Cost Accounting
Foundations and Evolutions
Kinney and Raiborn
Seventh Edition
Chapter 3
Predetermined Overhead Rates, Flexible
Budgets, and Absorption/Variable Costing
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Learning Objectives
(1 of 3)
• Explain why and how overhead costs are allocated to products and services
• Describe what causes underapplied or overapplied overhead and how is it treated at the end of the period

Learning Objectives
(2 of 3)
• Explain how different capacity measures affect predetermined overhead rates
• Describe two methods of analyzing mixed costs – high-low method and least squares regression analysis

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

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

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

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

Alternative Capacity Levels
(The Denominator Level)
• Theoretical capacity
– All production factors are operating perfectly
– Disregards
• Machinery breakdown
• Holiday downtime
– Results in
• Significant underapplied overhead
• Lowest product cost

Alternative Capacity Levels
(The Denominator Level)
• Practical capacity
– Theoretical capacity reduced by ongoing, regular operating interruptions (holidays, downtime, and start-up time)
– Usually results in
• Underapplied overhead
• Low product cost

Alternative Capacity Levels
Alternative Capacity Level
(The Denominator Level)
• Normal capacity
– Considers
• Historical production level
• Estimated future production level
• Cyclical fluctuations
– Attainable level of activity
– When normal capacity is greater than expected capacity, may result in
• Underapplied overhead
• Higher product cost

Alternative Capacity Levels
Alternative Capacity Level
(The Denominator Level)
• Expected capacity
– Anticipated activity level for the upcoming period based on projected product demand
– Determined during the budget process
– Should closely reflect actual costs
– Results in
• Immaterial overapplied or underapplied overhead
• Highest product cost

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

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

Separating Mixed Costs
Use formula for a straight line y = a + bX y = total cost a = fixed portion of total cost b = variable cost
X = activity base to which y is related

Separating Mixed Costs
• Two Methods
– High-Low Method
– Least Squares Regression Analysis

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

Flexible Budget
• Shows manufacturing overhead costs and cost behavior
• Separates costs into fixed and variable elements
• Provides budgeted costs at various activity levels
• Shows impact of a change in the denominator level of activity

Plantwide vs. Departmental
Predetermined Overhead Rates
• Plantwide Overhead Rate
– Homogeneous activities throughout plant
• Departmental Overhead Rate
– Different types of work effort in departments
– Diverse material requiring different times in departments
– Usually provides better information for planning, control, and decision making

Differences
Absorption costing
• Fixed manufacturing overhead is a product cost
Variable costing
• Fixed manufacturing overhead is a period cost
• Variable operating expenses are subtracted from product contribution margin to equal contribution margin

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

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?

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

Potential Ethical Issues
• Treating period costs as product costs resulting in higher inventory and net income
• Manipulating sales reporting at the end of an accounting period
• Choosing overhead allocation methods that distort cost and profit of certain products or subunits