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Variable Costing:

A Tool for Management


Chapter 5

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Learning Objective 1

Explain how variable


costing differs from
absorption costing and
compute unit product
costs under each
method.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 2

Overview of Absorption and Variable


Costing

McGraw-Hill Education (Asia)

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Slide 3

Quick Check
Which
Which method
method will
will produce
produce the
the highest
highest values
values for
for
work
work in
in process
process and
and finished
finished goods
goods inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the
the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 4

Quick Check
Which
Which method
method will
will produce
produce the
the highest
highest values
values for
for
work
work in
in process
process and
and finished
finished goods
goods inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the
the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 5

Unit Cost Computations


Harvey Company produces a single product
with the following information available:
Number
Number of
ofunits
unitsproduced
produced annually
annually
Variable
Variable costs
costsper
per unit:
unit:
Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Selling
Selling &&administrative
administrative expenses
expenses

$$
$$

Fixed
Fixed costs
costsper
per year:
year:
Manufacturing
Manufacturing overhead
overhead
Selling
Selling &&administrative
administrative expenses
expenses

$$150,000
150,000
$$100,000
100,000

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Garrison, Noreen, Brewer, Cheng & Yuen

25,000
25,000

10
10
33

Slide 6

Unit Cost Computations


Unit product cost is determined as follows:

Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,00025,000
25,000units)
units)
Unit
Unitproduct
productcost
cost

Absorption
Absorption
Costing
Costing

Variable
Variable
Costing
Costing

$$

10
10

$$

10
10

$$

66
16
16

$$

-10
10

Under absorption costing, all production costs, variable


and fixed, are included when determining unit product
cost. Under variable costing, only the variable
production costs are included in product costs.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 7

Learning Objective 2

Prepare income
statements using both
variable and absorption
costing.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 8

Income Comparison of
Absorption and Variable Costing
Lets assume the following additional information
for Harvey Company.

20,000 units were sold during the year at a price


of $30 each.
There is no beginning inventory.

Now, lets compute net operating


income using both absorption
and variable costing.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 9

Absorption Costing

Fixed manufacturing overhead deferred in


inventory is 5,000 units $6 = $30,000.
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Slide 10

Variable Costing
Variable
manufacturing
Variable
VariableCosting
Costing
costs only.

Sales
Sales(20,000
(20,000$30)
$30)
Less
Lessvariable
variableexpenses:
expenses:
Beginning
$$
-Beginninginventory
inventory
Add
250,000
AddCOGM
COGM(25,000
(25,000$10)
$10)
250,000
Goods
250,000
Goodsavailable
availablefor
forsale
sale
250,000
Less
Lessending
endinginventory
inventory(5,000
(5,000$10)
$10) 50,000
50,000
Variable
200,000
Variablecost
costof
ofgoods
goodssold
sold
200,000
Variable
Variableselling
selling&&administrative
administrative
expenses
60,000
expenses(20,000
(20,000$3)
$3)
60,000
Contribution
Contributionmargin
margin
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
$$150,000
Manufacturingoverhead
overhead
150,000
Selling
Selling&&administrative
administrativeexpenses
expenses 100,000
100,000
Net
Netoperating
operatingincome
income
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$$600,000
600,000

All fixed
manufacturing
overhead is
expensed.
260,000
260,000
340,000
340,000
250,000
250,000
$$ 90,000
90,000
Slide 11

Learning Objective 3

Reconcile variable
costing and absorption
costing net operating
incomes and explain
why the two amounts
differ.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 12

Comparing the Two Methods


Cost
Costof
of
Goods
Goods
Sold
Sold

Absorption
Absorptioncosting
costing
Variable
Variable mfg.
mfg.costs
costs $$200,000
200,000
Fixed
120,000
Fixedmfg.
mfg.costs
costs
120,000
$$320,000
320,000
Variable
Variable costing
costing
Variable
Variable mfg.
mfg.costs
costs $$200,000
200,000
Fixed
-Fixedmfg.
mfg.costs
costs
$$200,000
200,000

McGraw-Hill Education (Asia)

