Chapter 3: Predetermined
Overhead Rates, Flexible
Budgets, and Absorption/
Variable Costing
Cost Accounting:
Foundations & Evolutions, 9e
Kinney and Raiborn
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accessible website, in whole or in part.
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 is the high-low method 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?
(Appendix) How is least squares regression used in analyzing mixed
costs?
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
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
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
The Activity Level: The Denominator
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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
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accessible website, in whole or in part.
Applying Overhead to Production
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Applied overhead is the dollar amount of
overhead assigned to WIP Inventory using the
activity measure that was selected to develop
the OH rate.
Applied overhead is calculated as the
predetermined OH rate multiplied by the actual
activity volume.
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accessible website, in whole or in part.
Disposing of Overhead Differences
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Underapplied overhead occurs when the OH applied to
WIP Inventory is less than the actual OH cost.
If overhead is underapplied, the adjusting entry
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increases Cost of Goods Sold
decreases Net Income
Overapplied overhead occurs when the OH applied to
WIP Inventory is more than actual OH cost.
If overhead is overapplied, the adjusting entry
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decreases Cost of Goods Sold
increases Net Income
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
Alternative Capacity Levels:
Theoretical Capacity
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Theoretical capacity
 All production factors are operating perfectly
 Disregards
 Machinery breakdown
 Holiday downtime
 Results in
 Significant underapplied overhead
 Lowest product cost
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
Alternative Capacity Levels: Practical
Capacity
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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
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
Alternative Capacity Levels: Normal
Alternative Capacity Level
Capacity
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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
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
Alternative Capacity Levels:
Alternative
Capacity Level
Expected
Capacity
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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
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
Analyzing Mixed Costs
A mixed cost contains both
a variable and fixed component
variable
Mixed Cost
$
fixed
Units
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accessible website, in whole or in part.
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
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
Separating Mixed Costs
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Two Methods
 High-Low Method
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Change in total cost divided by change in activity level equals
the unit variable cost per measure of activity
Considers only two data points of activity (highest and lowest)
Disregard outliers when analyzing mixed cost
Least Squares Regression Analysis
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Statistical technique that is used to develop an equation that
predicts an unknown value of a dependent variable (cost) from
the known values of one or more independent variables
(activities that create costs). (Appendix)
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
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
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accessible website, in whole or in part.
Flexible Budget
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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
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accessible website, in whole or in part.
Plantwide vs. Departmental
Predetermined Overhead Rates
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Plantwide Overhead Rate
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Homogeneous activities throughout plant
Departmental Overhead Rate
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Different types of work effort in departments
Diverse material requiring different times in
departments
Usually provides better information for planning,
control, and decision making
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accessible website, in whole or in part.
Differences
Absorption costing
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Fixed manufacturing
overhead is a product
cost
Also known as full costing
Variable costing
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Fixed manufacturing
overhead is a period cost
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Variable operating
expenses are subtracted
from product contribution
margin to equal contribution
margin
Also known as direct
costing
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accessible website, in whole or in part.
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
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Absorption Income < Variable Income
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accessible website, in whole or in part.
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?
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.
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
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.