Cost Accounting Chapter 3 PDF

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

3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/ Variable Costing Objectives After completing this chapter, you should be able to answer the following questions: LO.1 Why and how are overhead costs allocated to products and services? LO.2 What causes underapplied or overapplied overhead, and how is it treated at the end of a period? LO.3 What impact do different capacity measures have on setting predetermined © AXL 2009/USED UNDER LICENSE FROM SHUTTERSTOCK.COM overhead rates? LO.4 How are the high–low method and least squares regression analysis used in analyzing mixed costs? LO.5 How do managers use flexible budgets to set predetermined overhead rates? LO.6 How do absorption and variable costing differ? LO.7 How do changes in sales or production levels affect net income computed under absorption and variable costing? 66 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 67 Introduction Any cost incurred to make products or perform services that is not direct material or direct labor is overhead. Overhead costs are incurred both in the production area and in sell- ing and administrative departments. Manufacturers traditionally considered direct material and direct labor as the primary production costs, and overhead was often an “additional” cost that was necessary but not of an exceptionally significant amount. However, many manufacturing firms have begun to heavily invest in automation, which has increased the costs of manufacturing overhead. Regardless of where costs are incurred, a simple fact exists: for a company to be profit- able, product or service selling prices must cover all costs. Direct material and direct labor costs can be easily traced to output and, as such, create few accounting difficulties. In contrast, indirect costs (overhead) cannot be traced directly to separately distinguishable outputs. Whereas Chapter 2 discusses and illustrates actual cost systems in which actual direct material, direct labor, and manufacturing overhead are assigned to products, this chapter discusses normal costing and its use of predetermined overhead rates to determine product cost. Separation of mixed costs into variable and fixed elements, flexible budgets, and vari- ous production capacity measures are also discussed. In addition, this chapter discusses two methods of presenting information on financial reports: absorption and variable costing. Absorption costing is commonly used for external reporting; variable costing is commonly used for internal reporting. Each method uses the same input data but structures and processes those data differently. Either method can be used in job order or process costing and with actual, normal, or standard costs. Normal Costing and Predetermined LO.1 Why and how are overhead costs allocated to Overhead products and services? Normal costing is a costing system that is an alternative to actual costing. As shown in Exhibit 3–1, normal costing assigns actual direct material and direct labor to products but allocates manufacturing overhead (OH) to products using a predetermined rate. The overhead allocation can occur in real time as products are manufactured or as services are delivered. Many accounting procedures are based on allocations. Cost allocations can be made across time periods or within a single time period. For example, in financial account- ing, a building’s cost is allocated through depreciation charges over its useful life. This process is necessary for fulfilling the matching principle. In cost accounting, manufactur- ing OH costs are allocated to products or services within a period using predictors or cost drivers. This process reflects the application of the cost principle, which requires that all production or acquisition costs attach to the units produced, services rendered, or units purchased. Exhibit 3–1 Actual versus Normal Costing Actual Cost System Normal Cost System Direct material Assigned to product/service Assigned to product/service Direct labor Assigned to product/service Assigned to product/service Overhead Assigned to product/service Assigned to overhead (OH) control account; predetermined OH rate is used to allocate overhead to product/ service 68 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing There are four primary reasons for using predetermined OH rates in product costing. First, a predetermined rate facilitates the assignment of overhead during a period as goods are produced or sold and services are rendered. Thus, a predetermined OH rate improves the timeliness of information. Second, predetermined OH rates adjust for variations in actual overhead costs that are unrelated to fluctuations in activity. Overhead can vary monthly because of seasonal or calendar (days in a month) factors. For example, factory utility costs could be highest in summer because of the necessity to run air conditioning. If monthly production were constant and actual overhead were assigned to production, the increase in utilities would cause product cost per unit to be higher in summer than during the rest of the year. This is illustrated in the following example. Monthly production = 3,000 units April July Utility costs $1,200 $1,800 Divide by units 3,000 3,000 Utility cost per unit 0.40 0.60 Third, predetermined OH rates overcome the problem of fluctuations in activity levels that have no impact on fixed overhead costs. Even if total manufacturing overhead were the same for each period, changes in activity levels between periods would cause a per- unit change in fixed overhead cost. This is illustrated in the example that follows. Monthly production = 3,000 units October November Utility costs $ 600 $ 600 Divide by units 3,000 3,750 Utility cost per unit 0.20 0.16 As mentioned earlier, many such overhead cost differences could create major varia- tions in unit cost. By establishing a uniform annual predetermined OH rate for all units produced during the year, the problems illustrated in these examples are overcome. Finally, using predetermined OH rates—especially when the bases for those rates truly reflect the drivers of costs—often allows managers to be more aware of individual product or product line profitability as well as the profitability of business with a par- ticular customer or vendor. For instance, assume that a gift shop purchases a product that retails for $40 from Vendor X for $20. If the gift shop manager has determined that a reasonable OH rate per hour for vendor telephone conferences is $5 and that she often spends three hours on the phone with Vendor X because of customer complaints or shipping problems, the gift shop manager could decide that the $5 profit on the product [$40 selling price − ($20 product cost + $15 in overhead)] does not make it cost ben- eficial to continue working with Vendor X. Formula for Predetermined Overhead Rate With one exception, normal cost system journal entries are identical to those made in an actual cost system. In both systems, overhead is debited during the period to a manufactur- ing overhead account and credited to the various accounts that “created” the overhead costs. In an actual cost system, the total amount of actual overhead cost is then transferred from the overhead account to Work in Process (WIP) Inventory. Alternatively, in a normal cost system, overhead cost is assigned to WIP Inventory using a predetermined OH rate. To calculate a predetermined OH rate, total budgeted overhead cost at a specific activ- ity level is divided by the related activity level: Total Budgeted OH Cost at a Specified Activity Level Predetermined OH Rate = __________________________________________ Volume of Specified Activity Level  Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 69 Overhead cost and its related activity measure are typically budgeted for one year, although a longer or shorter period could be more appropriate in some orga- nizations’ production cycles. For example, a longer period is more appropriate in a company that constructs ships, bridges, or high-rise office buildings. Companies should use an activity base that is logi- cally related to actual overhead cost incurrence. Although production volume might be the first