Chapter 10
Standard Full Absorption Costing
James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
MAAW's Textbook Table of Contents
After you have read and studied this chapter, you should be able to:
1. Explain the difference between the accounting concept of control and statistical process control.
2. Discuss the various types of standard costing in terms of the timeliness and completeness of the information provided.
3. Explain how direct materials costs are recorded and analyzed in a standard costing, including the required variance calculations and journal entries.
4. Describe two ways to record and analyze direct materials price variances.
5. Discuss the meaning, causes, tradeoffs and criticisms of direct materials price and quantity variances.
6. Explain how direct labor costs are recorded and analyzed in a standard costing, including the required variance calculations and journal entries.
7. Discuss the meaning, causes, tradeoffs and criticisms of direct labor rate and efficiency variances.
8. Explain how variable overhead costs are recorded and analyzed in a standard costing.
9. Explain the usual, or traditional interpretation of the variable overhead variances and discuss the validity of this interpretation.
10. Explain how fixed overhead costs are recorded and analyzed in a standard costing.
11. Discuss the meaning of the fixed overhead variances.
12. Discuss the behavioral problems associated with standard costs variance analysis and the potential conflict between this accounting control methodology and the lean enterprise concepts of
JIT and TOC.
Learning objectives for Appendix 10-1:
13. Solve standard costs problems in a process costing environment.
14. Calculate and explain the meaning of direct material mix and yield variances.
15. Explain several alternative ways to analyze overhead costs.
The main purposes of a cost accounting system include providing product costs for both internal and external purposes as well as information for performance evaluation and control of the various aspects of operations (See Exhibit 2-4). However, the information needed in a top-down authoritarian management system is quite different from the needs in a bottom-up system emphasizing employee empowerment and self managed teams. Traditional standard cost accounting systems were designed to provide the needed information through 1) product costing, and 2) the accounting concept of cost control. Remember that control over a cost, or the activity that drives the cost, means to influence, or regulate the cost or activity to keep it within an acceptable range. One way to apply this concept is to use the statistical process control (SPC) approach illustrated in Chapter 3. In SPC, control limits are established to indicate when a process measurement is in control (i.e., results from a common, or system cause) or out of control (i.e., results from a special cause). Another way to apply the control concept is to use standard costing1, although it is a less precise form of control because it does not explicitly recognize the concept of variability. Developing upper and lower control limits is not part of the standard cost methodology. To understand the difference between accounting control and statistical process control, it is helpful to think of standard cost control as more of a macro concept, while statistical process control is a micro concept. SPC is normally used to control specific processes at the operator level by plotting real time process measurements. On the other hand, standard cost control is best used at the middle management level as an overall monitoring device where monthly aggregated actual costs are compared with estimates of what these costs should have been. Standard costing can create problems if it is used as a way to micro manage in a top down fashion, particularly for companies that are adopting the bottom-up, employee empowerment, self managed team concepts associated with just-in-time and the theory of constraints. Of course, these problems are closely related to the controversies discussed in Chapter 8 in connection with activity based management (ABM) and in Chapter 9 in connection with responsibility accounting. The controversy in Chapter 8 is over whether or not the cost dimension of the ABM model should connect with the activity management dimension. The controversy in Chapter 9 involves whether the individualistic nature of responsibility accounting is compatible with the team oriented lean enterprise concepts of JIT and TOC. In this chapter we extend those issues to consider some of the undesirable behavior associated with standard cost control and some ways to avoid, or reduce these behavioral conflicts.