Ending
Ending
Inventory
Inventory

Period
Period
Expense
Expense

$$ 50,000
50,000
30,000
30,000
$$ 80,000
80,000

$$

$$ 50,000
50,000
-$$ 50,000
50,000

$$
-150,000
150,000
$$150,000
150,000

Garrison, Noreen, Brewer, Cheng & Yuen

$$

----

Total
Total
$$250,000
250,000
150,000
150,000
$$400,000
400,000

$$250,000
250,000
150,000
150,000
$$400,000
400,000

Slide 13

Comparing the Two Methods


We can reconcile the difference between
absorption and variable income as follows:
Variable
Variable costing
costingnet
netoperating
operatingincome
income
Add:
Add:Fixed
Fixedmfg.
mfg. overhead
overheadcosts
costs
deferred
deferredin
ininventory
inventory
(5,000
(5,000units
units $6
$6per
perunit)
unit)
Absorption
Absorptioncosting
costingnet
netoperating
operatingincome
income

$$

90,000
90,000

30,000
30,000
$$ 120,000
120,000

Fixed mfg. overhead


$150,000
=
= $6 per unit
Units produced
25,000 units
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 14

Extended Comparisons of Income Data


Harvey Company Year Two
Number
Number of
ofunits
unitsproduced
produced
Number
Number of
ofunits
unitssold
sold
Units
Unitsin
in beginning
beginning inventory
inventory
Unit
Unitsales
salesprice
price
Variable
Variable costs
costsper
per unit:
unit:
Direct
Directmaterials,
materials, direct
directlabor
labor
variable
variable mfg.
mfg. overhead
overhead
Selling
Selling &&administrative
administrative
expenses
expenses
Fixed
Fixed costs
costsper
per year:
year:
Manufacturing
Manufacturing overhead
overhead
Selling
Selling &&administrative
administrative
expenses
expenses
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

25,000
25,000
30,000
30,000
5,000
5,000
$$
30
30

$$

10
10

$$

33

$$150,000
150,000
$$100,000
100,000
Slide 15

Unit Cost Computations

Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,00025,000
25,000units)
units)
Unit
Unitproduct
productcost
cost

Absorption
Absorption
Costing
Costing

Variable
Variable
Costing
Costing

$$

10
10

$$

10
10

$$

66
16
16

$$

-10
10

Since the variable costs per unit, total fixed costs,


and the number of units produced remained
unchanged, the unit cost computations also
remain unchanged.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 16

Absorption Costing

Unit product

Sales
Sales(30,000
(30,000 $30)
$30)
Less
Lesscost
costof
ofgoods
goodssold:
sold:
Beg.
Beg. inventory
inventory(5,000
(5,000 $16)
$16)
Add
AddCOGM
COGM (25,000
(25,000 $16)
$16)
Goods
Goodsavailable
available for
forsale
sale
Less
Lessending
endinginventory
inventory
Gross
Grossmargin
margin
Less
Lessselling
selling &&admin.
admin. exp.
exp.
Variable
Variable (30,000
(30,000 $3)
$3)
Fixed
Fixed
Net
Netoperating
operatingincome
income

cost.Absorption
AbsorptionCosting
Costing
$$900,000
900,000
$$ 80,000
80,000
400,000
400,000
480,000
480,000
-$$ 90,000
90,000
100,000
100,000

480,000
480,000
420,000
420,000
190,000
190,000
$$230,000
230,000

Fixed manufacturing overhead released from


inventory is 5,000 units $6 = $30,000.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 17

Variable Costing

Variable
manufacturing
costs only. Variable Costing
Variable Costing
Sales
$$900,000
Sales(30,000
(30,000 $30)
$30)
900,000
Less
Lessvariable
variable expenses:
expenses:
Beg.
$$ 50,000
Beg. inventory
inventory(5,000
(5,000 $10)
$10)
50,000
Add
250,000
AddCOGM
COGM(25,000
(25,000 $10)
$10)
250,000
All fixed
Goods
300,000
Goodsavailable
available for
forsale
sale
300,000
manufacturing
Less
-Lessending
endinginventory
inventory
overhead is
Variable
cost
of
goods
sold
300,000
Variable cost of goods sold
300,000
expensed.
Variable
Variable selling
selling&&administrative
administrative
expenses
90,000
390,000
expenses(30,000
(30,000 $3)
$3)
90,000
390,000
Contribution
510,000
Contributionmargin
margin
510,000
Less
Lessfixed
fixedexpenses:
expenses:
Manufacturing
$$150,000
Manufacturingoverhead
overhead
150,000
Selling
250,000
Selling&&administrative
administrative expenses
expenses 100,000
100,000
250,000
Net
$$260,000
Netoperating
operatingincome
income
260,000

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 18

Comparing the Two Methods


We can reconcile the difference between
absorption and variable income as follows:
Variable costing net operating income
$ 260,000
Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units $6 per unit)
30,000
Absorption costing net operating income $ 230,000

Fixed mfg. overhead


$150,000
=
= $6 per unit
Units produced
25,000 units
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 19

