Chapter 3

Matthew 11:28
Come to me,
all of you who are weary
and loaded down with burdens,
and I will give you rest.
 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?
How is the least squares regression used in analyzing mixed costs?
(Appendix)
 CostMethods
Costing allocation methods

Actual Costing

Normal Costing

Standard Costing
 Actual vs Normal vs Standard

Product Cost

Direct Materials

Direct Labor

Overhead
What is Overhead?
Definition
What are other names of overhead?
Give 5 examples of overhead.
 Examples
Indirect labor, indirect materials

Wages paid to employees Materials used to support the

who are not directly involved production process.
in production work. Examples: lubricants and
Examples: maintenance cleaning supplies used in the
workers, janitors and security automobile assembly plant.
guards.
Factory rental, factory utilities,
factory plant and equipment depreciation,
Amortization of patent etc

and other indirect manufacturing costs

What are the characteristics
of overhead?
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 predetermined overhead rate?
 What is pOHr?

A budgeted, constant charge per unit

of activity used to assign overhead
to production or services
What are the four primary reasons for using
POHR in product costing?
 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

Total budgeted
Predetermined overhead
Overhead = Activity level
Rate (Volume)

$20 per $100,000

DL Hours = 5,000 DL Hours
 Numerator
Overhead is typically budgeted for one
year.
What is the allocation base that
directly causes the incurrence of
overhead cost?
 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.
 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
 Based to be used cost driver
a. Physical output
b. Direct materials cost
c. Direct labor cost
d. Direct labor hours
e. Machine hours
f. 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 expected to be
$800,000.
 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
Assignment please answer
exercises 13 & 14
 Enumerate the
four capacity levels.
 Activity level selection
a. Theoretical capacity
b. Practical Capacity
c. Expected Actual Capacity
d. 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. Total estimated overhead
is expected to be $800,000.
 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 100,000direct labor hours

Expected production 80,000 direct 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 Applied Overhead
Variable xxx
Variable xxx
Fixed 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
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
 Assignment
Group Exercise/Problem
1 11
2 12
3 13
4 14
5 15
6 16
7 17
8 18
9 19
10 20
 A mixed cost contains both
a variable and fixed component

variable
Mixed Cost $
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
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 variableCost
Independent variables
Activities
Regression line provides line
of best fit for the data
 Using the HighLow Method ex. 3-6
Machine
Hours Cost
High 9,000 $3,500
Low 4,600 2,180
Difference 4,400 $1,320
$1,320
= $0.30/unit Variable cost per unit
4,400
3,500 = a + ($0.30)(9,000)
a = 800 Fixed cost
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 constant
Estimated Total Costs
HighLow Method Regression Analysis
$800.00 + $0.30X $354.62 + $0.35X

More data
points
mean a
better
estimate of
total costs
(X = machine hours)
Please answer exercises 34-35
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 or Full Costing Variable or Direct Costing
External use Internal use
GAAP Not GAAP
Classify by Function Classify by Behavior
Cost of goods sold Variable
Selling expense Fixed
Administrative expense
 Absorption vs. Variable Costing
Absorption or Full Variable or Direct
Product costs Product costs

Direct material Direct material

Direct labor Direct labor

Variable mfg. overhead Variable mfg. overhead

Fixed mfg. overhead Period costs

Period costs Fixed mfg. overhead

Selling Selling

General General

Administrative Administrative
 Absorption Costing Variable Costing
Fixed manufacturing Fixed manufacturing
overhead is a product cost overhead is a period cost
Variable operating expenses
are subtracted from product
contribution margin to equal
contribution margin
Income Statement
Absorption Costing
Product Costs
Sales Direct Material
Less: Cost of Goods Sold Direct Labor
Gross Profit Fixed and Variable
Less: Operating Expenses Mfg. Overhead
Net Income
Period Costs
Selling, General,
Administrative
 Sales Direct Material
Less: Variable Cost of Goods Sold Direct Labor
Product Contribution Margin Variable Mfg.
Overhead
Less: Variable Operating Expenses
Contribution Margin Selling,
Selling
General,
General
Less: Fixed Mfg. Overhead Administration
Administrative
Less: Fixed Operating Expenses
Net Income
 Illustration
Given:
2010 2011 2012
Production (units) 1,000 1,000 1,000
Sales (units) 1,000 800 1,200

Selling price = $10 / unit sold

Production costs:
DM = $1 / unit produced
DL = $2 / unit produced
VOH = $1 / unit produced
FOH = $2,000 ($2 / unit produced)
Selling and admin expenses
VSAE = $1 / unit sold
FSAE = $500
 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
ASSIGN : Please answer
exercises 26 to 33