CHAPTER
3
PREDETERMINED OVERHEAD RATES,
FLEXIBLE BUDGETS, AND ABSORPTION
VARIABLE COSTING
Learning Objectives
After reading and studying Chapter 3, you should be able to answer the following
questions:
1.
Why and how are overhead costs allocated to products and services?
2.
What causes underapplied or overapplied overhead, and how is it treated at
the end of a period?
3.
What impact do different capacity measures have on setting predetermined
overhead rates?
4.
How are the high-low method and least squares regression analysis used in
analyzing mixed costs?
5.
How do managers use flexible budgets to set predetermined overhead rates?
6.
How do absorption and variable costing differ?
7.
How do changes in sales or production levels affect net income computed
under absorption and variable costing?
Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
Terminology
Absorption costing a cost accumulation and reporting method that treats the costs
of all manufacturing components (direct material, direct labor, variable overhead,
and fixed overhead) as inventoriable or product costs in accordance with generally
accepted accounting principles
Applied overhead the amount of overhead that has been assigned to Work in
Process Inventory as a result of productive activity; credits for this amount are to an
overhead account
Contribution margin the difference between total revenues and total variable
expenses; this amount indicates the dollar amount available to “contribute” to
cover all fixed expenses, both manufacturing and nonmanufacturing
Dependent variable an unknown variable that is to be predicted using one or more
independent variables
Direct costing see variable costing
Expected capacity a short-run concept that represents the anticipated level of
capacity to be used by a firm in the upcoming period, based on projected product
demand
Flexible budget a planning document that presents expected variable and fixed
overhead costs at different activity levels
Full costing see absorption costing
Functional classification is a group of costs that were all incurred for the same
principle purpose; it includes cost of goods sold and detailed selling and
administrative expenses
High-low method a technique used to determine the fixed and variable portions of
a mixed cost; it uses only the highest and lowest levels of activity within the
relevant range
Independent variable a variable that, when changed, will cause consistent,
observable changes in another variable; a variable used as the basis of predicting
the value of a dependent variable
Least squares regression analysis a statistical technique that investigates the
association between dependent and independent variables; it determines the line of
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
“best fit” for a set of observations by minimizing the sum of the squares of the
vertical deviations between actual points and the regression line; it can be used to
determine the fixed and variable portions of a mixed cost
Multiple regression a statistical technique that uses two or more independent
variables to predict a dependent variable
Normal capacity the long-run (5–10 years) average production or service volume of
a firm; it takes into consideration cyclical and seasonal fluctuations
Outlier an abnormal or nonrepresentative point within a data set
Overapplied overhead the balance of the overhead account that remains at the end
of the period when the applied overhead amount is greater than the actual that was
incurred; it means that too much overhead was applied to production
Phantom profits a temporary absorption costing profit caused by producing more
inventory than is sold
Practical capacity the physical production or service volume that a firm could
achieve during normal working hours with consideration given to ongoing,
expected operating interruptions
Product contribution margin the difference between selling price and variable cost
of goods sold
Regression line any line that goes through the means (or averages) of the set of
observations for an independent variable and its dependent variables;
mathematically, there is a line of “best fit”, which is the least squares regression line
Simple regression a statistical technique that uses only one independent variable to
predict a dependent variable
Theoretical capacity is the estimated maximum production or service volume that
a firm could achieve during a period; it disregards realities such as machine
breakdowns and reduced or stopped plant operations on holidays
Underapplied overhead the condition wherein actual overhead is greater than
overhead charged to production
Variable costing a cost accumulation and reporting method that includes only
variable production costs (direct material, direct labor, and variable overhead) as
inventoriable or product costs; it treats fixed overhead as a period cost; it is not
acceptable for external reporting and tax returns
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
Volume variance reflects the monetary impact of a difference between the
budgeted capacity used to determine the fixed overhead application rate and the
actual capacity at which the company operates
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
Lecture Outline
A. Normal Costing and Predetermined Overhead
1. Normal Costing and Predetermined Overhead.
a. Normal costing is an alternative costing system to actual costing.
