and $30,000 is deferred in ending inventory as an asset on the balance sheet. Under variable costing, the entire $150,000 of fixed manufacturing overhead is treated as a period expense.
The variable costing ending inventory is $30,000 less than absorption costing, thus explaining the difference in net operating income between the two methods.

15. Comparing the Two Methods
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Comparing the Two Methods
We can reconcile the difference between absorption and variable income as follows:
The difference in net operating income between the two methods ($30,000) can also be reconciled by multiplying the number of units in ending inventory (5,000 units) by the fixed manufacturing overhead per unit ($6) that is deferred in ending inventory under absorption costing.
Fixed mfg. overhead $150,000
Units produced ,000 units
= = $6 per unit

16. Extended Comparisons of Income Data Harvey Company – Year Two
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Extended Comparisons of Income Data Harvey Company – Year Two
In the second year, Harvey Company sells 30,000 units. The selling price per unit, variable costs per unit, total fixed costs, and number of units produced remain unchanged. Five thousand units are in beginning inventory, left from last year.

17. Unit Cost Computations
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Unit Cost Computations
Since the variable costs per unit, total fixed costs, and the number of units produced remained unchanged, the unit cost computations also remain unchanged.
Since the variable costs per unit, total fixed costs, and the number of units produced remained unchanged, the unit cost computations also remain unchanged.

18. 7-17
Absorption Costing
Unit product cost.
Part I.
Of the 30,000 units sold in the second year, 25,000 units were produced in the second year and 5,000 units came from beginning inventory. The $30,000 of fixed manufacturing overhead deferred into inventory in the first year is released from inventory this year as part of the $16 unit product cost. Selling and administrative expenses are deducted from gross margin to obtain the net operating income of $230,000.
Part II.
Fixed manufacturing overhead is released from inventory as a result of the 5,000 units sold in the second year that were produced in the first year. The amount released is $30,000 (5,000 units at $6 of fixed overhead per unit).
Fixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000.

19. Variable Costing All fixed manufacturing overhead is expensed.
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Variable Costing
Variable manufacturing costs only.
All fixed manufacturing overhead is expensed.
Now, let’s examine a variable cost income statement for the second year. Again, notice that this is a contribution format statement. At a product cost of $10 per unit, the variable cost of goods sold for 30,000 units is $300,000.
After computing contribution margin, we subtract fixed expenses to get the $260,000 net operating income. Note that all $150,000 of fixed manufacturing overhead is expensed in the current period.

20. Comparing the Two Methods
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Comparing the Two Methods
We can reconcile the difference between absorption and variable income as follows:
The difference in net operating income between the two methods ($30,000) can be reconciled by multiplying the number of units in beginning inventory (5,000 units) by the fixed manufacturing overhead per unit ($6) that is released from beginning inventory under absorption costing.
Fixed mfg. overhead $150,000
Units produced ,000 units
= = $6 per unit

21. Comparing the Two Methods
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Comparing the Two Methods
Across the two-year time frame, both methods reported the same total net operating income ($350,000). This is because over an extended period of time sales cannot exceed production, nor can production much exceed sales. The shorter the time period, the more the net operating income figures will tend to differ.

22. Summary of Key Insights
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Summary of Key Insights
On your screen is a summary of what we have observed from the Harvey Company’s two years:
When units produced equal units sold, the two methods report the same net operating income.
When units produced are greater units sold, as in year 1 for Harvey, absorption income is greater than variable costing income. 
When units produced are less than units sold, as in year 2 for Harvey, absorption costing income is less than variable costing income. 

23. 7-22
Learning Objective 4
Understand the advantages and disadvantages of both variable and absorption costing.
Learning objective number 4 is to understand the advantages and disadvantages of both variable and absorption costing.

24. 7-23
Impact on the Manager
Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between periods can lead to faulty decisions.
These opponents argue that variable costing income statements are easier to understand because net operating income is only affected by changes in unit sales. This produces net operating income figures that are consistent with managers’ expectations.
Part I.
Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between periods can lead to faulty decisions.
Part II.
These opponents argue that variable costing income statements are easier to understand because net operating income is only affected by changes in unit sales. This produces net operating income figures that are consistent with managers’ expectations.

