3 the effect of under and overapplied overhead on net

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3. The Effect of Under- and Overapplied Overhead on Net Operating Income . a. If overhead is underapplied, less overhead has been applied to inventory than has actually been incurred. Enough overhead must be added to Cost of Goods Sold (and perhaps ending inventories) to eliminate this discrepancy. Since Cost of Goods Sold is increased, underapplied overhead reduces net income. b. If overhead is overapplied, more overhead has been applied to inventory than has actually been incurred. Enough overhead must be removed from Cost of Goods Sold (and perhaps ending inventories) to eliminate this discrepancy. Since Cost of Goods Sold is decreased, overapplied overhead increases net operating income. E. The Predetermined Overhead Rate and the Level of Activity (Appendix 3A). (Exercise 3-16.) Interest has been recently rekindled in the issue of how to select the denominator level of activity in the predetermined overhead rate. In the main body of the chapter, it is assumed that the denominator is the estimated total amount of the allocation base for the period. While this is the most common method used in practice, it has some serious drawbacks. 1. Drawbacks of basing the predetermined overhead rate on the estimated level of activity. a. If overhead contains substantial fixed costs, then as the estimated level of activity decreases, the predetermined overhead rate will increase. Thus if the company starts losing sales due to a recession or other reason, the company’s unit costs will increase. This could result in some managers increasing prices or dropping products, which is likely to be exactly the wrong thing to do in this situation. b. Products are charged with resources they don’t use. If a product uses 10% of the capacity of a fixed resource, it is argued that it should be charged with only 10% of the cost of that resource. If all of the products a company makes use only 50% of the capacity of the fixed resource, the cost of that idle capacity should be separately recognized as a period expense rather than spread over the products that use the resource during the period. Under the conventional approach, products are charged for both their share of the capacity they use and for a share of the idle capacity they do not use. So if a product uses 10% of the capacity of a resource, but 50% of the capacity is 13
MANAGERIAL ACCOUNTING - IIE 211 CLASS 4 idle, then under the conventional approach the product would be charged with 20% of the total cost of the resource. CHAPTER ASSIGNMENTS   Exercise 3-1 INTL 3-1 (10 minutes) a. g. b. h. c. i. d. j. e. k. f. l. *  Some of the companies listed might use either a job-order or a  process costing system, depending on how operations are carried  out. For example, a chemical manufacturer would typically operate  with a process costing system, but a job-order costing system  might be used if products are manufactured in relatively small  batches. The same thing might be true of the tire manufacturing  plant in item “j.” Exercise 3-3  (10 minutes) INTL 3-5

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