CHAPTER

PREDETERMINED OVERHEAD RATES,

3 FLEXIBLE BUDGETS, AND ABSORPTION
VARIABLE COSTING

Learning Objectives
After reading and studying Chapter 3, you should be able to answer the following
questions:

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?

3. What impact do different capacity measures have on setting predetermined

overhead rates?

4. How are the high-low method and least squares regression analysis used in
analyzing mixed costs?

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

6. How do absorption and variable costing differ?

7. How do changes in sales or production levels affect net income computed

under absorption and variable costing?
Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing

Terminology
Absorption costing a cost accumulation and reporting method that treats the costs of all
manufacturing components (direct material, direct labor, variable overhead, and fixed
overhead) as inventoriable or product costs in accordance with generally accepted
accounting principles

Applied overhead the amount of overhead that has been assigned to Work in Process
Inventory as a result of productive activity; credits for this amount are to an overhead
account

Contribution margin the difference between total revenues and total variable expenses;
this amount indicates the dollar amount available to “contribute” to cover all fixed
expenses, both manufacturing and nonmanufacturing

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 firm in the upcoming period, based on projected product demand

Flexible budget a planning document that presents expected variable and fixed overhead
costs at different activity levels

Full costing see absorption costing

Functional classification is a group of costs that were all incurred for the same principle
purpose; it includes cost of goods sold and detailed selling and administrative expenses

High-low method a technique used to determine the fixed and variable portions of a mixed
cost; it uses only the highest and lowest levels of activity within the relevant range

Independent variable a variable that, when changed, will cause consistent, observable
changes in another variable; a variable used as the basis of predicting the value of a
dependent variable

Least squares regression analysis a statistical technique that investigates the association
between dependent and independent variables; it determines the line of “best fit” for a set
of observations by minimizing the sum of the squares of the vertical deviations between
actual points and the regression line; it can be used to determine the fixed and variable
portions of a mixed cost

Multiple regression a statistical technique that uses two or more independent variables to
predict a dependent variable
 Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing

Normal capacity the long-run (5–10 years) average production or service volume of a firm;
it takes into consideration cyclical and seasonal fluctuations

Outlier an abnormal or nonrepresentative point within a data set

Overapplied overhead the balance of the overhead account that remains at the end of the
period when the applied overhead amount is greater than the actual that was incurred; it
means that too much overhead was applied to production

Phantom profits 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 working hours with consideration given to ongoing, expected operating
interruptions

Product contribution margin the difference between selling price and variable cost of
goods sold

Regression line any line that goes through the means (or averages) of the set of
observations for an independent variable and its dependent variables; mathematically,
there is a line of “best fit”, which is the least squares regression line

Simple regression a statistical technique that uses only one independent variable to predict
a dependent variable

Theoretical capacity is the estimated maximum production or service volume that a firm
could achieve during a period; it disregards realities such as machine breakdowns and
reduced or stopped plant operations on holidays

Underapplied overhead the condition wherein actual overhead is greater than overhead
charged to production

Variable costing a cost accumulation and reporting method that includes only variable
production costs (direct material, direct labor, and variable overhead) as inventoriable or
product costs; it treats fixed overhead as a period cost; it is not acceptable for external
reporting and tax returns

Volume variance reflects the monetary impact of a difference between the budgeted
capacity used to determine the fixed overhead application rate and the actual capacity at
which the company operates
Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing

Lecture Outline
A. Normal Costing and Predetermined Overhead

1. Normal Costing and Predetermined Overhead.

a. Normal costing is an alternative costing system to actual costing.

b. Normal costing assigns actual direct material and direct labor to products but
allocates production overhead to products using a predetermined overhead
rate.

c. Four primary reasons for using predetermined overhead rates in product

costing.

i. A predetermined overhead rate allows overhead to be assigned during the

period to the goods produced or sold and to the services rendered. We
sacrifice some precision for timeliness.

ii. Predetermined overhead rates adjust for variations in actual overhead costs
that are unrelated to activity. For example, electricity costs run higher in
the summer because of 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. Fixed cost
per unit varies when activity levels change. To minimize such variations in
unit cost, we use an annual predetermined overhead rate for fixed overhead
for all units produced during the year.

iv. Using predetermined overhead rates allows managers to be more aware of

individual product or product line profitability as well as the profitability of
doing business with a particular customer or vendor.

2. Formula for Predetermined Overhead Rate.

Predetermined OH rate = Total Budgeted OH Cost at a Specified Activity Level

Volume of Specified Activity Level

a. Overhead is typically budgeted for one year.

b. Companies should use an activity base that is logically related to actual

overhead cost incurrence. Common activity bases include:

i. Direct labor hours;

ii. Direct labor dollars; and

iii. Machine hours.