25. CVP Analysis, Decision Making and Absorption costing
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CVP Analysis, Decision Making and Absorption costing
Absorption costing does not dovetail with CVP analysis, nor does it support decision making. It treats fixed manufacturing overhead as a variable cost. It assigns per unit fixed manufacturing overhead costs to production.
Treating fixed manufacturing overhead as a variable cost can:
Lead to faulty pricing decisions and faulty keep-or-drop decisions.
Absorption costing does not dovetail with CVP analysis, nor does it support decision making. It treats fixed manufacturing overhead as a variable cost. This can lead to faulty pricing decisions and faulty keep-or-drop decisions. It also assigns per unit fixed manufacturing overhead costs to production. This can potentially produce positive net operating income even when the number of units sold is less than the breakeven point.
Assigning per unit fixed manufacturing overhead costs to production can:
Potentially produce positive net operating income even when the number of units sold is less than the breakeven point.

26. External Reporting and Income Taxes
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External Reporting and Income Taxes
To conform to IFRS and US GAAP
requirements, absorption costing
must be used for external financial reports.
In many countries,
including US, absorption costing must be used when filling out income tax returns.
Since top executives are typically evaluated based on earnings reported to shareholders in external reports, they may feel that
decisions should be based on absorption costing data.
Practically speaking, absorption costing is required for external reports in the United States and countries following IFRS. In many countries, including US, a form of absorption costing must be used when filling out income tax forms. Since top executives are typically evaluated based on earnings reported to shareholders in external reports, they may feel that decisions should be based on absorption costing data.

27. Advantages of Variable Costing and the Contribution Approach
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Advantages of Variable Costing and the Contribution Approach
Consistent with
CVP analysis.
Management finds it more useful.
Net operating income
is closer to net cash flow.
Consistent with standard costs and flexible budgeting.
Advantages
Easier to estimate profitability of products and segments.
The advantages of variable costing and the contribution approach include:
The data required for CVP analysis can be taken directly from a contribution format income statement.
Profits move in the same direction as sales, assuming other things remain the same.
Managers often assume that unit product costs are variable costs. Under variable costing, this assumption is true.
Fixed costs appear explicitly on a contribution format income statement; thus, the impact of fixed costs on profits is emphasized.
Variable costing data make it easier to estimate the profitability of products, customers, and other business segments.
Variable costing ties in with cost control methods, such as standard costs and flexible budgeting.
Variable costing net operating income is closer to net cash flow than absorption costing net operating income.
Profit is not affected by changes in inventories.
Impact of fixed
costs on profits
emphasized.

28. Variable versus Absorption Costing
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Variable versus Absorption Costing
Fixed manufacturing costs must be assigned to products to properly match revenues and costs.
Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced.
With all of these advantages, why is absorption costing still so prevalent? One reason (in addition to the external reporting issue) relates to the matching principle.
Advocates of absorption costing argue that it better matches costs with revenues. They contend that fixed manufacturing costs are just as essential to manufacturing products as are the variable costs. However, advocates of variable costing view fixed manufacturing costs as capacity costs. They argue that fixed manufacturing costs would be incurred even if no units were produced.
Absorption Costing
Variable Costing

29. Variable Costing and the Theory of Constraints (TOC)
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Variable Costing and the Theory of Constraints (TOC)
Companies involved in TOC use a form of variable costing. However, one difference of the TOC approach is that it treats direct labor as a fixed cost for three reasons:
Many companies have a commitment to guarantee workers a minimum number of paid hours.
Direct labor is usually not the constraint.
TOC emphasizes the role direct laborers play in driving continuous improvement. Since layoffs often devastate morale, managers involved in TOC are extremely reluctant to lay off employees.
Companies involved in TOC use a form of variable costing. However, one difference of the TOC approach is that it treats direct labor as a fixed cost for three reasons:
 Although direct laborers are paid an hourly wage, many companies have a commitment — sometimes enforced by labor contracts or by the law — to guarantee workers a minimum number of paid hours.
 Direct labor is usually not the constraint; therefore, there is no reason to increase the number of direct laborers.
 TOC emphasizes the role direct laborers play in driving continuous improvement. Since layoffs often devastate morale, managers involved in TOC are extremely reluctant to lay off employees.

30. Impact of Lean Production
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Impact of Lean Production
When companies use Lean Production . . .
Production tends to equal sales . . .
When companies use Lean Production, the goal is to eliminate finished goods inventories and reduce work in process inventory to almost nothing. This causes absorption costing net operating income to essentially move in the same direction as sales. Therefore, the difference between absorption costing and variable costing income tends to disappear.
So, the difference between variable and
absorption income tends to disappear.

31. 7-30
Learning Objective 5
Compute predetermined overhead rates and explain why estimated overhead costs (rather than actual overhead costs) are being used in the costing process.
Learning objective number 5 is to compute predetermined overhead rates and explain why estimated overhead costs (rather than actual overhead costs) are being used in the costing process.