The purpose of this chapter is to: 1) discuss the various types of standard costing, 2) to show how standard costs are used to value inventory and measure performance and 3) to discuss a variety of potential behavioral problems associated with standard cost control and the controversial issues involved. The chapter is divided into six sections, plus some appendix materials. The first section provides a short discussion of the different types of standard costing in relation to when the standard costs are recorded. The next three sections illustrate how to record and analyze direct materials, direct labor and variable overhead costs using the standard cost methodology. These sections include discussions of potential behavioral problems associated with these methods. Section four also includes a discussion of the traditional interpretation of variable overhead analysis and the potential for misinterpretation. The fifth section is devoted to the accounting and analysis of fixed overhead costs, while the last section summarizes the controversial question over the compatibility of standard costing with the lean enterprise concepts of just-in-time and the theory of constraints. Appendix 10-1 provides a discussion of standard costing in a process costing environment, illustrates an extension of direct materials cost analysis referred to as material mix and yield variances, and provides some alternative methods for analyzing overhead variances. These topics are placed in an appendix because they are extensions of standard costing that sometimes appear on the professional exams (e.g., CPA, CMA), although they are not needed to obtain a basic understanding of the standard cost methodology.
There are many ways to use standard costing in terms of the timeliness and completeness of the information recorded. However, it is convenient to separate standard costing into two general categories: 1. complete methods, and 2. partial methods. The difference between these concepts is illustrated in Exhibit 10-1.
Complete Standard Cost Methods
When a complete standard cost method is used, standard costs are charged to work in process (WIP). The differences between actual and standard costs are charged to variance accounts. This method is illustrated in the top section of Exhibit 10-1 where the materials, payroll and overhead accounts are aggregated into a summary account to simplify the illustration. The debits to WIP represent the standard costs allowed for all finished and partially finished units during the period. The credits to the materials, payroll and factory overhead accounts represent the cost of all work performed during the period. This method is said to be complete because all work performed during the period is represented and evaluated in the performance measurements, i.e., variance analysis.
Partial Standard Cost Methods
When a partial method is used only part of the productive work performed during the period is evaluated during the period. In the partial method illustrated in the middle section of Exhibit 10-1, actual costs are charged to work in process. Standard costs are not recorded until the completed units are transferred to finished goods. Variances are calculated and recorded at the time of the transfer. This is a partial method because the work remaining in WIP is not evaluated. From the performance measurement point of view, a complete standard cost method is better because: 1) it identifies the variances or differences between actual costs and standard costs in a more timely manner and 2) the variances are based on all productive work performed during the period, not just the work performed on the completed units.
Another partial method is illustrated in the bottom section of Exhibit 10-1. In this approach, actual costs flow into finished goods. Then standard costs are charged to cost of goods sold and the variances are recorded at the time of sale. The credit to finished goods represents the actual cost of the units sold. One reason for using this method is to avoid having to adjust the inventory accounts from standard to actual costs for external reporting purposes. However, for internal evaluation and control purposes this is even less useful than the second method illustrated, because only the work performed on the units sold is evaluated. Again, from a performance evaluation perspective, it is better to evaluate all productive work, not just the work performed on the units completed as in the first partial method, or only the work performed on the units sold as in this approach. For this reason, the illustrations in this chapter are based on a complete standard cost method, rather than either of the partial methods.
Other Uses of Standard Costs
There are some other ways to use standard costs. As noted in Chapter 8, backflush accounting usually relies on standard costs for the amounts charged back to the inventory accounts at the end of the period. Backflush cost accumulation methods might be thought of as partial methods, although they are simplified with little, or no variance analysis. Another approach involves using standard cost as a control device without recording the standard costs in the accounts. In this approach variance analysis is performed to provide information for management, but normal historical costing is used in the general ledger.
Cost Flow and Analysis in Complete Standard Costing
The following pages include illustrations of how each type of manufacturing cost is recorded and analyzed using a complete standard cost method. Several types of illustrations are presented to help you see the concepts and techniques from different perspectives. First, a T-account approach is presented to provide a comprehensive view of the product costing and variance analysis involved. T-accounts are very useful for organizing and working comprehensive standard cost problems. The generic set of accounts introduced in Chapter 4, in connection with normal historical costing, is also used in this chapter, although some additional accounts are needed for the variances. This generic standard cost account structure appears in Exhibit 10-2.
