CHAPTER 3

Predetermined Overhead Rates, Flexible Budgets,and Absorption/Variable Costing

Questions

1. Although both variable and mixed costs change in total with activity measure changes, the difference is that variable costs change in direct proportion to such activity changes and mixed costs do not. Since a mixed cost has both a fixed and variable component, the cost per unit at different activity levels is not constant as it is with a variable cost.

2. No, these are not always the best points of observation. First, the points must be within the relevant range of activity. Second, to be useful, the points must be reflective of the entire data set of observation points. If the high and low points do not meet these two conditions, alternative points should be selected.

3. There are several reasons for using predetermined overhead rates. First, the company does not need to wait to assign overhead costs to products or services until the end of the period when actual costs are known. Second, such rates eliminate overhead cost fluctuations that have nothing to do with volume levels. Third, predetermined overhead rates provide a means to control distortions in product costs caused by changes in volume between or among periods, and the resulting product/service cost changes caused by differences in fixed cost per period.

4. Departmental overhead rates are superior to plant-wide overhead rates in that overhead application bases can be identified that more accurately reflect the causes of costs in each department. In effect, use of departmental rates permit more cost drivers

to be identified and used as allocation bases.

Separation of variable and fixed costs allows managers to make decisions that rely on knowledge of cost behavior. For example, some decisions require that a manager identify costs that will change if a particular decision alternative (such as whether to manufacture and sell additional units) is implemented. Total variable cost responds differently from total fixed cost to managerial actions. Use of a total overhead rate does not easily allow managers to determine the impact of such differences.

5. The regression method has the major advantage of using all points in the data set to determine the fixed and variable cost elements of the mixed costs. This is in contrast to the high-low method, which uses only two points in the data set.

6. The two differences between absorption and variable costing lie in the treatment of fixed factory overhead and the presentation of costs/expenses on the income statement. Absorption costing treats fixed factory overhead as a product cost and allocates it to the units produced during the period; variable costing treats fixed overhead as a period expense and charges the full amount incurred to the income of the period. Absorption costing presents costs on the income statement in functional categories without regard to cost behavior; variable costing presents costs on the income statement first as product or period, secondly by cost behavior (variable or fixed), and possibly by functional categories.

The underlying cause of the difference between absorption and variable costing is found in the definition of an asset. Asset cost should include all costs necessary to

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get an item into place, position, and ready for sale or use. Absorption costing considers fixed overhead to be inventoriable (part of asset cost) because products could not be made without the basic manufacturing capacity represented by fixed overhead cost. Variable costing proponents, however, believe that fixed overhead is not inventoriable because it is incurred regardless of whether production occurs or not. The “correct” answer cannot be determined because both positions have logical and rational arguments to support them.

7. Functionally classifying a cost refers to classification based on the reason the cost was incurred (production, selling, or administrative) by category (wages, salaries, utilities, etc.). Behaviorally classifying a cost refers to classification based on the reaction that the cost has to a change in underlying activity (such as production or sales volume) and, thus, as variable or fixed. A company is concerned about behavioral classification because (as long as the company is operating in the relevant range of activity) variable costs will change in a direct relationship with changes in some underlying activity measure, but fixed costs will remain constant. If variable and fixed costs are combined and shown merely as functional categories, management will not be able to see how each functional category of cost will change with changes in activity.

8. Absorption costing is required for external reporting. The rationale is that fixed manufacturing overhead is a product cost and, thus, it should be added to variable production cost and assigned to inventory. The total cost per unit will be shown as an expense only in the period in which the related products are sold.

9. Use of monetary, quantitative information varies greatly between external and internal users. External users emphasize profitability potential; internal users emphasize information that helps make

sales, production, and capital expenditure decisions.

Both absorption and variable costing have a place in decision making. Accountants and decision makers need to understand the applications and limitations of the two techniques within the context of past, present, and future cost information needs. No matter which type of costing a firm uses, the firm’s total revenue must cover all costs – both variable and fixed – and also generate a satisfactory profit if a firm is to survive in the long run.

The methods of cost accumulation and cost presentation used for reporting are determined by what is acceptable to those parties for whom the reports are intended. External reporting is guided by the characteristics of reliability, uniformity, and consistency. Internal reporting is guided by flexibility in helping managers with planning, controlling, decision making and performance evaluations.

10. When production exceeds volume, absorption costing income will be higher than variable costing income because some of the fixed factory overhead incurred during the period will be deferred into inventory rather than appearing on the income statement. Since no fixed overhead is inventoried under variable costing, there will be a larger expense on the income statement under variable costing than under absorption costing.

When production is less than sales volume, some of the fixed overhead deferred in previous periods will be charged against income as part of cost of goods sold under absorption costing in addition to all of the current period fixed overhead. Thus, there will be a higher income statement charge under absorption costing than under variable costing (which will only expense the current period fixed overhead). Therefore, under this circumstance, absorption costing income will be less than variable costing income.

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Chapter 3

Exercises

11. a. (1) At any level, the variable cost is $4 per machine hour. Since two hours are needed to make one unit, the variable rate is $8 per unit. At production of 5,490 units, the fixed rate is $164,700 ÷ 5,490 or $30 per unit.

(2) At any level, the variable cost is $4 per machine hour. At production of 5,490 units, the fixed rate is $164,700 ÷ (5,490 x 2) = $164,700 ÷ 10,980 MHs = $15 per machine hour.

b. (1) Combined rate = $8 + $30 = $38 per unit.