activity base consid- ered, this base is reasonable only if the company manufac- tures one type of product or renders just one type of service. If a company makes multiple products or performs multiple GETTY IMAGES services, production volumes cannot be summed to deter- mine “activity” because of the heterogeneous nature of the items. To effectively allocate overhead to heterogeneous products or services, a measure of A company that builds high-rise office buildings will likely budget activity that is common to all output must be selected. The activity base should be a cost overhead cost for a period longer driver that directly causes the incurrence of overhead costs. Direct labor hours and direct than one year. labor dollars are common activity measures; however, these bases could be deficient if a company is highly automated. Using any direct labor measure to allocate overhead costs in automated plants results in extremely high overhead rates because the costs are applied over a relatively small activity base. In automated plants, machine hours could be a more appropriate base for allocating overhead. Other possible measures include the number of purchase orders, product-related physical characteristics such as tons or gallons, number of, or amount of time used performing, machine setups, number of parts, material handling time, product complexity, and number of product defects. LO.2 What causes underapplied or Applying Overhead to Production overapplied overhead, and how is it treated at the end Once calculated, the predetermined OH rate is used throughout the period to apply over- of a period? head to WIP Inventory using the predetermined OH rate and the actual level of activity. Thus, applied overhead is the dollar amount of overhead assigned to WIP Inventory using the activity measure that was selected to develop the application rate. Overhead can be applied when goods or services are transferred out of WIP Inventory or at the end of each month if financial statements are to be prepared. Or, under the real-time systems currently in use, overhead can be applied continuously as production occurs. For convenience, both actual and applied overhead are recorded in a single general led- ger account.1 Debits to the account represent actual overhead costs, and credits represent applied overhead. Variable and fixed overhead may be recorded either in a single account or in separate accounts, although separate accounts provide better information to managers. Exhibit 3–2 (p. 70) presents the alternative overhead recording possibilities. If variable and fixed overhead are applied using separate rates, the general ledger will have separate variable and fixed overhead accounts. Because overhead represents an ever-larger part of product cost in automated factories, the benefits of separating overhead according to its variable or fixed behavior are thought to be greater than the time and effort needed to make that separation. Separation of mixed costs is discussed later in this chapter. 1 Some companies may use separate overhead accounts for actual and applied overhead. In such cases, the actual overhead account has a debit balance and the applied overhead account has a credit balance. The applied overhead account is closed at the end of the year against the actual overhead account to determine the amount of underapplied or overapplied overhead. 70 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing Exhibit 3–2 Cost Accounting System Possibilities for Manufacturing Overhead Single overhead account for variable and fixed overhead: Manufacturing Overhead Control Total actual Total OH OH incurred applied Separate overhead accounts for variable and fixed overhead: Manufacturing Variable Manufacturing Fixed Overhead (VOH) Control Overhead (FOH) Control Total actual Total VOH Total actual Total VOH incurred applied FOH incurred FOH applied Regardless of the number of predetermined OH rates used, actual overhead is debited to the general ledger overhead account and credited to the source of the overhead cost. Overhead is applied to WIP Inventory as production occurs, as measured by the activity identified in the denominator in the predetermined OH rate formula. Applied overhead is debited to WIP Inventory and credited to the overhead general ledger account. Assume that Mizzou Mechanical, a manufacturer of children’s car seats, budgeted and then experienced the following amounts for the current year: Variable Overhead Fixed Overhead Budgeted amount $ 375,000 $ 630,000 Budgeted machine hours 50,000 50,000 Predetermined overhead rate 7.50 12.60 Assume actual machine hours are 4,300 in January Applied overhead $ 32,500 $54,180.00 Journal entries to record the actual and applied overhead for this example follow. Variable Manufacturing Overhead 31,385 Fixed Manufacturing Overhead 55,970 Various accounts 87,355 To record actual manufacturing overhead Work in Process Inventory 86,430 Variable Manufacturing Overhead 32,250 Fixed Manufacturing Overhead 54,180 To apply variable and fixed manufacturing overhead to WIP At year-end, total actual overhead will differ from total applied overhead. The difference is called underapplied or overapplied overhead. Underapplied overhead means that the overhead applied to WIP Inventory is less than the actual overhead incurred. Overapplied overhead means that the overhead applied to WIP Inventory is more than actual overhead incurred. Underapplied or overapplied overhead must be closed at year-end because a single year’s activity level was used to set the predetermined OH rate(s). Under- or overapplication is caused by two factors that can work independently or jointly. These two factors are cost differences and utilization differences. For example, if actual fixed overhead (FOH) cost differs from expected FOH cost, a fixed manufacturing overhead spending variance is created. If actual capacity utilization differs from expected  Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 71 utilization, a volume variance arises.2 The independent effects of these differences (or for similar differences related to variable OH) are as follows: Actual FOH Cost ! Expected FOH Cost = Underapplied FOH Actual FOH Cost " Expected FOH Cost = Overapplied FOH Actual Utilization ! Expected Utilization = Overapplied FOH Actual Utilization " Expected Utilization = Underapplied FOH In most cases, however, both cost and utilization differ from estimates. When this occurs, no generalizations can be made as to whether overhead will be underapplied or overapplied. Disposition of Underapplied and Overapplied Overhead Overhead accounts are temporary accounts and, as such, are closed at period-end. Closing the accounts requires disposition of the underapplied or overapplied overhead. Disposition depends on the materiality of the amount involved. If the amount is immaterial, it is closed to Cost of Goods Sold. As shown in Exhibit 3–3, when overhead is underapplied (debit balance), an insufficient amount of overhead was applied to production and the closing process causes Cost of Goods Sold to increase. Alternatively, overapplied overhead (credit balance) reflects the fact that too much overhead was applied to production, so closing overapplied overhead causes Cost of Goods Sold to decrease. Exhibit 3–3 Effects of Underapplied and Overapplied Overhead Underapplied OH Closing the control If overhead account causes CGS rises is underapplied cost of goods sold (CGS) to increase CGS falls Overapplied OH Closing the control If overhead account causes is overapplied cost of goods sold to decrease To illustrate the closing process in the case that the underapplied or overapplied overhead is immaterial, assume that Mizzou Mechanical incurred and applied overhead as follows. Actual and applied overhead based on 51,500 hours for the year Variable Overhead Fixed Overhead Actual (assumed) $383,000 $657,000 Applied Variable ($7.50 × 51,500) 386,250 Fixed ($12.60 × 51,500) 648,900 Over- (under-) applied amount $ 3,250 −$ 8,100 2 These variances are covered in depth in Chapter 7. 