Accounting for Overhead Costs

©2008 Prentice Hall Business Publishing, ©2008 Prentice Hall Business Publishing, Introduction to Management AccountingIntroduction to Management Accounting 14/e,14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 13 - Horngren/Sundem/Stratton/Schatzberg/Burgstahler 13 - 11

Accounting for Accounting for Overhead CostsOverhead Costs

Introduction to Management AccountingIntroduction to Management Accounting

Chapter Chapter 1313


Accounting for Factory OverheadAccounting for Factory Overhead

Methods for assigning overhead costsMethods for assigning overhead coststo the products is an important part ofto the products is an important part ofaccurately measuring product costs.accurately measuring product costs.

LearningLearningObjective 1Objective 1


Budgeted Overhead Application RatesBudgeted Overhead Application Rates

1. Select one or more cost drivers.1. Select one or more cost drivers.2. Prepare a factory overhead budget.2. Prepare a factory overhead budget.3. Compute the factory overhead rate.3. Compute the factory overhead rate.4. Obtain actual cost-driver data.4. Obtain actual cost-driver data.5. Apply the budgeted overhead5. Apply the budgeted overhead to the products.to the products.6. Account for any differences between the6. Account for any differences between the amount of actual and applied overhead.amount of actual and applied overhead.


Budgeted overhead application rateBudgeted overhead application rate= Total budgeted factory overhead= Total budgeted factory overhead

÷ Total budgeted amount of cost driver÷ Total budgeted amount of cost driver

Budgeted Overhead Application RatesBudgeted Overhead Application Rates

Overhead rates are Overhead rates are budgeted; they are budgeted; they are estimates. The budgeted estimates. The budgeted rates are used to apply rates are used to apply overhead based on actual overhead based on actual events.events.


Illustration of Overhead ApplicationIllustration of Overhead Application

The company’s budgeted manufacturing overheadThe company’s budgeted manufacturing overheadfor the machining department is $277,800.for the machining department is $277,800.

Budgeted machine hours are 69,450.Budgeted machine hours are 69,450.

The budgeted overhead application rate is:The budgeted overhead application rate is:$277,800 ÷ 69,450 = $4 per machine hour$277,800 ÷ 69,450 = $4 per machine hour

Enriquez Machine Parts Company selects a Enriquez Machine Parts Company selects a single cost-allocation in each department for single cost-allocation in each department for applying overhead, machine hours in applying overhead, machine hours in machining and direct-labor in assembly.machining and direct-labor in assembly.


Illustration of Overhead ApplicationIllustration of Overhead Application

Suppose that at the end of the year EnriquezSuppose that at the end of the year Enriquezhad used 70,000 hours in Machining.had used 70,000 hours in Machining.

How much overhead was applied to Machining?How much overhead was applied to Machining?


Choice of Cost-Allocation BasesChoice of Cost-Allocation Bases

No one cost –allocation base is right for all situations.No one cost –allocation base is right for all situations.

The accountant’s goal is to find the cost-The accountant’s goal is to find the cost-allocation base that best links cause and effect.allocation base that best links cause and effect.



Choice of Cost-Allocation BasesChoice of Cost-Allocation Bases

A separate cost pool should be A separate cost pool should be Identified for each cost-allocation base.Identified for each cost-allocation base.

Base 1 Base 1 Pool 1Pool 1

Base 2 Base 2 Pool 2Pool 2


Normalized Overhead RatesNormalized Overhead Rates

““Normal” product costs includeNormal” product costs includean average or normalizedan average or normalized

chunk of overhead.chunk of overhead.

Actual direct materialActual direct material+ Actual direct labor+ Actual direct labor

+ Normal applied overhead+ Normal applied overhead= Cost of manufactured product= Cost of manufactured product



Disposing of Underapplied Disposing of Underapplied or Overapplied Overheador Overapplied Overhead

Suppose that Enriquez appliedSuppose that Enriquez applied$375,000 to its products.$375,000 to its products.

Also, suppose that Enriquez actually incurred $392,000 Also, suppose that Enriquez actually incurred $392,000 of actual manufacturing overhead during the year.of actual manufacturing overhead during the year.