32. Why Use an Allocation Base?
Manufacturing overhead is applied to products/jobs that are in process. An allocation base, such as direct labor hours, direct labor dollars, or machine hours, is used to assign manufacturing overhead to individual products/jobs.
We use an allocation base because:
It is impossible or difficult to trace overhead costs to particular products/jobs.
Manufacturing overhead consists of many different items ranging from the grease used in machines to production manager’s salary.
Many types of manufacturing overhead costs are fixed even though output fluctuates during the period.
Part I
Manufacturing overhead is applied to all products/jobs that are in process. We apply overhead using a base we believe causes overhead costs to be incurred. Some companies allocate manufacturing overhead using direct labor hours or machine hours.
Part II
We must allocate overhead costs to products/jobs for a variety of reasons. First, it is difficult, if not impossible, to actually trace overhead costs to a particular product/job. The cost of grease for machinery to manufacture our product is part of our manufacturing costs. It would be impossible to accurately trace the amount of grease consumed to manufacture one unit of output.
Manufacturing overhead also includes a number of different costs and it would be very difficult to gather all of them together in time to charge them to a particular product/job. A product/job may be complete and sold before we can determine the actual overhead costs incurred. Finally, many types of overhead are fixed in nature even though output fluctuates during the period.

33. Manufacturing Overhead Application
The predetermined overhead rate (POHR) used to apply overhead to products/jobs is determined before the period begins.
Estimated total manufacturing overhead cost for the coming period
Estimated total units in the allocation base for the coming period
POHR =
Part I
To facilitate the allocation of manufacturing overhead to each product/job, we calculate a predetermined overhead rate before the period begins. The rate is calculated by dividing the total estimated manufacturing overhead for the coming period by the estimated total units of the allocation base. If our allocation base is machine hours, we would estimate the total number of machine hours used in production in the coming period.
Part II
Ideally, the allocation base should be a cost driver, that is, it causes overhead to be incurred.
Ideally, the allocation base is a cost driver that causes overhead.

34. The Need for a POHR
Using a predetermined rate makes it possible to estimate total product/job costs sooner.
Actual overhead for the period is not known until the end of the period.
Predetermined overhead rates that rely upon estimated data are often used because: (1) actual overhead costs for the period are not known until the end of the period, thus inhibiting the ability to estimate product/job costs during the period; and (2) actual overhead costs can fluctuate seasonally, thus misleading decision makers.

35. Determining Predetermined Overhead Rates
Predetermined overhead rates are calculated using a three-step process. 
Estimate the level of production for the period.
 Estimate total amount of the allocation base for the period.
 Estimate total manufacturing overhead costs.
The predetermined overhead rate is calculated using a three-step process:
We must estimate the level of production for the period,
Next, we estimate the total amount of the allocation base in the denominator that would be required for that level of production.
Finally, we estimate the total manufacturing overhead cost in the numerator that would be incurred for the estimated amount of the allocation base.
So, the predetermined overhead rate is calculated by dividing step 2 by step 3.
POHR =  ÷ 

36. Application of Manufacturing Overhead
Based on estimates, and determined before the period begins.
Overhead applied = POHR × Actual activity
Under the normal costing system, we calculate the predetermined overhead rate before the period begins.
As we work on a particular product/job, we apply overhead by multiplying the predetermined rate times the actual level of activity
(i.e. Overhead Applied = POHR x Actual Activity).
If overhead is applied on the basis of machine hours, we would apply overhead by multiplying the predetermined rate by the actual number of machine hours used on a particular product/job.
Actual amount of allocation is based upon the actual level of activity (normal costing system).

37. Overhead Application Rate for the Harvey Example
Estimated total manufacturing overhead cost for the coming period
Estimated total units in the allocation base for the coming period
POHR =
$150,000
50,000 direct labor hours (DLH)
POHR =
POHR = $3.00 per DLH
For each direct labor hour worked on a particular product, $3.00 of factory overhead will be applied to it. For product valuation, it must be valued by unit. In this case, assume each unit requires 2 direct labor hours. Hence, each unit of the product absorbs $6 predetermined overhead. In order to match back with Harvey’s example, we further assume that variable manufacturing overhead = 0. So the predetermined overhead represents only fixed manufacturing overhead cost as shown in slides 14 & 19.
Part I
Recall the equation for calculating the predetermined manufacturing overhead rate. In the Harvey example (Slide 14), overhead can be allocated on the basis of direct labor hours worked on a particular product. Harvey’s predetermined overhead rate is $3 per direct labor hour. Assume it takes 2 direct labor hours to complete a unit of product, it applies $6 ($3 x 2) manufacturing overhead costs to each unit of the product. Part II
At Harvey, each product will be charged $6 of overhead for each hour of direct labor worked. In order to match the earlier figures in Harvey, we further assume that variable manufacturing overhead cost = 0 so that the POHR represents only fixed manufacturing overhead rate, matching information on the earlier slides (see slides 14 and 19).

