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

LO1 Why and how are overhead costs allocated to products and services? (6)

(Why) They are allocated to products to -eliminate the problems caused by delays in obtaining actual cost data. -make overhead allocation process more effective -allocate a uniform amount of overhead to goods based on related production efforts -allow manager to be aware of individual product (line) profitability, or profitability of doing business with a particular customer or vendor. (How) Cost allocation can be made using actual or normal costing (normal costing necessitates the computation of one or more predetermined overhead rates) - A predetermined OH rate is calculated as total budgeted OH cost at a specified activity level divided by the volume at the specified activity level. -Applied OH is the amount of overhead debited to WIP inventory using the actual volume of the specified activity measure multiplied by the predetermined OH rate.

LO6 How do absorption and variable costing differ?

Absorption Costing - includes all manufacturing costs, both variable and fixed, as product costs. -presents non manufacturing costs on the income statement according to function areas. Variable Costing -includes only the variable costs of production (direct, material, labor, and variable manufacturing overhead) as product costs. - presents both non manufacturing and manufacturing costs on the income statement according to cost behavior.

Which of the following would most likely generate an immaterial amount of over or under applied OH A) Theoretical Capacity B) Practical Capacity C) Normal Capacity D) Expected Capacity E) Immaterial Capacity

Answer D) Because: -expected capacity- will result in a predetermined OH rate that would likely be most closely related to an actual OH rate

LO3 What impact do different capacity measures have on setting predetermined overhead rates?

Capacity measures affect the setting of predetermined OH rates because the use of: -expected capacity- will result in a predetermined OH rate that would likely be most closely related to an actual OH rate -practical capacity- Will be generally result in a predetermined OH rate that is substantially lower than an actual OH rate would be. -normal capacity- can result in an OH rate hat is higher or lower than an actual OH rate, depending on whether capacity has been over or under utilized during the years under consideration. -theoretical capacity- will result in a predetermined OH rate that is substantially lower than n actual OH rate; however, this rate reflects a company's utopian use of its capacity.

What is the key differences between Absorption and Variable Costing.

Fixed product costs are not included in inventory under variable costing.

LO5 How do managers use flexible budgets to set predetermined overhead rates?

Flexible budgets are used by managers to help set predetermined OH rates by: - allowing managers to identify the manufacturing H costs to be incurred and what the behaviors (variable, fixed, or mixed) or those costs are. -allowing managers to separate mixed costs into their variable and fixed elements - providing information on the budgeted costs to be incurred at various levels of activity - providing the impacts on the predetermined fixed OH rate (or on a plant wide rate) from changing the denominator level of activity. If an organization's departments use significantly different types of work effort or material processing, flexible budgets and predetermined OH rates generally should be computed using departmental rather than plant wide information

LO8 How is least squares regression used in analyzing mixed costs.

Least squares regression also helps to select the independent variable that is the best predictor of the dependent variable (cost driver).

What is Regression and what are the pieces of linear regression.

Linear regression gives the equation for the line that best fits the data Slope of the line= variable cost rate Y Intercept = fixed cost (cost driver)

LO4 How is the high-low method used in analyzing mixed costs?

Mixed costs may be separated into their variable and fixed components using the high-low method. - The change in cost between the highest and lowest activity levels in the data set (excluding outliers) is used to compute a variable cost per unit. -Fixed cost is determined by subtracting total variable cost at either the highest or lowest activity level from total cost at that level.

How to calculate and apply OH

OH Applied= Actual volume of activity level * Predetermined OH rate Actual OH costs are DR to OH control account Applied OH costs are CR to OH control account

What is the High-Low Method

Uses two points (the high activity level and low activity level to deter min the cost formula.

What is the calculation using variable rate and fixed cost for the High-Low Method.

Variable rate= change in cost between high & low point / change in output between high & low point. Fixed cost= Total cost at low point - variable rate * output at low point

LO7 How do changes in Sales or production levels affect variable costing

Result in differences in the income between absorption and variable costing because: Absorption costing requires fixed costs to be expensed as a function of the number of units sold - if production >sales, some fixed costs will be deferred in inventory at year end, making net income higher than under variable costing. -if Sales > production, the deferred fixed costs from previous periods will be expensed as apart of COGS, making net income lower than under variable costing. Variable costing- requires all fixed costs to be expensed in the period incurred, regardless of when the related inventory is sold. -If Production> sales, all fixed manufacturing costs are expensed in the current period and are not deferred until the inventory is sold, making net income lower than under absorption costing. -If Sales > production only current period fixed manufacturing costs are expensed in the current period, making net income higher than under absorption costing.

How do you calculate a predetermined OH rate?

Total budgeted OH cost at a specified activity level / Volume of specified activity level. The activity base must be common to all products. - Direct labor hours - Machine hours

LO2 What causes under applied and over applied overhead, and how is it treated at the end of period?

Under applied ( actual is more than applied) Over applied ( actual is less than applied) - Over head is caused by a difference between actual and budgeted OH costs and/or a difference between the actual and budgeted level of activity chosen to compute the predetermined OH rate. - Closed at the end of each period (unless normal capacity is used for the denominator level of activity) to - COGS- if the amount of under/over applied OH is immaterial. (Under applied will cause CGS to increase and over applied will cause CGS to decrease.) - WIP Inventory, FG inventory, and COGS (based on their proportional balances), if the amount of under applied or over applied OH is material)

What do you do if Over/Underapplied OH is material or immaterial.

if immaterial apply to COGS If material then: 1. Calculate relative % of WIP, FG, and COGS 2. Apply to these accounts based on %

What is Normal Costing and its benefits.

is an alternative to actual costing that allocates overhead using a pre determined OH rate. Its benefits include; Timeliness, smoothing (seasonality), smoothing (activity), Awareness (product, line, customer)