72 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing Each amount is immaterial, so the journal entries to close these amounts are: Variable Manufacturing Overhead 3,250 Cost of Goods Sold 3,250 To close overapplied VOH Cost of Goods Sold 8,100 Fixed Manufacturing Overhead 8,100 To close underapplied FOH If the amount of applied overhead differs materially (significantly) from actual over- head costs, it should be prorated among the accounts in which applied overhead resides: Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Proration of the underapplied or overapplied overhead makes the account balances conform more closely to actual historical cost as required by generally accepted accounting principles (GAAP) for external reporting. Exhibit 3–4 uses assumed data for Mizzou Mechanical to illustrate proration of a material amount of overapplied fixed overhead to the accounts based on their year-end account balances.3 If the overhead had been underapplied, the accounts debited and credited in the journal entry would be reversed. Exhibit 3–4 Proration of Overapplied Fixed Overhead Fixed Manufacturing Overhead Account Balances Actual FOH $220,000 Work in Process Inventory $ 45,640 Applied FOH 260,000 Finished Goods Inventory 78,240 Overapplied FOH $ 40,000 Cost of Goods Sold 528,120 STEP 1: Add balances of accounts and determine proportional relationships: Balance Proportion Percentage Work in Process $ 45,640 $45,640 ÷ $652,000 7 Finished Goods 78,240 $78,240 ÷ $652,000 12 Cost of Goods Sold 528,120 $528,120 ÷ $652,000 81 Total $652,000 100 STEP 2: Multiply percentages by the overapplied overhead amount to determine the adjustment amount: Overapplied Adjustment Account % ! FOH " Amount Work in Process 7 # $40,000 = $2,800 Finished Goods 12 # $40,000 = $4,800 Cost of Goods Sold 81 # $40,000 = $32,400 STEP 3: Prepare the journal entry to close manufacturing overhead account and assign adjustment amount to appropriate accounts: Fixed Manufacturing Overhead 40,000 Work in Process Inventory 2,800 Finished Goods Inventory 4,800 Cost of Goods Sold 32,400 To close overapplied fixed overhead 3 Theoretically, underapplied or overapplied overhead should be allocated based on the amounts of applied overhead contained in each account rather than on total account balances. Use of total account balances could cause distortion because they con- tain direct material and direct labor costs that are not related to actual or applied overhead. In spite of this potential distortion, use of total balances is more common in practice for two reasons. First, the theoretical method is complex and requires detailed account analysis. Second, overhead tends to lose its identity after leaving Work in Process Inventory, thus making the determina- tion of the amount of overhead in Finished Goods Inventory and Cost of Goods Sold account balances more difficult.  Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 73 Alternative Capacity Measures LO.3 What impact do different capacity The two primary causes of underapplied or overapplied overhead are measures have on setting a difference between budgeted and actual costs and predetermined overhead rates? a difference in the activity level chosen to compute the predetermined OH rate and the actual activity level experienced. The activity level used in setting the predetermined OH rate generally reflects a consider- ation of organizational capacity. The estimated maximum potential activity for a specified time is the theoretical capacity. This measure assumes that all production factors are operating perfectly. Theoretical capacity disregards realities such as machinery breakdowns and reduced or stopped plant operations on holidays. Choosing this activity level for setting a predetermined OH rate nearly guaran- tees a significant amount of underapplied overhead cost. The amount by which overhead is underapplied reflects the difference between actual capacity and theoretical capacity. Reducing theoretical capacity by ongoing, regular operating interruptions (such as holidays, downtime, and start-up time) provides the practical capacity that could be achieved during regular working hours. Consideration of historical and estimated future production levels and the cyclical fluctuations provides a normal capacity mea- sure that encompasses the firm’s long-run (5–10 years) average activity and represents an attainable level of activity. Although it may generate substantial differences between actual and applied overhead in the short run, use of this capacity measure has been required under GAAP.4 Expected capacity is a short-run concept that represents the firm’s anticipated activity level for the coming period based on projected product demand. Expected capacity level is determined during the budgeting process, which is discussed in Chapter 8. If actual results are close to budgeted results (in both dollars and volume), this measure should result in product costs that most closely reflect actual costs and, thus, generate an immaterial amount of underapplied or overapplied overhead.5 See Exhibit 3–5 (p. 74) for a visual representation of capacity measures. Although expected capacity is shown in this diagram as much smaller than practical capacity, it is possible for expected and practical capacity to be more equal—especially in a highly automated plant. Regardless of the capacity level chosen for the denominator in calculating a predeter- mined OH rate, any mixed overhead costs must be separated into their variable and fixed components. Separating Mixed Costs As discussed in Chapter 2, a mixed cost contains both a variable and a fixed component. For example, a cell phone plan that has a flat charge for basic service (the fixed component) plus a stated rate for each minute of use (the variable component) creates a mixed cost. A mixed cost does not remain constant with changes in activity, nor does it fluctuate on a per-unit basis in direct proportion to changes in activity. To simplify estimation of costs, accountants typically assume that costs are linear rather than curvilinear. Because of this assumption, the general formula for a straight line can 4 FASB Statement No. 151, titled Inventory Costs, was issued in November 2004. The statement indicates that some variation in production levels from period to period is expected and establishes the range of normal capacity. The range of normal capacity will vary based on business- and industry-specific factors. The actual level of production may be used if it approximates nor- mal capacity. In periods of abnormally high production, the amount of fixed overhead allocated to each unit of production is decreased so that inventories are not measured above cost. The amount of fixed overhead allocated to each unit of production is not increased as a consequence of abnormally low production or an idle plant. 5 Except where otherwise noted in the text, expected capacity has been chosen as the basis for calculating the predetermined fixed manufacturing overhead rate because it is believed to be the most prevalent practice. This choice, however, may not be the most effective for planning and control purposes as is discussed further in Chapter 7 with regard to standard cost variances. 