Exhibit 10-2 includes eight variance accounts along with the usual generic accounts used in normal historical costing. There are two variances for direct materials (DM). These include the direct materials price variance and the direct materials quantity variance. Since a cost always involves a price and a quantity, the idea is to isolate (analyze or separate) the effects of differences between actual and standard prices from the effects of differences between actual and standard quantities. The same idea is used to analyze direct labor (DL) costs, although the DL variances are frequently referred to as the DL rate variance and DL efficiency variance. The analysis of factory overhead (i.e., indirect resource) costs is less precise because the individual prices and quantities of the various types of indirect resources are not captured by traditional cost accounting systems. However, there are a variety of ways to analyze factory overhead costs. The four overhead variances that appear in Exhibit 10-2 provides one possibility. These include the variable overhead (VO) spending variance, VO efficiency variance, the fixed overhead (FO) spending variance and the production volume variance. As we shall see later in this chapter, the overhead variances are not price and quantity variances and are much more difficult to interpret in any meaningful way.
The illustrations in this chapter extend the Expando Company problem illustrated in Chapter 9 to provide a comprehensive illustration of the planning and control aspects of accounting systems. In addition to the T-account approach, the costs and variances are recorded using general journal entries. Variance analysis is also illustrated for each type of cost using equations, flexible budget diagrams and graphs. Each approach provides a different view of the analysis to help you strengthen your understanding of the mechanics and concepts associated with standard cost systems.
The following symbols are used below to illustrate how direct material costs are recorded and analyzed in standard costing.
AQP = Actual quantity of direct material purchased.
AQU = Actual quantity of direct material used in production.
SQA = Standard quantity of direct material allowed for the good output. Good units produced multiplied by the standard quantity per unit.
AP = Actual price of material per unit of measure, e.g., pounds, gallons, board feet.
SP = Standard price of material per unit of measure.
There are two methods of evaluating material prices and recording direct materials costs in the perpetual inventory accounts. These include:
1. Recording the material price variance when material is received, i.e., based on the quantity purchased. This means that direct materials purchases are charged to materials control at standard prices and the direct materials price variance is recorded when the purchase is recorded. Then the direct material quantity variance is recorded when direct materials are used.
2. Recording the material price variance when material is used, i.e., based on the quantity used in production. This means that direct materials purchases are charged to materials control at actual prices. Then both the direct materials price variances and direct materials quantity variances are recorded when the material is used.
EXAMPLE 10-1
Recall from Chapter 9 that the Expando Company uses a type of pressed wood referred to as particle board to produce entertainment centers. Other materials, such as glue and screws are viewed as insignificant and are charged to overhead as indirect materials. The information needed to record direct materials purchases and usage is given below.
Standard price = $10 per particle board sheet. (Each sheet is 3/4" by 4' by 8')
Standard quantity allowed per unit = 2 sheets
Direct material purchased = 22,000 sheets at $10.20 per sheet
Direct material used = 20,050 sheets
Units of output (entertainment centers) produced = 10,000
METHOD 1: DM PRICE VARIANCE BASED ON QUANTITY PURCHASED
The T-account Approach
Direct material purchases and usage are recorded and analyzed in T-accounts in Exhibit 10-3. The 22,000 sheets of direct material purchased are charged to materials control at the standard price (SP) of $10, although the actual price (AP) is $10.20 per sheet. As a result, the debit to materials control is $4,400 less than the credit to accounts payable. This difference represents an unfavorable materials price variance.
The WIP account is charged with the standard materials cost of the 10,000 units produced. The standard quantity allowed (SQA) is 20,000 sheets, i.e., 2 sheets multiplied by 10,000 units. Thus, the debit to WIP is for 20,000 sheets at the standard price of $10 per sheet, or $200,000. Since direct materials flow through the materials control account at standard prices, the difference between the debit to WIP and the credit to materials control results solely because of the difference between the actual quantity of material used and the standard quantity allowed. In this case the $500 difference represents an unfavorable materials quantity variance since the company used 50 sheets more material (20,050 - 20,000) than the standard allowed.