(2) Combined rate - $4 + $15 = $19 per unit.

c. At actual production of 5,600 units and applying OH on units of production:

Expected = Actual Applied Under/Overapp.VOH (5,600 x $8) $ 44,800 (5,600 x $ 8) = $ 44,800 $ 0FOH 164,700 (5,600 x$30) = 168,000 3,300 overapp.

12. a. Applied VOH = 4,420 x $8 = $35,360

b. Applied FOH = 4,420 x $30 = $132,600

c. VOH: Actual VOH – Applied VOH = $32,980 - $35,360 = $2,380 overappliedFOH: Actual FOH – Applied FOH = $163,800 - $132,600 = $31,200 underapplied

13. a. Expected overhead = ($42,900 x 12) + ($6 x 156,000) = $514,800 + $936,000 = $1,450,800

Predetermined overhead rate = $1,450,800 ÷ 156,000 = $9.30 per DL hour

Overhead per unit = $9.30 x 3 hours per unit = $27.90

b. Manufacturing Overhead 128,550Various Accounts 128,550

Work in Process Inventory (12,780 x $9.30) 118,854Manufacturing Overhead 118,854

c. 12,780 DL hours ÷ 3 = 4,260 units should have been produced

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14. a. Jan: $360,000 x 1.75 = $630,000Feb: $330,000 x 1.75 = $577,500Mar: $340,000 x 1.75 = $595,000

b. Jan : Actual – Applied = $640,000 - $630,000 = $10,000 underapplied Feb: Actual – Applied = $570,400 - $577,500 = $ 7,100 overappliedMar: Actual – Applied = $600,000 - $595,000 = $ 5,000 underapplied

15. a. Manufacturing Overhead 66,000Cost of Goods Sold 66,000

b. Manufacturing overhead 66,000Work in Process Inventory 21,120Finished Goods Inventory 5,280Cost of Goods Sold 39,600

WIP $ 384,000 384,000 ÷ 1,200,000 = 32% .32 x $66,000 = $21,120FG 96,000 96,000 ÷ 1,200,000 = 8% .08 x $66,000 = 5,280CGS 720,000 720,000 ÷ 1,200,000 = 60% .60 x $66,000 = 39,600Total $1,200,000

c. The method in part (b) would be more appropriate in this instance because of the magnitude of the amount of overapplied overhead. It is 5.5 percent of the total balances in all of the accounts containing overhead, so to close it directly to cost of goods sold would cause a distortion of the costs remaining in inventory.

16. a. Given the relationship within the account balances, it appears that overhead is applied based on direct labor cost. Thus, using the information in the WIP account, the rate is $40,000 ÷ $20,000 or 200% of direct labor cost.

b. The amount should be prorated because it is very large relative to the balances in Work in Process Inventory, Finished Goods Inventory and Cost of Goods Sold.

c. Work in Process Inventory : $50,000 x ($100,000 ÷ $570,000) = $ 8,772Finished Goods Inventory: $50,000 x ($200,000 ÷ $570,000) = 17,544Cost of Goods Sold: $50,000 x ($270,000 ÷ $570,000) = 23,684Total $50,000

d. Work in Process Inventory: $50,000 x ($ 40,000 ÷ $220,000) = $ 9,091Finished Goods Inventory: $50,000 x ($ 80,000 ÷ $220,000) = 18,182Cost of Goods Sold: $50,000 x ($100,000 ÷ $220,000) = 22,727Total $50,000

Chapter 3

d. A debit balance in the manufacturing overhead account can be the result of several causes including: (1) paying higher prices than budgeted for the resources comprising actual overhead, (2) using more overhead resources than attached to inventory for actual output, (3) producing at less capacity than the planned level of activity upon which the predetermined overhead rate was based, or (4) a combination of the prior three causes.

17. a. VOH rate (can be calculated at either level): $435,000 ÷ 100,000 MHs = $4.35 per MH or $652,500 ÷ 150,000 MHs = $4.35 per MH

b. FOH rate: $405,000 ÷ 180,000 = $2.25 per MH

c. Expected capacity = 2/3 x 180,000 = 120,000 MHsFOH rate: $405,000 ÷ 120,000 = $3.375 per MH

d. At 115,000 MHs:Total VOH applied = 115,000 x $4.35 = $500,250Total FOH applied (practical capacity rate): 115,000 x $2.25 = $258,750Total FOH applied (expected capacity rate): 115,000 x $3.375 = $338,125

Total OH applied (practical) ($500,250 + $258,750) $759,000Actual OH (900,000)Underapplied OH $141,000

Total OH applied (expected) ($500,250 + $338,125) $838,375Actual OH (900,000)Underapplied OH $ 61,625

18. a. A fixed overhead cost of $28 per unit is obtained by dividing total fixed overhead cost ($1,400,000) by the total number of units actually produced (50,000). A fixed overhead cost of $17.50 is obtained by dividing the $1,400,000 by the actual capacity of 80,000 units.The price bid by Chaney Tool should include a fixed overhead cost of $28 per unit, which reflects the actual level of activity unless Chaney Tool has another contract to produce the additional 30,000 units. A fixed overhead cost of $17.50 is more likely to cause Chaney Tool to obtain the contract because the amount will lower the per unit cost of the bid ($15 DM & DL + $4 VOH + $17.50 FOH = $36.50 x 1.5 = $54.75).

b. The cost per unit was $47 ($15 + $4 + $28). Therefore, the invoice price per unit should be $70.50 ($47 x 1.5), and the total invoice price should be $70.50 x 50,000 units or $3,525,000.