$392,000 actual $392,000 actual ––375,000375,000 applied applied $ 17,000 Underapplied$ 17,000 Underapplied

The $375,000 becomes part of Cost of The $375,000 becomes part of Cost of Goods Sold when the product is sold. The Goods Sold when the product is sold. The $17,000 must also become an expense.$17,000 must also become an expense.


Disposing of Underapplied Disposing of Underapplied or Overapplied Overheador Overapplied Overhead

The applied overhead is The applied overhead is $17,000 less than the $17,000 less than the amount incurred. It is:amount incurred. It is:

Overapplied overhead occurs when Overapplied overhead occurs when the amount applied exceeds the the amount applied exceeds the amount incurred.amount incurred.


Immediate Write-OffImmediate Write-Off

Manufacturing OverheadManufacturing Overhead

392,000392,000 375,000375,000 17,00017,000

00

Cost of Goods SoldCost of Goods Sold

17,00017,000Incurred Incurred Overhead Overhead (Actual)(Actual)

Applied Applied Overhead Overhead

(Budgeted)(Budgeted)

This method regards the $17,000 as a This method regards the $17,000 as a reduction in current income and adds it reduction in current income and adds it to Cost of Goods Sold.to Cost of Goods Sold.


Prorating Among InventoriesProrating Among Inventories

This method prorates the $17,000 of This method prorates the $17,000 of underapplied overhead to Work-In Process (WIP),underapplied overhead to Work-In Process (WIP),Finished Goods, and Cost of Goods Sold accountsFinished Goods, and Cost of Goods Sold accountsassuming the following ending account balances:assuming the following ending account balances:

Work-in-Process InventoryWork-in-Process Inventory $ 155,000$ 155,000Finished Goods InventoryFinished Goods Inventory 32,000 32,000Cost of Goods SoldCost of Goods Sold 2,480,000 2,480,000

TotalTotal $2,667,000$2,667,000


Prorating Among InventoriesProrating Among Inventories

$17,000 × 155/2,667$17,000 × 155/2,667= 988 to Work-in-Process Inventory= 988 to Work-in-Process Inventory

$17,000 × 32/2,667$17,000 × 32/2,667= $204 to Finished Goods Inventory= $204 to Finished Goods Inventory

$17,000 × 2,480/2,667$17,000 × 2,480/2,667= $15,808 to Cost of Goods Sold= $15,808 to Cost of Goods Sold


Variable and Fixed Application RatesVariable and Fixed Application Rates

The presence of fixed costs is aThe presence of fixed costs is amajor reason of costing difficulties.major reason of costing difficulties.

Some companies distinguish betweenSome companies distinguish betweenvariable overhead and fixedvariable overhead and fixed

overhead for product costing.overhead for product costing.


Variable Versus Absorption CostingVariable Versus Absorption Costing

Variable costing excludes fixed manufacturing Variable costing excludes fixed manufacturing overhead from the cost of products.overhead from the cost of products.

Absorption costing includes fixed manufacturing Absorption costing includes fixed manufacturing overhead in the cost of products.overhead in the cost of products.

VariableVariablecostingcosting

AbsorptionAbsorptioncostingcosting


Facts and IllustrationFacts and Illustration

Basic Production Data at Standard CostBasic Production Data at Standard Cost

Direct materialDirect material $205$205Direct laborDirect labor 75 75

Variable manufacturing overheadVariable manufacturing overhead 20 20Standard variable costs per unitStandard variable costs per unit $300$300



The annual budget for fixed The annual budget for fixed manufacturing overhead is $1,500,000manufacturing overhead is $1,500,000

Budgeted production is 15,000 computers.Budgeted production is 15,000 computers.

Sales price = $500 per unitSales price = $500 per unit

$20 per computer is variable overhead.$20 per computer is variable overhead.

Sales commissions = 5% of dollar salesSales commissions = 5% of dollar sales

Fixed S&A expenses = $650,000Fixed S&A expenses = $650,000



UnitsUnits 20X7 20X7 20X8 20X8

Opening inventoryOpening inventory –– 3,000 3,000ProductionProduction 17,00017,000 14,00014,000SalesSales 14,00014,000 16,00016,000Ending inventoryEnding inventory 3,000 3,000 1,000 1,000

There are no variances from the There are no variances from the standard variable manufacturing costs, standard variable manufacturing costs, and the actual fixed manufacturing and the actual fixed manufacturing overhead incurred is exactly overhead incurred is exactly $1,500,000. $1,500,000.