The Equation Approach
The variances are easy to calculate and record using the T-account approach because they are the differences between the debits and credits to the original generic set of accounts. Mechanically, the variances represent a bookkeeping tool to insure that the debits and credits are equal. As a result, the calculations that appear in the variance T-accounts in Exhibit 10-3 are not needed except to check, or validate the accuracy of the entries. If you look closely you will see that the T-account analysis shows that each variance calculation can be performed in two ways using the following equations:
Material Price Variance = (AP)(AQP) - (SP)(AQP) or (AP-SP)(AQP)
Material Quantity Variance = (SP)(AQU) - (SP)(SQA) or (AQU-SQA)(SP).
Comparing the first form of each equation to the entries in Exhibit 10-3 shows that the variances are simply the differences between the credits and debits in the accounts payable, materials control and work in process accounts. While the short form of each equation is used in Exhibit 10-3, the longer form of each equation is used below in the Flexible budget diagram approach.
The Journal Entry Approach
General journal entries provide a somewhat more formal approach for recording and analyzing direct materials costs. The entries to record materials purchases and usage for the example above are presented in Exhibit 10-4.
| EXHIBIT 10-4 Journal Entries When DM Price Variances are Based on Quantity Purchased |
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| Entry to record direct material purchases | Materials control | 220,000 | |
| Direct material price variance | 4,400 | ||
| Accounts payable | 224,400 | ||
| Entry to record direct material usage | Work in process | 200,000 | |
| Direct material quantity variance | 500 | ||
| Materials control | 200,500 | ||
Flexible Budget Diagram Approach
Although the mechanics of standard costing are adequately illustrated with T-accounts, journal entries and equations, the concepts are somewhat more illusive. Conceptually the variances represent an attempt to evaluate materials costs by isolating the effects of price and quantity differences. The flexible budget diagram in Exhibit 10-5 provides a more revealing way to emphasize these performance measurement concepts.
The difference between the actual cost of direct material purchased (A) and a flexible budget based on actual quantity purchased (B) is the material price variance. The flexible budget (B) represents an estimate of what the purchase costs should have been. The flexible budget (B) is the debit to the materials control account. The actual cost (A) is the credit to accounts payable. The difference between the debit and credit is the performance measurement, i.e., the price variance.
Be careful with the term flexible budget. Every time the standard price of a variable input is multiplied by any quantity of the input, the result is a flexible budget. In fact, there are three flexible budgets included above. The direct material quantity variance is the difference between a flexible budget based on actual quantity used (C, which is also the credit to materials control) and a flexible budget based on standard quantity allowed (D, which is the standard material costs charged to work in process). When the entries are made, flexible budgets are used to record and provide a way to evaluate the costs simultaneously.
Graphic Approach
A graphic approach provides a different way to place emphasis on the flexible budgets and concepts involved. Consider Figure 10-1. Point A represents the actual cost of material purchases. Points B, C and D represent the three flexible budgets that all fall on the flexible budget line. The slope of the flexible budget line is the standard price (SP). The fact that point A does not fall on the flexible budget line means that the actual price must be different from the standard price. Therefore, the vertical difference between points A and B represents the material price variance based on quantity purchased. The vertical difference between points C and D represents the material quantity variance.
