Solution manual cost accounting 8e by kinney

Terminology Authority: The right usually by virtue of position or rank to use resources to accomplish a task or achieve an objective Balanced scorecard: A framework that restates an orga

Learning Objectives

After completing this chapter, you should be able to answer the following questions:

1 What are the relationships among financial, management, and cost accounting?

2 What are the sources of authoritative pronouncements for the practice of cost accounting?

3 What are the sources of ethical standards for cost accountants?

4 What is a mission statement, and why is it important to organizational strategy?

5 What must accountants understand about an organization’s structure and business environment to perform effectively in that organization?

6 What is a value chain, and what are the major value chain functions?

7 How is a balanced scorecard used to implement an organization’s strategy?

8 Why is ethical behavior so important in organizations?

INTRODUCTION TO COST ACCOUNTING CHAPTER

1

Terminology Authority: The right (usually by virtue of position or rank) to use resources to accomplish a task or

achieve an objective

Balanced scorecard: A framework that restates an organization’s strategy into clear and objective

performance measures focused on customers, internal business processes, employees, and

shareholders

Competence: Professional ethics standard that requires professionals to develop and maintain the skills

needed to practice their profession

Confidentiality: Professional ethics standard that requires professionals to refrain from disclosing

company information to inappropriate parties (such as competitors)

Core competency: Any critical function or activity in which an organization seeks a higher proficiency

than its competitors, making it the root of competitiveness and competitive advantage

Cost accounting: A discipline that addresses the demands of both financial and management

accounting by providing product cost information to (1) external parties (stockholders, creditors, and various regulatory bodies) for investment and credit decisions and (2) internal managers who are

responsible for planning, controlling, decision making, and evaluation of performance

Cost leadership: A company’s ability to maintain its competitive advantage by undercutting competitor

prices

Credibility: Professional ethics standard that requires individuals to provide full, fair, and timely

disclosure of all relevant information in a given situation

Customer value perspective: The balanced scorecard perspective that addresses how well the

organization is doing relative to important customer criteria such as speed (lead time), quality, service, and price (both purchase and after purchase)

Downstream cost: Costs such as marketing, distribution, and customer service which are typically

incurred after production of the product as opposed to upstream costs of research and development and product design

Earnings management: The act of using accounting methods or practices to deliberately “adjust” a

company’s profit amount to meet a predetermined internal or external target

Environmental constraint: any limitation caused by external cultural, fiscal (such as taxation structures),

legal/regulatory, or political situations and by the competitive market structures that cannot be directly controlled by management

Financial performance perspective: The balanced scorecard perspective that addresses the concerns

of stockholders and other stakeholders about profitability and organizational growth

Integrity: Professional ethics standard that prohibits individuals from participating in activities that would

discredit their company or profession

Intellectual capital: All of the intangible assets contained in an organization, including knowledge, skills,

and information that are used to create ideas for products and services, to train and develop employees, and to attract and retain customers

Internal business perspective: The balanced scorecard perspective that addresses those things that

the organization needs to do well to meet customer needs and expectations

Lag indicator: Historical financial data or other outcomes resulting from past actions, such as installing a

new production process or implementing a new software system

Lead indicator: Future financial and non-financial outcomes including opportunities and problems that

help an organization assess strategic progress and guide decision making before lag indicators are known

Learning and growth perspective: The balanced scorecard perspective that focuses on using the

organization’s intellectual capital to adapt to changing customer needs or to influence new customer needs and expectations through product or service innovations

Line personnel: Employees who work directly toward attaining organizational goals Line personnel

are often held responsible for achieving targeted balanced scorecard measures or budgeted operating income for their divisions or geographic regions; examples would include managers in production, sales, and distribution

Management accounting: That part of accounting that is concerned with providing information to parties

inside an organization so that they can plan, control operations, make decisions, and evaluate

performance

Mission statement: A written expression of organizational purpose that describes how the organization

uniquely meets its targeted customers’ needs with its products or services

Organizational structure: Reflects the way in which authority and responsibility for making decisions is

distributed in an organization

Product Cost: The sum of the costs incurred within the factory to make one unit of product

Product differentiation: A company’s ability to offer superior quality products or more unique services

than competitors; such products and services, generally, are sold at a premium price

Responsibility: The obligation to accomplish a task or achieve an objective

Return on investment (ROI): A measure calculated as net income divided by total assets which was

used historically to allocate resources and evaluate divisional performance

Staff personnel: Employees who give assistance and advice to line personnel; examples include

employees in marketing, engineering, accounting, and finance

Strategy: The link between an organization’s goals and objectives and the activities actually conducted

by the organization

Upstream cost: Costs such as research and development and product design which are typically

incurred before production of the product as opposed to downstream costs of marketing, distribution, and customer service

Value chain: The set of value-adding functions or processes that convert inputs into products and

services for the firm’s customers

Lecture Outline

LO.1 What are the relationships among financial, management, and cost accounting?

A Introduction

1 This chapter compares financial, management, and cost accounting, introduces the

organizational setting and environment in which the cost accountant must operate, and stresses the importance of professional ethics

B Comparison of Financial, Management, and Cost Accounting

c Financial accounting requires compliance with GAAP established by the FASB, the IASB,

and the SEC (or other influential organizations such as the APB and the AICPA)

i Publicly traded companies are required to have their financial statements audited by an independent auditing firm

ii Oversight of auditing standards for public companies is the responsibility of the Public Company Accounting Oversight Board (PCAOB) which was created by the Sarbanes-Oxley Act of 2002 (SOX) as a response to perceived abuses of accounting information by corporate managers

d In the early 1900s, financial accounting was the dominant source of information for evaluating business operations

i Return on Investment (ROI) was one of the most popular performance measures:

 ROI is calculated as Income divided by Total Assets

 ROI was a reasonable performance measure when companies were engaged in one type of activity, operated primarily domestically, were labor intensive, and were managed/owned by a small number of people

ii As the securities market grew, so did the demand for audited financial statements

 The high cost of preparing financial reports due primarily to the lack of information technology prevented organizations from developing a management accounting system separate from the financial accounting system

2 Management Accounting

a Management accounting comprises the financial and nonfinancial information needed by internal users (i.e., managers)

i Managers are concerned with fulfilling corporate goals, communicating and implementing strategy, and coordinating product design, production, and marketing while

simultaneously running distinct business segments

b Management accounting information is not required to adhere to GAAP and thus can provide both historical and forward-looking information to managers

i Management accounting information commonly addresses individual or divisional

concerns rather than those of the firm as a whole

c By the mid-1900s, companies were operating in a globally competitive, multiple product environment

i Trying to manage by using only financial reporting information often created dysfunctional behavior and thus led to the need and demand for a management accounting system

 Introduction of reasonably priced information technology greatly aided the cause

ii The differences between financial and management accounting are summarized in text