Comparing the Two Methods

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Slide 20

Summary of Key Insights

McGraw-Hill Education (Asia)

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Slide 21

Learning Objective 4

Understand the
advantages and
disadvantages of both
variable and absorption
costing.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 22

Impact on the Manager


Opponents of absorption costing argue that
shifting fixed manufacturing overhead costs
between periods can lead to faulty decisions.
These opponents argue that variable costing income
statements are easier to understand because net operating
income is only affected by changes in unit sales. This
produces net operating income figures that are
consistent with managers expectations.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 23

CVP Analysis, Decision Making


and Absorption costing
Absorption costing does not dovetail with CVP analysis,
nor does it support decision making. It treats fixed
manufacturing overhead as a variable cost. It assigns per
unit fixed manufacturing overhead costs to production.
Treating fixed manufacturing overhead as a
variable
variable cost can:
can:
Lead to faulty pricing decisions and
and faulty
keep-or-drop decisions.
Assigning per unit fixed manufacturing overhead
costs to production can:
Potentially produce positive
positive net operating income
income
even when the number of units sold is
is less than
the breakeven point.
McGraw-Hill Education (Asia)

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Slide 24

External Reporting and Income Taxes


To
To conform
conform to
to
IFRS
IFRS and
and US
US GAAP
GAAP
requirements,
requirements, absorption
absorption costing
costing
must
must be
be used
used for
for
external
external financial
financial reports.
reports.

In
In many
many countries,
countries,
including
including US,
US,
absorption
absorption costing
costing must
must be
be
used
used when
when filling
filling out
out
income
income tax
tax returns.
returns.

Since
Since top
top executives
executives
are
are typically
typically evaluated
evaluated based
based on
on
earnings
earnings reported
reported to
to shareholders
shareholders
in
in external
external reports,
reports, they
they may
may feel
feel that
that
decisions
decisions should
should be
be based
based on
on
absorption
absorption costing
costing data.
data.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 25

Advantages of Variable Costing


and the Contribution Approach
Management finds
it more useful.

Advantages

Impact of fixed
costs on profits
emphasized.
McGraw-Hill Education (Asia)

Consistent with
CVP analysis.
Net operating income
is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Easier to estimate profitability
of products and segments.
Profit is not affected by
changes in inventories.
Garrison, Noreen, Brewer, Cheng & Yuen

Slide 26

Variable versus Absorption Costing


Fixed manufacturing
costs must be assigned
to products to properly
match revenues and
costs.

Fixed manufacturing
costs are capacity costs
and will be incurred
even if nothing is
produced.

Variable
Costing
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Slide 27

Variable Costing and the Theory of


Constraints (TOC)
Companies involved in TOC use a form of variable
costing. However, one difference of the TOC approach
is that it treats direct labor as a fixed cost for three
reasons:

Many companies have a commitment to guarantee


workers a minimum number of paid hours.

Direct labor is usually not the constraint.

TOC emphasizes the role direct laborers play in driving


continuous improvement. Since layoffs often devastate
morale, managers involved in TOC are extremely
reluctant to lay off employees.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 28

Impact of Lean Production


When companies use Lean Production . . .
Production
tends to equal
sales . . .

So, the difference between variable and


absorption income tends to disappear.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 29

Learning Objective 5

Compute predetermined
overhead rates and explain
why estimated overhead
costs (rather than actual
overhead costs) being used
in the costing process.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 30

Why Use an Allocation Base?


Manufacturing overhead is applied to products/jobs
that are in process. An allocation base, such as
direct labor hours, direct labor dollars, or machine
hours, is used to assign manufacturing overhead to
individual products/jobs.
We use an allocation base because:
1.It is impossible or difficult to trace overhead costs to particular
products/jobs.
2.Manufacturing overhead consists of many different items ranging
from the grease used in machines to production managers salary.
3.Many types of manufacturing overhead costs are fixed even though
output fluctuates during the period.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 31

Manufacturing Overhead Application


The predetermined overhead rate (POHR) used
to apply overhead to products/jobs is determined
before the period begins.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 32

The Need for a POHR


Using a predetermined rate makes it
possible to estimate total product/job costs sooner.

Actual overhead for the period is not


known until the end of the period.
McGraw-Hill Education (Asia)

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Slide 33

Determining Predetermined Overhead


Rates
Predetermined overhead rates are calculated
using a three-step process.

Estimate
Estimate the
the level
level of
of
production
production for
for the
the
period.
period.

Estimate
Estimate total
total amount
amount
of
of the
the allocation
allocation base
base
for
for the
the period.
period.

Estimate
Estimate total
total
manufacturing
manufacturing
overhead
overhead costs.
costs.