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

c. Other activity bases could include:

i. Number of purchase orders;

ii. Physical characteristics such as tons or gallons;

iii. Number of machine setups;

iv. Number of parts; and

v. Material handling time.

d. Activity based costing is discussed in chapter 4.

3. Applying Overhead to Production.

a. Applied overhead is the amount of overhead assigned to Work in Process

Inventory using the activity that was employed to develop the application rate.
For convenience, both actual and applied overhead are recorded in a single
general ledger account.

b. The amount of applied overhead is determined by multiplying the predetermined

rate by the actual activity level.

c. Debits to the overhead account represent actual overhead credits to the

overhead account represent applied overhead.

d. The general ledger may contain a single overhead account or separate accounts
for variable and fixed overhead.

e. Actual overhead incurred during a period will rarely equal applied overhead;
this difference represents underapplied or overapplied overhead.

i. Underapplied overhead is the amount of overhead that remains at the end

of the period when the applied overhead is less than the actual overhead.

ii. Overapplied overhead is the amount of overhead that remains at the end of
the period when the applied overhead is greater than the actual overhead.

f. There are two factors that cause underapplied or overapplied overhead.

i. A difference between actual and budgeted variable overhead cost per unit;
and

ii. A difference between actual and budgeted total fixed overhead cost; and a
difference between actual activity and the budgeted capacity used to
calculate the fixed overhead application rate, only if the company’s actual
activity level exactly equals the expected activity level will the total
budgeted amount of fixed overhead be applied to production.
Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing

4. Disposition of underapplied or overapplied overhead is recorded annually.

a. The method of disposition of underapplied or overapplied overhead depends

upon the materiality of the amount involved.

b. The amount is closed to Cost of Goods Sold if it is immaterial.

c. The amount, if it is material, should be allocated among the accounts containing

applied overhead: Work in Process Inventory, Finished Goods Inventory, and
Cost of Goods Sold.

5. Alternative Capacity Measures

a. Theoretical capacity is the estimated maximum production or service volume

that a firm could achieve during a period. It disregards realities such as
machine breakdowns and reduced or stopped plant operations on holidays.

b. Practical capacity the physical production or service volume that a firm could
achieve during normal working hours with consideration given to ongoing,
expected operating interruptions.

c. Normal capacity the long-run (5–10 years) average production or service

volume of a firm; it takes into consideration cyclical and seasonal fluctuations.

d. Expected capacity a short-run concept that represents the anticipated level of

capacity to be used by a firm in the upcoming period, based on projected
product demand.

B. Separating Mixed Costs

1. Separating Mixed Costs.

a. Accountants describe a given cost’s behavior pattern according to the way its
total cost (rather than its unit cost) reacts to changes in a related activity
measure.

b. A fixed cost remains fixed in total within the relevant range of activity under
consideration.

c. A variable cost varies as production changes, but the cost per unit remains the
same.

d. Mixed costs contain both a variable and a fixed cost element and are assumed
by accountants to be linear rather than curvilinear, within a relevant range of
activity.

e. The linear formula for a mixed cost is y = a + bx

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

Where:

y = total cost (dependent variable)

a = fixed portion of total cost

b = unit change of variable cost relative to unit changes in activity

(slope)

x = activity base to which y is being related (the predictor, cost

driver, or independent variable)

i. The linear formula for a variable cost is y = bx

ii. The linear formula for a fixed cost is y = a

2. The High-Low Method

a. The high-low method is a technique used to determine the fixed and variable
portions of a mixed cost; it uses only the highest and lowest levels of activity
and related costs within the relevant range.

b. The method uses the highest and lowest observed levels of actual activity to
determine the change in costs which reflects the variable cost element b 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

c. The fixed portion of a mixed cost is found by subtracting total variable cost from
total cost.

d. Outliers are abnormal or nonrepresentative observations within a data set that

may be inadvertently used in the application of the high-low method.

3. Least Squares Regression Analysis is a statistical technique that analyzes the

association between dependent and independent variables. It determines the line of
“best fit” for a set of observations by minimizing the sum of the squares of the
vertical deviations between actual points and the regression line. It can be used to
determine the fixed and variable portions of a mixed cost. The least square method
is used to develop an equation that predicts the unknown value of a dependent
variable (cost) from the known values of one or more independent variables
(activities). When multiple independent variables exist, the least squares method
Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing

can be used to select the best predictor of the dependent variable based on which
independent variable has the highest correlation with the dependent variable.

a. A dependent variable (cost) is an unknown variable that is to be predicted

using one or more independent variables.

b. An independent variable (activity) is a variable that, when changed, will cause

consistent, observable changes in another variable; a variable used as the basis
of predicting the value of a dependent variable.

c. Simple regression is a statistical technique that uses only one independent

variable to predict a dependent variable.

d. Multiple regression is a statistical technique that uses two or more independent

variables to predict a dependent variable.

e. A regression line is any line that goes through the means (or averages) of the set
of observations for an independent variable and its dependent variables.
Mathematically, there is a line of “best fit” which is the least squares regression
line.

f. A scattergraph is a graph that plots all known activity observations and the
associated costs; it is used to separate mixed costs into their variable and fixed
components and to examine patterns reflected by the plotted observations.

