Learning Objectives
1. Why and how are overhead costs allocated to products and services?
2. What causes underapplied or overapplied overhead and how is it treated at the end of a period?
variable costing?
8. (Appendix) How is least squares regression used in analyzing mixed costs?
PREDETERMINED OVERHEAD RATES,
FLEXIBLE BUDGETS, AND ABSORPTION/
VARIABLE COSTING
CHAPTER
3
Chapter 03: Predetermined Overhead Rates, Flexible Budgets, & Absorption/Variable Costing IM 2
Terminology
Absorption costing: A cost accumulation and reporting method that treats the costs of all manufacturing
Applied overhead: The dollar amount of overhead assigned from an overhead account to Work in
Contribution margin: The difference between total revenues and total variable expenses (manufacturing
Dependent variable: An unknown variable that is to be predicted using one or more independent
variables
Direct costing: See variable costing
Expected capacity: A short-run concept that represents the anticipated level of capacity to be used by a
Flexible budget: A planning document that presents expected variable and fixed overhead costs at
different activity levels
Full costing: See absorption costing
Functional classification: A group of costs that were all incurred for the same principle purpose (e.g.,
High-low method: A technique that determines the fixed and variable portions of a mixed cost using only
Independent variable: A variable that, when changed, will cause consistent, observable changes in
Least squares regression analysis: A statistical technique that analyzes the relationship between
independent (causal) and dependent (effect) variables in order to develop an equation that can be used
Multiple regression: A statistical technique that uses two or more independent variables to predict a
dependent variable
Normal capacity: The long-run (5–10 years) average production or service volume of a firm; normal
Normal costing: An alternative to actual costing, this costing system assigns to WIP Inventory the actual
Chapter 03: Predetermined Overhead Rates, Flexible Budgets, & Absorption/Variable Costing IM 3
Overapplied overhead: The credit balance in the overhead account that remains at the end of the period
Phantom profit: A temporary absorption costing profit caused by producing more inventory than is sold
Practical capacity: The physical production or service volume that a firm could achieve during normal
Product contribution margin: The difference between the selling price and variable manufacturing cost
Regression line: Any line that goes through the means (or averages) of the independent and dependent
Simple regression: A statistical technique that uses only one independent variable to predict a
dependent variable
Theoretical capacity: The estimated maximum production or service volume that a firm could achieve
Underapplied overhead: The debit balance in the overhead account that remains at the end of the
Variable costing: A cost accumulation and reporting method that includes only variable production costs
Volume variance: The monetary impact of the difference between the budgeted capacity used to
Chapter 03: Predetermined Overhead Rates, Flexible Budgets, & Absorption/Variable Costing IM 4
Lecture Outline
LO.1 Why and how are overhead costs allocated to products and services?
A. Introduction
1. This chapter discusses normal costing and its use of predetermined overhead rates to determine
area and in selling and administrative departments.
3. Historically, direct material and direct labor were the manufacturer’s primary costs but today such
of overhead costs.
B. Normal Costing and Predetermined Overhead
1. General
a. Normal costing is an alternative costing system to actual costing.
i. A predetermined overhead rate allows overhead to be assigned during the period as
the costs of air conditioning;
iii. Predetermined overhead rates overcome the problem of fluctuations in activity levels that
have no impact on actual fixed overhead costs. Since unit fixed costs vary with activity
and
iv. Using predetermined overhead rates allows managers to be more aware of individual
Chapter 03: Predetermined Overhead Rates, Flexible Budgets, & Absorption/Variable Costing IM 6
publicly accessible website, in whole or in part.
Depreciation, Pre-paid Insurance, etc.)
LO.2 What causes underapplied or overapplied overhead and how is it treated at the end of a
period?
overhead.
ii. Overapplied overhead is the credit balance in the overhead control account that
g. Two factors cause underapplied or overapplied overhead:
4. Disposition of underapplied or overapplied overhead
a. Since overhead accounts are temporary accounts, their ending balances must be closed at
the end of the accounting period.
materiality of the amount involved.
i. If immaterial, the ending balances in the overhead control accounts are closed entirely to
Cost of Goods Sold. Text Exhibit 3.3 (p. 67) illustrates the impact of under-and-over-
overapplied fixed overhead.
5. Alternative Capacity Measures
a. The choice of activity level (i.e., the denominator in the predetermined OH rate equation)
reduced or stopped plant operations on holidays.
Chapter 03: Predetermined Overhead Rates, Flexible Budgets, & Absorption/Variable Costing IM 7
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a
publicly accessible website, in whole or in part.
ii. Practical capacity is the physical production or service volume that a firm could achieve
during regular working hours with consideration given to ongoing, expected operating
interruptions.
iii. Normal capacity is the long-run (5–10 years) average production or service volume of a
demand.
b. If actual results are close to budgeted results (in both dollars and volume), expected capacity
as the Denominator Level.
c. See text Exhibit 3.5 (p. 69) for a visual representation of measures of capacity.
i. Note that expected capacity and practical capacity may be closer to equal than depicted
LO.4 How is the high-low method used in analyzing mixed costs?
C. Separating Mixed Costs
1. General
a. Accountants describe a given cost’s behavior pattern according to the way its total cost
a relevant range of activity:
y = a + bx
Where:
y = total cost (dependent variable)
a = fixed portion of total cost (y-intercept)
independent variable)
Chapter 03: Predetermined Overhead Rates, Flexible Budgets, & Absorption/Variable Costing IM 8
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a
publicly accessible website, in whole or in part.
c. A fixed cost remains constant in total within the relevant range of activity under consideration.
i. The linear formula for a fixed cost is y = a.
d. A variable cost varies in total as production changes, but the cost per unit remains constant.
i. The linear formula for a variable cost is y = bx.
e. Mixed costs contain both a variable and a fixed cost element.
2. The High-Low Method
a. The high-low method is a technique for determining the fixed and variable portions of a
relevant range.
b. The method determines the variable cost per unit b as follows:
a = y – bx
discarded when applying the high-low method.
e. Text Exhibit 3.6 (p. 71) illustrates the high low method.
3. Least Squares Regression Analysis
a. Ordinary Least Squares (OLS) regression is a statistical technique that analyzes the
i. A dependent variable (cost) is an unknown variable that is to be predicted using one or
more independent variables.
©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a
publicly accessible website, in whole or in part.
predicting the value of a dependent variable.
b. OLS determines the line of “best fit” for a set of observations by minimizing the sum of the
c. When multiple independent variables exist, the least squares method can be used to select
variables to predict a dependent variable.
e. A regression line is any line that goes through the means (or averages) of the set of
i. As depicted in text Exhibit 3.15 (p. 81), mathematically, there is a line of “best fit” which
is referred to as the least squares regression line (the red line in Graph B).
i. For regression analysis to be useful, the independent variable must be a valid predictor of
ii. OLS should only be used within a relevant range of activity; and
development remain constant.
LO.5 How do managers use flexible budgets to set predetermined overhead rates?
4. Flexible Budgets
cost per unit by the activity level volume.