POHR =
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Slide 34

Application of Manufacturing Overhead


Based
Based on
on estimates,
estimates, and
and
determined
determined before
before the
the
period
period begins.
begins.

Overhead applied = POHR Actual activity


Actual
Actual amount
amount of
of allocation
allocation is
is
based
based upon
upon the
the actual
actual level
level of
of
activity
activity (normal
(normal costing
costing system).
system).

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 35

Overhead Application Rate for the Harvey Example


POHR =

Estimated total manufacturing


overhead cost for the coming period
Estimated total units in the
allocation base for the coming period

$150,000
POHR =
50,000 direct labor hours (DLH)

POHR = $3.00 per DLH


For
For each
each direct
direct labor
labor hour
hour worked
worked on
on aa particular
particular product,
product, $3.00
$3.00 of
of factory
factory
overhead
overhead will
will be
be applied
applied to
to it.
it. For
For product
product valuation,
valuation, itit must
must be
be valued
valued by
by
unit.
unit. In
In this
this case,
case, assume
assume each
each unit
unit requires
requires 22 direct
direct labor
labor hours.
hours. Hence,
Hence,
each
each unit
unit of
of the
the product
product absorbs
absorbs $6
$6 predetermined
predetermined overhead.
overhead. In
In order
order
to
to match
match back
back with
with Harveys
Harveys example,
example, we
we further
further assume
assume that
that variable
variable
manufacturing
manufacturing overhead
overhead == 0.
0. So
So the
the predetermined
predetermined overhead
overhead represents
represents
only
only fixed
fixed manufacturing
manufacturing overhead
overhead cost
cost as
as shown
shown in
in slides
slides 14
14 &
& 19.
19.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 36

Learning Objective 6

Understand the implications


of basing the predetermined
overhead rate on activity at
capacity rather than on
estimated activity for the
period.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 37

Predetermined Overhead Rate and Capacity


Calculating predetermined overhead rates using an
estimated, or budgeted amount of the allocation base
has been criticized because:
1.Basing the predetermined overhead rate upon
budgeted activity results in product costs that fluctuate
depending upon the activity level.
2.Calculating predetermined rates based upon
budgeted activity charges products for costs that they
do not use.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 38

Capacity-Based Overhead Rates


Criticisms
Criticisms can
can be
be overcome
overcome by
by using
using
estimated
estimated total
total units
units in
in the
the allocation
allocation base
base
at
at capacity
capacity in
in the
the denominator
denominator of
of the
the
predetermined
predetermined overhead
overhead rate
rate calculation.
calculation.
Lets look at the difference!

McGraw-Hill Education (Asia)

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Slide 39

An Example

Equipment is leased for $100,000 per


year. Running at full capacity, 50,000
units may be produced. The company
estimates that 40,000 units will be
produced and sold next year. What is
the predetermined overhead rate?

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 40

An Example
Equipment is leased for $100,000 per year.
Running at full capacity, 50,000 units may be
produced. The company estimates that 40,000 units
will be produced and sold next year.
Traditional
=
Method

$100,000
40,000

= $2.50 per unit

Capacity
Method

$100,000
50,000

= $2.00 per unit

McGraw-Hill Education (Asia)

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Slide 41

Quick Check
Barossa
Barossa Winery
Winery in
in Barossa
Barossa Valley,
Valley,South
South
Australia,
Australia, leases
leases an
an automatic
automatic corking
corking machine
machine
for
for $100,000
$100,000 per
per year.
year.At
At full
full capacity,
capacity,itit can
can cork
cork
50,000
50,000 cases
cases of
of wine
wine per
per year.
year.The
The company
company
estimates
estimates 40,000
40,000 cases
cases of
of wine
wine will
will be
be produced
produced
and
and sold
sold next
next year.
year.What
What is
is the
the predetermined
predetermined
overhead
overhead rate
rate based
based on
on the
the estimated
estimated number
number of
of
cases
cases of
of wine?
wine?
a.
a.$2.00
$2.00per
percase.
case.
b.
b.$2.50
$2.50per
percase.
case.
c.
c.$4.00
$4.00per
percase.
case.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 42

