Variable Costing:
A Tool for Management
Chapter 5
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Learning Objective 1
Explain how variable costing
differs from absorption
costing and compute unit
product costs under each
method.
McGraw-Hill Education (Asia)
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Slide 2
Overview of Absorption and Variable Costing
Absorption C osting
Income State me nt
Sale s
Variable C osting
Income State me nt
Sale s
Dire ct mate rials
Dire ct labor
C ost of Goods Sold
( V a ria b le P ro d uc t C o s t s )
C ost of Goods Sold
(Fixe d and variable
product costs)
Variable manufacturing ove rhe ad
Variable
Se lliing &
Administrative
e xpe nse s
Gross Profit
(Gross Margin)
Fixe d manufacturing ove rhe ad
C ontribution Margin
Fixe d
Manufacturing
ove rhe ad
Se lling &
Adminstrative
e xpe nse s
Se lling & Administrative e xpe nse s
Ne t O pe rating Income
KEY:
McGraw-Hill Education (Asia)
Fixe d
Se lling &
Administrative
e xpe nse s
Ne t O pe rating Income
= Pe riod e xpe nse s
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 3
Quick Check 
Which method will produce the highest values for
work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends. . .
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 4
Quick Check 
Which method will produce the highest values for
work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends. . .
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 5
Unit Cost Computations
Harvey Company produces a single product
with the following information available:
McGraw-Hill Education (Asia)
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Slide 6
Unit Cost Computations
Unit product cost is determined as follows:
Under absorption costing, all production costs, variable
and fixed, are included when determining unit product
cost. Under variable costing, only the variable
production costs are included in product costs.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 7
Learning Objective 2
Prepare income statements
using both variable and
absorption costing.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 8
Income Comparison of
Absorption and Variable Costing
Let’s assume the following additional information
for Harvey Company.


20,000 units were sold during the year at a price
of $30 each.
There is no beginning inventory.
Now, let’s compute net operating
income using both absorption
and variable costing.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 9
Absorption Costing
Fixed manufacturing overhead deferred in
inventory is 5,000 units × $6 = $30,000.
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Slide 10
Variable Costing
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30)
Less variable expenses:
Beginning inventory
$
Add COGM (25,000 × $10)
250,000
Goods available for sale
250,000
Less ending inventory (5,000 × $10)
50,000
Variable cost of goods sold
200,000
Variable selling & administrative
expenses (20,000 × $3)
60,000
Contribution margin
Less fixed expenses:
Manufacturing overhead
$ 150,000
Selling & administrative expenses 100,000
Net operating income
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
$ 600,000
All fixed
manufacturing
overhead is
expensed.
260,000
340,000
250,000
$ 90,000
Slide 11
Learning Objective 3
Reconcile variable costing
and absorption costing net
operating incomes and
explain why the two
amounts differ.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 12
Comparing the Two Methods
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 13
Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:
Variable costing net operating income
$ 90,000
Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit)
30,000
Absorption costing net operating income $ 120,000
Fixed mfg. overhead
$150,000
=
= $6 per unit
Units produced
25,000 units
McGraw-Hill Education (Asia)
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Slide 14
Extended Comparisons of Income Data
Harvey Company – Year Two
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Slide 15
Unit Cost Computations
Since the variable costs per unit, total fixed costs,
and the number of units produced remained
unchanged, the unit cost computations also
remain unchanged.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 16
Absorption Costing
Unit product
cost.
Absorption Costing
Sales (30,000 × $30)
Less cost of goods sold:
Beg. inventory (5,000 × $16)
Add COGM (25,000 × $16)
Goods available for sale
Less ending inventory
Gross margin
Less selling & admin. exp.
Variable (30,000 × $3)
Fixed
Net operating income
$ 900,000
$ 80,000
400,000
480,000
-
$ 90,000
100,000
480,000
420,000
190,000
$ 230,000
Fixed manufacturing overhead released from
inventory is 5,000 units × $6 = $30,000.
McGraw-Hill Education (Asia)
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Slide 17
Variable Costing
Variable
manufacturing
costs only.
All fixed
manufacturing
overhead is
expensed.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 18
Comparing the Two Methods
We can reconcile the difference between
absorption and variable income as follows:
Variable costing net operating income
$ 260,000
Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit)
30,000
Absorption costing net operating income $ 230,000
Fixed mfg. overhead
$150,000
=
= $6 per unit
Units produced
25,000 units
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 19
Comparing the Two Methods
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Slide 20
Summary of Key Insights
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 21
Learning Objective 4
Understand the
advantages and
disadvantages of both
variable and absorption
costing.
