Chapter 3:

Predetermined Overhead
Rates, Flexible Budgets, and
Absorption/Variable Costing

Product Costing steps

Product Costing
Methods of product costing:
Cost Accumulation System defines
Cost object
Method of assigning costs to production
Valuation Method specifies
How product costs will be measured

Six Possibilities
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COST ACCUMULATION
SYSTEM
Job Order

Actual
Normal
Standard

Process

Actual
Normal
Standard

Valuation Methods
Actual
Actual direct material
Actual direct labor
Actual overhead

Standard
Standard direct material
Standard direct labor
Standard overhead

Normal
Actual direct material
Actual direct labor
Predetermined

overhead

The
Difference

 2011 Cen

Accounting for
Overhead Costs

What is Overhead?

Definition
Manufacturing costs that
cannot be traced directly to
specific units produced.

Factory overhead

Manufacturing expense

Factory burden

Ind

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Production
Overhea
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o

Manufacturing overhead

Factory expense
Indirect manufacturing costs

Give 5 examples of
overhead.

Examples
Indirect
Indirect labor,
labor,
Wages paid to employees
who are not directly involved
in production work.
Examples: maintenance
workers, janitors and security
guards.

indirect
indirect materials
materials
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 etc

and
and other
other indirect
indirect manufacturing
manufacturing costs
costs

Characteristics
Deals 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.

2. 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.

3. 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?

Formula
Predetermined
Overhead
Rate
$20 per
DL Hours

Total budgeted
overhead
Activity level
(Volume)

$100,000
5,000 DL Hours

Numerator
Overhead is typically
budgeted for one year.

Denominator
Relationship between the
overhead cost and the
activity
aka Cost Driver
Companies 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 rates
1. Based to be used
2. Activity level selection
3. Including or excluding fixed

overhead
4. Use of single rate or several
rates
5. Use of separate rates for
service activities

What are the based

to be used in pOHr?

a.
b.
c.
d.
e.
f.

Based to be used cost

driver
Physical output
Direct materials cost
Direct labor cost
Direct labor hours
Machine hours
Transactions 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

Required
Compute 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 hours
o SOLUTION

Factors considered in
selecting OH rates
1. Based to be used
2. Activity level selection
3. Including or excluding fixed

overhead
4. Use of single rate or several
rates
5. Use of separate rates for
service activities

a.
b.
c.
d.

Activity level selection

Theoretical capacity
Practical Capacity
Expected Actual Capacity
Normal Capacity

Theoretical capacity
The capacity to produce at

full speed without

interruptions or downturns
100% of its rated capacity
Not realistic

Practical Capacity
Theoretical 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 etc
75% to 85% of theoretical capacity

Expected actual capacity

Amount of output expected to

be produced during the period

Planned production
Usually results in a different
POHR for each period because
of increases and decreases in
planned production

Normal Capacity
Average 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 periods

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.

Required
Compute 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 hours
o SOLUTION

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
$300,000
Direct labor
520,000
Factory overhead (fixed)
300,000
Factory overhead (variable)
240,000
Normal capacity

100,000 direct labor hours

Expected 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 Application
Applied 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.

Sample
Actual 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).

Entries
Actual Overhead (combined journal entry)
Variable Manufacturing Overhead xxx
Fixed Manufacturing Overhead
xxx
Various Accounts
xxx

Apply Overhead (combined journal entry)

Work in Process Inventory
xxx
Variable Manufacturing Overhead
xxx
Fixed Manufacturing Overhead
xxx

T-account
Overhead Account
(Combined Fixed/Variable)
Actual Overhead
Variable xxx
Fixed
xxx

Applied Overhead
Variable

xxx

Fixed

xxx

differences
Actual OH > Applied
OH
underapplied

Actual OH < Applied

OH

overapplied

Disposition of OH differences
Immaterial close to COGS
Material prorated and

assigned to WIP, FGI and

COGS

Entries - immaterial
Manufacturing OH
xxx
COGS
xxx
To close overapplied OH
COGS
xxx
Manufacturing OH
xxx
To close underapplied OH

Disposition of OH differences
If overhead is underapplied
Cost of Goods Sold increases
Income decreases
If overhead is overapplied
Cost of Goods Sold decreases
Income increases