Quick Check
Barossa
Barossa Winery
Winery in
in Barossa
Barossa Valley,
Valley, South
South
Australia,
Australia, leases
leases an
an automatic
automatic corking
corking
machine
machine for
for $100,000
$100,000 per
per year.
year. At
At full
full
capacity,
capacity, it
it can
can cork
cork 50,000
50,000 cases
cases of
of
wine
wine per
per year.
year. The
The company
company estimates
estimates
40,000
40,000 cases
cases of
of wine
wine will
will be
be produced
produced
and
and sold
sold next
next year.
year. What
What is
is the
the
predetermined
predetermined overhead
overhead rate
rate based
based on
on
the
the estimated
estimated number
number of
of cases
cases of
of wine?
wine?
a.
a. $2.00
$2.00 per
per case.
case.
b.
b. $2.50
$2.50 per
per case.
case.
c.
c. $4.00
$4.00 per
per case.
case.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 43

Quick Check
Barossa Winery in Barossa Valley, South
Australia, leases an automatic corking machine
for $100,000 per year. At full capacity, it can cork
50,000 cases of wine per year. The company
estimates 40,000 cases of wine will be produced
and sold next year. What is the predetermined
overhead rate based on the number of cases of
wine at capacity?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 44

Quick Check
Barossa Winery in Barossa Valley, South
Australia, leases an automatic corking
machine for $100,000 per year. At full
capacity, it can cork 50,000 cases of
wine per year. The company estimates
40,000 cases of wine will be produced
and sold next year. What is the
predetermined overhead rate based on
the number of cases of wine at capacity?
a. $2.00 per case.
b. $2.50 per case.
c. $4.00 per case.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 45

Quick Check
When
When capacity
capacity is
is used
used in
in the
the denominator
denominator of
of the
the
predetermined
predetermined rate,
rate, what
what happens
happens to
to the
the
predetermined
predetermined overhead
overhead rate
rate as
as estimated
estimated activity
activity
decreases?
decreases?
a.
a.The
Thepredetermined
predeterminedoverhead
overheadrate
rategoes
goesup
upwhen
whenactivity
activity
goes
goesdown.
down.
b.
b.The
Thepredetermined
predeterminedoverhead
overheadrate
ratestays
staysthe
thesame
samebecause
because
ititis
isnot
notaffected
affectedby
bychanges
changesin
inactivity.
activity.
c.
c.The
Thepredetermined
predeterminedoverhead
overheadrate
rategoes
goesdown
downwhen
when
activity
activitygoes
goesdown.
down.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 46

Quick Check
When
When capacity
capacity is
is used
used in
in the
the denominator
denominator of
of
the
the predetermined
predetermined rate,
rate, what
what happens
happens to
to
the
the predetermined
predetermined overhead
overhead rate
rate as
as
estimated
estimated activity
activity decreases?
decreases?

a.
a. The
The predetermined
predetermined overhead
overhead rate
rate goes
goes up
up when
when
activity
activity goes
goes down.
down.
b.
b. The
The predetermined
predetermined overhead
overhead rate
rate stays
stays the
the
same
same because
because it
it is
is not
not affected
affected by
by changes
changes in
in
activity.
activity.
c.
c. The
The predetermined
predetermined overhead
overhead rate
rate goes
goes down
down
when
when activity
activity goes
goes down.
down.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 47

Quick Check
When estimated activity is used in the
denominator of the predetermined rate, what
happens to the predetermined overhead rate as
estimated activity decreases?
a. The predetermined overhead rate goes up when
activity goes down.
b. The predetermined overhead rate stays the same
because it is not affected by changes in activity.
c. The predetermined overhead rate goes down when
activity goes down.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 48

Quick Check
When estimated activity is used in the
denominator of the predetermined rate,
what happens to the predetermined
overhead rate as estimated activity
decreases?
a. The predetermined overhead rate goes up
when activity goes down.
b. The predetermined overhead rate stays the
same because it is not affected by changes
in activity.
c. The predetermined overhead rate goes
down when activity goes down.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 49

Income Statement Preparation Capacity

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 50

Income Statement Preparation Traditional

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 51

Learning Objective 7
Compute underapplied or
overapplied overhead cost and
prepare the journal entry to
close the balance in
Manufacturing Overhead to the
appropriate accounts.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 52

Problems of Overhead Application


The difference between the overhead cost applied to
Work in Process and the actual overhead costs of a
period is referred to as either underapplied or
overapplied overhead.
Overapplied overhead
Underapplied overhead
exists when the amount of
exists when the amount of
overhead applied to
overhead applied to
products/jobs during the
products/ jobs during the
period using the
period using the
predetermined overhead
predetermined overhead
rate is greater than the total
rate is less than the total
amount of overhead actually amount of overhead actually
incurred during the period.
incurred during the period.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 53

Overhead Application Example


Recall the Harvey example between slides 9 and 36.
Lets rename the example as Harvey Fresh and
assume actual overhead for the year was $120,000
(instead of $150,000 in the original Harvey example).
The total direct labor hours incurred were 50,000. The
rest remains the same.
How much total overhead was applied to Harvey Freshs
products during the year? Use Harveys predetermined
overhead rate of $3.00 per direct labor hour.