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Slide 22
Impact on the Manager
Opponents of absorption costing argue that
shifting fixed manufacturing overhead costs
between periods can lead to faulty decisions.
These opponents argue that variable costing income
statements are easier to understand because net operating
income is only affected by changes in unit sales. This
produces net operating income figures that are
consistent with managers’ expectations.
McGraw-Hill Education (Asia)
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Slide 23
CVP Analysis, Decision Making
and Absorption costing
Absorption costing does not dovetail with CVP analysis,
nor does it support decision making. It treats fixed
manufacturing overhead as a variable cost. It assigns per
unit fixed manufacturing overhead costs to production.
Treating fixed manufacturing overhead as a
variable cost can:
• Lead to faulty pricing decisions and faulty
keep-or-drop decisions.
Assigning per unit fixed manufacturing overhead
costs to production can:
• Potentially produce positive net operating income
even when the number of units sold is less than
the breakeven point.
McGraw-Hill Education (Asia)
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Slide 24
External Reporting and Income Taxes
To conform to
IFRS and US GAAP
requirements, absorption costing
must be used for
external financial reports.
In many countries,
including US,
absorption costing must be
used when filling out
income tax returns.
Since top executives
are typically evaluated based on
earnings reported to shareholders
in external reports, they may feel that
decisions should be based on
absorption costing data.
McGraw-Hill Education (Asia)
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Slide 25
Advantages of Variable Costing
and the Contribution Approach
Management finds
it more useful.
Consistent with
CVP analysis.
Net operating income
is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Advantages
Easier to estimate profitability
of products and segments.
Impact of fixed
costs on profits
emphasized.
McGraw-Hill Education (Asia)
Profit is not affected by
changes in inventories.
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 26
Variable versus Absorption Costing
Fixed manufacturing
costs must be assigned
to products to properly
match revenues and
costs.
Fixed manufacturing
costs are capacity costs
and will be incurred
even if nothing is
produced.
Variable
Costing
Absorption
Costing
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 27
Variable Costing and the Theory of
Constraints (TOC)
Companies involved in TOC use a form of variable
costing. However, one difference of the TOC approach
is that it treats direct labor as a fixed cost for three
reasons:

Many companies have a commitment to guarantee
workers a minimum number of paid hours.

Direct labor is usually not the constraint.

TOC emphasizes the role direct laborers play in driving
continuous improvement. Since layoffs often devastate
morale, managers involved in TOC are extremely
reluctant to lay off employees.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 28
Impact of Lean Production
When companies use Lean Production . . .
Production
tends to equal
sales . . .
So, the difference between variable and
absorption income tends to disappear.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 29
Learning Objective 5
Compute predetermined
overhead rates and explain
why estimated overhead
costs (rather than actual
overhead costs) being used
in the costing process.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 30
Why Use an Allocation Base?
Manufacturing overhead is applied to products/jobs
that are in process. An allocation base, such as
direct labor hours, direct labor dollars, or machine
hours, is used to assign manufacturing overhead to
individual products/jobs.
We use an allocation base because:
1.It is impossible or difficult to trace overhead costs to particular
products/jobs.
2.Manufacturing overhead consists of many different items ranging
from the grease used in machines to production manager’s salary.
3.Many types of manufacturing overhead costs are fixed even though
output fluctuates during the period.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 31
Manufacturing Overhead Application
The predetermined overhead rate (POHR) used to
apply overhead to products/jobs is determined
before the period begins.
POHR =
Estimated total manufacturing
overhead cost for the coming period
Estimated total units in the
allocation base for the coming period
Ideally, the allocation base
is a cost driver that causes
overhead.
McGraw-Hill Education (Asia)
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Slide 32
The Need for a POHR
Using a predetermined rate makes it
possible to estimate total product/job costs sooner.
Actual overhead for the period is not
known until the end of the period.
McGraw-Hill Education (Asia)
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Slide 33
Determining Predetermined Overhead Rates
Predetermined overhead rates are calculated
using a three-step process.



Estimate the level of
production for the
period.
Estimate total amount
of the allocation base
for the period.
Estimate total
manufacturing
overhead costs.
POHR =  ÷ 
McGraw-Hill Education (Asia)
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Slide 34
Application of Manufacturing Overhead
Based on estimates, and
determined before the
period begins.
