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 Overhead Actual vs. Normal
Product Cost
Direct Materials
Direct Labor
Overhead
Actual Cost System
Actual
Normal Cost System
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 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
© 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. = = Predetermined Overhead Rate Total budgeted overhead Predetermined
A budgeted, constant charge per unit of activity used to assign overhead to production or services
Total budgeted overhead
Activity level
(Volume)
(usually for a year)
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
Predetermined Overhead Rate
Total budgeted variable overhead
Activity level
(Volume)
$375,000
50,000
machine hours
$7.50
per machine
hour =
Total budgeted
fixed overhead
Activity level
(Volume)
$630,000
50,000
machine hours
$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 ,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. 4,300 actual machines hours times
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 ,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. (Combined Fixed/Variable)
Recording and Applying Overhead
For one month
Overhead Account
(Combined Fixed/Variable)
Actual Overhead
Applied Overhead
Variable ,250
Fixed ,180
Apply Overhead (combined journal entry)
Work in Process Inventory ,430
Variable Manufacturing Overhead 32,250
Fixed Manufacturing Overhead ,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. (Combined/Fixed/Variable)
Recording Actual Overhead
For one month
Overhead Account
(Combined/Fixed/Variable)
Actual Overhead
Applied Overhead
Variable ,385
Fixed ,970
Variable ,250
Fixed ,180
Record actual overhead
Variable Manufacturing Overhead 31,385
Fixed Manufacturing Overhead 55,970
Various Accounts ,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. (Combined Fixed/Variable)
Manufacturing Overhead
For the entire year
Overhead Account
(Combined Fixed/Variable)
Actual Overhead
Applied Overhead
Fixed ,000
Fixed ,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 Machinery breakdown Holiday downtime
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 Attainable level of activity
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)
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 $ Mixed Cost # of Units
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. Methods for Separating Mixed Costs
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
© 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. Using the High–Low Method
Machine
Hours
Cost
High
9,000
$3,500
Low
4,600
2,180
Difference
4,400
$1,320
$1,320
4,400
= $0.30/unit
Variable cost per 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. better estimate of total costs
Estimated Total Costs
High—Low Method
$ $0.30X
Regression Analysis
$ $0.35X
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 vs. Variable Costing
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
© 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. Differences Between Absorption and Variable Costing
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
© 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. 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
Selling,
General,
Administration
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.

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
© 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.