38. 7-37
Learning Objective 6
Understand the implications of basing the predetermined overhead rate on activity at capacity rather than on estimated activity for the period.
Learning objective number 6 is to understand the advantages and disadvantages of both variable and absorption costing.

39. Predetermined Overhead Rate and Capacity
Calculating predetermined overhead rates using an estimated, or budgeted amount of the allocation base has been criticized because:
Basing the predetermined overhead rate upon budgeted activity results in product costs that fluctuate depending upon the activity level.
Calculating predetermined rates based upon budgeted activity charges products for costs that they do not use.
There are two major criticisms of calculating the predetermined overhead rate based on estimated amounts. The first is that the predetermined rate creates problems when actual levels of activity are different from estimated, or budgeted, amounts. The second is that in some cases basing the predetermined overhead rate on estimated amounts charges products for costs that they do not use.

40. Capacity-Based Overhead Rates
Criticisms can be overcome by using estimated total units in the allocation base at capacity in the denominator of the predetermined overhead rate calculation.
Let’s look at the difference!
We can minimize the criticisms by basing estimated total units in the allocation base at capacity levels of activity (rather than the estimated total units).

41. An Example
Equipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year. What is the predetermined overhead rate?
Here is a simple example where a company leases a piece of equipment for $100,000 per year. Full capacity at the company is 50,000 units of output. Management estimates that 40,000 units will be produced and sold in the coming year. Let’s calculate the predetermined overhead rate.

42. An Example
Equipment is leased for $100,000 per year. Running at full capacity, 50,000 units may be produced. The company estimates that 40,000 units will be produced and sold next year.
Traditional Method
= $2.50 per unit
$100,000
40,000 =
Part I
Under the traditional method we have used in this chapter, the predetermined overhead rate will be $2.50. We divide the total cost of $100,000 by the estimated level of activity, 40,000 units.
Part II
Under the capacity approach, the predetermined overhead rate is $2.00 per unit. We divide the total cost of $100,000 by production at capacity, 50,000 units.
Capacity Method
= $2.00 per unit
$100,000
50,000 =

43. Quick Check 
Barossa Winery in Barossa Valley, South Australia, leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the estimated number of cases of wine?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
Based on the information given, what is the predetermined overhead rate using the traditional method?

44. Quick Check 
Barossa Winery in Barossa Valley, South Australia, leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the estimated number of cases of wine?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
The correct answer is $2.50 per case. How did you do?

45. Quick Check 
Barossa Winery in Barossa Valley, South Australia, leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the number of cases of wine at capacity?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
Now calculate the predetermined overhead rate using the capacity approach.

46. Quick Check 
Barossa Winery in Barossa Valley, South Australia, leases an automatic corking machine for $100,000 per year. At full capacity, it can cork 50,000 cases of wine per year. The company estimates 40,000 cases of wine will be produced and sold next year. What is the predetermined overhead rate based on the number of cases of wine at capacity?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
Did you get the correct answer of $2.00 per case?

47. Quick Check 
When capacity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases?
a. The predetermined overhead rate goes up when activity goes down.
b. The predetermined overhead rate stays the same because it is not affected by changes in activity.
c. The predetermined overhead rate goes down when activity goes down.
Recall your answers to the previous questions and answer this question about changes in the predetermined overhead rate.

48. Quick Check 
When capacity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases?
a. The predetermined overhead rate goes up when activity goes down.
b. The predetermined overhead rate stays the same because it is not affected by changes in activity.
c. The predetermined overhead rate goes down when activity goes down.
The predetermined overhead rate stays the same because it is not affected by changes in the level of activity.

49. Quick Check 
When estimated activity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases?
a. The predetermined overhead rate goes up when activity goes down.
b. The predetermined overhead rate stays the same because it is not affected by changes in activity.
c. The predetermined overhead rate goes down when activity goes down.
Now, take that same information and answer this question assuming the traditional approach is used by the company.

50. Quick Check 
When estimated activity is used in the denominator of the predetermined rate, what happens to the predetermined overhead rate as estimated activity decreases?
a. The predetermined overhead rate goes up when activity goes down.
b. The predetermined overhead rate stays the same because it is not affected by changes in activity.
c. The predetermined overhead rate goes down when activity goes down.
Now we know that the predetermined overhead rate goes up when activity goes down.