Overhead applied = POHR × Actual activity
Actual amount of allocation is
based upon the actual level of
activity (normal costing system).
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 35
Overhead Application Rate for the Harvey Example
POHR =
Estimated total manufacturing
overhead cost for the coming period
Estimated total units in the
allocation base for the coming period
$150,000
POHR =
50,000 direct labor hours (DLH)
POHR = $3.00 per DLH
For each direct labor hour worked on a particular product, $3.00 of factory
overhead will be applied to it. For product valuation, it must be valued by
unit. In this case, assume each unit requires 2 direct labor hours. Hence,
each unit of the product absorbs $6 predetermined overhead. In order
to match back with Harvey’s example, we further assume that variable
manufacturing overhead = 0. So the predetermined overhead represents
only fixed manufacturing overhead cost as shown in slides 14 & 19.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 36
Learning Objective 6
Understand the implications
of basing the predetermined
overhead rate on activity at
capacity rather than on
estimated activity for the
period.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 37
Predetermined Overhead Rate and Capacity
Calculating predetermined overhead rates using an
estimated, or budgeted amount of the allocation base
has been criticized because:
1.Basing the predetermined overhead rate upon
budgeted activity results in product costs that fluctuate
depending upon the activity level.
2.Calculating predetermined rates based upon
budgeted activity charges products for costs that they
do not use.
McGraw-Hill Education (Asia)
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Slide 38
Capacity-Based Overhead Rates
Criticisms can be overcome by using
estimated total units in the allocation base
at capacity in the denominator of the
predetermined overhead rate calculation.
Let’s look at the difference!
McGraw-Hill Education (Asia)
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Slide 39
An Example
Equipment is leased for $100,000 per
year. Running at full capacity, 50,000
units may be produced. The company
estimates that 40,000 units will be
produced and sold next year. What is
the predetermined overhead rate?
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 40
An Example
Equipment is leased for $100,000 per year.
Running at full capacity, 50,000 units may be
produced. The company estimates that 40,000 units
will be produced and sold next year.
Traditional
=
Method
$100,000
40,000
= $2.50 per unit
Capacity
Method
$100,000
50,000
= $2.00 per unit
McGraw-Hill Education (Asia)
=
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 41
Quick Check 
Barossa Winery in Barossa Valley, South
Australia, leases an automatic corking machine
for $100,000 per year. At full capacity, it can cork
50,000 cases of wine per year. The company
estimates 40,000 cases of wine will be produced
and sold next year. What is the predetermined
overhead rate based on the estimated number of
cases of wine?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 42
Quick Check 
Barossa Winery in Barossa Valley, South Australia,
leases an automatic corking machine for $100,000
per year. At full capacity, it can cork 50,000 cases
of wine per year.The company estimates 40,000
cases of wine will be produced and sold next year.
What is the predetermined overhead rate based
on the estimated number of cases of wine?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 43
Quick Check 
Barossa Winery in Barossa Valley, South
Australia, leases an automatic corking machine
for $100,000 per year. At full capacity, it can cork
50,000 cases of wine per year. The company
estimates 40,000 cases of wine will be produced
and sold next year. What is the predetermined
overhead rate based on the number of cases of
wine at capacity?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 44
Quick Check 
Barossa Winery in Barossa Valley, South Australia,
leases an automatic corking machine for $100,000
per year. At full capacity, it can cork 50,000 cases
of wine per year.The company estimates 40,000
cases of wine will be produced and sold next year.
What is the predetermined overhead rate based
on the number of cases of wine at capacity?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 45
Quick Check 
When capacity is used in the denominator of the
predetermined rate, what happens to the
predetermined overhead rate as estimated activity
decreases?
a. The predetermined overhead rate goes up when activity
goes down.
b. The predetermined overhead rate stays the same because
it is not affected by changes in activity.
c. The predetermined overhead rate goes down when activity
goes down.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 46
Quick Check 
When capacity is used in the denominator of the
predetermined rate, what happens to the
predetermined overhead rate as estimated activity
decreases?
a.The predetermined overhead rate goes up when activity
goes down.
b.The predetermined overhead rate stays the same because it
is not affected by changes in activity.
c.The predetermined overhead rate goes down when activity
goes down.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 47
Quick Check 
When estimated activity is used in the
denominator of the predetermined rate, what
happens to the predetermined overhead rate as
estimated activity decreases?
a. The predetermined overhead rate goes up when
activity goes down.
