Chapter 3:
Predetermined Overhead Rates,
Flexible Budgets, and
Absorption/Variable Costing
Cost Accounting:
Foundations and Evolutions, 8e
Kinney ● Raiborn
Learning Objectives
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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?
Allocating Overhead
Actual vs. Normal
Product Cost
Direct Materials
Actual Cost
System
Actual
Normal Cost
System
Actual
Direct Labor
Actual
Actual
Overhead
Actual
Predetermined
Overhead Rate
Predetermined Overhead Rate
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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
Predetermined Overhead Rate
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)
$100,000
5,000
Direct Labor (DL) Hours
=
Predetermined
Overhead
Rate
=
$20 per
DL Hour
The Activity Level: The
Denominator

Relationship between the overhead cost
and the activity
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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)
Total budgeted
fixed overhead
Activity level
(Volume)
$375,000
50,000
=
machine hours
$630,000
50,000
machine hours
=
$7.50
per machine
hour
$12.60
per machine
hour
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
Variable Manufacturing Overhead
32,250
32,250
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
Fixed Manufacturing Overhead
54,180
54,180
Recording and Applying Overhead
For one month
Overhead Account
(Combined Fixed/Variable)
Actual Overhead
Applied Overhead
Variable
32,250
Fixed
54,180
Apply Overhead (combined journal entry)
Work in Process Inventory
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
86,430
32,250
54,180
Recording Actual Overhead
For one month
Overhead Account
(Combined/Fixed/Variable)
Actual Overhead
Applied Overhead
Variable
31,385
Variable
32,250
Fixed
55,970
Fixed
54,180
Record actual overhead
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Various Accounts
31,385
55,970
87,355
Manufacturing Overhead
For the entire year
Overhead Account
(Combined Fixed/Variable)
Actual Overhead
Fixed
220,000
Applied Overhead
Fixed
260,000
Overhead is $40,000 overapplied
$220,000 of actual overhead was incurred
$260,000 was applied to Work in Process
Manufacturing Overhead: Single
Account, Variable, and Fixed
Disposing of Overhead Differences
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If overhead is underapplied, the
adjusting entry
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increases Cost of Goods Sold
decreases Net Income
If overhead is overapplied, the adjusting
entry
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decreases Cost of Goods Sold
increases Net Income
Disposing of Overhead Differences

Immaterial
 Material—
 Cost of Goods
Prorate to
Sold
 Work in Process
 Finished Goods
 Cost of Goods Sold
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)
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Capacity measure of volume or some other
activity base
Alternative measures
 Theoretical
 Practical
 Normal
 Expected
Choice of capacity level affects product cost
Theoretical Capacity
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All production factors are operating
perfectly
Disregards
 Machinery breakdown
 Holiday downtime
Results in
 Significant underapplied overhead
 Lowest product cost
Practical Capacity
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Theoretical capacity reduced by ongoing,
regular operating interruptions (holidays,
downtime, and start-up time)
Usually results in
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Underapplied overhead
Low product cost
Normal Capacity
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Considers
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Historical production level
Estimated future production level
Cyclical fluctuations
Attainable level of activity
When normal capacity is greater than
expected capacity, may result in
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Underapplied overhead
Higher product cost
Expected Capacity
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Anticipated activity level for the upcoming
period based on projected product demand
Determined during the budget process
Should closely reflect actual costs
Results in
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Immaterial overapplied or underapplied overhead
Highest product cost
Alternative Capacity Levels
Alternative
Capacity
(The
Denominator
Level) Level
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Theoretical
Practical
Normal
Expected
lowest product cost
low product cost
higher product cost *
highest product cost
*assuming normal exceeds expected capacity
Analyzing Mixed Costs
A mixed cost contains both
a variable and fixed component
Mixed Cost
variable
$
fixed
# of Units
Separating Mixed Costs
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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
Methods for Separating Mixed Costs
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High-Low Method
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Actual cost observations
Considers only two data
points
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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
Using the High–Low Method
High
Low
Difference
$1,320
Machine
Hours
Cost
9,000
4,600
4,400
$3,500
2,180
$1,320
= $0.30/unit Variable cost per unit
4,400
3,500 = a + ($0.30)(9,000)
Fixed cost
a = 800
Y = $800 + $0.30X
(X = machine hours)
Regression Analysis Assumptions
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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
Estimated Total Costs
High—Low Method
$800.00 + $0.30X
Regression Analysis
$354.62 + $0.35X
More data
points
mean a
better
estimate of
total costs
(X = machine hours)
Flexible Budgets
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Separate overhead costs into fixed and
variable components in order to estimate
the amount of overhead at various levels
of the denominator activity
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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.
2.
3.
4.
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
Flexible Budgets
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
Absorption vs. Variable Costing
Absorption or Full
Variable or Direct
 Product costs
 Product costs
 Direct material
 Direct material
 Direct labor
 Direct labor
 Variable mfg. overhead
 Variable mfg. overhead
 Fixed mfg. overhead
 Period costs
 Period costs
 Fixed mfg. overhead
 Selling
 Selling
 General
 General
 Administrative
 Administrative
Differences Between Absorption and
Variable Costing
Absorption Costing
Variable Costing
Fixed manufacturing
overhead is a product
cost
Fixed manufacturing
overhead is a period
cost
Variable operating
expenses are
subtracted from product
contribution margin to
equal contribution
margin
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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
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,
Selling
General,
General
Administration
Administrative
Difference in Income
Absorption vs. Variable
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No change in inventory level
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Increase in inventory level
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Absorption Income = Variable Income
Absorption Income > Variable Income
Phantom Profits
Decrease in inventory level

Absorption Income < Variable Income
Questions
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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?
Potential Ethical Issues
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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