51. Income Statement Preparation – Capacity
Critics suggest that the underapplied overhead that results from idle capacity should be disclosed on the income statement as the cost of unused capacity  a period expense.
Look carefully at the income statement on this slide prepared using the capacity approach to calculate the predetermined overhead rate. Notice the disclosure of the $20,000 cost of idle capacity that is recorded as a period expense. This cost is incurred because we were not able to fully utilize our capacity. Using a measure of capacity in the denominator of the predetermined overhead rate enables this type of disclosure.

52. Income Statement Preparation – Traditional
Here is the income statement using the traditional approach. Notice that cost of goods sold is charged with the cost of idle capacity. Using the estimated or budgeted amount of the allocation base in the denominator of the predetermined overhead rate calculation does not allow for disclosure of the idle capacity. In this example, underapplied overhead is not treated as a period expense, but instead, it is allocated to the work in process, finished goods, and/or cost of goods sold.

53. Learning Objective 7
Compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in Manufacturing Overhead to the appropriate accounts.
Learning objective number 7 is to compute underapplied or overapplied overhead cost and prepare the journal entry to close the balance in Manufacturing Overhead to the appropriate accounts.

54. Problems of Overhead Application
The difference between the overhead cost applied to Work in Process and the actual overhead costs of a period is referred to as either underapplied or overapplied overhead.
Underapplied overhead exists when the amount of overhead applied to products/ jobs during the period using the predetermined overhead rate is less than the total amount of overhead actually incurred during the period.
Overapplied overhead exists when the amount of overhead applied to products/jobs during the period using the predetermined overhead rate is greater than the total amount of overhead actually incurred during the period.
When we apply overhead on the basis of a predetermined overhead rate, it’s likely that the amount of overhead applied will be different from the amount of overhead actually incurred during the period. When there is a difference, we refer to the amount as either underapplied overhead or overapplied overhead.
Underapplied overhead exists when the amount of overhead applied to products/jobs during the period using the predetermined overhead rate is less than the total amount of overhead actually incurred during the period.
Overapplied overhead exists when the amount of overhead applied to products/jobs during the period using the predetermined overhead rate is greater than the total amount of overhead actually incurred during the period.

55. Overhead Application Example
Recall the Harvey example between slides 9 and 36. Let’s rename the example as Harvey Fresh and assume actual overhead for the year was $120,000 (instead of $150,000 in the original Harvey example). The total direct labor hours incurred were 50,000. The rest remains the same.
How much total overhead was applied to Harvey Fresh’s products during the year? Use Harvey’s predetermined overhead rate of $3.00 per direct labor hour.
Part I
Recall the Harvey example between slides 9 and 36 and rename the example as Harvey Fresh. Assume Harvey Fresh incurred actual overhead of $120,000 during the period and worked a total of 50,000 direct labor hours. Harvey Fresh applies overhead at the rate of $3 per direct labor hour worked (equivalent to $6 per unit). How much overhead did Harvey Fresh apply to products during the period? Part II
Harvey Fresh would have applied $150,000 of overhead during the period. That is $3 per direct labor hour times the 50,000 direct labor hours actually worked (equivalent to $6 per unit for the 25,000 units produced). Can you see our problem?
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $3.00 per DLH × 50,000 DLH = $150,000

56. Overhead Application Example
Harvey Fresh’s actual overhead for the year was $120,000 with a total of 50,000 direct labor hours worked on products.
How much total overhead was applied to Harvey Fresh’s products during the year? Use Harvey’s predetermined overhead rate of $4.00 per direct labor hour.
Harvey Fresh has overapplied overhead for the year by $30,000. What will Harvey Fresh do?
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $3.00 per DLH × 50,000 DLH = $150,000
The difference between the overhead cost applied to Work in Process and the actual overhead costs of a period is termed either underapplied or overapplied overhead. Harvey Fresh incurred actual overhead of $120,000 and applied $150,000, so the company overapplied $30,000 of overhead for the year. How do we dispose of this overapplied overhead?

57. Quick Check 
Tiger, Ltd. had actual manufacturing overhead costs of $1,210,000 and a predetermined overhead rate of $4.00 per machine hour. Tiger, Ltd. worked 290,000 machine hours during the period. Tiger’s manufacturing overhead is
a. $50,000 overapplied. b. $50,000 underapplied. c. $60,000 overapplied. d. $60,000 underapplied.
In this question, you are asked to calculate the overapplied or underapplied overhead. Be careful with your intermediate computations.