c. No, since production totaled 80,000 units, the fixed overhead cost per unit is $17.50. Thus, the price to Manantuka should be reduced to

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$2,737,500 ($54.75 x 50,000). Additionally, since the margin is most likely less than 50 percent on products sold to other buyers, Chaney Tool should charge a reasonable price on the government contract.

d. Without the additional contract, Chaney should not have bid $54.75 per unit. However, if the government was willing to pay “full cost” (regardless of how that amount was defined) it was ethical to bill $3,525,000 since the company was merely applying a fixed overhead rate that approximated actual fixed overhead. The fact that Chaney Tool was able to secure another contract should not affect the company’s ability to recover all costs from Manantuka. If management is aware of the existence of other contracts before the bill is presented, the price could be adjusted or, if future production levels are significant, Chaney could consider rebating a portion of Manantuka’s contract cost.

e. Chaney Tool should consider the following: relationship between the bid price and the final contract price ability of companies to manipulate bid prices, especially in cost-

plus contracts effect on other companies’ abilities to compete for the contract future sales to the same customer effects on profits and stock prices if the contract were settled at

$54.75 per unit versus $70.50 per unitThe ethical dilemma is overcome if Chaney Tool has no other customer and no prospect of other customers to purchase the goods that would have been produced by the excess capacity. In such a case, the $28 overhead rate is totally ascribable to the Manantuka contract.

19. a. MHs Total Cost = Variable Cost + Fixed CostHigh activity 34,000 $ 6,100 $2,720 $3,380Low activity 31,000 5,860 2,480 3,380Differences 3,000 $ 240

Variable rate = $240 ÷ 3,000 MHs = $0.08 per MH

High activity variable cost = 34,000 x $0.08 = $2,720Low activity variable cost = 31,000 x $0.08 = $2,480

Fixed cost at high activity = $6,100 - $2,720 = $3,380Fixed cost at low activity = $5,860 - $2,480 = $3,380

Budget formula: TC = FC + VC(X)TC = $3,380 + $0.08 MH

b. TC = $3,380 + $0.08(33,175) = $3,380 + $2,654 = $6,034

Chapter 3

20. a. MHs Total Cost = Variable Cost + Fixed CostHigh activity 9,000 $ 440 $(810) $1,250Low activity 3,000 980 (270) 1,250Differences 6,000 $(540)Variable rate = $(540) ÷ 6,000 MHs = $(0.09) per MHHigh activity variable cost = 9,000 x $(0.09) = $(810)Low activity variable cost = 3,000 x $(0.09) = $(270)Fixed cost at low activity = $980 – $(270) = $1,250Total maintenance cost = $1,250 - $0.09 MH

b. The variable cost component is negative which implies that, as the number of machine hours increase, the amount of maintenance costs declines. Such a relationship is implausible. One explanation that would account for the perceived inverse relationship would be that Historic Abodes performs the maintenance chores when there is idle time available. As business activity increases, less and less time is available to perform maintenance activities.

c. For a cost prediction formula to work effectively, it is not required for there to be a positive relationship between the activity measure and the cost pool. Thus, the formula developed in part (a) might function effectively. However, one cannot interpret the parameters of the model (-$0.09, $1,250) as variable and fixed costs, respectively.

21. a. x y xy x 2 100 $ 175 $ 17,500 10,000

87 162 14,094 7,56980 154 12,320 6,40070 142 9,940 4,900

105 185 19,425 11,025 115 200 23,000 13,225

120 202 24,240 14,400 677 $1,220 $120,519 67,519

b = = =

= $1.23

(# of shipments)

b.

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22. x y xy x 2 200 $ 250 $ 30,000 40,000 325 220 71,500 105,625 400 240 96,000 160,000 410 245 100,450 168,100 525 310 162,750 275,625 680 395 268,600 462,400 820 420 344,400 672,400 900 450 405,000 810,0004,260 $2,430 $1,478,700 2,694,150

= = = $0.43

MH

23. a. If the purpose is to control costs, the comparison is inappropriate. Actual costs should be compared with flexible budget costs at the same level of output as that of the actual cost – in this case 17,600 units (not 16,000 units). A flexible budget formula allows the determination of costs at any level of activity.

b. Variable rate (b) (at any point) = $4 (for example, $80,000 ÷ 20,000 units)

Fixed amount (a) (given) = $32,000

The flexible budget for the 17,600 unit level is:Variable (17,600 x $4) $ 70,400Fixed 32,000Total $102,400

A comparison with the budget follows: Budget Actual Variances

Variable $ 70,400 $ 69,000 $1,400 FFixed 32,000 32,800 800 UTotal $102,400 $101,800 $ 600 F

The company did well controlling variable costs, but fixed costs were $800 over the budgeted amount.

24. a. MHs Total Cost = Variable Cost + Fixed CostHigh activity 3,800 $1,160 $760 $400

Chapter 3

Low activity 2,500 900 500 400Differences 1,300 $ 260

Variable rate = $260 ÷ 1,300 MHs = $0.20 per MH

Cost formula: y = $400 + $0.20 MH

b. 2,000 3,000 4,000Variable utilities cost @ $0.20 per MH $400 $ 600 $ 800Fixed utilities cost 400 400 400Expected total utilities cost $800 $1,000 $1,200

25. a. 250 300 350 400Variable costs:

Supplies @ $4.00 per DLH $1,000 $1,200 $1,400 $1,600Direct labor @ $7.00 per DLH 1,750 2,100 2,450 2,800Utilities @$5.40 per DLH 1,350 1,620 1,890 2,160

