Chapter 3: Predetermined Overhead Rates, Flexible Budgets, - PowerPoint Presentation

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Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption/ Variable Costing

Cost Accounting:

Foundations & Evolutions, 9e

Kinney and RaibornSlide2

Learning Objectives Why and how are overhead costs allocated to products and services?What causes underapplied or overapplied overhead, and how is it treated at the end of a period?What impact do different capacity measures have on setting predetermined overhead rates?

How is the high-low method used in analyzing mixed costs?How do managers use flexible budgets to set predetermined overhead rates?How do absorption and variable costing differ?How do changes in sales or production levels affect net income computed under absorption and variable costing?(Appendix) How is least squares regression used in analyzing mixed costs?Slide3

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 profitabilitySlide4

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 timeSlide5

Applying Overhead to ProductionApplied overhead is the dollar amount of overhead assigned to WIP Inventory using the activity measure that was selected to develop the OH rate. Applied overhead is calculated as the predetermined OH rate multiplied by the actual activity volume. Slide6

Disposing of Overhead DifferencesUnderapplied overhead occurs when the OH applied to WIP Inventory is less than the actual OH cost. If overhead is underapplied, the adjusting entry

increases Cost of Goods Sold decreases Net Income Overapplied overhead occurs when the OH applied to WIP Inventory is more than actual OH cost. If overhead is overapplied, the adjusting entrydecreases Cost of Goods Sold increases Net Income Slide7

Theoretical

capacity

All production factors are operating perfectly

Disregards

Machinery breakdown

Holiday downtime

Results in

Significant underapplied overhead

Lowest product cost

Alternative Capacity Levels: Theoretical CapacitySlide8

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: Practical CapacitySlide9

Alternative Capacity 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: Normal CapacitySlide10

Alternative Capacity 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

Alternative Capacity Levels: Expected CapacitySlide11

Mixed Cost

Analyzing Mixed Costs

$

Units

fixed

variable

A mixed cost contains both

a variable and fixed componentSlide12

Separating Mixed Costs

y = a + bX

y = total cost

a =

fixed

portion of total cost

b =

variable

cost

X = activity base to which

y is related

Use formula for a straight lineSlide13

Separating Mixed Costs

Two Methods

High-Low Method

Change in total cost divided by change in activity level equals the unit variable cost per measure of activity

Considers only two data points of activity (highest and lowest)

Disregard outliers when analyzing mixed cost

Least Squares Regression Analysis

Statistical technique that is used to develop an equation that predicts an unknown value of a dependent variable (cost) from the known values of one or more independent variables (activities that create costs). (Appendix)Slide14

Flexible Budgets Separate overhead costs into fixed and variable components in order to estimate the amount of overhead at various levels of the denominator activitySlide15

Flexible BudgetShows 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 activitySlide16

Plantwide Overhead Rate

Homogeneous activities throughout plantDepartmental Overhead RateDifferent types of work effort in departments

Diverse material requiring different times in departments

Usually provides better information for planning, control, and decision making

Plantwide vs. Departmental Predetermined Overhead RatesSlide17

DifferencesAbsorption costingFixed manufacturing overhead is a product costAlso known as full costing

Variable costingFixed manufacturing overhead is a period costVariable operating expenses are subtracted from product contribution margin to equal contribution marginAlso known as direct costingSlide18

Difference in Income Absorption vs. VariableNo change in inventory levelAbsorption Income = Variable IncomeIncrease in inventory level

Absorption Income > Variable IncomePhantom ProfitsDecrease in inventory levelAbsorption Income < Variable Income Slide19

QuestionsHow 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?Slide20

Potential Ethical IssuesUsing high activity level for overhead application rate resulting in lower overhead rate, lower product cost, and higher operating incomeUsing high production estimate resulting in lower overhead rate, lower product cost, and higher operating income

Treating period costs as product costs resulting in higher inventory and net incomeManipulating sales reporting at the end of an accounting periodChoosing overhead allocation methods that distort cost and profit of certain products or subunits