Variable- Costing Method Variable- Costing Method Cost of Goods Sold Cost of Goods Sold

Variable expenses:Variable expenses:Variable manufacturing costVariable manufacturing cost of goods soldof goods sold Opening inventory, atOpening inventory, at – – $ 900$ 900

standard costs of $300standard costs of $300Add: variable cost of goodsAdd: variable cost of goods manufactured at standard,manufactured at standard, 17,000 and 14,000 units 17,000 and 14,000 units 5100 5100 4200 4200

Available for sale, 17,000 units Available for sale, 17,000 units 5100 5100 5100 5100Ending inventory, at $300Ending inventory, at $300 900 900¹¹ 300 300²²Variable manufacturingVariable manufacturing cost of goods soldcost of goods sold $4200$4200 $4800$4800

(thousands of dollars)(thousands of dollars) 20X7 20X7 20X8 20X8

¹3,000 units × $300 = $900,000 ²1,000 units × $300 = $300,000



Variable-Costing Method Variable-Costing Method Comparative Income StatementComparative Income Statement

Sales, 14,000 and 16,000 unitsSales, 14,000 and 16,000 units $7,000$7,000 $8,000$8,000Variable expenses:Variable expenses:

Variable manufacturingVariable manufacturing cost of goods soldcost of goods sold 420042001 480048001

Variable selling expenses,Variable selling expenses, at 5% of dollar salesat 5% of dollar sales 350 350 400 400

Contribution marginContribution margin $2,450$2,450 $2,800$2,800Fixed expenses:Fixed expenses:

Fixed factory overheadFixed factory overhead $1,500$1,500 $1,500$1,500Fixed selling and admin. expensesFixed selling and admin. expenses 650 650 650 650

Operating income, variable costingOperating income, variable costing $ 300$ 300 $ 650$ 650

(thousands of dollars) 20X7 20X8

1 from Cost of Goods Sold previous calculation from Cost of Goods Sold previous calculation


Fixed-Overhead RateFixed-Overhead Rate

The fixed-overhead rateThe fixed-overhead rate is theis theamount of fixed manufacturingamount of fixed manufacturing

overhead applied to eachoverhead applied to eachunit of production.unit of production.

$1,500,000 ÷ 15,000 = $100$1,500,000 ÷ 15,000 = $100

budgeted fixed budgeted fixed manufacturing overheadmanufacturing overhead expected volume of expected volume of production production

Fixed overhead rate = Fixed overhead rate =


Beginning inventoryBeginning inventory $ –$ – $1,200$1,200Add: Cost of goods manufacturedAdd: Cost of goods manufactured

at standard, of $400at standard, of $400** 6,800 6,800 5,600 5,600Available for saleAvailable for sale $6,800$6,800 $6,800$6,800Deduct: Ending inventoryDeduct: Ending inventory 1,200 1,200 400 400Cost of goods sold, at standardCost of goods sold, at standard $5,600$5,600 $6,400$6,400


Absorption-Costing Method Absorption-Costing Method Cost of Goods Sold Cost of Goods Sold

*Variable cost*Variable cost $300 $300 Fixed costFixed cost 100 100 Standard absorption costStandard absorption cost $400 $400



Absorption-Costing Method Absorption-Costing Method Comparative Income StatementComparative Income Statement

*Based on expected volume of production of 15,000 units:*Based on expected volume of production of 15,000 units: 20X7: (17,000 – 15,000) × $100 = $200,000 F20X7: (17,000 – 15,000) × $100 = $200,000 F 20X8: (14,000 – 15,000) × $100 = $100,000 U20X8: (14,000 – 15,000) × $100 = $100,000 U1From Cost of Goods Sold previous calculation1From Cost of Goods Sold previous calculation

SalesSales $7,000$7,000 $8,000$8,000Cost of goods sold, at standardCost of goods sold, at standard 5,6005,6001 6,4006,40011