Exhibit 1-1 (p 3)

d To prepare plans, evaluate performance, and make more complex decisions, management needed forward looking information and information on the organization’s upstream and downstream costs

i When making pricing decisions, managers needed to add these upstream and

downstream costs to the GAAP-determined product cost as illustrated in Exhibit 1–2 (p 4)

 Upstream costs are costs such as research and development and product design which are typically incurred before production of the product

 Downstream costs include costs such as marketing, distribution, and customer service which are typically incurred after production of the product

3 Cost Accounting

a Cost accounting information addresses the demands of both financial and management accounting and is thus represented as the intersection of the financial and management

accounting systems (See text Exhibit 1-3 (p 4))

i Cost accounting supports the financial accounting system by providing product cost information to external parties (stockholders, creditors, and various regulatory bodies) for investment and credit decisions

 For external reporting purposes, GAAP defines product cost as the sum of the costs incurred within the factory to make one unit of product

ii Cost accounting supports the management accounting system by providing product cost information to internal managers who are responsible for planning, controlling, decision making, and evaluating performance

 For internal reporting purposes, product cost information can be developed outside the constraints of GAAP to assist management with specific needs

b As companies expanded operations, managers recognized that a single cost could no longer

be computed for a product

i For example, product costs could not easily be compared between multiple locations when production processes were not similar in each location Such complications resulted in the evolution of the cost accounting database to include more than simply financial accounting measures

LO.2 What are the sources of authoritative pronouncements for the practice of cost accounting?

C Cost Accounting Standards

1 The Institute of Management Accountants (IMA)

a The IMA, a voluntary membership organization of accountants, finance specialists,

academics, and others, issues directives on the practice of management and cost

accounting

i These directives, called Statements on Management Accounting (SMAs) are not legally binding standards but they undergo a rigorous developmental and exposure process that ensures wide support

2 The Society of Management Accountants of Canada

a The IMA counterpart in Canada also issues guidelines on the practice of management accounting called Management Accounting Guidelines (MAGs) and again, while not

mandatory, do represent best practices for high-quality organizational accounting

3 The Cost Accounting Standards Board (CASB)

a The CASB is a public sector body established in 1970 to issue uniform cost accounting standards for defense contractors and federal agencies

b The CASB produced 20 cost accounting standards (one of which has been withdrawn) from its inception until it was terminated in 1980

c The CASB was recreated in 1988 as an independent board of the Office of Federal

Procurement Policy to help ensure uniformity and consistency in government contracting

d CASB standards do not constitute a comprehensive set of rules, but compliance is required for companies bidding on or pricing cost-related contracts with the federal government

4 No official agency publishes generic management accounting standards for all companies

a Although the IMA, Society of Management Accountants of Canada, and CASB have been instrumental in standards development, much of the body of knowledge and practice in management accounting has been provided by industry practice and economic and finance theory

LO.3 What are the sources of ethical standards for cost accountants?

a Earnings management involves using an accounting method or practice to deliberately

adjust a company’s profit amount to meet earnings estimates, preserve a specific earnings trend, convert a loss to a profit, increase management compensation, or hide illegal transactions, for example

b Aggressive Accounting involves exceeding the boundaries of reason in applying

accounting principles in order to meet a predetermined internal or external target

3 The Sarbanes-Oxley Act of 2002 was passed to hold CEOs and CFOs personally

accountable for the accuracy of their organization’s financial reporting

a Under SOX, chief financial officers who knowingly certify false financial reports may be punished with a maximum penalty of a $5 million fine, 20 years in prison, or both

4 Certified Management Accountants (CMA) must adhere to the standards of ethical conduct

published in the Statement of Ethical Professional Practice issued by the IMA

5 The IMA’s Code of Ethics (See text Exhibit 1–4 (p 6)) has four standards:

a Competence means that individuals will develop and maintain the skills needed to

practice their profession

b Confidentiality means that individuals will refrain from disclosing company information to

inappropriate parties (such as competitors) that could be specifically defined in the company’s code of ethics

c Integrity means that individuals will not participate in activities that would discredit their

company or profession

d Credibility means providing full, fair, and timely disclosure of all relevant information

6 Cost and management accountants who discover illegal or immoral behavior such as

financial fraud, theft, environmental violations, or employee discrimination should evaluate the situation and, if appropriate, “blow the whistle” on the activities by disclosing them to appropriate persons or agencies

a The accountant should keep the information confidential and report it to his/her

immediate supervisor (unless that person is suspected of being involved)

b The accountant should continue up the chain of command to the first manager who is not involved in the situation —meaning that it could be necessary to take the matter all the way to the audit committee of the board of directors

c If the matter cannot be resolved, the only recourse available may be to resign and consult

a legal adviser before reporting the matter to regulatory authorities

LO.4 What is a mission statement and why is it important to organizational strategy?

E Compteting in a Global Environment

1 General

a A mission statement expresses the purposes for which the organization exists, what the

organization wants to accomplish, and how its products and services can uniquely meet its targeted customers’ needs

b Mission statements are used to develop the organization’s strategy or plan of how the firm will fulfill its goals and objectives and achieve an advantage over its competitors

2 Organizational Strategy (see text Exhibit 1-5 (p 8))

a A core competency is any critical function or activity such as technological innovation,

engineering, product development, and after-sale service in which an organization seeks a higher proficiency than its competitors, making it the root of competitiveness and competitive advantage

b Most companies compete using either a “cost leadership” or “product differentiation” strategy

i Cost leadership refers to a company’s ability to maintain its competitive edge by

undercutting competitor prices (e.g., Wal-Mart)

ii Product differentiation refers to a company’s ability to offer superior quality products or

more unique services than competitors; such products and services are, however, generally sold at premium prices (e.g., Rolex watches)

c Cost accountants gather financial and nonfinancial information to help management achieve

organizational strategy Text Exhibit 1–6 (p 9) provides a checklist of questions that help

indicate whether an organization has a comprehensive strategy in place

LO 5 What must accountants understand about an organization’s structure and business

environment to perform effectively in that organization?