4. Flexible Budgets

a. Using Flexible Budgets in Setting Predetermined Overhead Rates.

i. A flexible budget is a series of individual budgets that present costs

according to their behavior at different levels of activity.

ii. A flexible budget presents variable and fixed costs at various levels of
activity within a relevant range of activity.

iii. Flexible budgets are prepared for both product and period costs.

5. Plantwide versus Departmental Overhead Rates.

a. Because companies may produce many types of products, a single plantwide

overhead rate does not produce the most useful information.

b. Departmental overhead rates will provide more useful information by using the
most appropriate cost driver for each department.
 Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing

C. Overview of Absorption and Variable Costing

1. An Overview of Absorption and Variable Costing.

a. Cost accumulation is an approach to product costing that determines which

manufacturing costs are recorded as part of product cost and which are
recorded as part of period costs.

b. Cost presentation is an approach to product costing that focuses on how costs

are shown on external financial statements or internal management reports.

c. The two methods of cost accumulation and presentation are absorption costing
and variable costing.

2. Absorption costing is a cost accumulation and reporting method that treats the
costs of all manufacturing components (direct material, direct labor, variable
overhead, and fixed overhead) as inventoriable or product costs; it is the traditional
approach to product costing.

a. Absorption costing is alternatively termed full costing since all types of

manufacturing costs are included as product cost.

b. 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 principle purpose. Examples include cost of
goods sold, selling expenses, and administrative expenses.

c. Total variable product costs increase with each additional product made or each
additional service rendered and are therefore considered to be product costs
and are inventoried until the product or service is sold.

d. Fixed overhead does not vary with units of production or level of service; it
provides the manufacturing capacity necessary for production to occur.
Production could not take place without the incurrence of fixed overhead, so
fixed overhead is considered to be a product cost under absorption costing.

3. Variable costing is a cost accumulation and reporting method that includes only
variable production costs (direct material, direct labor, and variable overhead) as
inventoriable or product costs; it treats fixed overhead as a period cost; it is also
known as direct costing.

a. Variable costing treats fixed overhead as a period cost while absorption costing
treats fixed overhead as a product cost.

b. A variable costing income statement presents expenses according to cost

behavior (variable and fixed), although it may present expenses by functional
classification within the behavioral categories.
Chapter 3: Predetermined Overhead Rates, Flexible Budgets, and Absorption Variable Costing

c. Cost of goods sold is more appropriately called variable cost of goods sold since it is
composed of only the variable production costs related to the units sold.

d. Product contribution margin is the difference between selling price and

variable cost of goods sold and indicates how much revenue is available to
cover all period costs and to potentially provide net income. Product
contribution margin is commonly called manufacturing margin.

e. Total contribution margin is the difference between revenue and all variable
costs regardless of the area of incurrence (production or nonproduction).

f. The accounting profession has unofficially disallowed the use of variable

costing as a generally accepted inventory valuation method for external
reporting purposes.

D. Comparison of the Two Approaches

1. Absorption costing income will equal variable costing income if production is equal
to sales.

a. Absorption costing income will be greater than variable costing income if

production is greater than sales.

b. Some fixed overhead cost is deferred as part of inventory cost on the balance
sheet under absorption costing.

c. The total amount of fixed overhead cost is expensed as a period cost under
variable costing.

2. Absorption costing income will be less than variable costing income if production is
less than sales.

a. Absorption costing expenses all of the current period fixed overhead cost as
well as releasing some fixed overhead cost from beginning inventory where it
had been deferred from a prior period.

b. Variable costing shows on the income statement only current period fixed
overhead, so that the additional fixed overhead released from beginning
inventory makes absorption costing income lower.

c. The process of deferring and releasing fixed overhead costs into and from
inventory makes it possible to manipulate income under absorption costing by
adjusting levels of production relative to sales. This leads some to believe that
variable costing might be more useful for external reporting purposes than
absorption costing.

d. For internal reporting purposes, variable costing provides managers

information about the behavior of the various product and period costs.