Gross profit at standardGross profit at standard $1,400$1,400 $1,600$1,600Production-volume varianceProduction-volume variance** 200 200 F F 100 100 U UGross margin or gross profit “actual”Gross margin or gross profit “actual” $1,600$1,600 $1,500$1,500Selling and administrative expensesSelling and administrative expenses 1,000 1,000 1,050 1,050Operating income, variable costingOperating income, variable costing $ 600$ 600 $ 450$ 450



Production-Volume VarianceProduction-Volume Variance

Production-volume variance =Production-volume variance =(actual volume – expected volume) X fixed overhead rate (actual volume – expected volume) X fixed overhead rate

In practice, the production-volume varianceIn practice, the production-volume varianceis usually called simply the volume variance.is usually called simply the volume variance.


A production-volume variance appears when actual A production-volume variance appears when actual production deviates from the expected volume of production production deviates from the expected volume of production

used in computing the fixed overhead rate.used in computing the fixed overhead rate.


Production-Volume VarianceProduction-Volume Variance

There is no production-volume variance for variable overhead. There is no production-volume variance for variable overhead. The production-volume variance for fixed overhead arises becauseThe production-volume variance for fixed overhead arises becauseof the conflict between accounting for control (flexible budgets) of the conflict between accounting for control (flexible budgets)

and accounting for product costing (applied rates).and accounting for product costing (applied rates).

A flexible budget for fixed overhead is a lump-sum A flexible budget for fixed overhead is a lump-sum budgeted amount; volume does not affect it. However, budgeted amount; volume does not affect it. However,

applied fixed cost depends on actual volume.applied fixed cost depends on actual volume.


Variable Costing and Absorption CostingVariable Costing and Absorption Costing

The difference between income reportedThe difference between income reportedunder these two methods is entirely due tounder these two methods is entirely due tothe treatment of fixed manufacturing costs.the treatment of fixed manufacturing costs.


Variable Costing and Absorption CostingVariable Costing and Absorption Costing

On a variable-costing income statement, costs are On a variable-costing income statement, costs are separated into the major categories of fixed and variable.separated into the major categories of fixed and variable.

Revenue less all variable costs (both manufacturing Revenue less all variable costs (both manufacturing and non-manufacturing) is the contribution margin.and non-manufacturing) is the contribution margin.

On an absorption-costing income statement, costsOn an absorption-costing income statement, costsare separated into the major categories of are separated into the major categories of

manufacturing and non-manufacturing. Revenue manufacturing and non-manufacturing. Revenue less manufacturing costs (both fixed and variable)less manufacturing costs (both fixed and variable)

is gross profit or gross margin.is gross profit or gross margin.


Why Use Variable Costing?Why Use Variable Costing?

One reason is that absorption-costingOne reason is that absorption-costingincome is affected by productionincome is affected by production

volume while variable-costingvolume while variable-costingincome is not.income is not.

Another reason is based on whichAnother reason is based on whichsystem the company believessystem the company believes

gives a better signal aboutgives a better signal aboutperformance.performance.



Flexible-Budget VariancesFlexible-Budget Variances

All variances other than theAll variances other than theproduction-volume variance areproduction-volume variance are

essentially flexible-budget variances.essentially flexible-budget variances.

All other All other variances appear variances appear on both variable- on both variable- and absorption-and absorption-costing income costing income

statements.statements.


Flexible-Budget VariancesFlexible-Budget Variances

Flexible budgets are Flexible budgets are primarily designed to primarily designed to assist planning and assist planning and

control rather control rather than product costing.than product costing.

Flexible-budget variances measure components of Flexible-budget variances measure components of the differences between actual amounts and thethe differences between actual amounts and theflexible-budget amounts for the output achieved.flexible-budget amounts for the output achieved.


Effects of Sales and ProductionEffects of Sales and Productionon Reported Incomeon Reported Income

Production > Sales Production > Sales

Variable costing income is lowerVariable costing income is lowerthan absorption income.than absorption income.

Production < Sales Production < Sales

Variable costing income is higherVariable costing income is higherthan absorption income.than absorption income.


End of Chapter 13End of Chapter 13

The EndThe End

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Accounting for Overhead Costs