Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 73

Managing Earnings, Denominator Capacity-Level, and Ethics Any given cost-information system is a function of a number of design choices. For product-costing purposes, one such design choice relates to how overhead, particularly fixed manufacturing overhead, application rates are determined. As controller for your company, you have been asked to prepare a written presentation for an upcoming meeting of the board of directors of your company. In preparing this assignment, assume that board members are reasonably knowledgeable about financial-reporting issues, but not necessarily about the intricacies of cost accounting systems. As you construct your document, feel free to consult outside references in addition to the material in your text. You can assume that this document is meant as a formal presentation to members of the board. Thus, your writing should be concise, clear, and reflective of proper grammar and construction.

Required Prepare, in proper form, a memo for the board that addresses the following issues:

1. Explain how manufacturing overhead rates are constructed in conventional cost accounting systems. Speak separately about fixed versus variable overhead application rates. What key choices must be made in establishing these rates? In answering this question, you might want to discuss differences (if any) between current IRS (income tax) requirements and internal reporting purposes, and between financial reporting requirements (e.g., FASB ASC 330-10-30, previously SFAS No. 151—available at www.asc .fasb.org) and internal reporting purposes.

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2. Your company uses a standard cost system. As such, at the end of each period it must “clean up” the accounts by disposing of any standard cost variances that occurred for the period. You need to educate members of the board about how the variances for fixed manufacturing overhead are disposed of at the end of the period. In your answer, pay particular attention to the following two financial-reporting issues: (a) the requirements of FASB ASC 330-10-30, and (b) how, under absorption costing, reported earnings can be “managed” by choice of the denominator volume used to establish the fixed overhead application rate.

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3. Access the Institute of Management Accountant’s Statement of Ethical Professional Practice ( www. imanet.org/about_ethics_statement.asp). Which of the stated standards relate directly to the issue of setting (fixed) overhead application rates and the decision as to how any resulting production-volume variances are disposed of for financial-reporting purposes? Be specific.

Step 1 of 3

Managing Earnings, Denominator Capacity-Level, and Ethics (45-60 Minutes)

1.?Predetermined overhead application rates (for both normal cost systems and standard cost systems) are developed prior to the operating period. These rates are predetermined in the sense that they rely on two pieces of estimated information.

?The estimated variable overhead cost rate per unit of activity can be determined on the basis of the cost-estimation techniques discussed in Chapter 8. The fixed component requires an estimate of all capacity-related (i.e., short-term fixed) manufacturing support costs. These costs provide the capacity or ability to produce, but are unrelated to actual volume of activity. Estimated fixed overhead costs are then divided by some denominator activity level (viz., budgeted activity, theoretical capacity, practical capacity, or normal capacity): budgeted costs (numerator) and budgeted activity level (denominator). Budgeted fixed costs divided by a specified activity variable, at a particular denominator volume, produces the budgeted fixed overhead that along with the budgeted variable overhead cost rate can be used to assign indirect manufacturing costs to outputs during the period.

?Under an ABC system the process is conceptually the same. The primary difference is the use under ABC of multiple manufacturing support cost pools, each of which has its own cost driver. These cost drivers in conventional ABC systems are of the following variety: unit-level, batch-level, and product-sustaining. Under Time-Driven ABC (TDABC) each process or department creates its own cost-allocation rate, based on the amount of time available in that process or department.

?For the determination of the fixed overhead component of predetermined overhead costs in conventional cost systems, and for the determination of cost-allocation rates under ABC systems (both traditional and Time-Driven), a critical assumption is choice of the denominator volume level. Since cost-allocation rates are determined using both a numerator and a denominator value, choice of the denominator volume level (over which fixed overhead costs are spread) directly affects the predetermined rates.

?For financial reporting purposes, GAAP (FASB ASC 330-10-30-3, previously SFAS 151: Inventory Costs—An Amendment of ARB No. 43, Chapter 4, and available at: www.fasb.org) specifies that normal capacity be used as the denominator volume for purposes of allocated fixed overhead costs to outputs. GAAP further specifies that “normal capacity refers to a range of production levels.” Alternatively, “normal capacity” can be viewed as the level of production expected over a number of periods.

?The Internal Revenue Code (IRC) does not deal directly with the issue of the choice of the denominator volume level for purposes of allocating indirect manufacturing costs to inventory. This issue is, however, dealt with in the Treasury Department Regulations. Reg. §1.263A specifies only that the chosen method “reasonably allocates indirect costs among production … activities.” Reg. §1.471-11 (“Inventories of Manufacturers”) does not specify how the denominator volume is to be defined. It

?does say, however, that when practical capacity is used to set fixed overhead rates, then allocated cost (to outputs) equals the ratio of actual output to practical capacity. Further, this Regulation stipulates that any resulting fixed overhead variance, when the fixed overhead rate is based on practical capacity, can be written off as a period cost (rather than being pro-rated across inventories and CGS).

?The instructor can make the point that we may observe differences across managerial, tax, and financial-reporting requirements as regards the setting of predetermined fixed overhead rates. The managerial accountant can add value to his/her organization by keeping abreast of the differential requirements (or convergence of these requirements) over time.