METHOD 2: DM PRICE VARIANCE BASED ON QUANTITY USED
T-account Approach
In the second method of evaluating material prices, the price variance is based on the quantity of material used in production, rather than the quantity purchased. This means that direct materials are charged to materials control at actual, rather than standard prices. Then, both the price and quantity variances are calculated when materials are charged to work in process. This approach is illustrated in Exhibit 10-6. The debit to work in process is the same as in the previous example. However, the credit to materials control is based on the actual price of $10.20. The difference between the debit to WIP and the credit to materials control represents the total mixed price and quantity variance of $4,510. Thus, both variances must be calculated separately and recorded when standard costs are charged to the WIP account. In this method the DM price variance is only $4,010, rather than $4,400 as in the previous example because the unused material is not considered in the performance measurement.
The Equation Approach
The equations for the DM price variance based on quantity used are:
Material Price Variance = (AP)(AQU) - (SP)(AQU) or (AP-SP)(AQU)
The difference between these equations and the previous price variance calculations is that the actual quantity used (AQA) replaces the actual quantity purchased (AQP). Although (AP)(AQU) represents the credit to materials control, (SP)(AQU) does not represent the debit to WIP. This is because the entry to WIP involves both price and quantity variances.
The quantity variance calculations are the same regardless of how the price variance is calculated. Therefore, the equations for the material quantity variance are not restated here. Comparing Exhibits 10-3 and 10-6 is a good way to see the similarities and differences between the two methods.
Journal Entries
The entries to record the materials purchases and usage when the price variance is based on quantity used are presented in Exhibit 10-7.
| EXHIBIT 10-7 Journal Entries When DM Price Variances are Based on Quantity Used |
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| Entry to record direct materials purchases | Materials control | 224,400 | |
| Accounts payable | 224,400 | ||
| Entry to record direct material usage | Work in process | 200,000 | |
| Direct material price variance | 4,010 | ||
| Direct material quantity variance | 500 | ||
| Materials control | 204,510 | ||
Flexible Budget Diagram Approach
The diagram in Exhibit 10-8 emphasizes the flexible budgets involved in the analysis above. Only two flexible budgets are used in this approach. Since the total variance for direct material is the difference between actual and standard costs (A' and D), the flexible budget based on actual quantity used (C) separates the total variance of $4,510 into two parts to isolate the effects of price and quantity differences.
The Graphic Approach
The relationships in the analysis above are also illustrated in the graphic approach presented in Figure 10-2. The total variance is the vertical difference between points A' and D. Since the actual costs, represented by point A' do not fall on the flexible budget line, the actual price must be different from the standard price. The vertical difference between points A' and C represents the material price variance based on quantity used. Points A and B are no longer relevant because they are based on the quantity purchased. The vertical difference between points C and D (two points on the flexible budget line) represents the materials quantity variance. The quantity variance is the same as in Figure 10-1.
From a control perspective, recording material price variances based on the quantity purchased provides several advantages over the second method. These include the following:
1. The entire price variance is calculated in Method 1, i.e., based on all materials purchased. In Method 2, the price variance is only calculated for the material used. However, obtaining the best price for materials is a purchasing function, not a responsibility of the production manager. Therefore, it is logical to calculate the price variance on the basis of the entire quantity purchased. This is consistent with the concept of responsibility accounting discussed in Chapter 9.
2. Using quantity purchased means evaluating prices at the time the materials and invoice are received. This is more timely than waiting until materials are charged into work in process. The idea is that if a cost is out of control, it is better to find out sooner, rather than later, so corrective action can be taken as soon as possible.
3. Using quantity purchased means comparing current period standard prices with current period actual prices. If the quantity used is the basis of the evaluation, then materials are charged into materials control at actual prices. This means that a cost flow assumption (FIFO, average cost, or LIFO) will determine which actual prices are compared with the current period standard prices. In some cases prior period actual prices may be compared with current period standard prices. This is not a very meaningful or useful comparison. Determining the credit to materials control is also more difficult when several inventory layers exist, i.e., layers of materials that were purchased at different prices.
In summary, Method 1 provides more complete, more timely and more relevant information concerning the purchasing function than Method 2. A disadvantage of method 1 is that the materials control account would need to be adjusted to actual cost periodically for external reporting purposes.