b. Normal costing assigns actual direct material and direct labor to products
but allocates production overhead to products using a predetermined
overhead rate.
c. See text Exhibit 3-1 for actual and normal costing compared.
d. Four primary reasons for using predetermined overhead rates in product
costing.
i. A predetermined overhead rate allows overhead to be assigned
during the period to the goods produced or sold and to the services
rendered. We sacrifice some precision for timeliness.
ii. Predetermined overhead rates adjust for variations in actual overhead
costs that are unrelated to activity. For example, electricity costs run
higher in the summer because of the costs of air conditioning.
iii. Predetermined overhead rates overcome the problem of fluctuations
in activity levels that have no impact on actual fixed overhead costs.
Fixed cost per unit varies when activity levels change. To minimize
such variations in unit cost, we use an annual predetermined
overhead rate for fixed overhead for all units produced during the
year.
iv. Using predetermined overhead rates allows managers to be more
aware of individual product or product line profitability as well as the
profitability of doing business with a particular customer or vendor.
2. Formula for Predetermined Overhead Rate.
Predetermined OH rate = Total Budgeted OH Cost at a Specified Activity Level
Volume of Specified Activity Level
a. Overhead is typically budgeted for one year.
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
b. Companies should use an activity base that is logically related to actual
overhead cost incurrence. Common activity bases include:
i. Direct labor hours;
ii. Direct labor dollars; and
iii. Machine hours.
c. Other activity bases could include:
i. Number of purchase orders;
ii. Physical characteristics such as tons or gallons;
iii. Number of machine setups;
iv. Number of parts; and
v. Material handling time.
d. Activity based costing is discussed in chapter 4.
3. Applying Overhead to Production.
a. Applied overhead is the amount of overhead assigned to Work in
Process Inventory using the activity that was employed to develop the
application rate. For convenience, both actual and applied overhead are
recorded in a single general ledger account.
b. The amount of applied overhead is determined by multiplying the
predetermined rate by the actual activity level.
c. Debits to the overhead account represent actual overhead credits to the
overhead account represent applied overhead (see text Exhibit 3-2).
d. The general ledger may contain a single overhead account or separate
accounts for variable and fixed overhead.
e. Actual overhead incurred during a period will rarely equal applied
overhead; this difference represents underapplied or overapplied
overhead.
i. Underapplied overhead is the amount of overhead that remains at
the end of the period when the applied overhead is less than the
actual overhead.
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
ii. Overapplied overhead is the amount of overhead that remains at the
end of the period when the applied overhead is greater than the
actual overhead.
f. There are two factors that cause underapplied or overapplied overhead.
i. A difference between actual and budgeted variable overhead cost per
unit; and
ii. A difference between actual and budgeted total fixed overhead cost;
and a difference between actual activity and the budgeted capacity
used to calculate the fixed overhead application rate, only if the
company’s actual activity level exactly equals the expected activity
level will the total budgeted amount of fixed overhead be applied to
production.
4. Disposition of underapplied or overapplied overhead is recorded annually.
a. The method of disposition of underapplied or overapplied overhead
depends upon the materiality of the amount involved.
b. The amount is closed to Cost of Goods Sold if it is immaterial (see text
Exhibit 3-3 and the journal entries on text page 73).
c. The amount, if it is material, should be allocated among the accounts
containing applied overhead: Work in Process Inventory, Finished
Goods Inventory, and Cost of Goods Sold (see text Exhibit 3-4).
5. Alternative Capacity Measures
a. Theoretical capacity is the estimated maximum production or service
volume that a firm could achieve during a period. It disregards realities
such as machine breakdowns and reduced or stopped plant operations
on holidays.
b. Practical capacity the physical production or service volume that a firm
could achieve during normal working hours with consideration given to
ongoing, expected operating interruptions.
c. Normal capacity the long-run (5–10 years) average production or service
volume of a firm; it takes into consideration cyclical and seasonal
fluctuations.
