Accounting For Overhead Costs

Accounting for
Overhead Costs
Chapter 13
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 13 - 1
Learning Objective 1
Compute budgeted
factory-overhead rates
and apply factory
overhead to production.
Accounting for Factory Overhead
Methods for assigning overhead costs

to the products is an important part of
accurately measuring product costs.
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.
Budgeted Overhead
Application Rates
Budgeted overhead application rate

= Total budgeted factory overhead
÷ Total budgeted amount of cost driver
Illustration of Overhead
Application
Enriquez Machine Parts Company’s
budgeted manufacturing overhead for
the machining department is $277,800.
Budgeted machine hours are 69,450.
$277,800 ÷ 69,450 = $4 per machine hour
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?
Objective 2
Determine and use appropriate

cost drivers for overhead
application.
Choice of Cost Drivers
No one cost driver is right for all situations.
The accountant’s goal is to find the

driver that best links cause and effect.
Choice of Cost Drivers
A separate cost pool should

be identified for each driver.
Driver 1 Pool 1
Driver 2 Pool 2
Identify the meaning and

purpose of normalized
overhead rates.
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
Disposing of Underapplied or
Overapplied Overhead
Suppose that Enriquez applied

$375,000 to its products.
Also, suppose that Enriquez incurred

$392,000 of actual manufacturing
overhead during the year.
Disposing of Underapplied or
Overapplied Overhead
How much was underapplied?
$392,000 actual – $375,000 applied = $17,000
Immediate Write-Off
Manufacturing Overhead
375,000
392,000
17,000
0
Cost of Goods Sold

17,000
Prorating Among Inventories
Prorate $17,000 of underapplied

overhead 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
The Use of 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
This section compares two

methods of product costing.
Variable Absorption
costing costing
Variable Versus
Absorption Costing
Variable costing excludes fixed

manufacturing overhead
from inventoriable costs.
Absorption costing treats fixed

manufacturing overhead
as inventoriable costs.
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
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.
Fixed S&A expenses = $650,000
Sales commissions = 5% of dollar sales

Units 2003 2004

Opening inventory – 3,000
Production 17,000 14,000
Sales 14,000 16,000
Ending inventory 3,000 1,000
Construct an income statement

using the variable-costing
approach.
Cost of Goods Sold for
Variable- Costing Method
(thousands of dollars) 2003 2004
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 900¹ 300²
Variable manufacturing
cost of goods sold $4200 $4800
¹3,000 units × $300 = $900,000 ²1,000 units × $300 = $300,000
Comparative Income Statement
for Variable-Costing Method
Sales, 14,000 and 16,000 units $7,000 $8,000
Variable expenses:
Variable manufacturing
cost of goods sold 4200 4800
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
Construct an income statement

using the absorption-
costing approach.
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
Cost of Goods Sold for
Absorption-Costing Method
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
*Variable cost $300
Fixed cost 100
Standard absorption cost $400
Comparative Income Statement
for Absorption-Costing Method
Sales $7,000 $8,000
Cost of goods sold, at standard 5,600 6,400
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
*Based on expected volume of production of 15,000 units:
2003: (17,000 – 15,000) × $100 = $200,000 F
2004: (14,000 – 15,000) × $100 = $100,000 U
Compute the production-

volume variance and show
how it should appear in
the income statement.
Production-Volume Variance
Applied fixed overhead – Budgeted fixed overhead

= (Actual volume × Fixed-overhead rate) –
(Expected volume × Fixed-overhead rate)
In practice, the production-volume variance

is usually called simply the volume variance.
Actual volume
– Expected volume
× Fixed overhead rate
= Production-volume variance
A production-volume variance arises when

the actual production volume achieved
does not coincide with the expected
volume of production used as a denominator
for computing the fixed-overhead rate.
There is no production-volume
variance for variable overhead.
Reconciliation of Variable Costing
and Absorption Costing
Absorption unit cost is higher.
Output-level (production-volume)
variance exists only under
absorption costing.
Under absorption costing, fixed overhead

appears in the cost of goods sold and
also in the production-volume variance.
Under variable costing, fixed

overhead is a period cost.
The difference between income reported

under these two methods is entirely due to
the treatment of fixed manufacturing costs.
Under absorption costing, these costs are

treated as assets (inventory) until the
associated goods are sold.
Explain how a company might

prefer to use a variable-
costing approach.
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.
Flexible-Budget Variances
All variances other than the

production-volume variance are
essentially flexible-budget variances.
Flexible-budget variances measure

components of the differences
between actual amounts and
the flexible-budget amounts
for the output achieved.
Flexible budgets are primarily

designed to assist planning and
control rather than product costing.
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.
End of Chapter 13

Accounting For Overhead Costs

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Accounting for

Methods for assigning overhead costs

1. Select one or more cost drivers.

Budgeted overhead application rate

Budgeted machine hours are 69,450.

$277,800 ÷ 69,450 = $4 per machine hour

How much overhead was applied to Machining?

Determine and use appropriate

No one cost driver is right for all situations.

The accountant’s goal is to find the

A separate cost pool should

Identify the meaning and

“Normal” product costs include

Actual direct material

Suppose that Enriquez applied

Also, suppose that Enriquez incurred

How much was underapplied?

$392,000 actual – $375,000 applied = $17,000

Cost of Goods Sold

Prorate $17,000 of underapplied

Work-in-Process Inventory $ 155,000

The presence of fixed costs is a

Some companies distinguish between

This section compares two

Variable costing excludes fixed

Absorption costing treats fixed

Basic Production Data at Standard Cost

Sales price = $500 per unit

$20 per computer is variable overhead.

Fixed S&A expenses = $650,000

Sales commissions = 5% of dollar sales

Units 2003 2004

Construct an income statement

Construct an income statement

The fixed-overhead rate is the

$1,500,000 ÷ 15,000 = $100

Compute the production-

Applied fixed overhead – Budgeted fixed overhead

In practice, the production-volume variance

× Fixed overhead rate

A production-volume variance arises when

Absorption unit cost is higher.

Under absorption costing, fixed overhead

Under variable costing, fixed

The difference between income reported

Under absorption costing, these costs are

Explain how a company might

One reason is that absorption-costing

Another reason is based on which

All variances other than the

Flexible-budget variances measure

Flexible budgets are primarily

Production > Sales

Production < Sales

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