b. The predetermined overhead rate stays the same
because it is not affected by changes in activity.
c. The predetermined overhead rate goes down when
activity goes down.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 48
Quick Check 
When estimated activity is used in the
denominator of the predetermined rate, what
happens to the predetermined overhead rate as
estimated activity decreases?
a.The predetermined overhead rate goes up when
activity goes down.
b.The predetermined overhead rate stays the same
because it is not affected by changes in activity.
c.The predetermined overhead rate goes down when
activity goes down.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 49
Income Statement Preparation – Capacity
Actual volume
Selling price
Variable production cost
Fixed manufacturing overhead
Capacity
Predetermined overhead rate
Fixed selling and admin. expense
Revenue
Cost of goods sold
Gross margin
Cost of idle capacity
Selling and admin. expense
Net operating income
McGraw-Hill Education (Asia)
40,000
$40.00
$24.00
$100,000
50,000
$2.00
$500,000
cases
per case
per case
per year
cases
per case
per year
$ 1,600,000
1,040,000
560,000
20,000
500,000
40,000
$
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 50
Income Statement Preparation – Traditional
Actual volume
Selling price
Variable production cost
Fixed manufacturing overhead
Capacity
Predetermined overhead rate
Fixed selling and admin. expense
Revenue
Cost of goods sold
Gross margin
Cost of idle capacity
Selling and admin. expense
Net operating income
McGraw-Hill Education (Asia)
40,000
$40.00
$24.00
$100,000
40,000
$2.50
$500,000
cases
per case
per case
per year
cases
per case
per year
$ 1,600,000
1,060,000
540,000
500,000
$
40,000
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 51
Learning Objective 7
Compute underapplied or
overapplied overhead cost and
prepare the journal entry to
close the balance in
Manufacturing Overhead to the
appropriate accounts.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 52
Problems of Overhead Application
The difference between the overhead cost applied to
Work in Process and the actual overhead costs of a
period is referred to as either underapplied or
overapplied overhead.
Overapplied overhead
Underapplied overhead
exists when the amount of
exists when the amount of
overhead applied to
overhead applied to
products/jobs during the
products/ jobs during the
period using the
period using the
predetermined overhead
predetermined overhead
rate is greater than the total
rate is less than the total
amount of overhead actually amount of overhead actually
incurred during the period.
incurred during the period.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 53
Overhead Application Example
Recall the Harvey example between slides 9 and 36.
Let’s rename the example as Harvey Fresh and
assume actual overhead for the year was $120,000
(instead of $150,000 in the original Harvey example).
The total direct labor hours incurred were 50,000. The
rest remains the same.
How much total overhead was applied to Harvey Fresh’s
products during the year? Use Harvey’s predetermined
overhead rate of $3.00 per direct labor hour.
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $3.00 per DLH × 50,000 DLH = $150,000
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 54
Overhead Application Example
Harvey Fresh’s actual overhead for the year was
$120,000 with a total of 50,000 direct labor hours
worked on products.
How much
totalhas
overhead
was applied to Harvey Fresh’s
Harvey
Fresh
overapplied
products
the year? Use Harvey’s
overhead
for during
the year
predetermined
by $30,000. overhead
What will rate of $4.00 per direct labor
Harvey Fresh do? hour.
Overhead Applied During the Period
Applied Overhead = POHR × Actual Direct Labor Hours
Applied Overhead = $3.00 per DLH × 50,000 DLH = $150,000
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 55
Quick Check 
Tiger, Ltd. had actual manufacturing overhead
costs of $1,210,000 and a predetermined overhead
rate of $4.00 per machine hour. Tiger, Ltd. worked
290,000 machine hours during the period. Tiger’s
manufacturing overhead is
a. $50,000 overapplied.
b. $50,000 underapplied.
c. $60,000 overapplied.
d. $60,000 underapplied.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 56
Quick Check 
Tiger, Ltd. had actual manufacturing overhead
costs of $1,210,000 andOverhead
a predetermined
overhead
Applied
rate of $4.00 per machine$4.00
hour.
Ltd. worked
per Tiger,
hour × 290,000
hours
= $1,160,000
290,000 machine hours during
the period. Tiger’s
Underapplied
Overhead
manufacturing overhead
is
a. $50,000 overapplied.
$1,210,000 - $1,160,000
= $50,000
b. $50,000 underapplied.
c. $60,000 overapplied.
d. $60,000 underapplied.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 57
Disposition of Under- or Overapplied
Overhead
Harvey Fresh’s
Method
$30,000
may be allocated
to these accounts.
