Factory

Overhead

COST ACCOUNTING
& MANAGEMENT
learning objectives
1. Assign direct and indirect costs to cost
objects
2. Explain the alternative capacity measures
3. Explain how to develop flexible budget
4. Distinguish between plant-wide overhead
rates and departmental overhead rates

15-
Allocating Overhead
Actual vs. Normal
Product Cost Actual Cost Normal Cost
System System
Direct Materials Actual Actual

Direct Labor Actual Actual

Overhead Actual Predetermined

Overhead Rate
Predetermined Overhead Rate
 Allows overhead to be assigned during the
period, fulfilling the matching principle
 Adjusts for variations not related to activity
 Compensates for fluctuations in activity
level that do not affect fixed overhead
 Allows managers to be aware of product,
product line, customer, and vendor
profitability
Predetermined Overhead Rate
A budgeted, constant charge per unit of activity used to
assign overhead to production or services
Total budgeted
overhead Predetermined
Activity level
= Overhead
Rate
(Volume)
(usually for a year)

$100,000 $20 per

5,000 = DL Hour
Direct Labor (DL) Hours
The Activity Level: The
Denominator
 Relationship between the overhead cost
and the activity
 Production volume
 Direct labor hours
 Direct labor cost
 Machine hours
 Number of purchase orders or parts
 Machine setups
 Material handling time
 Predetermined Overhead Rate
Total budgeted
variable overhead $375,000 $7.50
Activity level 50,000 = per machine
hour
(Volume) machine hours

Total budgeted
fixed overhead $630,000 $12.60
Activity level 50,000 = per machine
hour
(Volume) machine hours
Applying Variable Overhead
For one month
Actual activity level
times
4,300 actual machine
hours times
Predetermined
$7.50 Predetermined
overhead rate variable overhead rate
equals equals
overhead applied $32,250 overhead applied

Apply Variable Overhead

Work in Process Inventory 32,250
Variable Mfng Overhead 32,250
 Applying Fixed Overhead
For one month
Actual activity level 4,300 actual machines
times hours times
Predetermined $12.60 Predetermined
overhead rate fixed overhead rate
equals equals
overhead applied $54,180 overhead applied

Apply Fixed Overhead

Work in Process Inventory 54,180
Fixed Manufacturing Overhead 54,180
 Recording and Applying Overhead
For one month
Overhead Account
(Combined Fixed/Variable)
Actual Overhead Applied Overhead
Variable 32,250
Fixed 54,180
Apply Overhead (combined journal entry)
Work in Process Inventory 86,430
Variable Manufacturing Overhead 32,250
Fixed Manufacturing Overhead 54,180
 Recording Actual Overhead
For one month
Overhead Account
(Combined/Fixed/Variable)
Actual Overhead Applied Overhead
Variable 31,385 Variable 32,250
Fixed 55,970 Fixed 54,180

Record actual overhead

Variable Manufacturing Overhead 31,385
Fixed Manufacturing Overhead 55,970
Various Accounts 87,355
 Manufacturing Overhead
For the entire year
Overhead Account
(Combined Fixed/Variable)
Actual Overhead Applied Overhead
Fixed 220,000 Fixed 260,000

Overhead is $40,000 overapplied

$220,000 of actual overhead was incurred
$260,000 was applied to Work in Process
Manufacturing Overhead: Single
Account, Variable, and Fixed
Disposing of Overhead
Differences
If overhead is underapplied,
the adjusting entry
increases Cost of Goods Sold
decreases Net Income
If overhead is overapplied, the
adjusting entry
decreases Cost of Goods Sold
increases Net Income
Disposing of
Overhead Differences
 Immaterial  Material—

 Cost of Goods Prorate to

Sold  Work in Process

 Finished Goods

 Cost of Goods Sold

Disposing of
Overhead Differences
 Immaterial  Material
 Cost of Goods  Prorate to
Sold  Work in Process

 Finished Goods

 Cost of Goods Sold

Alternative Capacity Levels
(The Denominator Level)
 Capacity measure of volume or some other
activity base
 Alternative measures
 Theoretical

 Practical

 Normal

 Expected

 Choice of capacity level affects product cost

Theoretical Capacity

All production factors are

operating perfectly
Disregards
Machinery breakdown
Holiday downtime
Results in
Significant underapplied
overhead
Lowest product cost
Practical Capacity
Theoretical capacity reduced by
ongoing, regular operating
interruptions (holidays, downtime,
and start-up time)
Usually results in
 Underapplied overhead
 Low product cost
Normal Capacity
 Considers
 Historical production level
 Estimated future production level
 Cyclical fluctuations

 Attainable level of activity

 When normal capacity is greater than
expected capacity, may result in
 Underapplied overhead
 Higher product cost
Expected Capacity

 Anticipated activity level for the upcoming period

based on projected product demand

 Determined during the budget process

 Should closely reflect actual costs

 Results in
 Immaterial overapplied or underapplied overhead
 Highest product cost
Alternative Capacity Levels
Alternative
(The Capacity
Denominator Level) Level

 Theoretical lowest product cost

 Practical low product cost
 Normal higher product cost *
 Expected highest product cost
*assuming normal exceeds expected capacity
Analyzing Mixed Costs
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 = total cost y = a + bX
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 variable—
Cost
 Independent variables—
Activities
 Regression line provides
line of best fit for the data
 Using the High–Low Method
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)
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

High—Low Method Regression Analysis

$800.00 + $0.30X $354.62 + $0.35X

More data
points
mean a
better
estimate of
(X = machine hours) total costs
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
Plant-Wide vs. Departmental
Overhead