Fixed costs:Direct labor 500 500 500 500Utilities 350 350 350 350Rent 450 450 450 450Advertising 75 75 75 75

Total cost $5,475 $6,295 $7,115 $7,935

b. Cost per DLH $21.90 $20.98 $20.33 $19.84

c. $20.33 x 1.4 = $28.46$28.46 x 1.25 hours per groom = $35.58 or $36 per groom

26. a. ($300,200 + $99,800) ÷ (5,000 + 20,000) = $400,000 ÷ 25,000 = $16.00 DLH

b. ($300,200 + $99,800) ÷ (38,000 + 2,000) = $400,000 ÷ 40,000 = $10.00 MH

c. Assembly: $300,200 ÷ 38,000 = $7.90 MHFinishing: $99,000 ÷ 20,000 = $4.99 DLH

d. Overhead assigned using answer from part (a): 1 x $16.00 = $16.00Overhead assigned using answer from part (b): 5 x $10.00 = $50.00Overhead assigned using answer from part (c): (5 x $7.90) + (1 x $4.99) = $39.50 + $4.99 = $44.49

27. a. (18,000 – 16,560) x $8.50 = 1,440 x $8.50 = $12,240

b. (18,000 – 16,560) x ($8.50 - $1.50) = 1,440 x $7.00 = $10,080c. Absorption costing would have produced the higher net income

because it would have required $2,160 (1,440 x $1.50) of fixed

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manufacturing overhead to be inventoried rather than to be charged against income.

28. The variance between variable and absorption net income is caused by the difference in treatment of fixed manufacturing overhead.

Fixed overhead expensed:Variable costing $500,000Absorption costing [$500,000 x (46,000 ÷ 50,000) 460,000

Net income difference $ 40,000

The company’s net income would have been $40,000 higher under absorption costing.

29. a. Ingredients $224,000Labor 104,000Variable overhead 192,000 Total variable cost $520,000Divided by units ÷104,000Variable cost per unit $5.00

Total variable cost $520,000Fixed overhead 93,600 Total cost $613,600Divided by units ÷104,000Absorption cost per unit $5.90

b. Variable cost of goods sold = 98,000 x $5.00 = $490,000

c. Absorption cost of goods sold = 98,000 x $5.90 = $578,200

d. Ending inventory (variable costing) = 6,000 x $5.00 = $30,000Ending inventory (absorption costing) = 6,000 x $5.90 = $35,400

e. Fixed overhead charged to expense (variable costing) = $93,600Fixed overhead charged to expense (absorption costing) = $88,200

30. a. Income – variable costing $94,000Deduct increase in CGS [FOH out of inventory ($8 x 4,800)] (38,400)Income – absorption costing $55,600

b. Income – variable costing $ 94,000Add decrease in CGS [FOH inventoried ($8 x 1,000) 8,000Income – absorption costing $102,000

31. a. 1. KICK’IN SPORTSWEAR Income Statement (Absorption Costing Basis)

Chapter 3

For the Month Ended April 30, 2006

Sales ($7,200,000 ÷ $72 = 100,000 units sold) $7,200,000Cost of goods sold ($51 x 100,000) (5,100,000)Production volume variance ($15 x 42,500)* (637,500)Gross margin $1,462,500Fixed selling & administrative expenses (1,200,000)Income before taxes $ 262,500

*Total production (100,000 units sold + 7,500 units inventoried) 107,500 Expected production (150,000) Units creating volume variance 42,500

2. Differences in incomes = $150,000 - $262,500 = $(112,500)This amount is equal to the increase in inventory of 7,500 units x $15 per unit fixed overhead deferred in ending inventory under absorption costing.

b. The vice-president of marketing should find the variable costing approach to income determination desirable for many reasons, including the following: Variable costing income varies with units sold, not units produced. Fixed manufacturing overhead costs are charged against revenue in

the period in which they are incurred; consequently, manufacturing cost per unit does not change with a change in production level.

The contribution margin offers a useful tool for marketing decisions that consider changes in relationships among costs, volume levels, and profit figures.

(CMA adapted)

32. a. Budgeted fixed overhead = $0.32 x 100,000 = $32,000

b. Actual (and budgeted) fixed overhead $32,000Applied fixed overhead (90,000 x $0.32) 28,800Underapplied fixed overhead (absorption) $ 3,200

There is no underapplied or overapplied fixed overhead under variable costing because fixed overhead is not applied to units of product.

c. Direct material $1.80Direct labor 1.00

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Variable overhead 0.15Cost per unit (variable) $2.95Fixed overhead 0.32Cost per unit (absorption) $3.27

d. Absorption cost of goods sold (97,500 x $3.27) $318,825Plus underapplied overhead (10,000 x $0.32) 3,200Adjusted cost of goods sold $322,025Selling and administrative costs:

Variable (97,500 x $0.28) $27,300Fixed 75,000 102,300

Total expense (absorption) $424,325

Variable cost of goods sold (97,500 x $2.95) $287,625Variable selling expenses (97,500 x $0.28) 27,300Fixed overhead 32,000Fixed selling and administrative expenses 75,000Total expense (variable) $421,925

e. Income is higher under variable costing because the sales level is greater than the production level. It will be higher by the fixed overhead per unit ($0.32) times the change in inventory (7,500 unit decline) or $2,400.