F Organizational Structure

1 An organization is composed of people, resources other than people, and commitments that are acquired and arranged to achieve organizational strategy and goals

2 Organizational structure reflects the way in which authority and responsibility for making

decisions are distributed in an organization

a Authority refers to the right (usually by virtue of position or rank) to use resources to

accomplish a task or achieve an objective

b Responsibility is the obligation to accomplish a task or achieve an objective

3 Work in organizations is directed by line personnel who work directly toward attaining

organizational goals, and staff personnel who give assistance and advice to line managers

a The treasurer is generally responsible for achieving short- and long-term financing, investing,

and cash management goals

b The controller is responsible for delivering to management financial reports in conformity

with GAAP

4 Management style, the way managers interact with the entity’s stakeholders, especially

employees, impacts the organization’s decision-making processes, risk taking, willingness to encourage change, and employee development

5 Organizational culture refers to the basic manner in which the organization interacts with its

business environment, the way in which employees interact with each other and with

management, and the underlying beliefs and attitudes held by employees about the organization

6 Short-term organizational constraints that may be overcome by existing business opportunities:

a Monetary capital If additional capital cannot be obtained at a reasonable cost management

must determine how to reallocate existing capital in an effective and efficient manner

b Intellectual capital, which encompasses the knowledge, skills, and information that an

organization possesses, impacts the firm’s ability to create ideas for products or services, to train and develop its employees, and to attract and retain customers

c Technology Companies must adopt emerging technologies to stay at the top of their

industry and achieve a competitive advantage over competitors

7 An environmental constraint is any limitation caused by external cultural, fiscal (such as

taxation structures), legal/regulatory, or political situations and by competitive market structures

LO 6 What is a value chain, and what are the major value chain functions?

G Value Chain

1 The value chain is a set of value-adding functions or processes that convert inputs into products

and services for the organization’s customers (See text Exhibit 1–7 (p 11)):

a Research and Development—experimenting to reduce costs or improve quality

b Design—developing alternative product, service, or process designs

c Supply—managing raw materials received from vendors to reduce costs and improve quality

d Production—acquiring and assembling resources to produce a product or render a service

e Marketing—promoting a product or service to current and prospective customers

f Distribution—delivering a product or service to a customer

g Customer Service—supporting customers after the sale of a product or service

2 Cost accountants help design the communication network that is used to communicate corporate strategy to all members in the value chain so that the strategy can be effectively implemented

LO.7 How is a balanced scorecard used to implement an organization’s strategy?

H Balanced Scorecard

1 Firms use a portfolio of lag and lead indicators to determine not only how the organization has performed in the past but also how it is likely to perform in the future

a Lag indicators which are historical financial data that reflect outcomes that have resulted

from past actions, such as installing a new production process or implementing a new

software system, are often recognized and assessed too late to significantly improve current

or future actions

b Lead indicators which reflect future financial and nonfinancial outcomes (including

opportunities and problems) help managers assess strategic progress and guide decision making before lag indicators are known

2 Organizations often use both lead and lag indicators in a balanced scorecard to assess strategy congruence

3 The balanced scorecard (BSC) is a framework that restates an organization’s strategy into clear

and objective performance measures focused on customers, internal business processes, employees, and shareholders

4 The BSC includes long-term and short-term, internal and external, financial and nonfinancial measures to balance management’s view and execution of strategy

5 As illustrated in text Exhibit 1–8 (p 13), the balanced scorecard has four perspectives:

a The learning and growth perspective focuses on using the organization’s intellectual

capital to adapt to changing customer needs or to influence new customers’ needs and expectations through product or service innovations

b The internal business perspective focuses on those things that the organization needs to

do well to meet customer needs and expectations

c The customer value perspective addresses how well the organization is doing relative to

important customer criteria such as speed (lead time), quality, service, and price (both purchase and after purchase)

d The financial perspective addresses the concerns of stockholders and other stakeholders

about profitability and organizational growth

6 See text Exhibit 1–9 (p 14) for a more realistic and more complicated balanced scorecard

LO.8 Why is ethical behavior so important in organizations?

I Ethics in Multinational Corporations

1 Accountants and other individuals working for multinational companies should be aware of not only their company’s and the IMA’s code of ethical conduct but also the laws and ethical

parameters within countries in which the multinational operates

2 The Foreign Corrupt Practices Act (FCPA) of 1977 prohibits U.S corporations from offering or

giving bribes (directly or indirectly) to foreign officials to influence those individuals (or cause them

to use their influence) to help businesses obtain or retain business

3 The Organization of Economic Cooperation and Development (OECD) has released a document that makes it a crime to offer, promise or give a bribe to a foreign public official in order to obtain

or retain international business deals

a As of March 2008, 37 countries (see Text Exhibit 1–10 (p 15)) had signed this document,

including the United States

b Signing the OECD convention illustrates that companies globally are beginning to

acknowledge that bribery should not be considered an appropriate means of doing business

Multiple Choice Questions

1 (LO.1) Select the incorrect comparison between financial and management accounting:

Financial Accounting Management Accounting

b Overriding criteria Verifiability GAAP

c Information timeframe Historical Current/future

2 (LO.1) Oversight of auditing standards for public companies is the responsibility of the

a Public Company Accounting Oversight Board

b Securities and Exchange Commission

c Financial Accounting Standards Board

d Institute of Management Accountants

3, (LO.1) The acronym IASB stands for

a Internal Accounting Standards Board

b Internal Auditing Standards Board

c International Auditing Standards Board

d International Accounting Standards Board

4 (LO.1) Cost accounting can best be described as

a the intersection between financial and management accounting

b a system that meets the informational demands of both financial and management

accounting

c a system that provides product cost information to Internal managers for planning,

controlling, decision making and evaluating performance

d all of the above

5 (LO.2) Statements on Management Accounting (SMA) are directives on the practice of

management and cost accounting Select the incorrect statement concerning SMAs from the

following

a SMAs are issued by the Cost Accounting Standards Board

b SMAs are not legally binding

c SMAs go through a rigorous developmental and exposure process

d SMAs describe high-quality or best practices in management accounting

6 (LO.3) A management accountant who fails to perform professional duties in accordance with relevant standards is acting contrary to which of the following standards?

to resolve an ethical conflict by talking with their immediate supervisor they should

a communicate the problem to authorities outside the organization

b contact the next higher managerial level

c notify the audit committee of the board of directors

d contact the chief financial officer

8 (LO.3) According to the IMA Code of Ethics a practitioner has the responsibility to recognize professional limitations Under which standard of ethical conduct would this responsibility be included?

a Competency

b Confidentiality

c Integrity

d Objectivity

9 (LO.4) Strategic planning includes all of the following except:

a top-level management participation

b a long-term focus

c analysis of the current month’s actual variances from budget

d identification of long-term key variables including external influences

10 (LO.4) The strategy that is being used by a company that seeks to provide superior quality products or more unique services than its competitors is a

a cost leadership strategy

b differentiation strategy

c customer value strategy

d value chain strategy

11 (LO.5) All of the following are staff personnel except:

14 (LO.7) Which balanced scorecard perspective focuses on those things that the organization must

do well to meet customer needs and expectations?

a Customer perspective

b Learning and growth perspective

c Financial perspective

d Internal business perspective

15 (LO.8) Which of the following is a violation of the Foreign Corrupt Practices Act?

a Paying cash bribes to foreign officials

b Giving sporting event tickets to foreign officials

c Providing free samples to the families of foreign officials

d All of the above

Multiple Choice Solutions

Learning Objectives

After reading and studying Chapter 2, you should be able to answer the following questions:

1 Why are costs associated with a cost object?

2 What assumptions do accountants make about cost behavior, and why are these assumptions necessary?

3 How are costs classified on the financial statements, and why are such classifications useful?

4 How does the conversion process occur in manufacturing and service companies?

5 What are the product cost categories, and what items comprise those categories?

6 How and why does overhead need to be allocated to products?

7 How is cost of goods manufactured calculated and used in preparing an income statement?

COST TERMINOLOGY AND COST

BEHAVIORS CHAPTER

2

Terminology Actual cost system: A costing system that charges Work in Process Inventory with the actual direct

material, direct labor, and overhead costs of producing a product

Appraisal costs: Costs incurred to find mistakes not eliminated through prevention

Conversion costs: The costs (direct labor and overhead) required to convert direct material into a

finished good or service

Cost: The monetary measure of resources given up to attain an objective such as producing a product or

providing a service

Cost allocation: The assignment of an indirect cost to one or more cost objects using some reasonable

allocation base or driver

Cost driver: A factor that has an absolute cause-effect relationship to a cost

Cost management system (CMS): A set of formal methods developed for planning and controlling an

organization’s cost-generating activities relative to its strategy, goals, and objectives

Cost object: Anything for which management wants to collect or accumulate costs

Cost of goods manufactured (CGM): The total cost of the goods completed and transferred to Finished

Goods Inventory during the period

Direct costs: Costs which are conveniently and economically traceable to a particular cost object

Direct labor: Labor costs of individuals who work specifically on manufacturing a product or performing a

service

Direct material: Material costs that can be easily and economically traced to a product

Distribution cost: Any cost incurred to warehouse, transport, or deliver a product or service

Expired cost: The portion of an asset’s value that has been consumed or sacrificed during the period

and which is reported as an expense or loss on the income statement

Failure costs: Internal costs (e.g., scrap and rework) and external costs (e.g., product returns, warranty

costs, complaints to customer service) caused by quality problems

Finished goods: The costs of units of inventory that have been fully completed

Fixed cost: A cost that remains constant in total within the relevant range of activity but varies on a unit

basis

Indirect costs: Costs that cannot be economically traced to a particular cost object and therefore must

be allocated to the object instead

Inventoriable costs: The direct costs of materials and labor plus the indirect costs of overhead which

become part of the cost of inventory

Manufacturer: A company engaged in a high degree of conversion of raw material that results in a

tangible output

Mixed cost: A cost that has both a variable and a fixed component and that changes with changes in

activity, but not proportionately

Normal cost system: A costing system that charges the Work in Process Inventory with the actual costs

of direct material and direct labor and an assigned amount of overhead based on a predetermined overhead rate

Overhead: Any factory or production cost that is indirect to the product or service (that is, a

production-related cost that cannot be directly traced to the product)

Period costs: Costs related to business functions other than production (such as selling and

administrative costs) which are expensed in the current accounting period

Predetermined overhead rate: A charge per unit of activity used to allocate or apply overhead cost from

the Overhead Control account to Work in Process Inventory for the period’s production or services

Predictor: An activity measure that, when changed, is accompanied by consistent, observable changes

in a cost item

Prevention costs: Costs incurred to improve quality by precluding product defects and improper

processing from occurring

Prime costs: The primary costs (direct material and direct labor) of producing a product or delivering a

service

Product costs: Costs associated with making or acquiring the products or providing the services that

directly generate the revenues of an entity

Raw material: The materials used in the production process From the standpoint of conversion, raw

material represents work not yet started

Relevant range: The assumed range of activity that reflects the company’s normal operating range and

over which unit variable costs and total fixed costs are assumed to remain constant

Service company: A firm engaged in a high or moderate degree of conversion using a significant

amount of labor

Step cost: A cost that increases (decreases) in distinct amounts because of increased (decreased)

activity Step variable costs have small steps and step fixed costs have large steps

Total cost to account for: The sum of the beginning WIP Inventory and the total current manufacturing

costs (DM, DL, OH)

Unexpired cost: The portion of an asset’s value that has not yet been consumed or sacrificed and which

is reported on the balance sheet as an asset

Variable cost: A cost that varies in total proportionately with changes in activity but which is a constant

amount per unit

Work in process: The costs of work started but not yet completed

2 To effectively communicate information, accountants must clearly understand the differences among the various types of costs, their computations, and their usage

3 To be useful, the term cost must be defined more specifically before “the cost” of a product or

service can be determined and communicated to others

a Cost reflects the monetary measure of resources given up to attain an objective such as

making a good or delivering a service

b Unexpired cost: The portion of an asset’s value that has not yet been consumed or

sacrificed and which is reported on the balance sheet as an asset

c Expired cost: The portion of an asset’s value that has been consumed or sacrificed during

the period and which is reported as an expense on the income statement

B Cost Terminology

1 A cost management system is a set of formal methods developed for planning and controlling

an organization’s cost-generating activities relative to its strategy, goals, and objectives

2 Some important types of costs are summarized in text Exhibit 2–1 (p 25)

3 Association with Cost Object

a A cost object is anything (e.g., a product, a product line, a customer) for which management

wants to collect or accumulate costs

b The costs associated with any cost object can be classified according to their relationship to the cost object

c Direct costs are costs that can be conveniently and economically traced to the cost object

i For example, the cost of steel used by Toyota to manufacture a Tundra pickup truck is a direct cost when the cost object is the Tundra product

d Indirect costs are costs that cannot be economically traced to the cost object but instead

must be allocated to the cost object

i For example, the cost of glue used to manufacture a Tundra pickup truck is an indirect cost when the cost object is the Tundra pickup truck

e Costs may be direct or indirect depending upon the cost object

i As above, the glue used used to manufacture a Tundra pickup truck is an indirect cost when the cost object is the Tundra pickup truck but is a direct cost when the cost object is the Princeton plant in which the Tundra is manufactured

LO.2 What assumptions do accountants make about cost behavior, and why are these

d Accountants assume that there are three cost behavior patterns: variable, fixed, and mixed

i A variable cost is a cost that varies in total in direct proportion to changes in activity but

is constant on a unit basis Although accountants view variable costs as linear,

economists view these costs as curvilinear as shown in text Exhibit 2–2 (p 27)

ii A fixed cost is a cost that remains constant in total within the relevant range of activity

but varies inversely with changes in the level of activity on a per unit basis The variable

and fixed cost behavior patterns are summarized in text Exhibit 2–3 (p 28)

iii A mixed cost has both a variable and a fixed component as illustrated in text Exhibit 2-4 (p 28) Mixed costs must be separated into their variable and fixed components in order

to make valid estimates of total costs at various activity levels

e Management may decide to “trade” fixed and variable costs for one another

i For example, installing new automated production equipment would result in an additional large fixed cost for depreciation but would eliminate the variable cost of wages for hourly production workers

ii A shift from one type of cost behavior to another type changes a company’s basic cost structure and can have a significant impact on its profits