$30,000 may be
closed directly to
cost of goods sold.
OR
Work in
Process
Finished
Goods
Cost of
Goods Sold
McGraw-Hill Education (Asia)
Cost of
Goods Sold
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 58
Disposition of
Under/Overapplied Overhead
Harvey Fresh ’s
Mfg. Overhead
Harvey Fresh’s Cost
of Goods Sold
Actual
Overhead
overhead
applied
costs
to products
Unadjusted
Balance
$30,000
Adjusted
Balance
McGraw-Hill Education (Asia)
$120,000
$150,000
$30,000
$30,000
overapplied
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 59
Under/Overapplied Adjustment Through
COGS
If Harvey Fresh’s overapplied adjustment is directly through
COGS, then its profit will be as follows:
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 60
Allocating Under- or Overapplied
Overhead Between Accounts
In Year 1, Harvey Fresh ’s overhead applied in ending
Work in Process Inventory, ending Finished Goods
Inventory, and Cost of Goods Sold is shown below:
Work in process
Finished Goods
Cost of Goods Sold
Total overhead applied
McGraw-Hill Education (Asia)
Amount
$
30,000
120,000
$ 150,000
Garrison, Noreen, Brewer, Cheng & Yuen
Percent of
Total
0%
20%
80%
100%
Allocation
of $30,000
$
3,000
9,000
18,000
$
30,000
Slide 61
Allocating Under- or Overapplied
Overhead Between Accounts
We would complete the following allocation of
$30,000 overapplied overhead:
Work in process
Finished Goods
Cost of Goods Sold
Total
Amount
$
30,000
120,000
$ 150,000
Percent of
Total
0%
20%
80%
100%
Allocation
of $30,000
overapplied
overhead
$
6,000
24,000
$
30,000
20% × $30,000
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 62
Allocating Under- or Overapplied
Overhead Between Accounts
Work in process
Finished Goods
Cost of Goods Sold
Total
McGraw-Hill Education (Asia)
Amount
$
30,000
120,000
$ 150,000
Percent of
Total
0%
20%
80%
100%
Garrison, Noreen, Brewer, Cheng & Yuen
Allocation
of $30,000
$
6,000
24,000
$
30,000
Slide 63
Under/Overapplied Adjustment Through the
Proportional Allocation Method
Net result of
$24,000 adjusted
against COGS
Net Operating Income is different
from the one with adjustment
directly through COGS ($150,000)
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 64
Quick Check 
Revisit the earlier Tiger, Ltd. exercise on slide 56. Before
any manufacturing fixed overhead over/underapplied
adjustment, the relevant figures are as follows:
Work in process
20,000
Finished goods
30,000
Cost of goods sold
50,000
How much should Tiger’s over/underapplied manufacturing
fixed overhead be adjusted to Finished Goods (FG) if the
proportional allocation method is used?
a. $15,000 more (i.e. debit) to FG.
b. $15,000 less (i.e. credit) to FG.
c. $30,000 more (i.e. debit) to FG.
d. $30,000 less (i.e. credit) to FG.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 65
Quick Check 
Revisit the earlier Tiger, Ltd. exercise on slide 56. Before
any manufacturing fixed overhead
over/underapplied
Percent
of Underapplied
Amount
Total
of $50,000
adjustment, the relevant
figures are
as follows:
Work in process
$
Work in process
Finished Goods
Finished
goods
Cost
of Goods
Sold
Cost of goods sold$
Total
20,000
20,000
30,000
30,000
50,000
50,000
100,000
20%
30%
50%
100%
$
$
10,000
15,000
25,000
50,000
How much shouldTiger’s over/underapplied manufacturing
fixed overhead be adjusted to Finished Goods (FG) if the
proportional allocation method is used?
a. $15,000 more (i.e. debit) to FG.
b. $15,000 less (i.e. credit) to FG.
c. $30,000 more (i.e. debit) to FG.
d. $30,000 less (i.e. credit) to FG.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 66
Quick Check 
Revisit the earlier Tiger, Ltd. exercise on slide 55. Before
any manufacturing fixed overhead over/underapplied
adjustment, the relevant figures are as follows:
Work in process
$20,000
Finished goods
$30,000
Cost of goods sold
$50,000
How much shouldTiger’s over/underapplied manufacturing
fixed overhead be adjusted to Cost of Goods Sold (COGS) if
the proportional allocation method is used?