33. The debate surrounding the use of variable costing versus absorption costing for valuing inventory hinges on whether the incurrence of fixed overhead creates an asset. A cost incurred to create an asset, as opposed to a cost that is an expense of the period, must be capitalized and should not be charged against revenues (expensed) until its related benefit is recognized in income. Since inventory is an asset, any costs that are incurred to create that asset, including fixed overhead, should be considered for capitalization. This is the argument for use of absorption costing.However, proponents of variable costing argue that the incurrence of fixed overhead relates more to the capacity to produce than to production. Accordingly, these people argue that fixed overhead is not directly related to production sufficiently to be considered an inventoriable cost.

34. a. Normal Exp. Prac. Theor. 76 ,000 72,000 80 ,000 100,000

Chapter 3

Variable costs:Indirect material $ 95,000 $ 90,000 $100,000 $125,000Indirect labor 76,000 72,000 80,000 100,000Factory utilities 1,520 1,440 1,600 2,000Factory maintenance 12,920 12,240 13,600 17,000Material handling 4,560 4,320 4,800 6,000Machine depreciation 2,2 80 2,160 2, 400 3,000Total variable costs $ 192,2 80 $182,160 $2 02,40 0 $253,000

Fixed costs:Factory utilities $ 3,000 $ 3,000 $ 3,000 $ 3,000Factory maintenance 10,000 10,000 10,000 10,000Material handling 8,000 8,000 8,000 8,000Building rent 25,000 25,000 25,000 25,000Supervisors’ salaries 72,000 72,000 72,000 72,000Factory insurance 6,000 6,000 6,000 6,000Total fixed costs $124,000 $124,000 $124,000 $124,000

b. Variable OH rate per unit $2.53 $2.53 $2.53 $2.53Fixed OH rate per unit 1.63 1.72 1.55 1.24

c. 1. Variable Manufacturing Overhead 87,500Raw Materials (Supplies) Inventory 87,500

To record indirect material at $1.25 per unit produced

Variable Manufacturing Overhead 70,000Wages Payable (or Cash) 70,000

To record indirect labor at $1.00 per unit produced

Variable Manufacturing Overhead 1,400Fixed Manufacturing Overhead 3,000

Utilities Payable (or Cash) 4,400To record factory utilities

Variable Manufacturing Overhead 11,900Fixed Manufacturing Overhead 10,000

Cash (or Supplies) 21,900To record factory maintenance

Variable Manufacturing Overhead 4,200Fixed Manufacturing Overhead 8,000

Cash 12,200To record material handling charges

Variable Manufacturing Overhead 2,100Accumulated Depreciation 2,100

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To record depreciation at $0.03 per unit produced

Fixed Manufacturing Overhead 25,000Cash 25,000

To record building rent

Fixed Manufacturing Overhead 72,000Salaries Payable (or Cash) 72,000

To record supervisors’ salaries

Fixed Manufacturing Overhead 6,000Cash (or Prepaid Ins. or Ins. Payable) 6,000

To record factory insurance

Work in Process Inventory 297,500Variable Manufacturing Overhead 177,100Fixed Manufacturing Overhead 120,400

To apply variable and fixed manufacturing overhead to WIP

2. Actual fixed overhead $124,000Applied fixed overhead (70,000 x $1.72) 120,400Underapplied fixed overhead $ 3,600

d. Use of expected capacity would create costs that would be more closely related to actual production costs. However, use of practical capacity would help indicate to management the costs of unused capacity.

35. a. Total overhead = $635,340 + $324,000 = $959,340Total MHs = 72,000 + 9,300 = 81,300OH rate per MH = $959,340 ÷ 81,300 MH = $11.80 MH

Applied overhead = $11.80 x 8.15 = $96.17

b. Fabrication: $635,340 ÷ 72,000 MH = $8.82 per MH x 8 $70.56Finishing: $324,000 ÷ 48,000 DLH = $6.75 per DLH x 2 13.50Total OH applied per unit using departmental rates $84.06

c. Because each department has such a difference in the type of work being performed (machine intensive vs. labor intensive), plant-wide rates will not most accurately attach overhead costs.

36. a. 1. Total DLHs = 27,000 + 3,000 = 30,000OH rate per DLH = $969,020 ÷ 30,000 DLHs = $32.30 per DLH

2. Total MHs = 2,100 + 65,800 = 67,900OH rate per MH = $969,020 ÷ 67,900 MHs = $14.27 per MH

Chapter 3

b. Cutting: $383,400 ÷ 27,000 DLHs = $14.20 per DLHAssembly: $585,620 ÷ 65,800 MHs = $8.90 per MH

c. RW22SKI SD45ROWDirect material $ 34.85 $ 19.57Direct labor – Cutting (6 x $14.00; 4.8 x $14.00) 84.00 67.20Direct labor – Assembly (.03 x $6.50; .05 x $6.50) .20 .33Total cost other than overhead $119.05 $ 87.10(1) Overhead (plant-wide rate using DLHs)

(6.03 x $32.30; 4.85 x $32.30) 194.77 156.66Total cost $313.82 $243.76

Total cost other than overhead $119.05 $ 87.10(2) Overhead (plant-wide rate using MHs)

(5.96 x $14.27; 9.45 x $14.27) 85.05 134.85Total cost $204.10 $221.95

Total cost other than overhead $119.05 $ 87.10(3) Cutting Department overhead

(6 x $14.20; 4.8 x $14.20) 85.20 68.16Assembly Department overhead (5.9 x $8.90; 9.3 x $8.90) 52.51 82.77

Total cost $256.76 $238.03

d. Given that a competitor sells the similar product for $270, management would probably conclude that production of RW22SKI was not feasible if the cost determined from a plant-wide overhead rate based on DLHs was used; competing on price would create a “loss” per unit. Using the cost determined from a plant-wide rate based on MHs might cause management to undercut the competitor’s price substantially, believing that a significant profit margin could be made. Using the cost determined from departmental rates (which is the most accurate of the three costs) would allow management to meet the competition’s price but would provide a small 5 percent profit margin. Possibly management needs to determine if the product could be produced more efficiently.