74 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing Exhibit 3–5 Measures of Capacity Actual Capacity 2005 # Actual Capacity 2006 Practical Capacity # Actual Capacity 2007 Expected Capacity 2010 # Actual Capacity 2008 # Theoretical Capacity Actual Capacity 2009 Divide total by 5 to get normal capacity for 2010 be used to describe any type of cost within a relevant range of activity. The straight-line formula is y = a + bX where y = total cost (dependent variable), a = fixed portion of total cost, b = unit change of variable cost relative to unit changes in activity, and X = activity base to which y is being related (the predictor, cost driver, or independent variable). If a cost is entirely variable, the a value in the formula is zero. If the cost is entirely fixed, the b value in the formula is zero. If a cost is mixed, it is necessary to determine formula values for both a and b. Two methods of determining these values—and thereby separating a mixed cost into its variable and fixed components—are the high–low method and regression analysis. LO.4 How are the high–low method and least squares regression analysis High–Low Method used in analyzing mixed costs? The high–low method analyzes a mixed cost by first selecting the highest and lowest levels of activity in a data set if these two points are within the relevant range. Activity levels are used because activities cause costs to change, not vice versa. Occasionally, operations occur  Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 75 at a level outside the relevant range (e.g., a special rush order could require excess labor or machine time), or cost distortions occur within the relevant range (a leak in a water pipe goes unnoticed for a period of time). Such nonrepresentative or abnormal observations are called outliers and should be disregarded when analyzing a mixed cost. Next, changes in activity and cost are determined by subtracting low values from high values. These changes are used to calculate the b (variable unit cost) value in the y = a + bX formula as follows: Cost at High Activity Level − Cost at Low Activity Level b = ____________________________________________ High Activity Level − Low Activity Level Change in Total Cost b = ____________________ Change in Activity Level The b value is the unit variable cost per measure of activity. This value is multiplied by the activity level to determine the amount of total variable cost contained in the total cost at either the high or the low level of activity. The fixed portion of a mixed cost is found by subtracting total variable cost from total cost. As the activity level changes, the change in total mixed cost equals the change in activ- ity multiplied by the unit variable cost. By definition, the fixed cost element does not fluctu- ate with changes in activity. Exhibit 3–6 (p. 76) illustrates the high–low method using machine hours and utility cost information for Mizzou Mechanical. In November 2010, the company wanted to calcu- late its predetermined OH rate to use in calendar year 2011. Mizzou Mechanical gathered information for the prior 10 months’ machine hours and utility costs. During 2010, the company’s normal operating range of activity was between 3,500 and 9,000 machine hours per month. Because it is substantially in excess of normal activity levels, the May observa- tion is viewed as an outlier and should not be used in the analysis of utility cost. One potential weakness of the high–low method is that outliers can inadvertently be used in the calculation. Estimates of future costs calculated from a line drawn using such points will not indicate actual costs and probably are not good predictions. A second weak- ness of this method is that it considers only two data points. A more precise method of analyzing mixed costs is least squares regression analysis. Least Squares Regression Analysis Least squares regression analysis is a statistical technique that analyzes the relationship between independent (causal) and dependent (effect) variables. The least squares method 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). When multiple independent variables exist, least squares regression also helps to select the independent variable that is the best predictor of the dependent variable. For example, managers can use least squares to decide whether machine hours, direct labor hours, or pounds of material moved best explain and predict changes in a specific overhead cost.6 Simple regression analysis uses one independent variable to predict the dependent variable based on the y = a + bX formula for a straight line. In multiple regression, two or more inde- pendent variables are used to predict the dependent variable. All text examples use simple regres- sion and assume that a linear relationship exists between variables so that each one-unit change in the independent variable produces a constant unit change in the dependent variable.7 6 Further discussion of finding independent variable(s) that best predict the value of the dependent variable can be found in most textbooks on statistical methods treating regression analysis under the headings of dispersion, coefficient of correlation, coefficient of determination, or standard error of the estimate. 7 Curvilinear relationships between variables also exist. For example, quality defects (dependent variable) tend to increase at an increasing rate in relationship to machinery age (independent variable). 76 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing Exhibit 3–6 Analysis of Mixed Cost for Mizzou Mechanical The following machine hours and utility cost information is available: Month Machine Hours Utility Cost January 7,260 $2,960 February 8,850 3,410 March 4,800 1,920 April 9,000 3,500 May 11,000 3,900 Outlier June 4,900 1,860 July 4,600 2,180 August 8,900 3,470 September 5,900 2,480 October 5,500 2,310 STEP 1: Select the highest and lowest levels of activity within the relevant range and obtain the costs associated with those levels. These levels and costs are 9,000 and 4,600 hours, and $3,500 and $2,180, respectively. STEP 2: Calculate the change in cost compared to the change in activity. Machine Hours Associated Total Cost High activity 9,000 $3,500 Low activity 4,600 2,180 Changes 4,400 $1,320 STEP 3: Determine the relationship of cost change to activity change to find the variable cost element. b = $1,320 ÷ 4,400 MH = $0.30 per machine hour STEP 4: Compute total variable cost (TVC) at either level of activity. High level of activity: TVC = $0.30(9,000) = $2,700 Low level of activity: TVC = $0.30(4,600) = $1,380 STEP 5: Subtract total variable cost from total cost at the associated level of activity to deter- mine fixed cost. High level of activity: a = $3,500 − $2,700 = $800 Low level of activity: a = $2,180 − $1,380 = $800 STEP 6: Substitute the fixed and variable cost values in the straight-line formula to get an equa- tion that can be used to estimate total cost at any level of activity within the relevant range. y = $800 + $0.30X where X = machine hours A regression line is any line that goes through the means (or averages) of the indepen- dent and dependent variables in a set of observations. As shown in Exhibit 3–7, numerous straight lines can be drawn through any set of data observations, but most of these lines would provide a poor fit to the data. Actual observation values are designated as y values;  Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 77 Exhibit 3–7 Illustration of Least Squares Regression Line Graph A $ y values Activity Graph B—Trend lines with deviations Possible trend lines Line of approximately $ best fit with deviations from line; points on this yc line are referred to as y c. y Activity these points do not generally fall directly on a regression line. The least squares method mathematically fits the best possible regression line to observed data points. The method fits this line by minimizing the sum of the squares of the vertical deviations between the actual observation points and the regression line. The regression line represents com- puted values for all activity levels, and the points on the regression line are designated as yc values. The regression line of best fit is found by predicting the a and b values in a straight- line formula using the actual activity and cost values (y values) from the observations. The equations necessary to compute b and a values using the method of least squares are as follows:8 _ _ ∑xy $ n( x )( y ) b = ____________ _ ∑x2 $ n( x )2 _ _ a = y $ bx _ where x_ = mean of the independent variable y = mean of the dependent variable __ n = number of observations 8 These equations are derived from mathematical computations beyond the scope of this text but can be found in many statis- tics books. The symbol Σ means “the summation of.” 78 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing Using the machine hour and utility cost data for Mizzou Mechanical (presented in Exhibit 3–6 and excluding the May outlier), the following calculations can be made: x y xy x2 7,260 $ 2,960 $ 21,489,600 52,707,600 8,850 3,410 30,178,500 78,322,500 4,800 1,920 9,216,000 23,040,000 9,000 3,500 31,500,000 81,000,000 4,900 1,860 9,114,000 24,010,000 4,600 2,180 10,028,000 21,160,000 8,900 3,470 30,883,000 79,210,000 5,900 2,480 14,632,000 34,810,000 5,500 2,310 12,705,00 30,250,000 59,710 $24,090 $169,746,100 424,510,100 _ _ The mean of x (or x) is 6,634.44 (59,710 ÷ 9), and