58. Quick Check 
Tiger, Ltd. had actual manufacturing overhead costs of $1,210,000 and a predetermined overhead rate of $4.00 per machine hour. Tiger, Ltd. worked 290,000 machine hours during the period. Tiger’s manufacturing overhead is
a. $50,000 overapplied. b. $50,000 underapplied. c. $60,000 overapplied. d. $60,000 underapplied.
Overhead Applied $4.00 per hour × 290,000 hours = $1,160,000
Underapplied Overhead $1,210,000 - $1,160, = $50,000
The correct answer is $50,000 underapplied overhead. Tiger incurred $1,210,000 of actual overhead but applied only $1,160,000, thus the company underapplied its overhead costs during the period.

59. Disposition of Under- or Overapplied Overhead
$30,000 may be closed directly to cost of goods sold.
Cost of Goods Sold
Harvey Fresh’s Method
Work in Process
Finished Goods
Cost of Goods Sold
$30,000 may be allocated to these accounts. OR
There are two ways to dispose of over- or underapplied overhead. The more complex approach is to allocate a portion of the over- or underapplied overhead to work in process inventory, finished goods inventory, and cost of goods sold. The allocation would be based on the relative dollar value in each of the three accounts involved.
An easier way to deal with the problem, and the method Harvey Fresh uses, is to adjust cost of goods sold for the entire amount of the over- or underapplied overhead.

60. Disposition of Under/Overapplied Overhead
Harvey Fresh’s Cost of Goods Sold
Harvey Fresh ’s Mfg. Overhead
Unadjusted Balance
Actual overhead costs
$120,000
Overhead applied to products
$150,000
$30,000
Part I
We know that Harvey Fresh applied $150,000 of overhead but incurred only $120,000 of actual overhead. The manufacturing overhead account has a $30,000 credit balance, representing the overapplied overhead during the year.
Part II
Harvey Fresh chooses to adjust cost of goods sold for the entire amount. The adjustment necessary at the end of the year is to debit the manufacturing overhead account for $30,000, and credit, or reduce, cost of goods sold by the same amount.
Adjusted Balance
$30,000 overapplied

61. Under/Overapplied Adjustment Through COGS
If Harvey Fresh’s overapplied adjustment is directly through COGS, then its profit will be as follows:
If the under/overapplied overhead is adjusted through COGS directly, then it will appear under COGM to make the fixed manufacturing overhead tally the actual expense. In this case, $30,000 was deducted from COGM to reduce $150,000 applied overhead to the actual expense of $120,000.

62. Allocating Under- or Overapplied Overhead Between Accounts
In Year 1, Harvey Fresh ’s overhead applied in ending Work in Process Inventory, ending Finished Goods Inventory, and Cost of Goods Sold is shown below:
Let’s assume that at the end of the period Harvey Fresh applied $150,000 overhead costs in each of the following accounts:
Work in Process
Finished Goods $ 30,000
Cost of Goods Sold $120,000
We may elect to allocate the over- or underapplied overhead to ending Work in Process Inventory, ending Finished Goods Inventory, and Cost of Goods Sold.

63. Allocating Under- or Overapplied Overhead Between Accounts
We would complete the following allocation of $30,000 overapplied overhead:
We will allocate the $30,000 of overapplied overhead proportionally, resulting the reduction of ending Work in Process Inventory by $0, Finished Goods Inventory by $6,000, and Cost of Goods Sold for the period by $24,000.
20% × $30,000

64. Allocating Under- or Overapplied Overhead Between Accounts
The journal entry to record the allocation is to debit Manufacturing Overhead for $30,000, credit Work in Process Inventory for $0, credit Finished Goods Inventory for $6,000, and credit Cost of Goods Sold for $24,000.

65. Under/Overapplied Adjustment Through the Proportional Allocation Method
Net result of $24,000 adjusted against COGS
The under/overapplied overhead can also be adjusted through the proportional allocation method. On the surface of the income statement, adjustment can be shown under ending work in process and finished goods inventories. Total overapplied adjustment, in this case, $30,000 will be shown under COGM (instead of the expected $24,000) because we need the $30,000 to deduct the amount carried under ending inventories to get the net result of $24,000 remaining in COGS. In this case, the $30,000 overapplied adjustment minuses $6,000 overapplied to ending finished goods giving rise the expected $24,000 adjustment for COGS.
Using the proportional method normally will generate a different profit figure from the direct written off from COGS. In this Harvey Fresh example, the difference of $6,000 is not significant ($150,000 vs $144,000).
Net Operating Income is different from the one with adjustment directly through COGS ($150,000)

66. Quick Check 
Revisit the earlier Tiger, Ltd. exercise on slide 56. Before any manufacturing fixed overhead over/underapplied adjustment, the relevant figures are as follows:
Work in process 20,000
Finished goods 30,000
Cost of goods sold 50,000
How much should Tiger’s over/underapplied manufacturing fixed overhead be adjusted to Finished Goods (FG) if the proportional allocation method is used?
a. $15,000 more (i.e. debit) to FG. b. $15,000 less (i.e. credit) to FG. c. $30,000 more (i.e. debit) to FG. d. $30,000 less (i.e. credit) to FG.
In this question, you are asked to allocate the overapplied or underapplied overhead. Be careful with your intermediate computations and the debit and credit entries.