37. a. Variable indirect labor $100,000Variable indirect materials 20,000Variable utilities 80,000Variable portion of other mixed costs 120,000Total variable OH costs $320,000Total variable OH costs ÷ number of MHs = Variable OH rate per MH

$320,000 ÷ 100,000 MHs = $3.20 per MHFixed machinery depreciation $ 62,000Fixed machinery lease payments 13,000

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Fixed machinery insurance 16,000Fixed salaries 75,000Fixed utilities 12,000Total fixed overhead OH costs $178,000

Total fixed OH costs ÷ number of MHs = Fixed OH rate per MH$178,000 ÷ 100,000 MHs = $1.78 per MH

b. Variable Manufacturing Overhead 273,600Various accounts 273,600

To record actual VOH costs

Fixed Manufacturing Overhead 185,680Various accounts 185,680

To record actual FOH costs

Work in Process Inventory (103,000 MHs x $3.20) 329,600Variable Manufacturing Overhead 329,600

To apply VOH to production

Work in Process Inventory (103,000 MHs x $1.78) 183,340Fixed Manufacturing Overhead 183,340

To apply FOH to production

c. Actual VOH $273,600 Actual FOH $185,680Applied VOH 329,600 Applied FOH 183,340Overapplied VOH $ 56,000 Underapplied FOH $ 2,340

d. Cost of Goods Sold 2,340Fixed Manufacturing Overhead 2,340

To close FOH at year-end

e. Balance Proportion % Overapp. OH Adj.WIP $ 234,000 $234,000 ÷ $1,560,000 0.15 $56,000 $ 8,400FG 390,000 390,000 ÷ $1,560,000 0.25 $56,000 14,000CGS 936,000 936,000 ÷ $1,560,000 0.60 $56,000 33,600Total $1,560,000 1.00 $56,000

Variable Manufacturing Overhead 56,000Work in Process Inventory 8,400Finished Goods Inventory 14,000Cost of Goods Sold 33,600

Chapter 3

38. a. Indirect material: variable; at either level, $3.20 per animal day

Indirect labor: mixed; $4,000 + $6.00 per animal dayat 6,000 days $40,000at (4,000) days (28,000)

2,000 $12,000

$12,000 ÷ 2,000 = $6 per animal dayTotal cost $40,000Variable ($6 x 6,000 animal days) 36,000Fixed $ 4,000

Maintenance: mixed; $2,000 + $0.80 per animal dayat 6,000 days $ 6,800at (4,000) days (5,200)

2,000 $ 1,600

$1,600 ÷ 2,000 = $0.80 per animal dayTotal cost $ 6,800Variable ($0.80 x 6,000 animal days) (4,800)Fixed $ 2,000

Utilities: variable; at either level, $1.00 per animal day

All other: mixed; $1,200 + $1.60 per animal dayat 6,000 days $10,800at (4,000) days (7,600)

2,000 $ 3,200

$3,200 ÷ 2,000 = $1.60 per animal dayTotal cost $10,800Variable ($1.60 x 6,000 animal days) (9,600)Fixed $ 1,200

Total fixed cost = $4,000 + $2,000 + $1,200 = $7,200Total variable cost = $3.20 + $6.00 + $0.80 + $1.00 + $1.60 = $12.60Total OH cost formula: $7,200 + $12.60 per animal day

b. $7,200 ÷ ($13.40 - $12.60) = 9,000 animal days

c. $13.40 x 9,000 = $120,600

d. VOH rate remains constant at $12.60FOH rate ($7200 ÷ 12,000) 0.60Total OH rate at 12,000 animal days $13.20*

*This rate assumes that 12,000 days is still within the relevant range of activity and, therefore, no variable costs will change per unit and no fixed costs will change in total.

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39. a. Activity in MHs Low High 2,500 3,000 3,500

Production overhead costs:Variable $ 10,125 $ 12,150 $ 14,175Fixed 95,400 95,400 95,400Total $105,525 $107,550 $109,575

Activity in DLHs 6,000 7,000 8,000

Installation overhead costs:Variable $ 85,500 $ 99,750 $114,000Fixed 73,800 73,800 73,800Total $159,300 $173,550 $187,800

b. Number of pools: 8Production (25 MH per pool)

Variable (8 x 25 x $4.05) $ 810Fixed (monthly amount) 7,950 Total production overhead $ 8,760

Installation (60 DLH per pool)Variable (8 x 60 x $14.25) $ 6,840Fixed (monthly amount) 6,150 Total installation 12,990

Total $ 21,750

c. Number of pools: 120Production (25 MH per pool)

Variable (120 x 25 x $4.05) $ 12,150Fixed 95,400 $107,550

Installation (60 DLH per pool)Variable (120 x 60 x $14.25) $102,600Fixed 73,800 176,400

Total overhead $283,950Budgeted capacity ÷120Overhead cost per pool $2,366.25

40. a. MHs Total Cost = Variable Cost + Fixed Cost High activity 2,700 $13,160 $8,640 $4,520Low activity (1,400) (9,000) 4,480 4,520Differences 1,300 $ 4,160