the mean of y (or y) is $2,676.67 ($24,090 ÷ 9). Thus, $169,746,100 $ 9(6,634.44)($2,676.67) $9,922,241 b = _______________________________ = __________ = $0.35 424,510,100 $ 9(6,634.44)(6,634.44) $28,367,953 a = $2,676.67 $ $0.35(6,634.44) = $2,676.67 $ $2,322.05 = $354.62 The b (variable cost) and a (fixed cost) values for the company’s utility costs are $0.35 and $354.62, respectively. These values are close to, but not exactly the same as, the values com- puted using the high–low method. By using these values, predicted costs ( yc values) can be computed for each actual activ- ity level. The line drawn through all of the yc values will be the line of best fit for the data. Because actual costs do not generally fall directly on the regression line and predicted costs naturally do, these two costs differ at their related activity levels. It is acceptable for the regression line not to pass through any of the actual observation points because the line has been determined to mathematically “fit” the data. Like all mathematical models, regression analysis is based on certain assumptions that produce limitations on the model’s use. Three of these assumptions follow; others are beyond the scope of the text. First, for regression analysis to be useful, the independent variable must be a valid predictor of the dependent variable; the relationship can be tested by determining the coefficient of correlation. Second, like the high–low method, regression analysis should be used only within a relevant range of activity. Third, the regression model is useful only as long as the circumstances existing at the time of its development remain constant; consequently, if significant additions are made to capacity or if there is a major change in technology usage, the regression line will no longer be valid. Once a method has been selected and mixed overhead costs have been separated into fixed and variable components, a flexible budget can be developed to indicate the estimated amount of overhead at various levels of the denominator activity. LO.5 How do managers use flexible budgets to set predetermined overhead Flexible Budgets rates? A flexible budget is a planning document that presents expected variable and fixed over- head costs at different activity levels. Activity levels shown on a flexible budget usually cover the contemplated range of activity for the upcoming period. If all activity levels are within the relevant range, costs at each successive level should equal the previous level plus a uni- form monetary increment for each variable cost factor. The increment is equal to variable cost per unit of activity times the quantity of additional activity. Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 79 Expected cost information from the flexible budget is used for the numerator in com- puting the predetermined OH rate. See Exhibit 3–8 for a flexible overhead budget for Mizzou Mechanical at selected levels of activity. All amounts have been assumed. Note that the variable overhead cost per machine hour (MH) does not change within the rel- evant range, but the fixed overhead cost per machine hour varies inversely with the level of activity. Given that the company selected 50,000 machine hours as the denominator level of annual activity, the variable and fixed predetermined OH rates were $7.50 and $12.60, respectively. Exhibit 3–8 Flexible Overhead Budget for Mizzou Mechanical Number of Machine Hours (MHs) 40,000 45,000 50,000 55,000 75,000 Variable OH (VOH) Indirect material $ 60,000 $ 67,500 $ 75,000 $ 82,500 $112,500 Indirect labor 120,000 135,000 150,000 165,000 225,000 Utilities 14,000 15,750 17,500 19,250 26,250 Other 106,000 119,250 132,500 145,750 198,750 Total $300,000 $337,500 $375,000 $412,500 $562,500 VOH rate per MH $ 7.50 $ 7.50 $ 7.50 $ 7.50 $ 7.50 FOH Factory salaries $215,000 $215,000 $215,000 $215,000 $215,000 Depreciation 300,000 300,000 300,000 300,000 300,000 Utilities 9,600 9,600 9,600 9,600 9,600 Other 105,400 105,400 105,400 105,400 105,400 Total $630,000 $630,000 $630,000 $630,000 $630,000 FOH rate per MH $ 15.75 $ 14.00 $ 12.60 $ 11.45 $ 8.40 Plantwide versus Departmental Overhead Rates Because most companies produce many different kinds of products, calculation of a plantwide predetermined OH rate generally does not provide the most useful informa- tion. Assume that Mizzou Mechanical has two departments, Assembly and Finishing. Assembly is highly automated, but Finishing requires significant direct labor. As such, it is highly probable that machine hours would be the more viable overhead alloca- tion base for Assembly, and direct labor hours would be the better allocation base for Finishing. Exhibit 3–9 (p. 80) uses a single product (Part #AB79Z) to show the cost differences that can be created by using a plantwide predetermined OH rate. Production of this part requires 1 hour of machine time in Assembly and 5 hours of direct labor time in Finishing. The departmental cost amounts shown in Exhibit 3–9 have been assumed so that they will balance with information provided in Exhibit 3–8. Notice that the $20.10 plantwide OH rate using machine hours is the same total rate calculated in Exhibit 3–8: a variable rate of $7.50 per MH plus a fixed rate of $12.60 per MH. For purposes of this illustration, the use of separate variable and fixed OH rates is ignored. 80 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing Exhibit 3–9 Plantwide versus Departmental Predetermined OH Rate for Mizzou Mechanical Plantwide Assembly Finishing Budgeted annual overhead $1,005,000 $724,500 $280,500 Budgeted annual direct labor hours (DLHs) 13,000 3,000 10,000 Budgeted annual machine hours (MHs) 50,000 45,000 5,000 Departmental overhead rates Assembly (automated): $724,500 ÷ 45,000 = $16.10 per MH Finishing (manual): $280,500 ÷ 10,000 = $28.05 per DLH Plantwide overhead rates Using DLHs: $1,005,000 ÷ 13,000 = $77.31 per DLH Using MHs: $1,005,000 ÷ 50,000 = $20.10 per MH Part #AB79Z Overhead assigned using departmental rates Assembly 1 MH × $16.10 $ 16.10 Finishing 5 DLHs × $28.05 140.25 Total $156.35 Total overhead assigned using plantwide rates Based on DLHs 5 DLHs × $77.31 $386.55 Based on MHs 1 MH × $20.10 $20.10 Using assumed direct material and direct labor costs, the total cost of Part #AB79Z is Using a Using a Using Plantwide Plantwide Departmental Rate Based on Rate Based on OH Rates DLHs MHs Direct material $110.00 $110.00 $110.00 Direct labor 36.00 36.00 36.00 Overhead 156.35 386.55 20.10 Total cost $302.35 $532.55 $166.10 Exhibit 3–9 shows how product cost can change dramatically depending on the prede- termined OH rate. A company with multiple departments that use significantly different types of work effort (such as automated vs. manual), as well as diverse materials that require considerably different processing times in those departments, should use separate depart- mental predetermined OH rates to attach overhead to products to derive the most rational product cost. Homogeneity more likely exists within a department than across departments. Thus, separate departmental OH rates generally provide better information for manage- ment planning, control, and decision making than do plantwide OH rates. Computing departmental OH rates allows each department to select the most appropriate measure of activity (or cost driver) relative to its operations. Additionally, the use of variable and fixed categories within each department lets man- agement understand how costs react to changes in activity. The use of variable and fixed categories also makes it easier to generate different reports for external and internal report- ing purposes. Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 81 Overview of Absorption LO.6 How do absorption and Variable Costing and variable costing differ? In preparing financial reports, costs can be accumulated and presented in different ways. The choice of cost accumulation method determines which costs are recorded as part of product cost and which are considered period costs. In contrast, the choice of cost presenta- tion method determines how costs are shown on external financial statements or internal management reports. Accumulation and presentation procedures are accomplished using one of two methods: absorption costing or variable costing. Each method structures or pro- cesses the same basic data differently, and either method can be used in job order or process costing and with actual, normal, or standard costs. Absorption costing treats the costs of all manufacturing components (direct material, direct labor, variable overhead, and fixed overhead) as inventoriable, or product, costs in accordance with GAAP. Absorption costing is also known as full costing, and this method fits the product cost definition given in Chapter 2. Under absorption costing, costs incurred in the nonmanufacturing areas of the organization are considered period costs and are expensed in a manner that properly matches them with revenues. Exhibit 3–10 depicts the absorption costing model. In addition, absorption costing presents expenses on an income statement according to their functional classifications. A functional classification is a group of costs that were all incurred for the same principal purpose. Functional classifica- tions generally include cost of goods sold, selling expense, and administrative expense. In contrast, variable costing is a cost accumulation method that includes only direct material, direct labor, and variable overhead as product costs. This method treats fixed Exhibit 3–10 Absorption Costing Model TYPES OF COSTS INCURRED INCOME STATEMENT PRODUCT COSTS Revenue Less: Direct Material (DM) Direct Labor (DL) Work in Finished Cost of Variable Manufacturing Overhead (VOH) Process* Goods Goods Sold Fixed Manufacturing Overhead (FOH) Equals: Gross Margin Less: PERIOD COSTS All Nonmanufacturing Expenses— Selling Expenses regardless of cost behavior with Administrative Expenses respect to production or sales Other Expenses Equals: Income Before Income Taxes * The actual Work in Process Inventory cost that is transferred to Finished Goods Inventory is computed as follows: Beginning Work in Process $XXX % Production costs for period (DM % DL % VOH % FOH) XXX & Total Work in Process to be accounted for $XXX $ Ending Work in Process (computed using job order, process, or standard costing; also appears on end-of-period balance sheet) (XXX) & Cost of Goods Manufactured $XXX 82 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing manufacturing overhead (FOH) as a period cost. Like absorption costing, variable costing treats costs incurred in the organization’s selling and administrative areas as period costs. Variable costing income statements typically present expenses according to cost behav- ior (variable and fixed), although expenses can also be presented by functional classifica- tions within the behavioral categories. Variable costing is also known as direct costing. See Exhibit 3–11 for the variable costing model. Exhibit 3–11 Variable Costing Model TYPES OF COSTS INCURRED INCOME STATEMENT PRODUCT COSTS Revenue Less: Direct Material (DM) Work in Finished Variable Cost Direct Labor (DL) Process* Goods of Goods Sold Variable Manufacturing Overhead (VOH) Equals: Product Contribution Margin Less: PERIOD COSTS Variable Nonfactory Expenses Variable Nonmanufacturing (classified as selling and Expenses administrative, and other) Equals: Total Contribution Margin Less: Fixed Manufacturing Overhead Total Fixed Expenses (classified as factory, selling and Fixed Nonmanufacturing Expenses administrative, and other) Equals: Income Before Income Taxes * The actual Work in Process Inventory cost that is transferred to Finished Goods Inventory is computed as follows: Beginning Work in Process $XXX % Production costs for period (DM % DL % VOH) XXX & Total Work in Process to be accounted for $XXX $ Ending Work in Process (computed using job order, process, or standard costing; also appears on end-of-period balance sheet) (XXX) & Cost of Goods Manufactured $XXX Two differences exist between absorption and variable costing: one relates to cost accu- mulation and the other relates to cost presentation. The cost accumulation difference is that absorption costing treats FOH as a product cost; variable costing treats it as a period cost. Absorption costing advocates contend that products cannot be made without the production capacity provided by fixed manufacturing overhead costs, and, therefore, these costs “belong” to the product. Variable costing advocates contend that FOH costs would be incurred whether any products are manufactured; thus, such costs are not caused by produc- tion and cannot be product costs. The cost presentation difference is that absorption costing classifies expenses by func- tion on both the income statement and management reports, whereas variable costing cat- egorizes expenses first by behavior and then, possibly, by function. Under variable costing, Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 83 cost of goods sold is more appropriately called variable cost of goods sold because it is composed only of variable production costs. Sales minus variable cost of goods sold is called product contribution margin; it indicates how much revenue is available to cover all period expenses and to provide net income. Variable nonmanufacturing period expenses, such as sales commissions set at 10 percent of product selling price, are deducted from product contribution margin to determine the amount of total contribution margin. Total contribution margin is the difference between total revenues and total variable expenses. This amount indicates the dollars available to “contribute” to cover all fixed expenses, both manufacturing and non- manufacturing, and to provide net income A variable costing income statement is also referred to as a contribution income statement. See Exhibit 3–12 for a diagram of these variable costing relationships. Exhibit 3–12 Variable Costing Relationships Sales $ Variable Cost of Goods Sold (DM % DL % VOH) Product Contribution Margin $ Variable Nonmanufacturing Expenses Total Contribution Margin Total Fixed Costs Income before Tax Major authoritative bodies of the accounting profession, such as the Financial Accoun- ting Standards Board (FASB) and the Securities and Exchange Commission (SEC), require the use of absorption costing to prepare external financial statements. Absorption costing is also required for filing tax returns with the Internal Revenue Service. The accounting pro- fession has, in effect, disallowed the use of variable costing as a generally accepted inventory method for external reporting purposes. Because absorption costing classifies expenses by functional category, cost behavior (relative to changes in activity) cannot be observed from an absorption costing income statement or management report. Understanding cost behavior is extremely important for many managerial activities including budgeting, cost-volume-profit analysis, and relevant 84 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing costing.9 Thus, internal financial reports distinguishing costs by behavior are often prepared for use in management decision making and analysis. The next section provides a detailed illustration using both absorption and variable costing. Absorption and Variable Costing Illustrations Custom Covers began operations in 2009 and has been hired by Mizzou Mechanical to make car seat cushions. Product specifications are likely to be constant at least until model year 2012. Data for this product are used to compare absorption and variable costing pro- cedures and presentations. The company uses standard costs for material and labor and predetermined rates for variable and fixed overhead.10 See Exhibit 3–13 for unit production costs, annual bud- geted nonmanufacturing costs, and other basic operating data for Custom Covers. The Exhibit 3–13 Custom Covers Basic Data for 2009, 2010, and 2011 Sales price per unit $6.00 Standard variable cost per unit Direct material $2.04 Direct labor 1.50 Variable manufacturing overhead 0.18 Total variable manufacturing cost per unit $3.72 Budgeted Annual Fixed Factory Overhead Standard Fixed Factory Overhead Rate = __________________________________ Budgeted Annual Capacity in Units FOH rate = $162,000 ÷ 300,000 = $0.54 Total absorption cost per unit Standard variable manufacturing cost $ 3.72 Standard fixed manufacturing overhead (SFOH) 0.54 Total absorption cost per unit $ 4.26 Budgeted nonproduction expenses Variable selling expenses per unit $ 0.24 Fixed selling and administrative expenses $23,400 Total budgeted nonproduction expenses = ($0.24 per unit sold + $23,400) 2009 2010 2011 Total Actual units made 300,000 290,000 310,000 900,000 Actual unit sales (300,000) (270,000) (330,000) (900,000) Change in Finished Goods Inventory 0 +20,000 (20,000) 0 9 These topics are covered in Chapters 8 (budgeting), 9 (cost-volume-profit analysis), and 10 (relevant costing). 