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Accounting for Overhead Costs. Chapter 13. Pioneered the “direct business model “ of selling computers Many orders are taken over the internet Need to know product cost Chapter focuses on applying overhead to products. Learning Objective 1. Compute budgeted factory-overhead rates

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Pioneered the “direct business model “ of selling computers
  • Many orders are taken over the internet
  • Need to know product cost
  • Chapter focuses on applying overhead to products
learning objective 1
Learning Objective 1
  • Compute budgeted
  • factory-overhead rates
  • and apply factory
  • overhead to production.
accounting for factory overhead
Accounting for Factory Overhead

Methods for assigning overhead costs

to the products is an important part of

accurately measuring product costs.

budgeted overhead application rates
Budgeted OverheadApplication Rates


1. Select one or more cost drivers.

2. Prepare a factory overhead budget.

3. Compute the factory overhead rate.

4. Obtain actual cost-driver data.

5. Apply the budgeted overhead

to the products.

6. Account for any differences between the

amount of actual and applied overhead.

budgeted overhead application rates6
Budgeted OverheadApplication Rates

Budgeted overhead application rate

= Total budgeted factory overhead

÷ Total budgeted amount of cost driver

illustration of overhead application
Illustration of Overhead Application

Enriquez Machine Parts Company’s

budgeted manufacturing overhead for

the machining department is $277,800.

Budgeted machine hours are 69,450.

What is the rate?

$277,800 ÷ 69,450 = $4 per machine hour

illustration of overhead application8
Illustration of Overhead Application

Suppose that at the end of the year Enriquez

had used 70,000 hours in Machining.

How much overhead was applied to Machining?

70,000 × $4 = $280,000

objective 2
Objective 2
  • Determine and use appropriate
  • cost drivers for overhead
  • application.
choice of cost drivers
Choice of Cost Drivers

No one cost driver is right for all situations.

The accountant’s goal is to find the

driver that best links cause and effect.

choice of cost drivers11
Choice of Cost Drivers

A separate cost pool should

be identified for each driver.

Driver 1

Pool 1

Driver 2

Pool 2

learning objective 3
Learning Objective 3
  • Identify the meaning and
  • purpose of normalized
  • overhead rates.
normalized overhead rates
Normalized Overhead Rates

“Normal” product costs include

an average or normalized

chunk of overhead.

Actual direct material

+ Actual direct labor

+ Normal applied overhead

= Cost of manufactured product

disposing of underapplied or overapplied overhead
Disposing of Underapplied or Overapplied Overhead

Suppose that Enriquez applied

$375,000 to its products.

Also, suppose that Enriquez incurred

$392,000 of actual manufacturing

overhead during the year.

disposing of underapplied or overapplied overhead15
Disposing of Underapplied or Overapplied Overhead

How much was underapplied?

$392,000 actual – $375,000 applied = $17,000

immediate write off

Manufacturing Overhead





Cost of Goods Sold


Immediate Write-Off
prorating among inventories
Prorating Among Inventories

Prorate $17,000 of underapplied

overhead assuming the following

ending account balances:

Work-in-Process Inventory $ 155,000

Finished Goods Inventory 32,000

Cost of Goods Sold 2,480,000

Total $2,667,000

prorating among inventories18
Prorating Among Inventories

$17,000 × 155/2,667

= 988 to Work-in-Process Inventory

$17,000 × 32/2,667

= $204 to Finished Goods Inventory

$17,000 × 2,480/2,667

= $15,808 to Cost of Goods Sold

the use of variable and fixed application rates
The Use of Variable and Fixed Application Rates

The presence of fixed costs is a

major reason of costing difficulties.

Some companies distinguish between

variable overhead and fixed

overhead for product costing.

variable versus absorption costing
Variable VersusAbsorption Costing

This section compares two

methods of product costing.





variable versus absorption costing21
Variable VersusAbsorption Costing

Variable costing excludes fixed

manufacturing overhead

from inventoriable costs.

Absorption costing treats fixed

manufacturing overhead

as inventoriable costs.

facts and illustration

Basic Production Data at Standard Cost

Direct material $205

Direct labor 75

Variable manufacturing overhead 20

Standard variable costs per unit $300

Facts and Illustration
facts and illustration23
Facts and Illustration

The annual budget for fixed manufacturing

overhead is $1,500,000

Budgeted production is 15,000 computers.

Sales price = $500 per unit

$20 per computer is variable overhead.

