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Chapter 3:Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable CostingProduct Costing stepsProduct CostingMethods of product costing:Cost Accumulation System definesCost object Method of assigning costs to productionValuation Method specifiesHow product costs will be measured

Six PossibilitiesVAL MU EA TT HI OO DN COST ACCUMULATION SYSTEMJob OrderActualNormalStandardProcess ActualNormalStandardValuation MethodsActualActual direct materialActual direct laborActual overheadNormalActual direct materialActual direct laborPredetermined overheadStandardStandard direct materialStandard direct laborStandard overheadThe Difference55 2011 Cen

66Accounting for Overhead Costs

What is Overhead?DefinitionManufacturing costs that cannot be traced directly to specific units produced.Factory overheadFactory burdenProduction OverheadIndirect production costIndirect manufacturing costsManufacturing overheadManufacturing expenseFactory expenseGive 5 examples of overhead.ExamplesIndirect labor, indirect materials

and other indirect manufacturing costsWages paid to employees who are not directly involved in production work. Examples: maintenance workers, janitors and security guards.Materials used to support the production process. Examples: lubricants and cleaning supplies used in the automobile assembly plant.Factory rental, factory utilities, factory plant and equipment depreciation,Amortization of patent etcCharacteristicsDeals with relationship to the product and the volume of production (i.e. OH is invisible part of the product) --- INDIRECT

Deals with how different items of overhead change in response to change in production volume --- COST BEHAVIOR

What is pOHr?A budgeted, constant charge per unit of activity used to assign overhead to production or services

Four primary reasons for using POHR in product costing. 1. A predetermined overhead rate allows overhead to be assigned during the period to the goods produced or sold and to the services rendered.

We sacrifice some precision for timeliness.Predetermined overhead rates adjust for variations in actual overhead costs that are unrelated to activity.

For example, electricity costs run higher in the summer because of the costs of air conditioning.Predetermined overhead rates overcome the problem of fluctuations in activity levels that have no impact on actual fixed overhead costs.

- Fixed cost per unit varies when activity levels change. - To minimize such variations in unit cost, we use an annual predetermined overhead rate for fixed overhead for all units produced during the year.4. Using predetermined overhead rates allows managers to be more aware of individual product or product line profitability as well as the profitability of doing business with a particular customer or vendor.What is formula for pOHr?FormulaPredeterminedOverheadRateTotal budgeted overheadActivity level(Volume)= $100,0005,000 DL Hours$20 per DL Hours= Numerator Overhead is typically budgeted for one year.

DenominatorRelationship between the overhead cost and the activityaka Cost DriverCompanies should use an activity base that is logically related to actual overhead cost incurrence. What are the factors considered in selecting OH rates?Factors considered in selecting OH ratesBased to be usedActivity level selectionIncluding or excluding fixed overheadUse of single rate or several ratesUse of separate rates for service activitiesWhat are the based to be used in pOHr?Based to be used cost driverPhysical outputDirect materials costDirect labor costDirect labor hoursMachine hoursTransactions or activities (ABC) Desmond Corp. estimates that its production for the coming year will be 10,000 widgets, which is 80% of normal capacity, with the following unit costs: materials, $40; direct labor, $60. Direct labor is paid at the rate of $24 per hour. The widget shaper, the most expensive piece of machinery, must be run for 20 minutes to produce one widget. Total estimated overhead is expected to be $800,000.RequiredCompute the overhead rate for each of the following bases, using the expected actual capacity activity level:(1)physical output(2)materials cost(3)direct labor cost(4)direct labor hours(5)machine hoursSOLUTION