10 Actual costs can also be used under either absorption or variable costing. Standard costing was chosen for these illustrations because it makes the differences between the two methods more obvious. If actual costs had been used, production costs would vary each year, and such variations would obscure the distinct differences caused by the use of one method, rather than the other, over a period of time. Standard costs are also treated as constant over time to more clearly demonstrate the differ- ences between absorption and variable costing and to reduce the complexity of the chapter explanations. Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 85 predetermined fixed OH rate of $0.54 per unit is computed by dividing budgeted annual FOH ($162,000) by expected capacity (300,000 units). All costs are assumed to remain constant over the three years 2009 through 2011, and, for simplicity, Custom Covers is assumed to complete all units started and, therefore, will have no WIP Inventory at the end of a period. Also, all actual costs are assumed to equal the standard and budgeted costs for the years presented. The bottom section of Exhibit 3–13 is a comparison of actual unit production with actual unit sales to determine the change in inventory for each of the three years. Because Custom Covers began operations in 2009, that year has no beginning finished goods inventory. The next year, 2010, also has no beginning inventory because all units produced in 2009 were also sold in 2009. In 2010 and 2011, production and sales quan- tities differ, which is a common situation because production frequently “leads” sales so that inventory can be stockpiled to satisfy future sales demand. Refer to Exhibit 3–14 for Custom Covers’ operating results for the years 2009 through 2011 using both absorption and variable costing. This example assumes that Custom Covers had no beginning inven- tory and that cumulative units of production and sales for the three years are identical for both methods. Under these conditions, the data in Exhibit 3–14 demonstrate that, regard- less of whether absorption or variable costing is used, the cumulative income before tax will be the same ($1,279,800). Also, as in 2009, for any year in which there is no change in inventory from the beginning to the end of the year, both methods will result in the same net income. Exhibit 3–14 Custom Covers Absorption and Variable Costing Income Statements for 2009, 2010, and 2011 ABSORPTION COSTING PRESENTATION 2009 2010 2011 Total Sales ($6 per unit) $ 1,800,000 $1,620,000 $ 1,980,000 $5,400,000 Cost of goods sold (CGS) ($4.26 per unit) (1,278,000) (1,150,200) (1,405,800) (3,834,000) Standard gross margin $ 522,000 $ 469,800 $ 574,200 $1,566,000 Volume variance (U) 0 (5,400) 5,400 0 Adjusted gross margin $ 522,000 $ 464,400 $ 579,600 $1,566,000 Selling and administrative expenses (95,400) (88,200) (102,600) (286,200) Income before tax $ 426,600 $ 376,200 $ 477,000 $1,279,800 VARIABLE COSTING PRESENTATION 2009 2010 2011 Total Sales ($6 per unit) $ 1,800,000 $1,620,000 $ 1,980,000 $5,400,000 Variable CGS ($3.72 per unit) (1,116,000) (1,004,400) (1,227,600) (3,348,000) Product contribution margin $ 684,000 $ 615,600 $ 752,400 $2,052,000 Variable selling expenses ($0.24 × units sold) (72,000) (64,800) (79,200) (216,000) Total contribution margin $ 612,000 $ 550,800 $ 673,200 $1,836,000 Fixed expenses Manufacturing $ 162,000 $ 162,000 $ 160,200 $ 486,000 Selling and administrative 23,400 23,400 23,400 70,200 Total fixed expenses $ (185,400) $ (185,400) $ (185,400) $ (556,200) Income before tax $ 426,600 $ 365,400 $ 487,800 $1,279,800 Differences in income before tax $ 0 $ 10,800 $ (10,800) $ 0 86 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing Actual production and operating costs have been assumed to equal the standard and budgeted costs for years 2009 through 2011. However, differences in actual and budgeted capacity utilization occurred for 2010 and 2011, which created a volume variance for each of those years under absorption costing. A volume variance reflects the monetary impact of a difference between the budgeted capacity used to deter- mine the predetermined FOH rate and the actual capacity at which the company operated. Thus, for Custom Covers, there is no volume variance for 2009 because 300,000 units were both budgeted and produced. For 2010, the volume variance is calcu- lated as [$0.54 × (290,000 − 300,000)] or $5,400 unfavorable. For 2011, it is calculated as [$0.54 × (310,000 − 300,000)] or $5,400 favorable. Each of these amounts is consid- ered immaterial and is shown as an adjustment to the year’s gross margin. No volume variances are shown under variable costing because fixed manufacturing overhead is not applied to products using a budgeted capacity measure; the FOH is deducted in its entirety as a period expense. The income statements in Exhibit 3–14 show that absorption and variable costing pro- vide different income figures in some years. Comparing the two sets of statements indicates that the difference in income arises solely from the different treatment of fixed overhead. If no beginning or ending inventories exist, cumulative total income under both methods will be identical. Over the three-year period, Custom Covers produced and sold 900,000 units. Thus, all the costs incurred (whether variable or fixed) are expensed in one year or another under either method. The income difference in each year is caused solely by the timing of the expensing of fixed manufacturing overhead. In Exhibit 3–14, absorption costing income before tax for 2010 exceeds that of variable costing by $10,800. This difference is caused by the FOH assigned to the 20,000 units made but not sold ($0.54 × 20,000) and, thus, placed in inventory in 2010. Critics of absorption costing refer to this phenomenon as creating illusionary or phantom profits. Phantom profits are temporary absorption costing profits caused by producing more inventory than is sold. When previously produced inventory is sold, the phantom profits disappear. In contrast, variable costing expenses all FOH in the year it is incurred. In 2011, inventory decreased by 20,000 units. This decrease, multiplied by the FOH rate of $0.54, explains the $10,800 by which 2011 absorption costing income falls short of variable costing income in Exhibit 3–14. For 2011, not only is all current year fixed manufacturing overhead expensed through Cost of Goods Sold, but also the $10,800 of FOH that was retained in 2010’s ending inventory is shown in 2011’s Cost of Goods Sold. Only 2011 fixed manufacturing overhead is shown on the 2011 variable costing income statement. LO.7 How do changes in sales or production levels affect net income computed under Comparison of the Two Approaches absorption and variable costing? Whether absorption costing income is more or less than variable costing income depends on the relationship of production to sales. In all cases, to determine the effect on income, it must be assumed that variances from standard are immaterial and that unit product costs are constant over time. See Exhibit 3–15 for the possible relationships between production and sales levels and the effects of these relationships on income. These relationships are as follows: If production equals sales, absorption costing income will equal variable costing income. If production is more than sales, absorption costing income is greater than variable costing income. This result occurs because some fixed manufacturing overhead cost is deferred as part of inventory cost on the balance sheet under absorption costing, whereas Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 87 Exhibit 3–15 Production/Sales Relationships and Effects on Income and