Fixed S&A expenses = $650,000

Sales commissions = 5% of dollar sales

facts and illustration24
Facts and Illustration

Units 2003 2004

Opening inventory – 3,000

Production 17,000 14,000

Sales 14,000 16,000

Ending inventory 3,000 1,000

learning objective 4
Learning Objective 4
  • Construct an income statement
  • using the variable-costing
  • approach.
cost of goods sold for variable costing method

(thousands of dollars) 2003 2004

Variable expenses:

Variable manufacturing cost

of goods sold

Opening inventory, at – $ 900

standard costs of $300

Add: variable cost of goods

manufactured at standard,

17,000 and 14,000 units 5100 4200

Available for sale, 17,000 units 5100 5100

Ending inventory, at $300 900¹ 300²

Variable manufacturing

cost of goods sold $4200$4800

Cost of Goods Sold forVariable- Costing Method

¹3,000 units × $300 = $900,000 ²1,000 units × $300 = $300,000

comparative income statement for variable costing method

(thousands of dollars) 2003 2004

Sales, 14,000 and 16,000 units $7,000 $8,000

Variable expenses:

Variable manufacturing

cost of goods sold 42004800

Variable selling expenses,

at 5% of dollar sales 350 400

Contribution margin $2,450 $2,800

Fixed expenses:

Fixed factory overhead $1,500 $1,500

Fixed selling and admin. expenses 650 650

Operating income, variable costing $ 300 $ 650

Comparative Income Statement for Variable-Costing Method
learning objective 5
Learning Objective 5
  • Construct an income statement
  • using the absorption-
  • costing approach.
fixed overhead rate
Fixed-Overhead Rate

The fixed-overheadrateis the

amount of fixed manufacturing

overhead applied to each

unit of production.

$1,500,000 ÷ 15,000 = $100

cost of goods sold for absorption costing method

(thousands of dollars) 2003 2004

Beginning inventory $ – $1,200

Add: Cost of goods manufactured

at standard, of $400* 6,800 5,600

Available for sale $6,800 $6,800

Deduct: Ending inventory 1,200 400

Cost of goods sold, at standard $5,600$6,400

Cost of Goods Sold forAbsorption-Costing Method

*Variable cost $300

Fixed cost 100

Standard absorption cost $400

comparative income statement for absorption costing method

(thousands of dollars) 2003 2004

Sales $7,000 $8,000

Cost of goods sold, at standard 5,6006,400

Gross profit at standard $1,400 $1,600

Production-volume variance* 200 F 100 U

Gross margin or gross profit “actual” $1,600 $1,500

Selling and administrative expenses 1,000 1,050

Operating income, variable costing $ 600 $ 450

Comparative Income Statement for Absorption-Costing Method

*Based on expected volume of production of 15,000 units:

2003: (17,000 – 15,000) × $100 = $200,000 F

2004: (14,000 – 15,000) × $100 = $100,000 U

learning objective 6
Learning Objective 6
  • Compute the production-
  • volume variance and show
  • how it should appear in
  • the income statement.
production volume variance
Production-Volume Variance

Applied fixed overhead – Budgeted fixed overhead

= (Actual volume × Fixed-overhead rate) –

(Expected volume × Fixed-overhead rate)

In practice, the production-volume variance

is usually called simply the volume variance.

production volume variance34

Expected volume


Fixed overhead rate


Production-volume variance

Production-Volume Variance

Actual volume

production volume variance35
Production-Volume Variance

A production-volume variance arises when

the actual production volume achieved

does not coincide with the expected

volume of production used as a denominator

for computing the fixed-overhead rate.

There is no production-volume

variance for variable overhead.

Do 13-43

reconciliation of variable costing and absorption costing
Reconciliation of Variable Costing and Absorption Costing

Absorption unit cost is higher.

Output-level (production-volume)

variance exists only under

absorption costing.

reconciliation of variable costing and absorption costing37
Reconciliation of Variable Costing and Absorption Costing

Under absorption costing, fixed overhead

appears in the cost of goods sold and

also in the production-volume variance.

Under variable costing, fixed

overhead is a period cost.

reconciliation of variable costing and absorption costing38
Reconciliation of Variable Costing and Absorption Costing

The difference between income reported

under these two methods is entirely due to

the treatment of fixed manufacturing costs.

Under absorption costing, these costs are

treated as assets (inventory) until the

associated goods are sold.

learning objective 7
Learning Objective 7
  • Explain how a company might
  • prefer to use a variable-
  • costing approach.
why use variable costing
Why Use Variable Costing?

One reason is that absorption-costing

income is affected by production

volume while variable-costing

income is not.

Another reason is based on which

system the company believes

gives a better signal about


flexible budget variances
Flexible-Budget Variances

All variances other than the

production-volume variance are

essentially flexible-budget variances.

flexible budget variances42
Flexible-Budget Variances

Flexible-budget variances measure

components of the differences

between actual amounts and

the flexible-budget amounts

for the output achieved.

flexible budget variances43
Flexible-Budget Variances

Flexible budgets are primarily

designed to assist planning and

control rather than product costing.

effects of sales and production on reported income
Effects of Sales and Productionon Reported Income

Production > Sales

Variable costing income is lower

than absorption income.

Production < Sales

Variable costing income is higher

than absorption income.