f A step cost is a cost that shifts upward or downward when activity changes by a certain

interval or “step.” Step costs can be variable or fixed; step variable costs have small steps while step fixed costs have large steps

g Assuming a variable cost is constant per unit and a fixed cost is constant in total within the relevant range can be justified for two reasons:

i If the company operates only within the relevant range of activity, the assumed conditions approximate reality and, thus, the cost behaviors are appropriate

ii Second, selection of a constant per-unit variable cost and a constant total fixed cost provides a convenient, stable measurement for use in planning, controlling, and decision making activities

h Selection of an appropriate activity measure is important

i A predictor is an activity measure that, when changed, is accompanied by consistent,

observable changes in a cost item However, simply because two items change together does not prove that the predictor causes the change

ii A cost driver is a predictor that has an absolute cause-and-effect relationship with the

cost in question

iii Text Exhibit 2–5 (p 30) illustrates the linear cause-and-effect relationship between

production volume and total raw material cost

iv Traditionally, a single predictor has often been used to predict costs but accountants and managers are realizing that single predictors do not necessarily provide the most reliable forecasts, thus causing a movement toward activity-based costing, which uses multiple cost drivers to predict different costs

LO.3 How are costs classified on the financial statements, and why are such classifications useful?

2 Classification on the Financial Statements

a The balance sheet is a statement of unexpired costs (assets) and liabilities and owners’ capital whereas the income statement is a statement of revenues and expired costs (expenses and losses)

b The matching concept provides a basis for deciding when an unexpired cost becomes an expired cost and is moved from an asset category to an expense or loss category

c When the product is specified as the cost object, all costs can be classified as either product

or period costs

d Product costs, also called inventoriable costs, are related to making or acquiring the

products or providing the services that directly generate the revenues of an entity

i Direct material is any material that can be easily and economically traced to a product

ii Direct labor refers to the time spent by individuals who work specifically on manufacturing

a product or performing a service

iii Overhead is any factory or production cost that is indirect (i.e., not direct material or direct labor) to the product or service

e The sum of direct labor and overhead costs is referred to as conversion cost as those are

the costs incurred to convert materials into products

f The sum of direct material and direct labor cost is referred to as prime cost as those are the

primary costs in making most products

g Period costs are related to business functions other than production, such as selling and

iii Distribution costs are period costs incurred to warehouse, transport, or deliver a

product or service

LO.4 How does the conversion process occur in manufacturing and service companies?

D The Conversion Process

1 General

a In general, product costs are incurred in the production (or conversion) area and period costs are incurred in all nonproduction (or nonconversion) areas

b Conversion process outputs are usually either products or services

c See text Exhibit 2–6 (p 31) for a comparison of the conversion activities of different types of

accumulation costs as illustrated in text Exhibit 2-7 (p 32)

f A manufacturer is defined as any company engaged in a high degree of conversion of raw

material input into a tangible output using people and machines

g A service company refers to a for-profit business or not-for-profit organization that uses a

significant amount of labor to engage in a high or moderate degree of conversion, whose outputs can be tangible (e.g., an architectural drawing) or intangible (e.g., insurance

protection)

2 Retailers versus Manufacturers/Service Companies

a Retail companies purchase goods in finished or almost finished condition so those goods

b In comparison, manufacturers and service companies engage in activities that involve the physical transformation of inputs into, respectively, finished products and services

c A cost accounting system is required to assign the materials or supplies and conversion costs

of manufacturers and service companies to output to determine the cost of inventory

produced and cost of goods sold or services rendered

d The production or conversion process occurs in three stages:

i Work not started (raw material);

ii Work started but not completed (work in process); and

iii Work completed (finished goods)

e Text Exhibit 2–8 (p 33) compares the input–output relationships of a retail company with

those of a manufacturing/service company

i As shown in the exhibit, unlike manufacturers and service firms, retail firms have no

“production center” where input factors such as raw material enter and are transformed and stored until the goods or services are completed

f Text Exhibit 2–9 (p 35) depicts some of the costs associated with each stage of the

iii The total costs incurred in stages 1 and 2 equal the total production cost of finished goods in stage 3

3 Manufacturers versus Service Companies

a In a service firm, the work not started stage of processing normally consists of the cost of supplies needed to perform the services (Supplies Inventory)

i When supplies are placed into process, labor and overhead are added to achieve

finished results Thus, some service firms use two accounts (a Supplies Inventory account and a Work in Process Inventory account) to accumulate these costs

b Manufacturers use three inventory accounts: (1) Raw Material Inventory (instead of

Supplies), (2) Work in Process Inventory (for partially converted goods), and (3) Finished Goods Inventory

c Because services generally cannot be warehoused, costs of finished jobs are usually

transferred immediately to the income statement to be matched against service revenue rather than being carried on the balance sheet in a finished goods inventory account

d All organizations (retailers, manufacturers, and service firms) need management and cost accounting techniques to help them find ways to reduce costs without sacrificing quality or productivity

LO.5 What are the product cost categories, and what items comprise those categories?

E Components of Product Cost

a Direct labor refers to the effort of individuals who manufacture a product or perform a service

b Direct labor cost consists of the wages or salaries paid to direct labor personnel conveniently traceable to the product or service

i Direct labor should include basic compensation, production efficiency bonuses, the employees’ share of Social Security and Medicare taxes, and if the company’s operations are relatively stable, all employer-paid insurance costs, holiday and vacation pay, and pension and other retirement benefits

c Labor costs that cannot be reasonably or economically traced are classified as indirect costs and included in overhead

i Although fringe benefit costs should be treated as direct labor, the time, effort, and clerical expense of tracing such costs to production do not warrant such treatment

ii Costs for overtime or shift premiums are usually considered overhead rather than direct labor cost and are allocated among all units unless the overtime costs resulted from expediting a customer’s request

d Because laborers historically performed the majority of conversion activity, direct labor once represented a large portion of total manufacturing cost

i Now, in highly automated work environments, direct labor often represents only 10 to 15 percent of total manufacturing cost

3 Overhead

a Overhead is any factory or production cost that is indirect to manufacturing a product or providing a service

b Overhead includes indirect material, indirect labor and other production-related costs such as factory depreciation, factory utilities, factory insurance, etc

c Automated and computerized technologies have made manufacturing more capital intensive and overhead has become a progressively larger proportion, and such costs merit much more attention than they did in the past

d Variable overhead includes the costs of indirect material, indirect labor paid on an hourly basis, lubricants used for machine maintenance, and the variable portion of factory utility charges

e Fixed overhead includes costs such as straight-line depreciation on factory assets, factory license fees, factory insurance and property taxes, and fixed indirect labor costs such as salaries for production supervisors, shift superintendents, and plant managers

f Quality costs are an important component of overhead cost since high-quality products or services enhance a company’s ability to generate revenues and produce profits Managers are concerned about production process quality because higher process quality leads to shorter production time and reduced costs for spoilage and rework

i Prevention costs are incurred to improve quality by precluding product defects and

improper processing from occurring

ii Appraisal costs are costs incurred for monitoring or inspecting products in order to find

mistakes not eliminated through prevention

iii Internal Failure costs are costs such as scrap and rework that result when quality

problems are detected before the product reaches the final customer

iv External Failure costs are incurred when quality problems are not discovered until after

the product has been delivered to the final customer and include costs such as product returns and warranty claims

g Some quality costs are variable in relation to the quantity of defective output, some are step fixed with increases at specific levels of defective output, and some are fixed for a specific time

LO.6 How and why does overhead need to be allocated to products?