67. Quick Check 
Revisit the earlier Tiger, Ltd. exercise on slide 56. Before any manufacturing fixed overhead over/underapplied adjustment, the relevant figures are as follows:
Work in process 20,000
Finished goods 30,000
Cost of goods sold 50,000
How much shouldTiger’s over/underapplied manufacturing fixed overhead be adjusted to Finished Goods (FG) if the proportional allocation method is used?
a. $15,000 more (i.e. debit) to FG. b. $15,000 less (i.e. credit) to FG. c. $30,000 more (i.e. debit) to FG. d. $30,000 less (i.e. credit) to FG.
In this question, you are asked to allocate the overapplied or underapplied overhead. Be careful with your intermediate computations and the debit and credit entries. Applied overhead is not the actual manufacturing overhead expenses. Its entry is on the credit side of the manufacturing overhead account while the actual manufacturing overhead expenses, same as other expenses, is a debit entry. Therefore, adjustment on the underapplied is a credit entry to increase the application required which will increase the expenses on cost goods sold and increase the assets value on the inventories which are all debit in nature.

68. Quick Check 
Revisit the earlier Tiger, Ltd. exercise on slide 56. Before any manufacturing fixed overhead over/underapplied adjustment, the relevant figures are as follows:
Work in process $20,000
Finished goods $30,000
Cost of goods sold $50,000
How much shouldTiger’s over/underapplied manufacturing fixed overhead be adjusted to Cost of Goods Sold (COGS) if the proportional allocation method is used?
a. $50,000 more (i.e. debit) to COGS. b. $50,000 less (i.e. credit) to COGS. c. $25,000 more (i.e. debit) to COGS. d. $25,000 less (i.e. credit) to COGS.
n this question, you are asked to allocate the overapplied or underapplied overhead. Be careful with your intermediate computations and the debit and credit entries.

69. Quick Check 
Revisit the earlier Tiger, Ltd. exercise on slide 56. Before any manufacturing fixed overhead over/underapplied adjustment, the relevant figures are as follows:
Work in process 20,000
Finished goods 30,000
Cost of goods sold 50,000
How much shouldTiger’s over/underapplied manufacturing fixed overhead be adjusted to Cost of Goods Sold (COGS) if the proportional allocation method is used?
a. $50,000 more (i.e. debit) to COGS. b. $50,000 less (i.e. credit) to COGS. c. $25,000 more (i.e. debit) to COGS. d. $25,000 less (i.e. credit) to COGS.
In this question, you are asked to allocate the overapplied or underapplied overhead. Be careful with your intermediate computations and the debit and credit entries. Applied overhead is not the actual manufacturing overhead expenses. Its entry is on the credit side of the manufacturing overhead account while the actual manufacturing overhead expenses, same as other expenses, is a debit entry. Therefore, adjustment on the underapplied is a credit entry to increase the application required which will increase the expenses on cost goods sold and increase the assets value on the inventories which are all debit in nature.

70. Explain the potential problems of using absorption costing.
Learning Objective 8
Explain the potential problems of using absorption costing.
Learning objective number 8 is to explain the potential problems of using absorption costing.

71. Creating Extra Profit Without Increase In Sales
Continue with the Harvey Fresh example (slides 54, and 58 to 64). Assume the company had the same sales, revenue and cost structure but produced 35,000 units (instead of 25,000 units) to increase ending inventory by 10,000 units.
Extra profit can be created without additional sales within the absorption costing framework. Additional profit can be created by producing extra inventory. In this particular example, Harvey Fresh, extra $60,000 profit was created by increasing production of 10,000 units of inventory.
Profit increased by $60,000 without extra sales and revenue!