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
d. Expected capacity a short-run concept that represents the anticipated
level of capacity to be used by a firm in the upcoming period, based on
projected product demand.
e. See text Exhibit 3-5 for a visual representation of measures of capacity.
B. Separating Mixed Costs
1. Separating Mixed Costs.
a. Accountants describe a given cost’s behavior pattern according to the
way its total cost (rather than its unit cost) reacts to changes in a related
activity measure.
b. A fixed cost remains fixed in total within the relevant range of activity
under consideration.
c. A variable cost varies as production changes, but the cost per unit
remains the same.
d. Mixed costs contain both a variable and a fixed cost element and are
assumed by accountants to be linear rather than curvilinear, within a
relevant range of activity.
e. The linear formula for a mixed cost is y = a + bx
Where:
y = total cost (dependent variable)
a = fixed portion of total cost
b = unit change of variable cost relative to unit changes in
activity (slope)
x = activity base to which y is being related (the predictor, cost
driver, or independent variable)
i. The linear formula for a variable cost is y = bx
ii. The linear formula for a fixed cost is y = a
2. The High-Low Method
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
a. The high-low method is a technique used to determine the fixed and
variable portions of a mixed cost; it uses only the highest and lowest
levels of activity and related costs within the relevant range.
b. The method uses the highest and lowest observed levels of actual activity
to determine the change in costs which reflects the variable cost element b
as follows:
b
(Cost at High Activity Level) – (Cost at Low Activity Level)
(High Activity Level) – (Low Activity Level)
b
Change in Total Cost
Change in Activity Level
c. The fixed portion of a mixed cost is found by subtracting total variable
cost from total cost.
d. Outliers are abnormal or nonrepresentative observations within a data
set that may be inadvertently used in the application of the high-low
method.
e. Text Exhibit 3-6 illustrates the high low method.
3. Least Squares Regression Analysis is a statistical technique that analyzes
the association between dependent and independent variables. It determines
the line of “best fit” for a set of observations by minimizing the sum of the
squares of the vertical deviations between actual points and the regression
line. It can be used to determine the fixed and variable portions of a mixed
cost. The least square method is used to develop an equation that predicts
the unknown value of a dependent variable (cost) from the known values of
one or more independent variables (activities). When multiple independent
variables exist, the least squares method can be used to select the best
predictor of the dependent variable based on which independent variable
has the highest correlation with the dependent variable.
a. A dependent variable (cost) is an unknown variable that is to be
predicted using one or more independent variables.
b. An independent variable (activity) is a variable that, when changed, will
cause consistent, observable changes in another variable; a variable used
as the basis of predicting the value of a dependent variable.
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
c. Simple regression is a statistical technique that uses only one
independent variable to predict a dependent variable.
d. Multiple regression is a statistical technique that uses two or more
independent variables to predict a dependent variable.
e. A regression line is any line that goes through the means (or averages) of
the set of observations for an independent variable and its dependent
variables. Mathematically, there is a line of “best fit” which is the least
squares regression line.
f. A scattergraph is a graph that plots all known activity observations and
the associated costs; it is used to separate mixed costs into their variable
and fixed components and to examine patterns reflected by the plotted
observations.
4. Flexible Budgets
a. Using Flexible Budgets in Setting Predetermined Overhead Rates (see
text Exhibit 3-8).
i. A flexible budget is a series of individual budgets that present costs
according to their behavior at different levels of activity.
ii. A flexible budget presents variable and fixed costs at various levels of
activity within a relevant range of activity.
iii. Flexible budgets are prepared for both product and period costs.
5. Plantwide versus Departmental Overhead Rates.
a. Because companies may produce many types of products, a single
plantwide overhead rate does not produce the most useful information.
b. Departmental overhead rates will provide more useful information by
using the most appropriate cost driver for each department.
c. Text Exhibit 3-9 illustrates the differences between using a single
plantwide overhead rate, and separate overhead rates for the assembly
and finishing departments.