Overhead Applied During the Period


Applied Overhead = POHR Actual Direct Labor Hours
Applied Overhead = $3.00 per DLH 50,000 DLH = $150,000
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 54

Overhead Application Example


Harvey Freshs actual overhead for the year was
$120,000 with a total of 50,000 direct labor hours
worked on products.
How much total overhead was applied to Harvey Freshs
products during the year? Use Harveys
predetermined overhead rate of $4.00 per direct labor
hour.

Overhead Applied During the Period

Applied Overhead = POHR Actual Direct Labor Hours


Applied Overhead = $3.00 per DLH 50,000 DLH = $150,000

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 55

Quick Check
Tiger,
Tiger,Ltd.
Ltd. had
had actual
actual manufacturing
manufacturing overhead
overhead
costs
costs of
of $1,210,000
$1,210,000 and
and aa predetermined
predetermined
overhead
overhead rate
rate of
of $4.00
$4.00 per
per machine
machine hour.
hour. Tiger,
Tiger,
Ltd.
Ltd. worked
worked 290,000
290,000 machine
machine hours
hours during
during the
the
period.
period. Tigers
Tigersmanufacturing
manufacturing overhead
overhead is
is
a.
a.
b.
b.

$50,000
$50,000 overapplied.
overapplied.
$50,000
$50,000 underapplied.
underapplied.

c.
c.
d.
d.

$60,000
$60,000 overapplied.
overapplied.
$60,000
$60,000 underapplied.
underapplied.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 56

Quick Check
Tiger,
Tiger,Ltd.
Ltd. had
had actual
actual manufacturing
manufacturing overhead
overhead
costs
aa predetermined
costs of
of $1,210,000
$1,210,000 and
and
predetermined
Overhead
Applied
Overhead
Applied
overhead
machine
Tiger,
$4.00
per
290,000
hours
$4.00
per hour
hourhour.
290,000
hours
overhead rate
rate of
of $4.00
$4.00 per
per
machine
hour.
Tiger,
== $1,160,000
$1,160,000
Ltd.
hours
Ltd. worked
worked 290,000
290,000 machine
machine
hours during
during the
the
Underapplied
Overhead
period.
overhead
Underapplied
Overheadis
period. Tigers
Tigersmanufacturing
manufacturing
overhead
is
$1,210,000
$1,210,000 -- $1,160,000
$1,160,000
== $50,000
$50,000

a.
a.
b.
b.

$50,000
$50,000 overapplied.
overapplied.
$50,000
$50,000 underapplied.
underapplied.

c.
c.
d.
d.

$60,000
$60,000 overapplied.
overapplied.
$60,000
$60,000 underapplied.
underapplied.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 57

Disposition of Under- or Overapplied


Overhead
Harvey Freshs
Method

$30,000
may be allocated
to these accounts.

$30,000 may be
closed directly to
cost of goods sold.

OR
Work in
Process

Finished
Goods

Cost of
Goods Sold
McGraw-Hill Education (Asia)

Cost of
Goods Sold
Garrison, Noreen, Brewer, Cheng & Yuen

Slide 58

Disposition of
Under/Overapplied Overhead
Harvey Fresh s
Mfg. Overhead

Harvey Freshs Cost


of Goods Sold
Unadjusted
Balance

Actual
Overhead
overhead
applied
costs
to products
$30,000

Adjusted
Balance

McGraw-Hill Education (Asia)

$120,000
$30,000

Garrison, Noreen, Brewer, Cheng & Yuen

$150,000
$30,000
overapplied

Slide 59

Under/Overapplied Adjustment Through


COGS
If Harvey Freshs overapplied adjustment is directly through
COGS, then its profit will be as follows:

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 60

Allocating Under- or Overapplied


Overhead Between Accounts
In Year 1, Harvey Fresh s overhead applied in ending
Work in Process Inventory, ending Finished Goods
Inventory, and Cost of Goods Sold is shown below:

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 61

Allocating Under- or Overapplied


Overhead Between Accounts
We would complete the following allocation of
$30,000 overapplied overhead:

20%
20% $30,000
$30,000

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 62

Allocating Under- or Overapplied


Overhead Between Accounts

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 63

Under/Overapplied Adjustment Through the


Proportional Allocation Method
Net result of
$24,000 adjusted
against COGS

Net Operating Income is different


from the one with adjustment
directly through COGS ($150,000)
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 64

