Accounting for Overhead Costs Introduction to Management Accounting Chapter 13
Accounting for Factory Overhead Methods for assigning overhead costs to the products is an important part of accurately measuring product costs. Learning Objective 1
Budgeted Overhead Application 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. Steps:
Budgeted Overhead Application Rates Budgeted overhead application rate = Total budgeted factory overhead ÷ Total budgeted amount of cost driver Overhead rates are budgeted; they are estimates. The budgeted rates are used to apply overhead based on actual events.
Illustration of Overhead Application The company’s budgeted manufacturing overhead for the machining department is $277,800. Budgeted machine hours are 69,450. The budgeted overhead application rate is: $277,800 ÷ 69,450 = $4 per machine hour Enriquez Machine Parts Company selects a single cost-allocation in each department for applying overhead, machine hours in machining and direct-labor in assembly.
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
Choice of Cost-Allocation Bases No one cost –allocation base is right for all situations. The accountant’s goal is to find the cost- allocation base that best links cause and effect. Learning Objective 2
Choice of Cost-Allocation Bases A separate cost pool should be Identified for each cost-allocation base. Base 1 Pool 1 Base 2 Pool 2
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 Learning Objective 3
Disposing of Underapplied or Overapplied Overhead Suppose that Enriquez applied $375,000 to its products. Also, suppose that Enriquez actually incurred $392,000 of actual manufacturing overhead during the year. $392,000 actual – 375,000 applied $ 17,000 Underapplied The $375,000 becomes part of Cost of Goods Sold when the product is sold. The $17,000 must also become an expense.
Disposing of Underapplied or Overapplied Overhead The applied overhead is $17,000 less than the amount incurred. It is: Underapplied Overapplied overhead occurs when the amount applied exceeds the amount incurred.
Immediate Write-Off Incurred Overhead (Actual) Applied Overhead (Budgeted) This method regards the $17,000 as a reduction in current income and adds it to Cost of Goods Sold. Manufacturing Overhead 392,000 375,000 17,000 0 Cost of Goods Sold 17,000
Prorating Among Inventories This method prorates the $17,000 of underapplied overhead to Work-In Process (WIP), Finished Goods, and Cost of Goods Sold accounts 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 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
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 costing excludes fixed manufacturing overhead from the cost of products. Absorption costing includes fixed manufacturing overhead in the cost of products. Variable costing Absorption costing
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 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. Sales commissions = 5% of dollar sales Fixed S&A expenses = $650,000
Facts and Illustration Units 20X7 20X8 Opening inventory – 3,000 Production 17,000 14,000 Sales 14,000 16,000 Ending inventory 3,000 1,000 There are no variances from the standard variable manufacturing costs, and the actual fixed manufacturing overhead incurred is exactly $1,500,000.
Variable- Costing Method Cost of Goods Sold ¹ 3,000 units × $300 = $900,000 ²1,000 units × $300 = $300,000 Learning Objective 4 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 $300 900 ¹ 300 ² Variable manufacturing cost of goods sold $4200 $4800 (thousands of dollars) 20X7 20X8
Variable-Costing Method Comparative Income Statement 1 from Cost of Goods Sold previous calculation Sales, 14,000 and 16,000 units $7,000 $8,000 Variable expenses: Variable manufacturing cost of goods sold 4200 1 4800 1 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 ( thousands of dollars) 20X7 20X8
Fixed-Overhead Rate The fixed-overhead rate is the amount of fixed manufacturing overhead applied to each unit of production. $1,500,000 ÷ 15,000 = $100 budgeted fixed manufacturing overhead expected volume of production Fixed overhead rate =
Absorption-Costing Method Cost of Goods Sold *Variable cost $300 Fixed cost 100 Standard absorption cost $400 Learning Objective 5 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 (thousands of dollars) 20X7 20X8
Absorption-Costing Method Comparative Income Statement *Based on expected volume of production of 15,000 units: 20X7: (17,000 – 15,000) × $100 = $200,000 F 20X8: (14,000 – 15,000) × $100 = $100,000 U 1From Cost of Goods Sold previous calculation Sales $7,000 $8,000 Cost of goods sold, at standard 5,600 1 6,400 1 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 ( thousands of dollars) 20X7 20X8
Production-Volume Variance Production-volume variance = (actual volume – expected volume) X fixed overhead rate In practice, the production-volume variance is usually called simply the volume variance. Learning Objective 6 A production-volume variance appears when actual production deviates from the expected volume of production used in computing the fixed overhead rate.
Production-Volume Variance There is no production-volume variance for variable overhead. The production-volume variance for fixed overhead arises because of the conflict between accounting for control (flexible budgets) and accounting for product costing (applied rates). A flexible budget for fixed overhead is a lump-sum budgeted amount; volume does not affect it. However, applied fixed cost depends on actual volume.
Variable Costing and Absorption Costing The difference between income reported under these two methods is entirely due to the treatment of fixed manufacturing costs.
Variable Costing and Absorption Costing On a variable-costing income statement, costs are separated into the major categories of fixed and variable. Revenue less all variable costs (both manufacturing and non-manufacturing) is the contribution margin. On an absorption-costing income statement, costs are separated into the major categories of manufacturing and non-manufacturing. Revenue less manufacturing costs (both fixed and variable) is gross profit or gross margin.
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 performance. Learning Objective 7
Flexible-Budget Variances All variances other than the production-volume variance are essentially flexible-budget variances. All other variances appear on both variable- and absorption-costing income statements.
Flexible-Budget Variances Flexible budgets are primarily designed to assist planning and control rather than product costing. Flexible-budget variances measure components of the differences between actual amounts and the flexible-budget amounts for the output achieved.
Effects of Sales and Production on Reported Income Production > Sales Variable costing income is lower than absorption income. Production < Sales Variable costing income is higher than absorption income.