a. $50,000 more (i.e. debit) to COGS.
b. $50,000 less (i.e. credit) to COGS.
c. $25,000 more (i.e. debit) to COGS.
d. $25,000 less (i.e. credit) to COGS.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 67
Quick Check 
Revisit the earlier Tiger, Ltd. exercise on slide 56. Before
any manufacturing fixed overhead
over/underapplied
Percent
of Underapplied
adjustment, the relevant
figures are
as follows:
Amount
Total
of $50,000
Work
Workininprocess
process $
Finished Goods
Finished goods
Cost of Goods Sold
Cost of goods sold$
Total
20,000
20,000
30,000
30,000
50,000
50,000
100,000
20%
30%
50%
100%
$
$
10,000
15,000
25,000
50,000
How much shouldTiger’s over/underapplied manufacturing
fixed overhead be adjusted to Cost of Goods Sold (COGS) if
the proportional allocation method is used?
a. $50,000 more (i.e. debit) to COGS.
b. $50,000 less (i.e. credit) to COGS.
c. $25,000 more (i.e. debit) to COGS.
d. $25,000 less (i.e. credit) to COGS.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 68
Learning Objective 8
Explain the potential
problems of using
absorption costing.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 69
Creating Extra Profit Without Increase In Sales
Continue with the Harvey Fresh example (slides 54, and 58 to 64).
Assume the company had the same sales, revenue and cost structure
but produced 35,000 units (instead of 25,000 units) to increase ending
inventory by 10,000 units.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 70
Overapplied adjustments required



Harvey Fresh’s actual fixed manufacturing overhead
= $120,000
Based on the original scenario, the applied overhead
was based on actual production of 25,000 units at $6
each (slide 19), giving rise $150,000 being applied to
the items produced. Therefore, it was overapplied
by $30,000 ($150,000 applied - $120,000 actual).
Based on the new scenario, the applied overhead
was based on actual production of 35,000 units at $6
each (slide 19), giving rise $210,000 being applied to
the production. Therefore, it was overapplied by
$90,000 ($210,000 applied - $120,000 actual).
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 71
Profit Arising from Ending Inventory Value




The additional profit ($60,000) is the same amount as the
additional overapplied adjustment ($90,000 - $30,000).
The overapplied adjustment is to make good of the applied
fixed overhead to match with the actual overhead spent.
The additional profit actually arises from the additional fixed
overhead (based on the predetermined overhead rate,
POHR) carried forward through the change in ending
inventory, amounting the same as the over/underapplied
fixed overhead adjustment if the adjustment is written off
directly to cost of goods sold.
If the adjustment is done through the proportional method
shown in slides 61– 64, then the increased profit will not
match the overapplied adjustment.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 72
Value of Ending Inventory
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 73
Use of Variable Costing
Continue with the Harvey Fresh example but presenting the results
using the variable costing format.
Profits remain the same despite of changing quantity in production and ending inventory
Use of Variable Costing can avoid Profit inflation through producing more inventories
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 74
Overapplied and Underapplied Manufacturing
Overhead - Summary
Harvey Fresh’s
Method
If Manufacturing
Overhead is . . .
UNDERAPPLIED
Alternative 1
Close to Cost
of Goods Sold
Alternative 2
Proportional
Allocation
INCREASE
Cost of Goods Sold
INCREASE
Work in Process
Finished Goods
Cost of Goods Sold
DECREASE
Cost of Goods Sold
DECREASE
Work in Process
Finished Goods
Cost of Goods Sold
(Applied OH is less
than actual OH)
OVERAPPLIED
(Applied OH is greater
than actual OH)
More accurate but more complex to compute.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 75
Quick Check 
What effect will the overapplied overhead have
on Harvey’s net operating income?
a. Net operating income will increase.
b. Net operating income will be unaffected.
c. Net operating income will decrease.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 76
Quick Check 
What effect will the overapplied overhead have
on Harvey’s net operating income?
a. Net operating income will increase.
b. Net operating income will be unaffected.
c. Net operating income will decrease.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 77
Multiple Predetermined Overhead Rates
To this point, we have assumed that there is a single
predetermined overhead rate called a plantwide
overhead rate.
Large companies
often use multiple
predetermined
overhead rates.
May be more complex
but . . .
May be more accurate because
it reflects differences across
departments.
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 78
End of Chapter 5
McGraw-Hill Education (Asia)
Garrison, Noreen, Brewer, Cheng & Yuen
Slide 79