Variable rate = $4,160 ÷ 1,300 MHs = $3.20 per MH

High activity variable cost = 2,700 × $3.20 = $8,640 Low activity variable cost = 1,400 × $3.20 = $4,480

Chapter 3

Fixed cost at low activity = $9,000 – $4,480 = $4,520Total maintenance cost = $4,520 + $3.20MH

b. x y xy x 2 1,400 $ 9,000 $ 12,600,000 1,960,000 1,900 10,719 20,366,100 3,610,000 2,000 10,900 21,800,000 4,000,000 2,500 13,000 32,500,000 6,250,000 2,200 11,578 25,471,600 4,840,000 2,700 13,154 35,515,800 7,290,000 1,700 9,525 16,192,500 2,890,000 2,300 11,670 26,841,000 5,290,000

16,700 $89,546 $191,287,000 36,130,000

= 16,700 8 = 2,087.50 = $89,546 8 = $11,193.25

y = $4,012.25 + $3.44MH

c. Part (b) computations provide the better answer. The least squares regression approach takes into consideration all of the available data and employs a mathematical algorithm to minimize the variance around the fitted regression line.

41. a. x y xy x 2 10 $ 16,000 $ 160,000 10014 18,400 257,600 19622 24,000 528,000 48428 28,400 795,200 78440 37,000 1,480,000 1,60062 56,000 3,472,000 3,844

100 68,000 6,800,000 10,00090 60,000 5,400,000 8,100

80 48,000 3,840,000 6,400 446 $355,800 $22,732,800 31,508

= 446 9 = 49.56 = $355,800 9 = $39,533.33

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y = $12,654.46 + $542.35(# of charters)b. x y xy x 2

$ 12,000 $ 16,000 $ 192,000,000 144,000,000 18,000 18,400 331,200,000 324,000,000 26,000 24,000 624,000,000 676,000,000

36,000 28,400 1,022,400,000 1,296,000,000 60,000 37,000 2,220,000,000 3,600,000,000 82,000 56,000 4,592,000,000 6,724,000,000

120,000 68,000 8,160,000,000 14,400,000,000 100,000 60,000 6,000,000,000 10,000,000,000 96,000 48,000 4,608,000,000 9,216,000,000 $550,000 $355,800 $27,749,600,000 46,380,000,000

= $550,000 9 = $61,111.11 = $355,800 9 = $39,533.33

y = $10,811.11 + $0.47(gross receipts)

42. a. Salado Corp. Income Statement (Absorption)

For the Year Ended December 31, 2006

Sales $3,750,000Cost of goods sold – Variable $1,950,000

Fixed overhead [($1,505,000 ÷ 1,750) x 1,500] 1,290,000 (3,240,000)Gross profit $ 510,000Variable selling & administrative $ 270,000Fixed selling & administrative 190,000 (460,000)Net income $ 50,000

b. The difference in the amounts is equal to the fixed overhead of ($1,505,000 ÷ 1,750 units) or $860 per unit times the 250 units produced but not sold during the year. This $215,000 is contained in ending inventory under absorption costing, whereas it appears as part of total fixed overhead expense on the variable costing income statement.

c. It is not only ethical, it is required for the statements to be in conformity with generally accepted accounting principles.

Chapter 3

d. 1. Salado Corp. Income Statement (Variable)

For the Year Ended December 31, 2007

Sales (1,850 x $2,500) $4,625,000Variable cost of goods sold (1,850 × $1,300) (2,405,000)Product contribution margin $2,220,000Variable selling & administrative ($180 × 1,850) (333,000)Contribution margin $1,887,000Fixed overhead $1,505,000Fixed selling & administrative 190,000 (1,695,000)Net income $ 192,000

2. Salado Corp. Income Statement (Absorption)

For the Year Ended December 31, 2007

Sales $4,625,000Cost of goods sold - Variable $2,405,000Fixed overhead [($1,505,000 ÷ 1,750) x 1,850] 1,591,000 (3,996,000)Gross profit $ 629,000Variable selling & administrative $ 333,000Fixed selling & administrative 190,000 (523,000)Net income $ 106,000

3. Net income under variable costing $192,000Net income under absorption costing (106,000)Difference in net incomes $ 86,000

The difference in the net incomes is equal to the incremental decrease in the ending balances of the inventory accounts when compared to the beginning balances. Another way to look at this more easily is to multiply the 100 units sold in excess of the 1,750 units produced by the fixed overhead application rate of $860 per unit.

The decrease in income in absorption costing is due to previously inventoried costs now hitting the income statement. This

happens because the number of units sold exceeds the number of units produced.

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43. D-TectIncome Statements (Absorption)

For the Years Ended December 31, 2006 and 2007

2006 (20,000 units) 2007 (24,000 units)Sales (units × $200) $4,000,000 $4,800,000CGS (units × $130) $2,600,000 $3,120,000Underapplied FOH 0 (2,600,000) 90,000 (3,210,000)Gross Profit $1,400,000 $1,590,000 S&A:

Variable (units × $20)$ 400,000 $ 480,000 Fixed 180,000 (580,000) 180,000 (660,000)

Income before taxes $ 820,000 $ 930,000

D-TectIncome Statements (Variable)

For the Years Ended December 31, 2006 and 2007

2006 (20,000 units) 2007 (24,000 units)Sales (units × $200) $4,000,000 $4,800,000CGS (units × $100) (2,000,000) (2,400,000)Product CM $2,000,000 $2,400,000Variable SG&A(units × $20) (400,000) (480,000)Total CM $1,600,000 $1,920,000Fixed costs

Factory $750,000 $750,000S&A 180,000 (930,000) 180,000 (930,000)