C. Overview of Absorption and Variable Costing
1. An Overview of Absorption and Variable Costing.
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
a. Cost accumulation is an approach to product costing that determines
which manufacturing costs are recorded as part of product cost and
which are recorded as part of period costs.
b. Cost presentation is an approach to product costing that focuses on how
costs are shown on external financial statements or internal management
reports.
c. The two methods of cost accumulation and presentation are absorption
costing and variable costing.
2. Absorption costing is a cost accumulation and reporting method that treats
the costs of all manufacturing components (direct material, direct labor,
variable overhead, and fixed overhead) as inventoriable or product costs; it
is the traditional approach to product costing; it must be used for external
financial statements and tax returns (see text Exhibit 3-10).
a. Absorption costing is alternatively termed full costing since all types of
manufacturing costs are included as product cost.
b. Absorption costing presents expenses on an income statement according
to their functional classifications. A functional classification is a group of
costs that were all incurred for the same principle purpose. Examples
include cost of goods sold, selling expenses, and administrative expenses.
c. Total variable product costs increase with each additional product made
or each additional service rendered and are therefore considered to be
product costs and are inventoried until the product or service is sold.
d. Fixed overhead does not vary with units of production or level of service;
it provides the manufacturing capacity necessary for production to occur.
Production could not take place without the incurrence of fixed
overhead, so fixed overhead is considered to be a product cost under
absorption costing.
e. Absorption costing is perceived to furnish external parties with a more
informative picture of earnings, as compared to variable costing, by
authoritative accounting bodies such as the FASB and the SEC.
f. The IRS requires absorption costing for income tax purposes.
3. Variable costing is a cost accumulation and reporting method that includes
only variable production costs (direct material, direct labor, and variable
overhead) as inventoriable or product costs; it treats fixed overhead as a
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
period cost; it is also known as direct costing; it is not acceptable for external
reporting and tax returns (see text Exhibit 3-11).
a. Variable costing treats fixed overhead as a period cost while absorption
costing treats fixed overhead as a product cost.
b. A variable costing income statement presents expenses according to cost
behavior (variable and fixed), although it may present expenses by
functional classification within the behavioral categories.
c. Cost of goods sold is more appropriately called variable cost of goods sold
since it is composed of only the variable production costs related to the
units sold.
d. Product contribution margin is the difference between selling price and
variable cost of goods sold and indicates how much revenue is available
to cover all period costs and to potentially provide net income. Product
contribution margin is commonly called manufacturing margin.
e. Total contribution margin is the difference between revenue and all
variable costs regardless of the area of incurrence (production or
nonproduction).
f. The accounting profession has unofficially disallowed the use of variable
costing as a generally accepted inventory valuation method for external
reporting purposes.
D. Absorption and Variable Costing Illustrations
1. Absorption and Variable Costing Illustrations (See text Exhibits 3-13 and 314.)
a. Text Exhibit 3-13 provides unit production costs, annual budgeted
nonmanufacturing costs, and other basic operating data.
b. The FOH rate is calculated as follows.
Budgeted annual FOH/Budgeted Annual Capacity in Units
c. All costs are assumed to remain constant over the three years 2006
through 2008.
d. For simplicity, Renaldo is assumed to complete all units started and have
no WIP inventory at the end of the period.
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
e. All actual costs are assumed to be equal to standard and budgeted costs
for the years presented.
f. The bottom of text Exhibit 3-13 compares actual unit production and
actual unit sales to determine the change in inventory for each of the
three years.