Entries - material
Manufacturing OH xxx
WIP
xxx
FGI
xxx
COGS
xxx
To close overapplied OH
WIP
xxx
FGI
xxx
COGS
xxx
Manufacturing OH xxx
To close underapplied OH

Analyzing Mixed Costs

A mixed cost contains both

a variable and fixed component

Mixed Cost

variable

$
fixed

# of Units

Separating Mixed Costs

To determine variable and fixed

predetermined overhead rates, separate

mixed costs into variable and fixed
components
Use formula for a straight line:
y = a + bX
y = total cost
a = fixed portion of total cost
b = variable cost per unit
X = activity base to which y is related

Methods for Separating Mixed Costs

High-Low Method
Actual cost
observations
Considers only two
data points
Highest and lowest

levels of activity
Disregard outliers

when analyzing
mixed costs

Least Squares

Regression Analysis
Statistical technique

that analyzes the

relationship between
dependent and
independent variables
Dependent variable

Cost
Independent variables
Activities
Regression line

provides line of best fit

for the data

Using the HighLow Method ex. 3-6

High
Low
Difference
$1,320

Machine
Hours

Cost

9,000
4,600
4,400

$3,500
2,180
$1,320

= $0.30/unit

Variable cost per unit

4,400
3,500 = a + ($0.30)(9,000)
Fixed cost
a = 800

Y = $800 + $0.30X

(X = machine hours)

Please answer
exercises 3-21 to 3-23

Regression Analysis Assumptions

Independent variable must be a

valid predictor of the dependent

variable
Coefficient of correlation
Reliable only within the relevant
range
Useful only as long as
circumstances existing at the
time of its development remain

Estimated Total Costs

HighLow Method
$800.00 + $0.30X
More
data
Regression
Analysis
points
$354.62 + $0.35X

(X = machine hours)

mean a
better
estimate of
total costs

Flexible Budgets

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
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

Preparing a Flexible Budget

1. Separate mixed costs into variable and
fixed elements
2. Determine the a + bX cost formula
3. Select several potential levels of activity
within the relevant range
4. Determine total cost expected at each of
the activity levels

Flexible Budgets

Absorption vs. Variable

Costing

Absorption or Full
Costing
External use
GAAP
Classify by Function
Cost of goods sold
Selling expense
Administrative
expense

Variable or Direct
Costing
Internal use
Not GAAP
Classify by Behavior
Variable
Fixed

Absorption vs. Variable Costing

Absorption or Full
Product costs
Direct material
Direct labor
Variable mfg. overhead
Fixed mfg. overhead
Period costs
Selling
General
Administrative

Variable or Direct
Product costs
Direct material
Direct labor
Variable mfg. overhead
Period costs
Fixed mfg. overhead
Selling
General
Administrative

Differences Between Absorption and

Variable Costing

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

Income Statement
Absorption Costing
Sales
Less: Cost of Goods Sold
Gross Profit
Less: Operating Expenses
Net Income

Product Costs
Direct Material
Direct Labor
Fixed and Variable
Mfg. Overhead
Period Costs
Selling, General,
Administrative

Variable Costing or
Contribution
Margin Income Statement
Sales
Direct Material
Less: Variable Cost of Goods Sold Direct Labor
Product Contribution Margin Variable Mfg.
Overhead
Less: Variable Operating Expenses
Selling,
Selling
Contribution Margin
General,
General
Less: Fixed Mfg. Overhead
Administration
Administrative
Less: Fixed Operating Expenses
Net Income

Illustration

Given:
2010 2011 2012
Production (units) 1,000
Sales (units) 1,000
800

1,000 1,000
1,200

Selling price = $10 / unit sold

Production costs:
DM = $1.25 / unit produced
DL = $1.45 / unit produced
VOH = $1.30 / unit produced
FOH = $2,000 ($2 / unit produced)
Selling and admin expenses
VSAE = $1 / unit sold
FSAE = $500

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

Income Statement (Absorption Costing)

Sales
Less: COGS + Underapplied FOH ( overapplied FOH)
Gross Profit
Less: Operating Expenses
NORMAL COSTING:
Actual FOH Applied FOH
Net Income
(UNDER OR OVER APPLIED OH
STANDARD COSTING:
Budgeted FOH Applied FOH
(VOLUME VARIANCE)