72. Overapplied adjustments required
Harvey Fresh’s actual fixed manufacturing overhead = $120,000
Based on the original scenario, the applied overhead was based on actual production of 25,000 units at $6 each (slide 19), giving rise to $150,000 being applied to the items produced. Therefore, it was overapplied by $30,000 ($150,000 applied - $120,000 actual).
Based on the new scenario, the applied overhead was based on actual production of 35,000 units at $6 each (slide 19), giving rise to$210,000 being applied to the production. Therefore, it was overapplied by $90,000 ($210,000 applied - $120,000 actual).
Harvey Fresh’s actual fixed manufacturing overhead was $120,000
Based on the original scenario, the applied overhead was based on actual production of 25,000 units at $6 each (slide 19), giving rise to $150,000 being applied to the items produced. Therefore, it was overapplied by $30,000 ($150,000 applied - $120,000 actual). The $30,000 overapplied needs to be adjusted to match the actual fixed manufacturing overhead.
Based on the new scenario, the applied overhead was based on actual production of 35,000 units at $6 each (slide 19), giving rise to $210,000 being applied to the production. Therefore, it was overapplied by $90,000 ($210,000 applied - $120,000 actual). The $90,000 overapplied needs to be adjusted to match the actual fixed manufacturing overhead.

73. Profit Arising from Ending Inventory Value
The additional profit ($60,000) is the same amount as the additional overapplied adjustment ($90,000 - $30,000).
The overapplied adjustment is to make good of the applied fixed overhead to match with the actual overhead spent.
The additional profit actually arises from the additional fixed overhead (based on the predetermined overhead rate, POHR) carried forward through the change in ending inventory, amounting the same as the over/underapplied fixed overhead adjustment if the adjustment is written off directly to cost of goods sold.
If the adjustment is done through the proportional method shown in slides 61– 64, then the increased profit will not match the overapplied adjustment.
The additional profit ($60,000) is the same amount as the additional overapplied adjustment ($90,000 - $30,000).
The overapplied adjustment is to make good of the applied fixed overhead to match with the actual overhead spent.
The additional profit actually arises from the additional fixed overhead (based on the predetermined overhead rate, POHR) carried forward through the change in ending inventory, amounting the same as the over/underapplied fixed overhead adjustment if the adjustment is written off directly to cost of goods sold.
If the adjustment is done through the proportional method shown in slides 61– 64, then the increased profit will not match the overapplied adjustment.

74. Value of Ending Inventory
Additional inventories produced receive additional fixed manufacturing overhead ($60,000 = 10,000 units x $6) based on the predetermined overhead rate, not based on the total increase in ending inventory value ($240,000 vs $80,000). The variable costs associated with the additional inventories are net-off by the increase in the production cost and ending inventory. The additional fixed manufacturing overhead created hence reduces COGS by the same amount, giving rise the additional profit that matches the under/overapplied adjustment.
Comparing the net operating income arising from the absorption costing method and the variable costing method, we would find that the difference is the same as the under/overapplied overhead adjustment. Furthermore, there were no change of the net operating income regardless of the production and ending finished goods quantity, proving that variable costing is the technique for management to ensure no profit inflation can be done through producing more inventories.

75. Use of Variable Costing
Continue with the Harvey Fresh example but present the results using the variable costing format.
Using variable costing to compute the net operating income on production of 25,000 and 35,000 units produces the same figure of $120,000 when the sale and cost structures in both scenarios are the same, providing support to the previous slide.
Profits remain the same despite changing quantity in production and ending inventory
Use of Variable Costing can avoid Profit inflation through producing more inventories

76. Overapplied and Underapplied Manufacturing Overhead - Summary
Harvey Fresh’s Method
We have provided a good study aid for dealing with overapplied or underapplied overhead. We have shown the impact of both the allocation approach to the solution to the problem and the direct adjustment to cost of goods sold approach. Alternative 2 is considered more accurate, but it is more complex to apply.
More accurate but more complex to compute.

77. Quick Check  a. Net operating income will increase.
What effect will the overapplied overhead have on Harvey’s net operating income?
a. Net operating income will increase.
b. Net operating income will be unaffected.
c. Net operating income will decrease.
Give this question some thought before deciding on your answer.

78. Quick Check  a. Net operating income will increase.
What effect will the overapplied overhead have on Harvey’s net operating income?
a. Net operating income will increase.
b. Net operating income will be unaffected.
c. Net operating income will decrease.
How did you do?

79. Multiple Predetermined Overhead Rates
Up to this point, we have assumed that there is a single predetermined overhead rate called a plantwide overhead rate.
Large companies often use multiple predetermined overhead rates.
May be more complex but . . .
Part I
We have assumed that the company has used one single predetermined overhead rate for the entire factory.
Part II
Many large companies use multiple predetermined overhead rates.
Part III
Using multiple overhead rates can create more complexity. However, the use of multiple rates promotes greater accuracy in the allocation process because it reflects the differences across departments in how overhead costs are incurred.
May be more accurate because it reflects differences across departments.

80. 7-79
End of Chapter 5
End of chapter 5.