F Accumulation and Allocation of Overhead

b Cost allocation refers to the assignment of an indirect cost to one or more cost objects

using some reasonable allocation base or driver

c Overhead costs are allocated to cost objects for three reasons: (1) to determine the full cost of the cost object, (2) to motivate the manager in charge of the cost object to manage it efficiently, and (3) to compare alternative courses of action for management planning, controlling, and decision making

2 Allocating overhead

a In an actual cost system, actual direct material and direct labor costs are accumulated in

Work in Process (WIP) Inventory as the costs are incurred Actual production overhead costs are accumulated separately in an Overhead Control account and are assigned to WIP Inventory at the end of a period or at completion of production

i Use of an actual cost system is generally considered to be difficult because all production overhead information must be available before any cost allocation can be made to products or services

b In a normal cost system, actual direct material and direct labor costs and an estimated

amount of overhead (assigned using a predetermined overhead rate or rates) are

accumulated in WIP

i A predetermined overhead rate (or overhead application rate) is a charge per unit of

activity that is used to allocate (or apply) overhead cost from the Overhead Control account to WIP Inventory for the period’s production or services

c Product costs can be accumulated using either a perpetual or a periodic inventory system

i A perpetual inventory system, as illustrated in text Exhibit 2-10 (p 39), continuously

provides current information on the flow of product costs from Raw Materials Inventory through Work in Process Inventory to Finished Goods Inventory and, ultimately, to Cost

of Goods Sold Expense

d Text Exhibit 2-11 (p 40) presents journal entries to illustrate the flow of manufacturing costs

in an actual cost system while text Exhibit 2-12 (p 41) presents selected T-accounts

associated with the example

LO.7 How is cost of goods manufactured calculated and used in preparing an income

statement?

3 Cost of Goods Manufactured and Sold

a The Cost of Goods Manufactured (CGM) is the total production cost of the goods that were completed and transferred to Finished Goods Inventory during the period

i This amount is similar to the cost of net purchases in the cost of goods sold schedule for

a retailer

b Information needed for computing CGM is found in the Raw Materials Inventory, Work in Process Inventory, and Overhead Control accounts:

Beginning WIP

+ Cost of Direct Materials Added (See Note 1)

+ Cost of Direct Labor Added

+ Cost of Overhead

Total Cost to Account For

- Ending WIP

Cost of Goods Manufactured (CGM)

Note 1: Direct material added = Beginning Raw Materials + Raw Materials Purchased –

Ending Raw Materials

c Cost of Goods Sold (CGS)

i The Cost of goods sold is computed as follows:

Beginning Finished Goods

+ Cost of Goods Manufactured

Goods available for sale

- Ending Finished Goods

Cost of Goods Sold (CGS)

ii Formal schedules of cost of goods manufactured and cost of goods sold are presented in

text Exhibit 2–13 (p 42) based on the information provided in Exhibits 2–11 and 2–12

Multiple Choice Questions

1 (LO.1) Select the incorrect statement concerning cost objects

a When the cost object is the Production Department, the cost of a production supervisor’s salary would be a direct cost

b A direct cost must be conveniently and economically traceable to the cost object

c When the cost object is a Tundra truck, the cost of the truck’s engine is a direct cost

d When the cost object is the Toyota Princeton Indiana manufacturing plant the cost of

overhead is an indirect cost

2 (LO.2) Which of the following statements is correct concerning fixed costs?

a Within the relevant range, total fixed costs always increase when volume increases

b A step cost may be fixed or variable

c The fixed costs per unit will remain constant provided volume remains within the relevant range

d Within the relevant range, total fixed costs always decrease when volume increases

3 (LO.2) A utility bill that includes a flat charge for basic service plus a stated rate for each kilowatt hour of usage beyond a specified level is an example of a

a mixed cost

b step cost

c variable cost

d independent cost

4 (LO.2) In relation to the dollar amount of Tundra truck sales, which of the following classifications

is appropriate for the truck tires used in production and for the salaries of production supervisors? Truck Tires Production Supervisor Salaries

5 (LO.3) The estimated unit cost for a company planning to produce and sell at a level of 12,000 units per month is as follows:

Estimated

Variable manufacturing overhead 6

Fixed manufacturing overhead 12

6 (LO.3) Which of the following is not a product cost for Tundra trucks?

a Lee’s Landscaping Company

b Toyota Manufacturing Company

c Wal-Mart Stores

d All of the above

8 (LO.4) Select the incorrect statement concerning the stages of the production or conversion

process

a A manufacturing company’s Finished Goods inventory account is similar to a service

company’s Supplies inventory account

b Firms such as retailers that engage in only low or moderate degrees of conversion ordinarily have only a single inventory account

c The production process occurs in three stages: raw material, work in process, and finished goods

d At the point of sale, product costs flow from an inventory account to Cost of Goods Sold expense

9 (LO.5) Which of the following would not be classified as direct material for a Tundra truck?

a Cost of the battery

b Cost of the glue used to secure the carpet in the cab of the truck

c Cost of freight paid on the truck windshield

d Cost of the fuel tank

10 (LO.5) Which of the following would be classified as direct labor for the production of a Tundra truck?

a Wages paid to assembly line (production) workers

b Bonuses paid to production workers for exceeding production goals

c Production workers’ Social Security taxes

d All of the above

11 (LO.5) Which of the following costs would not be classified as overhead for the production of

Tundra trucks?

a Salary of plant manager

b Indirect labor costs

c Salary of Toyota Chief Executive Officer

d Depreciation of production machinery

12 (LO.6) All of the following are reasons why overhead costs are allocated to cost objects except:

a to compare alternative courses of action for management planning and decision making

b to identify the fixed and variable components of the various overhead costs

c to determine the full cost of the cost object

d to motivate the manager in charge of the cost object to manage it efficiently

13 (LO.7) A Company had the following inventories at the beginning and end of January:

Finished goods $12,500 $11,700

Work in process 23,500 25,100

Direct material 13,400 12,400

The following additional manufacturing data were available for the month of January:

Direct material purchased $18,900

Actual factory overhead 17,500

What was the total cost of direct material used for January?

