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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
variable
Mixed Cost
$
fixed
Units
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