2. Text Exhibit 3-14 presents absorption and variable costing income
statements for the three years.
a. Although it is assumed that production and operating costs were equal to
standard costs and budgeted costs for the years 2006 through 2008,
differences in actual and budgeted capacity utilization occurred for 2007
and 2008.
b. This creates a volume variance for each of those years under absorption
costing. The volume variance is the monetary impact of a difference
between the budgeted capacity used to determine the fixed overhead
application rate and the actual capacity at which the company operates.
c. There was no change in inventory in 2006, but ending inventory
increased by 20,000 units in 2007, then decreased by 20,000 units in 2008.
d. If we multiply the fixed overhead rate by the unit change in inventory,
we will calculate the difference in income (volume variance) under the
two methods:
20,000 units x $.54 = $10,800
i. If inventory levels increase, absorption costing will show higher
income because more fixed costs are trapped in ending inventory on
the balance sheet.
ii. If inventory levels decrease, absorption costing will show lower
income because more fixed costs are passed through to the income
statement as cost of goods sold.
e. The differences in income between the two methods are only timing
differences based on when fixed overhead costs flow through to the
income statement as part of cost of goods sold under absorption costing.
The total income for all three years (or over the life of the enterprise) will
ultimately be the same under both methods.
3. Phantom profits are the difference between absorption costing and variable
costing profits caused by fixed manufacturing overhead added to absorption
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
costing inventory and therefore not expensed during a period. The
absorption costing phantom profits are created when more inventory is
produced than is sold. There was $10,800 of phantom profits in 2007 from
the 20,000 unit increase in ending inventory.
E. Comparison of the Two Approaches
1. Absorption costing income will equal variable costing income if production
is equal to sales (See text Exhibit 3-15).
a. Absorption costing income will be greater than variable costing income if
production is greater than sales.
b. Some fixed overhead cost is deferred as part of inventory cost on the
balance sheet under absorption costing.
c. The total amount of fixed overhead cost is expensed as a period cost
under variable costing.
2. Absorption costing income will be less than variable costing income if
production is less than sales.
a. Absorption costing expenses all of the current period fixed overhead cost
as well as releasing some fixed overhead cost from beginning inventory
where it had been deferred from a prior period.
b. Variable costing shows on the income statement only current period fixed
overhead, so that the additional fixed overhead released from beginning
inventory makes absorption costing income lower.
c. The process of deferring and releasing fixed overhead costs into and from
inventory makes it possible to manipulate income under absorption
costing by adjusting levels of production relative to sales. This leads
some to believe that variable costing might be more useful for external
reporting purposes than absorption costing.
d. For internal reporting purposes, variable costing provides managers
information about the behavior of the various product and period costs.
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
Multiple Choice Questions from CMA Examinations
1.
In applying overhead, individual department rates would be used instead of
a plant wide rate if
a.
The manufactured products differ in the resources consumed from the
individual departments in the plant
b.
a company wants to adopt a standard cost system
c.
a company’s manufacturing operations are highly automated
d.
manufacturing overhead is the largest component of product cost
The correct answer is a. (CMA adapted)
2.
The appropriate method for disposing of underapplied or overapplied
factory
a.
is apportioned between cost of goods sold and finished goods
inventory
b.
is in finished goods inventory only
c.
is in cost of goods sold only
d.
it depends on the significance of the amount
The correct answer is d. (CMA adapted)
3.
The appropriate method for disposing of underapplied or overapplied
factory
a.
is apportioned between cost of goods sold and finished goods
inventory
b.
is in finished goods inventory only
c.
is in cost of goods sold only
d.
it depends on the significance of the amount
The correct answer is d. (CMA adapted)
4.
In determining cost behavior in business, the cost function is often expressed
as y = a + bx. Which one of the following cost estimation methods should not
be used in estimating fixed and variable costs for the equation?
a.
graphic method
b.
simple regression
c.
high and low point method
d.
multiple regression
e.
management analysis of data
The correct answer is d. (CMA December 1992, 3-3)
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
5.
The average amount of change in a dependent variable that is associated
with a change in an independent variable is determined through:
a.
factor analysis.
b.
normal analysis.
c.
correlation analysis.
d.
variance linearity analysis.
e.
regression analysis.