The following additional manufacturing data were available for the month of January:

Direct material used $189,000

Actual factory overhead 175,000

What was B Company’s cost of goods manufactured for January?

Multiple Choice Solutions

Total direct materials used:

Direct materials at January 1 $13,400 Direct materials purchased 18,900 Materials available for use $32,300 Less Direct materials at January 31 12,400 Direct materials used $19,900

14 d (CMA Adapted)

Cost of goods manufactured:

Work in process at January 1 $ 235,000

Work in process at January 31 (251,000) Cost of goods manufactured $ 648,000

15 b (CMA Adapted)

Cost of goods sold:

Finished goods at January 1 $ 125,000

Finished goods at January 31 (117,000) Cost of goods sold $ 668,000

Learning Objectives

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

1 Why and how are overhead costs allocated to products and services?

2 What causes underapplied or overapplied overhead and how is it treated at the end of a period?

3 What impact do different capacity measures have on setting predetermined overhead rates?

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

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

6 How do absorption and variable costing differ?

7 How do changes in sales or production levels affect net income computed under absorption and variable costing?

PREDETERMINED OVERHEAD RATES, FLEXIBLE BUDGETS, AND ABSORPTION/

VARIABLE COSTING CHAPTER

3

Terminology Absorption costing: A cost accumulation and reporting method that treats the costs of all manufacturing

components (direct material, direct labor, variable overhead, and fixed overhead) as inventoriable or product costs in accordance with generally accepted accounting principles

Applied overhead: The dollar amount of overhead assigned from an overhead account to Work in

Process Inventory using the activity measure that was selected to develop the activity rate

Contribution margin: The difference between total revenues and total variable expenses (manufacturing

and non-manufacturing) computed on either a total or per unit basis; the contribution margin indicates the dollar amount available to “contribute” to cover total fixed expenses, both manufacturing and

nonmanufacturing

Dependent variable: An unknown variable that is to be predicted using one or more independent

variables

Direct costing: See variable costing

Expected capacity: A short-run concept that represents the anticipated level of capacity to be used by a

firm in the upcoming period, based on projected product demand

Flexible budget: A planning document that presents expected variable and fixed overhead costs at

different activity levels

Full costing: See absorption costing

Functional classification: A group of costs that were all incurred for the same principle purpose (e.g.,

cost of goods sold, selling expenses, and administrative expenses)

High-low method: A technique that determines the fixed and variable portions of a mixed cost using only

the highest and lowest levels of activity within the relevant range

Independent variable: A variable that, when changed, will cause consistent, observable changes in

another variable; a variable used as the basis of predicting the value of a dependent variable

Least squares regression analysis: A statistical technique that analyzes the relationship between

independent (causal) and dependent (effect) variables in order to develop an equation that can be used

to predict the dependent variable; the method determines the line of “best fit” for a set of observations by minimizing the sum of the squares of the vertical deviations between actual points and the regression line; the method is used to determine the fixed and variable portions of a mixed cost

Multiple regression: A statistical technique that uses two or more independent variables to predict a

dependent variable

Normal capacity: The long-run (5–10 years) average production or service volume of a firm; normal

capacity represents an attainable level of activity since it takes into consideration cyclical and seasonal fluctuations; normal capacity is required by generally accepted accounting principles

Normal costing: An alternative to actual costing, this costing system assigns to WIP Inventory the actual

costs of direct material and direct labor but an estimated amount of manufacturing overhead

Outlier: Abnormal or non-representative observations within a data set that should be disregarded when

analyzing a mixed cost

Overapplied overhead: The credit balance in the overhead account that remains at the end of the period

when the amount charged (applied) to production (i.e., debited to Work in Process) exceeds the actual amount of overhead incurred

Phantom profit: A temporary absorption costing profit caused by producing more inventory than is sold Practical capacity: The physical production or service volume that a firm could achieve during normal

working hours (i.e., theoretical capacity less ongoing, regular operating interruptions such as start-up time, and down time due to machine maintenance and holidays, for example)

Product contribution margin: The difference between the selling price and variable manufacturing cost

of goods sold; this amount excludes non-manufacturing variable costs

Regression line: Any line that goes through the means (or averages) of the independent and dependent

variables in a set of observations; mathematically, however, there is a line of “best fit”, which is the least squares regression line

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

dependent variable

Theoretical capacity: The estimated maximum production or service volume that a firm could achieve

during a period disregarding realities such as machine breakdowns and reduced or stopped plant

operations on holidays

Underapplied overhead: The debit balance in the overhead account that remains at the end of the

period when the amount of overhead charged (applied) to production (i.e., debited to Work in Process) is less than the actual overhead incurred

Variable costing: A cost accumulation and reporting method that includes only variable production costs

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

Volume variance: The monetary impact of the difference between the budgeted capacity used to

determine the fixed overhead application rate and the actual capacity at which the company operates

Lecture Outline LO.1 Why and how are overhead costs allocated to products and services?

A Introduction

1 This chapter discusses normal costing and its use of predetermined overhead rates to determine product cost Separation of mixed costs into variable and fixed elements, flexible budgets, and various production capacity measures are also discussed Finally, the chapter discusses two methods of presenting information on financial statements: absorption and variable costing

2 Overhead consists of all non-direct material and non-direct labor costs incurred in the production area and in selling and administrative departments

3 Historically, direct material and direct labor were the manufacturer’s primary costs but today such firms have begun to invest more heavily in automation which has led to an increasing significance

of overhead costs

4 Overhead presents a costing problem since it cannot be traced directly to distinguishable outputs

B Normal Costing and Predetermined Overhead

1 General

a Normal costing is an alternative costing system to actual costing

b As shown in text Exhibit 3-1 (p 67) normal costing differs from actual costing in that normal

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

c There are four primary reasons for using predetermined overhead rates in product costing:

i A predetermined overhead rate allows overhead to be assigned during the period as goods are produced or sold and services rendered thus providing more timely information;

ii Predetermined overhead rates adjust for variations in actual overhead costs that are unrelated to activity For example, electricity costs run higher in the summer because of the costs of air conditioning;

iii Predetermined overhead rates overcome the problem of fluctuations in activity levels that have no impact on actual fixed overhead costs Since unit fixed costs vary with activity level changes, a uniform annual predetermined overhead rate for all units produced during the year is needed to avoid significant variations in unit costs during the period; and

iv Using predetermined overhead rates allows managers to be more aware of individual product or product line profitability as well as the profitability of doing business with a particular customer or vendor

2 Formula for Predetermined Overhead Rate

a Overhead is assigned to production (i.e., charged or debited to Work in Process) using a predetermined rate computed as follows:

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

Volume of Specified Activity Level

b Overhead is typically budgeted for one year although a longer period may be used by some companies (e.g., ship builder)

c To allocate overhead effectively to heterogeneous products or services, a measure of activity that is common to all output must be selected

d The activity base should be a cost driver that directly causes the incurrence of overhead costs

e Common activity bases include direct labor hours, direct labor dollars, and machine hours Other activity bases could include:

i Number of purchase orders;

ii Physical characteristics such as tons or gallons;

iii Number of, or amount of time used for performing, machine setups;

iv Number of parts;

v Material handling time;

vi Product complexity; and

vii Number of product defects

3 Applying Overhead to Production

a The journal entries required under normal costing are identical to those made in an actual cost system with one exception: the amount of overhead applied to production

b Applied overhead is the amount of overhead assigned (charged, debited) to Work in

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

c The amount of applied overhead is determined as follows:

OH Applied = Actual Volume of Activity Level x the Predetermined OH Rate

d Increasingly, because overhead represents an ever-larger part of product cost in automated factories, firms are applying variable and fixed overhead using separate rates In this case, the general ledger will have separate variable and fixed overhead accounts as illustrated in

text Exhibit 3-2 (p 70)

i Accounts are credited as appropriate (e.g., Cash, Accounts Payable, Accumulated Depreciation, Pre-paid Insurance, etc.)

LO.2 What causes underapplied or overapplied overhead and how is it treated at the end of a period?

f Actual overhead incurred during a period will rarely equal applied overhead

i Underapplied overhead is the debit balance in the overhead control account that

remains at the end of the period when the applied overhead is less than the actual overhead

ii Overapplied overhead is the credit balance in the overhead control account that

remains at the end of the period when the applied overhead is greater than the actual overhead

g Two factors cause underapplied or overapplied overhead:

i A difference between actual and budgeted overhead costs (numerator differences); and

ii A difference between actual and budget activity levels (denominator differences)

4 Disposition of underapplied or overapplied overhead

a Since overhead accounts are temporary accounts, their ending balances must be closed at the end of the accounting period

b The method of disposition of underapplied or overapplied overhead depends upon the materiality of the amount involved

i If immaterial, the ending balances in the overhead control accounts are closed entirely to

Cost of Goods Sold Text Exhibit 3-3 (p 71) illustrates the impact of

under-and-over-applied overhead on Cost of Good Sold expense

ii If material, the ending balances in the overhead control accounts should be prorated to the accounts containing applied overhead: Work in Process Inventory, Finished Goods

Inventory, and Cost of Goods Sold Text Exhibit 3-4 (p 72) illustrates the proration of

overapplied fixed overhead

LO.3 What impact do different capacity measures have on setting predetermined overhead rates?

5 Alternative Capacity Measures

a The choice of activity level (i.e., the denominator in the predetermined OH rate equation) impacts the amount of underapplied and overapplied overhead

i Theoretical capacity is the estimated maximum production or service volume that a firm

could achieve during a period, disregarding realities such as machine breakdowns and reduced or stopped plant operations on holidays

ii Practical capacity is the physical production or service volume that a firm could achieve

during regular working hours with consideration given to ongoing, expected operating interruptions

iii Normal capacity is the long-run (5–10 years) average production or service volume of a

firm that takes into consideration cyclical and seasonal fluctuations

iv Expected capacity is a short-run concept that represents the anticipated level of

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

b If actual results are close to budgeted results (in both dollars and volume), expected capacity should result in product costs that most closely reflect actual costs and thus result in

immaterial amounts of underapplied and overapplied overhead

i Unless otherwise noted in the text, overhead rates are based on expected capacity

ii The level selected for use in computing predetermined overhead rates is often referred to

as the Denominator Level

c See text Exhibit 3-5 (p 74) for a visual representation of measures of capacity

i Note that expected capacity and practical capacity may be closer to equal than depicted

in the exhibit, especially in highly automated factories

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

C Separating Mixed Costs

1 General

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

b Accountants assume that costs are linear rather than curvilinear

i Therefore, the general formula for a straight line can be used to describe any cost within

a relevant range of activity:

y = a + bx Where:

y = total cost (dependent variable)

a = fixed portion of total cost (y-intercept)

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

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

c A fixed cost remains constant in total within the relevant range of activity under consideration

i The linear formula for a fixed cost is y = a

d A variable cost varies in total as production changes, but the cost per unit remains constant

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

e Mixed costs contain both a variable and a fixed cost element

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

2 The High-Low Method

a The high-low method is a technique for determining the fixed and variable portions of a

mixed cost by using only the highest and lowest levels of activity and related costs within the relevant range

b The method determines the variable cost per unit b as follows:

Cost at High Activy Level – Cost at Low Activity Level

b = High Activity Level – Low Activity Level Changes in Total Cost

b = Changes in Activity Level

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

either the high or low activity level:

a = y – bx

where: y = total cost for either one of the observations used to determine b

x = activity volume of the observation used to determine y

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

discarded when applying the high-low method

e Text Exhibit 3-6 (p 76) illustrates the high low method

f Two potential weaknesses of the high-low method are that outliers can inadvertently be used and the method uses only two data points (observations) to determine the cost equation

3 Least Squares Regression Analysis

a Ordinary Least Squares (OLS) regression is a statistical technique that analyzes the

association between dependent and independent variables

i A dependent variable (cost) is an unknown variable that is to be predicted using one or

more independent variables

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

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

b OLS determines the line of “best fit” for a set of observations by minimizing the sum of the squares of the vertical deviations between actual points and the regression line

c When multiple independent variables exist, the least squares method can be used to select the best predictor of the dependent variable based on which independent variable has the highest correlation with the dependent variable

d Simple regression is a statistical technique that uses only one independent variable to predict a dependent variable while multiple regression uses two or more independent

variables to predict a dependent variable

e A regression line is any line that goes through the means (or averages) of the set of

observations for an independent variable and its dependent variables

i As depicted in text Exhibit 3-7 (p 77), mathematically, there is a line of “best fit” which is referred to as the least squares regression line (the red line in Graph B)

ii It is possible for a least squares regression line not to pass through any of the actual observation points since the line has been determined mathematically to best fit the data

f OLS can be used to determine the fixed and variable portions of a mixed cost

i The equations needed to compute the variable cost per unit (b) and total fixed cost (a) are provided and illustrated in the text on pages 77-78

g The following considerations are important when using the OLS model:

i For regression analysis to be useful, the independent variable must be a valid predictor of the dependent variable; this relationship can be tested by computing the coefficient of correlation;

ii OLS should only be used within a relevant range of activity; and

iii The OLS model is useful only as long as the circumstances existing at the time of its development remain constant

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

4 Flexible Budgets

a A flexible budget is a planning document that presents expected variable and fixed

overhead costs at different levels of activity within a relevant range

b Estimated variable costs at a given activity level may be computed by multiplying the variable cost per unit by the activity level volume

c See text Exhibit 3-8 (p 79) for an example of a flexible overhead budget

5 Plantwide versus Departmental Overhead Rates

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