Quick Check
Revisit
Revisitthe
theearlier
earlierTiger,
Tiger,Ltd.
Ltd.exercise
exerciseon
onslide
slide56.
56. Before
Beforeany
any
manufacturing
manufacturingfixed
fixedoverhead
overheadover/underapplied
over/underappliedadjustment,
adjustment,
the
therelevant
relevantfigures
figuresare
areas
asfollows:
follows:
Work
20,000
Workin
inprocess
process
20,000
Finished
Finishedgoods
goods30,000
30,000
Cost
Costof
ofgoods
goodssold
sold

50,000
50,000

How
How much
muchshould
shouldTigers
Tigersover/underapplied
over/underappliedmanufacturing
manufacturing
fixed
fixedoverhead
overheadbe
beadjusted
adjustedto
to Finished
FinishedGoods
Goods(FG)
(FG) ififthe
the
proportional
proportionalallocation
allocationmethod
methodis
isused?
used?

a.
a.
b.
b.

$15,000
$15,000 more
more (i.e.
(i.e. debit)
debit) to
to FG.
FG.
$15,000
$15,000 less
less (i.e.
(i.e. credit)
credit) to
to FG.
FG.

c.
c.
d.
d.

$30,000
$30,000 more
more (i.e.
(i.e. debit)
debit) to
to FG.
FG.
$30,000
$30,000 less
less (i.e.
(i.e. credit)
credit) to
to FG.
FG.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 65

Quick Check
Revisit
Revisitthe
theearlier
earlierTiger,
Tiger,Ltd.
Ltd.exercise
exerciseon
onslide
slide56.
56. Before
Beforeany
any
manufacturing
manufacturingfixed
fixedoverhead
overheadover/underapplied
over/underappliedadjustment,
adjustment,
the
therelevant
relevantfigures
figuresare
areas
asfollows:
follows:
Work
20,000
Workin
inprocess
process
20,000
Finished
Finishedgoods
goods30,000
30,000
Cost
Costof
ofgoods
goodssold
sold

50,000
50,000

How
How much
muchshouldTigers
shouldTigersover/underapplied
over/underappliedmanufacturing
manufacturing
fixed
fixedoverhead
overheadbe
beadjusted
adjustedto
to Finished
FinishedGoods
Goods(FG)
(FG)ififthe
the
proportional
proportionalallocation
allocationmethod
methodis
isused?
used?

a.
a.
b.
b.

$15,000
$15,000 more
more (i.e.
(i.e. debit)
debit) to
to FG.
FG.
$15,000
$15,000 less
less (i.e.
(i.e. credit)
credit) to
to FG.
FG.

c.
c.
d.
d.

$30,000
$30,000 more
more (i.e.
(i.e. debit)
debit) to
to FG.
FG.
$30,000
$30,000 less
less (i.e.
(i.e. credit)
credit) to
to FG.
FG.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 66

Quick Check
Revisit
Revisitthe
theearlier
earlierTiger,
Tiger,Ltd.
Ltd.exercise
exerciseon
onslide
slide55.
55. Before
Beforeany
any
manufacturing
manufacturingfixed
fixedoverhead
overheadover/underapplied
over/underappliedadjustment,
adjustment,
the
therelevant
relevantfigures
figuresare
areas
asfollows:
follows:
Work
$20,000
Workin
inprocess
process
$20,000
Finished
Finishedgoods
goods$30,000
$30,000
Cost
Costof
ofgoods
goodssold
sold

$50,000
$50,000

How
How much
muchshouldTigers
shouldTigersover/underapplied
over/underappliedmanufacturing
manufacturing
fixed
fixedoverhead
overheadbe
beadjusted
adjustedto
to Cost
Costof
ofGoods
GoodsSold
Sold(COGS)
(COGS) ifif
the
theproportional
proportionalallocation
allocationmethod
methodis
isused?
used?

a.
a.
b.
b.

$50,000
$50,000 more
more (i.e.
(i.e. debit)
debit) to
to COGS.
COGS.
$50,000
$50,000 less
less (i.e.
(i.e. credit)
credit) to
to COGS.
COGS.

c.
c.
d.
d.