Income before taxes $ 670,000 $ 990,000

2006 2007Net income (absorption) $820,000 $930,000Net income (variable) 670,000 990,000Difference in income $150,000 $(60,000)

Difference is equal to inventory change+ 5,000 - 2,000Times FOH application rate × $30 × $30Difference in income $150,000 $(60,000)

Chapter 3

44. a. Riveting Manufacturing Income Statement (Variable)

For the Year Ended December 31, 2007Sales $1,015,000Variable Cost of Goods Sold:

Work in Process 1/1/07 46,400Finished goods 1/1/07 $ 16,950

Manufacturing costs incurred 650,600Total costs available $713,950Work in process 12/31/07 (61,900)Finished goods 12/31/07 (13,180) (638,870)

Product Contribution Margin $ 376,130Variable Selling Expenses (50,750)Contribution Margin $ 325,380Fixed Expenses

Factory overhead $ 42,300Selling 44,250Administrative 75,000 (161,550)

Operating Income $ 163,830

Supporting calculations

Variable finished goods inventory at 1/1/07:Absorption finished goods inventory $18,000Less fixed overhead (1,050 hours × $1 per hour) (1,050)Variable finished goods inventory $16,950

Variable work in process inventory at 1/1/07:Absorption work in process inventory $48,000Less fixed overhead (1,600 hours × $1 per hour) (1,600)Variable work in process $46,400

Variable manufacturing costs incurred during 2007:Direct material $370,000Direct labor (23,000 hours × $6 per hour) 138,000Variable overhead (23,000 hours × $6.20 per hour) 142,600Variable manufacturing costs $650,600

The direct labor rate is ($150,000 ÷ 25,000 hours) or $6.00 per hour.

The variable overhead rate is ($155,000 ÷ 25,000 hours) or $6.20 per hour.

Variable work in process inventory at 12/31/07:Absorption work in process inventory $64,000Less fixed overhead (2,100 hours × $1) (2,100)Variable work in process inventory $61,900

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Variable finished goods inventory at 12/31/07:Absorption finished goods inventory $14,000Less fixed overhead (820 hours × $1) (820)Variable finished goods inventory $13,180

Variable selling expenses = Sales × 5% = $1,015,000 × 5% = $50,750

Fixed selling expenses:Total selling expenses $95,000Less variable selling expenses (50,750)Fixed selling expenses $44,250

b. The difference in the operating income of $270 is caused by the different treatment of fixed manufacturing overhead. Under absorption costing, fixed overhead costs are assigned to inventory and are not expensed until the goods are sold. Under variable costing, these costs are treated as expenses in the period incurred. Since the direct labor hours in the work in process and finished goods inventories had a net increase of 270 hours, the absorption costing operating profit is higher because the fixed factory overhead associated with the increased labor hours in inventory is not expensed when absorption costing is used.

1/1/07 12/31/07 Inventories Inventories Differences

Work in process 1,600 2,100 500Finished goods 1,050 820 (230)Total 2,650 2,920 270

The increase in hours (270) times the fixed overhead rate ($1 per hour) equals the difference in operating incomes ($270).

45. a. Royals Fashions CompanyIncome Statement (Variable)

For the Year Ended December 31, 2007

Sales (40,000 $20) $800,000Variable cost of goods sold (40,000 x $7.50) (300,000)Contribution margin $500,000Fixed costs:

Production $117,000Selling & administrative 125,000 (242,000)

Income before taxes $258,000

Chapter 3

b. Royals Fashions CompanyIncome Statement (Absorption)

For the Year Ended December 31, 2007

Sales (40,000 $20) $800,000Cost of goods sold (40,000 x $9.45) $378,000Underapplied fixed overhead* 23,400 (401,400)Gross margin $398,600Less selling and administrative costs (125,000)Income before taxes $273,600

Number of units in ending FG inventory = 4,000 + 48,000 – 40,000 = 12,000FOH: $117,000 ÷ 60,000 = $1.95 per unitUnderapplied FOH = $1.95 x (60,000 – 48,000) = $1.95 x 12,000 = $23,400

c. Inventory increased from 4,000 to 12,000 units or by 8,000 units. Each added unit absorbs $1.95 in allocated fixed overhead or a total of $15,600. The presumption in the problem is that the books are maintained on a variable costing basis. Assuming only the current year needs to be adjusted (the beginning inventory of 2007 was charged with the appropriate fixed overhead), then the entry would be:

Inventory (8,000 x $1.95) 15,600Cost of Goods Sold (40,000 x $1.95) 78,000Underapplied Overhead 23,400

Fixed Factory Overhead 117,000

d. Advantages: The fixed costs are reported at incurred values (and not applied), thus

increasing the likelihood of better control of those costs. Profits are directly influenced by changes in sales volume (and not

influenced by building inventory). The impact of fixed costs on profits is emphasized. Product line, territory, etc., marginal contribution is emphasized and

more readily ascertainable.

Disadvantages: Total costs may be overlooked when considering problems. Distinction between fixed and variable cost is arbitrary for many costs. Emphasis on variable cost may cause managers to ignore fixed costs.

e. Advantages: Statements would readily reflect the direct impact of sales volume on profits. The consequences of fixed costs would be more obvious. Inventory swings would not influence profits.

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Disadvantages: Costs are not matched with revenues. The difficulty in separating fixed and variable costs might cause

statements to be misleading. Statements would confuse investors used to absorption costing

statements. Confidential information (on the nature of costs) could be disclosed to

competitors. (CMA

adapted)