Inventory where P & Production and S & Sales AC & Absorption Costing and VC & Variable Costing Absorption vs. Variable Absorption vs. Variable Income Statement Balance Sheet Income before Taxes Ending Inventory P&S AC & VC No additional difference No difference from beginning inventory FOHEI $ FOHBI & 0 FOHEI & FOHBI P!S AC ! VC Ending inventory increased (Stockpiling By amount of fixed OH in (by fixed OH in additional inventory) ending inventory minus fixed units because P > S) OH in beginning inventory FOHEI $ FOHBI & % amount FOHEI ! FOHBI P"S AC " VC Ending inventory difference (Reducing By amount of fixed OH reduced (by fixed OH from inventory) released from balance BI charged to cost of goods sheet beginning inventory sold) FOHEI $ FOHBI & $ amount FOHEI " FOHBI The effects of the relationships presented here are based on two qualifying assumptions: (1) that unit costs are constant over time (2) that any fixed cost variances from standard are written off when incurred rather than being prorated to inventory balances. the total amount of fixed manufacturing overhead cost is expensed as a period cost under variable costing. If production is less than sales, income under absorption costing is less than income under variable costing. In this case, absorption costing expenses all of the current period fixed manufacturing overhead costs and releases some fixed manufacturing overhead cost from the beginning inventory where it had been deferred from a prior period. This process of deferring FOH costs into, and releasing FOH costs from, inventory makes it possible to manipulate income under absorption costing by adjusting levels of production relative to sales. For this reason, some people believe that variable costing is more useful for external purposes than absorption costing. For internal reporting, vari- able costing information provides managers information about the behavior of the vari- ous product and period costs. To plan, control, and make decisions, managers need to understand and be able to project how costs will change in reaction to changes in activity levels. Variable costing, through its emphasis on cost behavior, provides that necessary information. 88 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing Comprehensive Review Module Key Terms absorption costing, p. 81 normal costing, p. 67 applied overhead, p. 69 outlier, p. 75 contribution margin, p. 83 overapplied overhead, p. 70 dependent variable, p. 75 phantom profit, p. 86 direct costing, p. 82 practical capacity, p. 73 expected capacity, p. 73 predetermined OH rate, p. 68 flexible budget, p. 78 product contribution margin, p. 83 full costing, p. 81 regression line, p. 76 functional classification, p. 81 simple regression, p. 75 high–low method, p. 74 theoretical capacity, p. 73 independent variable, p. 75 underapplied overhead, p. 70 least squares regression analysis, p. 75 variable costing, p. 81 multiple regression, p. 75 volume variance, p. 86 normal capacity, p. 73 Chapter Summary LO.1 Overhead Cost Allocation - closed at the end of each period (unless normal capac- Manufacturing overhead costs are allocated to products to ity is used for the denominator level of activity) to - eliminate the problems caused by delays in obtaining Cost of Goods Sold (CGS) if the amount of actual cost data. underapplied or overapplied overhead is imma- terial (underapplied will cause CGS to increase, - make the overhead allocation process more effective. and overapplied will cause CGS to decrease) - allocate a uniform amount of overhead to goods or or services based on related production efforts. Work in Process Inventory, Finished Goods - allow managers to be more aware of individual prod- Inventory, and Cost of Goods Sold (based on their uct or product line profitability as well as the profit- proportional balances), if the amount of underap- ability of doing business with a particular customer plied or overapplied overhead is material. or vendor. LO.3 Predetermined Overhead Rates and Capacity LO.2 Underapplied and Overapplied Overhead Capacity measures affect the setting of predetermined Underapplied (actual is more than applied) or overap- OH rates because the use of plied (actual is less than applied) overhead is - expected capacity (the budgeted capacity for the - caused by a difference between actual and budgeted upcoming year) will result in a predetermined OH OH costs and/or a difference between the actual and rate that would probably be most closely related to an budgeted level of activity chosen to compute the pre- actual OH rate. determined OH rate. 88 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing 89 - practical capacity (the capacity that allows for normal LO.6 Absorption and Variable Costing operating interruptions) will generally result in a pre- Absorption and variable costing differ in that determined OH rate that is substantially lower than - absorption costing an actual OH rate would be. includes all manufacturing costs, both variable - normal capacity (the capacity that reflects a long-run and fixed, as product costs. average) can result in an OH rate that is higher or lower than an actual OH rate, depending on whether presents nonmanufacturing costs on the income capacity has been over- or underutilized during the statement according to functional areas. years under consideration. - variable costing - theoretical capacity (the estimated maximum poten- includes only the variable costs of production tial capacity) will result in a predetermined OH rate (direct material, direct labor, and variable manu- that is exceptionally lower than an actual OH rate; facturing overhead) as product costs. however, this rate reflects a company’s utopian use of presents both nonmanufacturing and manufac- its capacity. turing costs on the income statement according LO.4 High–Low Method and Least Squares Regression to cost behavior. Mixed costs are separated into their variable and fixed LO.7 Changing Sales or Production Levels in Absorption and components by Variable Costing - the high–low method, which considers the change Differences between sales and production volume result in cost between the highest and lowest activity levels in differences in income between absorption and vari- in the data set (excluding outliers) and determines a able costing because variable cost per unit based on that change; fixed cost - absorption costing requires fixed costs to be written is then determined by subtracting total variable cost off as a function of the number of units sold; at either the highest or the lowest activity level from thus, if production volume is higher than sales total cost at that level. volume, some fixed costs will be deferred in - regression analysis, which uses the costs and activ- inventory at year-end, making net income higher ity levels in the entire data set (excluding outliers) as than under variable costing. input to mathematical formulas that allow the deter- conversely, if sales volume is higher than produc- mination first of variable cost and, subsequently, of tion volume, the deferred fixed costs from pre- fixed cost. vious periods will be written off as part of Cost LO.5 Predetermined Overhead Rates and Flexible Budgets of Goods Sold, making net income lower than Flexible budgets are used by managers to help set pre- under variable costing. determined OH rates by - variable costing requires all fixed costs to be writ- - allowing managers to understand what manufactur- ten off in the period incurred, regardless of when the ing OH costs are incurred and what the behaviors related inventory is sold; (variable, fixed, or mixed) of those costs are. thus, if production volume is higher than sales - allowing managers to separate mixed costs into their volume, all fixed manufacturing costs are expensed variable and fixed elements. in the current period and are not deferred until - providing information on the budgeted costs to be the inventory is sold, making net income lower incurred at various levels of activity. than under absorption costing. - providing the impacts on the predetermined fixed conversely, if sales volume is higher than production OH rate (or on a plantwide rate) from changing the volume, only current period fixed manufacturing d