$25,000
$25,000 more
more (i.e.
(i.e. debit)
debit) to
to COGS.
COGS.
$25,000
$25,000 less
less (i.e.
(i.e. credit)
credit) to
to COGS.
COGS.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 67

Quick Check
Revisit
Revisitthe
theearlier
earlierTiger,
Tiger,Ltd.
Ltd.exercise
exerciseon
onslide
slide56.
56. Before
Beforeany
any
manufacturing
manufacturingfixed
fixedoverhead
overheadover/underapplied
over/underappliedadjustment,
adjustment,
the
therelevant
relevantfigures
figuresare
areas
asfollows:
follows:
Work
20,000
Workin
inprocess
process
20,000
Finished
Finishedgoods
goods30,000
30,000
Cost
Costof
ofgoods
goodssold
sold

50,000
50,000

How
How much
muchshouldTigers
shouldTigersover/underapplied
over/underappliedmanufacturing
manufacturing
fixed
fixedoverhead
overheadbe
beadjusted
adjustedto
to Cost
Costof
ofGoods
GoodsSold
Sold(COGS)
(COGS) ifif
the
theproportional
proportionalallocation
allocationmethod
methodis
isused?
used?

a.
a.
b.
b.

$50,000
$50,000 more
more (i.e.
(i.e. debit)
debit) to
to COGS.
COGS.
$50,000
$50,000 less
less (i.e.
(i.e. credit)
credit) to
to COGS.
COGS.

c.
c.
d.
d.

$25,000
$25,000 more
more (i.e.
(i.e. debit)
debit) to
to COGS.
COGS.
$25,000
$25,000 less
less (i.e.
(i.e. credit)
credit) to
to COGS.
COGS.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 68

Learning Objective 8

Explain the potential


problems of using
absorption costing.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 69

Creating Extra Profit Without Increase In Sales


Continue with the Harvey Fresh example (slides 54, and 58 to 64). Assume the company had the same sales, revenue and
cost structure but produced 35,000 units (instead of 25,000 units) to increase ending inventory by 10,000 units.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 70

Overapplied adjustments required

Harvey Freshs actual fixed manufacturing overhead


= $120,000
Based on the original scenario, the applied overhead
was based on actual production of 25,000 units at $6
each (slide 19), giving rise $150,000 being applied to
the items produced. Therefore, it was overapplied by
$30,000 ($150,000 applied - $120,000 actual).
Based on the new scenario, the applied overhead
was based on actual production of 35,000 units at $6
each (slide 19), giving rise $210,000 being applied to
the production. Therefore, it was overapplied by
$90,000 ($210,000 applied - $120,000 actual).

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 71

Profit Arising from Ending Inventory Value

The additional profit ($60,000) is the same amount as the


additional overapplied adjustment ($90,000 - $30,000).
The overapplied adjustment is to make good of the applied
fixed overhead to match with the actual overhead spent.
The additional profit actually arises from the additional fixed
overhead (based on the predetermined overhead rate,
POHR) carried forward through the change in ending
inventory, amounting the same as the over/underapplied
fixed overhead adjustment if the adjustment is written off
directly to cost of goods sold.
If the adjustment is done through the proportional method
shown in slides 61 64, then the increased profit will not
match the overapplied adjustment.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 72

Value of Ending Inventory

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 73

Use of Variable Costing


Continue with the Harvey Fresh example but presenting the results using the variable
costing format.

Profits remain the same despite of changing quantity in production and ending inventory
Use of Variable Costing can avoid Profit inflation through producing more inventories
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 74

Overapplied and Underapplied Manufacturing


Overhead - Summary
Harvey Freshs
Method

More
More accurate
accurate but
but more
more complex
complex to
to compute.
compute.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 75

Quick Check
What
What effect
effect will
will the
the overapplied
overapplied overhead
overhead have
have
on
on Harveys
Harveysnet
net operating
operating income?
income?

a.
a. Net
Net operating
operating income
income will
will increase.
increase.
b.
b. Net
Net operating
operating income
income will
will be
be unaffected.
unaffected.
c.
c. Net
Net operating
operating income
income will
will decrease.
decrease.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 76

Quick Check
What
What effect
effect will
will the
the overapplied
overapplied overhead
overhead have
have
on
on Harveys
Harveysnet
net operating
operating income?
income?

a.
a. Net
Net operating
operating income
income will
will increase.
increase.
b.
b. Net
Net operating
operating income
income will
will be
be unaffected.
unaffected.
c.
c. Net
Net operating
operating income
income will
will decrease.
decrease.

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 77

Multiple Predetermined Overhead Rates


To this point, we have assumed that there is a single
predetermined overhead rate called a plantwide
overhead rate.
Large companies
often use multiple
predetermined
overhead rates.

May be more complex


but . . .

May be more accurate because


it reflects differences across
departments.
McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 78

End of Chapter 5

McGraw-Hill Education (Asia)

Garrison, Noreen, Brewer, Cheng & Yuen

Slide 79