The correct answer is e. (CMA December 1986, 5-5)
Questions 11 and 12 are based on Mulvey Company, which derived the following
cost relationship from a regression analysis of its monthly manufacturing overhead
cost:
C = $80,000 + $12M
where
C = monthly manufacturing overhead cost
M = machine hours
The standard error of the estimate of the regression is $6,000.
The standard time required to manufacture one six-unit case of Mulvey’s single
product is 4 machine hours. Mulvey applies manufacturing overhead to production
on the basis of machine hours and its normal annual production is 50,000 cases.
6.
Mulvey’s estimated variable manufacturing overhead cost for a month in
which scheduled production is 5,000 cases would be:
a.
$80,000.
b.
$320,000.
c.
$240,000.
d.
$360,000.
e.
some amount other than those given.
The correct answer is c. (CMA December 1985, 5-17)
Solution
5,000 cases × 4 machine hours per case = 20,000 machine hours × $12 per
machine hour
= $240,000 variable overhead
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
7.
Mulvey’s predetermined fixed manufacturing overhead rate would be:
a.
$1.60 machine hour.
b.
$3.20 machine hour.
c.
$4.00 machine hour.
d.
$4.80 machine hour.
e.
$0.40 machine hour.
The correct answer is d. (CMA December 1985, 5-18)
Solution
Annual fixed overhead costs
Annual machine hours
Fixed overhead rate
$ 960,000 ($80,000 × 12)
÷ 200,000 (50,000 × 4)
$
4.80 per machine hour
Questions 8 through 11 are based on the following information. In preparing the
annual profit plan for the coming year, Wilkens Company wants to determine the
cost behavior pattern of the maintenance costs. Wilkens has decided to use linear
regression by employing the equation y = a + bx for maintenance costs. The prior
year’s data regarding maintenance hours and costs, and the results of the regression
analysis are as follows.
Hours of
Activity
January
February
March
April
May
June
July
August
September
October
November
December
Average
Maintenance
Costs
480
320
400
300
500
310
320
520
490
470
350
340
4,800
$ 4,200
3,000
3,600
5,820
4,350
2,960
3,030
4,470
4,260
4,050
3,300
3,160
$ 43,200
400
$3,600
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
Average cost per hour
a
b
Standard error of a
Standard error of b
Standard error of the estimate
r2
8.
$9.00
$684.65
$7.2884
49.515
0.12126
34.469
0.99724
In the standard regression equation y = a + bx, the letter b is best described as
a (n):
a.
independent variable.
b.
dependent variable.
c.
constant coefficient.
d.
variable coefficient.
e.
coefficient of determination.
The correct answer is d. (CMA December 1990, 4-27)
9.
The letter x in the standard regression equation is best described as a (n):
a.
independent variable.
b.
dependent variable.
c.
constant coefficient.
d.
variable coefficient.
e.
coefficient of determination.
The correct answer is a. (CMA December 1990, 4-28)
10.
Based upon the data derived from the regression analysis, 420 maintenance
hours in a month would mean the maintenance costs (rounded to the nearest
dollar) would be budgeted at:
a.
$3,780.
b.
$3,600.
c.
$3,790.
d.
$3,746.
e.
$3,756.
The correct answer is d. (CMA December 1990, 4-29)
Solution
y
= a + bx
= $684.65 + $7.2884 (420)
= $3,746
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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing
11.
Simple regression analysis may be used to approximate the relationship
between two variables, such as direct labor hours and total product cost.
This technique is:
a.
most appropriate when the relationship between the two variables is
expressed by an exponential (non-linear) graph.
b.
based on a two-dimensional model and the formula y = a + bx.
c.
similar to the quantitative technique simulation and is often used in
conjunction with it.
d.
useful in determining variable costs per unit produced, but is not
related to fixed costs.
e.
quantitative, but is not expressed graphically.
The correct answer is b. (CMA December 1989, 5-1
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