Factors considered in selecting OH ratesBased to be usedActivity level selectionIncluding or excluding fixed overheadUse of single rate or several ratesUse of separate rates for service activitiesActivity level selectionTheoretical capacityPractical CapacityExpected Actual CapacityNormal CapacityTheoretical capacityThe capacity to produce at full speed without interruptions or downturns100% of its rated capacity Not realisticPractical CapacityTheoretical capacity reduced by allowance for unavoidable interruptions such as crew changes, preventive maintenance, repairs, setups, failures, unsatisfactory materials, delay in deliveries of materials, labor shortages, absences, holidays etc75% to 85% of theoretical capacityExpected actual capacityAmount of output expected to be produced during the periodPlanned productionUsually results in a different POHR for each period because of increases and decreases in planned production Normal CapacityAverage activity over time period long enough to level out highs and lows Stabilize pOHr that would fluctuate as facilities are used to different degrees in different periodsDesmond Corp. estimates that its production for the coming year will be 10,000 widgets, which is 80% of normal capacity, with the following unit costs: materials, $40; direct labor, $60. Direct labor is paid at the rate of $24 per hour. The widget shaper, the most expensive piece of machinery, must be run for 20 minutes to produce one widget. Total estimated overhead is expected to be $800,000.RequiredCompute the overhead rate for each of the following bases, using the normal capacity activity level:(1)physical output(2)materials cost(3)direct labor cost(4)direct labor hours(5)machine hoursSOLUTION

St. Louis Sounds Inc. manufactures audio equipment. The company estimates the following costs at normal capacity and other items for the coming period:Direct materials$300,000Direct labor 520,000Factory overhead (fixed) 300,000Factory overhead (variable) 240,000

Normal capacity100,000direct labor hoursExpected production 80,000direct labor hours

Required:Compute the overhead application rate for fixed, variable, and total overhead per direct labor hour, using both the normal capacity and the expected actual capacity activity levels.

OH ApplicationApplied overhead is the amount of overhead assigned to Work in Process Inventory using the activity that was employed to develop the application rate. For convenience, both actual and applied overhead are recorded in a single general ledger account. The amount of applied overhead is determined by multiplying the predetermined rate by the actual activity level.

SampleActual activity level x POHR = overhead applied

4,300 machine hours x $7.50 = $32,250 overhead applied Debits to the overhead account represent actual overhead

Credits to the overhead account represent applied overhead (see text Exhibit 3-2).

EntriesApply Overhead (combined journal entry)Work in Process Inventory xxx Variable Manufacturing Overheadxxx Fixed Manufacturing Overhead xxxActual Overhead (combined journal entry) Variable Manufacturing Overhead xxx Fixed Manufacturing Overhead xxxVarious AccountsxxxT-accountOverhead Account(Combined Fixed/Variable)Actual OverheadApplied Overhead Variable xxxFixed xxxVariable xxxFixed xxxdifferencesActual OH > Applied OH underapplied

Actual OH < Applied OH overappliedDisposition of OH differencesImmaterial close to COGS

Material prorated and assigned to WIP, FGI and COGSEntries - immaterialManufacturing OH xxxCOGSxxxTo close overapplied OH

COGSxxxManufacturing OH xxxTo close underapplied OHDisposition of OH differencesIf overhead is underappliedCost of Goods Sold increasesIncome decreases

If overhead is overappliedCost of Goods Sold decreasesIncome increases

Entries - materialManufacturing OHxxxWIPxxxFGIxxxCOGSxxxTo close overapplied OH

WIP xxxFGI xxxCOGS xxxManufacturing OHxxxTo close underapplied OHAnalyzing Mixed CostsMixed Cost$# of UnitsfixedvariableA mixed cost contains both a variable and fixed component50Separating Mixed CostsTo determine variable and fixed predetermined overhead rates, separate mixed costs into variable and fixed componentsUse formula for a straight line:

y = a + bXy = total costa = fixed portion of total costb = variable cost per unitX = activity base to which y is relatedMethods for Separating Mixed CostsHigh-Low MethodActual cost observationsConsiders only two data pointsHighest and lowest levels of activityDisregard outliers when analyzing mixed costsLeast Squares Regression Analysis Statistical technique that analyzes the relationship between dependent and independent variablesDependent variableCostIndependent variablesActivitiesRegression line provides line of best fit for the data CostMachineHoursHighLow 9,0004,600 $3,5002,180Difference4,400$1,320 = $0.30/unitVariable cost per unit $1,3204,4003,500 = a + ($0.30)(9,000) a = 800Fixed costY = $800 + $0.30X (X = machine hours) Using the HighLow Method ex. 3-653Please answer exercises 3-21 to 3-23Regression Analysis AssumptionsIndependent variable must be a valid predictor of the dependent variableCoefficient of correlationReliable only within the relevant rangeUseful only as long as circumstances existing at the time of its development remain constantEstimated Total CostsHighLow Method $800.00 + $0.30X

Regression Analysis$354.62 + $0.35XMore data pointsmean abetter estimate of total costs(X = machine hours)56Flexible BudgetsFlexible BudgetsSeparate overhead costs into fixed and variable components in order to estimate the amount of overhead at various levels of the denominator activity Shows manufacturing overhead costs and cost behaviorSeparates costs into fixed and variable elementsProvides budgeted costs at various activity levelsShows impact of a change in the denominator level of activity58Preparing a Flexible BudgetSeparate mixed costs into variable and fixed elementsDetermine the a + bX cost formulaSelect several potential levels of activity within the relevant rangeDetermine total cost expected at each of the activity levels59Flexible Budgets

60Absorption vs. Variable CostingAbsorption or Full CostingExternal useGAAPClassify by FunctionCost of goods soldSelling expenseAdministrative expenseVariable or Direct CostingInternal use Not GAAPClassify by BehaviorVariableFixed

62Absorption vs. Variable CostingAbsorption or FullProduct costsDirect materialDirect laborVariable mfg. overheadFixed mfg. overheadPeriod costs SellingGeneralAdministrative

Variable or DirectProduct costsDirect materialDirect laborVariable mfg. overheadPeriod costsFixed mfg. overheadSellingGeneralAdministrative63Differences Between Absorption and Variable CostingAbsorption CostingFixed manufacturing overhead is a product costVariable CostingFixed manufacturing overhead is a period costVariable operating expenses are subtracted from product contribution margin to equal contribution margin

64Income Statement Absorption Costing SalesLess: Cost of Goods SoldGross ProfitLess: Operating ExpensesNet IncomeProduct CostsDirect MaterialDirect LaborFixed and Variable Mfg. OverheadPeriod CostsSelling, General,Administrative65Variable Costing or Contribution Margin Income Statement SalesLess:Variable Cost of Goods SoldProduct Contribution MarginLess: Variable Operating ExpensesContribution MarginLess:Fixed Mfg. OverheadLess:Fixed Operating ExpensesNet IncomeDirect MaterialDirect LaborVariable Mfg. OverheadSelling, General,AdministrationSelling GeneralAdministrative66IllustrationGiven:201020112012Production (units) 1,0001,0001,000Sales (units)1,000 800 1,200

Selling price = $10 / unit soldProduction costs:DM = $1.25 / unit producedDL = $1.45 / unit producedVOH = $1.30 / unit producedFOH = $2,000 ($2 / unit produced)Selling and admin expenses VSAE = $1 / unit soldFSAE = $500

Difference in Income Absorption vs. VariableNo change in inventory levelAbsorption Income = Variable IncomeIncrease in inventory levelAbsorption Income > Variable IncomePhantom ProfitsDecrease in inventory levelAbsorption Income < Variable Income

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69Income Statement (Absorption Costing)SalesLess: COGS + Underapplied FOH ( overapplied FOH)Gross ProfitLess: Operating ExpensesNet IncomeNORMAL COSTING:Actual FOH Applied FOH(UNDER OR OVER APPLIED OH

STANDARD COSTING:Budgeted FOH Applied FOH(VOLUME VARIANCE) 70