Direct Material Variance Causes and Tradeoffs
A conceptual view of direct material cost drivers is presented in Exhibit 10-9. The illustration shows that materials costs are driven by prices and quantities, which in turn are driven by many other factors. Prices are driven by the supply and demand for the materials involved, the quality and quantity of the materials purchased and other factors such as services included by the vendor, the negotiating skills of buyers and sellers and any contract specifications. Of course random variations in these factors are likely to cause a large percentage of the price fluctuations.
Price variances result when changes occur in any of the factors mentioned above that were not anticipated when the standards were established. For example, a price variance will normally result if the quality of the materials purchased is different from engineering specifications. Purchasing materials that are higher (or lower) in terms of design quality can produce unfavorable (or favorable) price variances. Favorable price variances can also be obtained by receiving quantity discounts for purchasing large quantities. Of course, purchasing more material than needed conflicts with the logic of JIT that focuses on the total cost of purchasing, handling, storing and using materials, not just the purchase price.
Material quantities are driven by product diversity, production volume, the productivity or yield associated with the materials and in some cases, material mix. The effects of product diversity (size and complexity) are reflected in the standard quantities allowed. Production volume variations are accounted for in the flexible budget used in the material quantity variance calculation. Therefore the major causes of material quantity variances are variations in materials productivity, or yield2 and material mix.
Responsibility for managing the quantity of material used is normally assigned to production management. However, before any attempt is made to identify the causes of a quantity variance, it is important to understand that most variances are caused by random variations in the system. It is best to think of any standard as a mean of acceptable outcomes that have upper and lower limits analogous to those on a control chart. Variances outside these limits (where the limits are based on management intuition and experience) are the only ones that might require additional attention. With this control concept in mind, there are some causes of a quantity variance that may require management attention. Low quality materials, in terms of conformance to specifications, (e.g., materials that become damaged easily, or dry up or evaporate more than expected) can cause unfavorable quantity variances. The purchasing department or vendor may be at fault in such cases. Direct labor might waste materials because of carelessness or inexperience. In addition, production equipment might damage materials if the equipment is not properly adjusted and maintained. This problem may be the responsibility of the machine operator, or the maintenance department, or a combination of both production workers and maintenance workers. Quantities may also vary beyond acceptable limits because of material mix differences. In some situations, different materials can be substituted for each other as in the case of many liquid products (e.g., beverages, soups cleaning fluids). These variations in the materials mix are influenced by the substitutability and availability of the various materials, as well as the skill and experience of the workers involved3.
An advantage of isolating price and quantity variances is that it allows for separate responsibility to be assigned. This is consistent with the responsibility accounting concept introduced in Chapter 9. However, a disadvantage is that isolating the variances for separate responsibility tends to ignore the fact that purchasing and production are interdependent. Purchasing inferior materials (low design quality) can cause favorable price variances, but result in unfavorable quantity variances. This can easily cause behavioral conflicts between purchasing and production employees. Purchasing higher quality materials (i.e., higher design quality) than required by the product specifications tends to have the opposite effect. The goal is to purchase the desired quality and quantity of material at the lowest price and to use it as efficiently as possible. Conceptually, the purpose of variance analysis is to constantly monitor whether or not this goal is being achieved.
To summarize the ideas in this section, the standard cost methodology recognizes that prices and quantities drive costs, but the typical analysis does not reveal the causes of the variances beyond that level. Variance analysis does not identify why actual prices and quantities are different from standard, only that they are different. From a practical standpoint, the benefits of developing routine analysis below the price and quantity level (see Exhibit 10-9) would not likely exceed the additional costs. However, when variances are outside an acceptable range established by management, they should be investigated and corrective action taken if it appears to be needed. When implementing this idea, management should take care not to blame workers for variations caused by the system. Corrective action refers to adjustments to eliminate special causes. Reduction in system variation requires an improvement in the system as explained in Chapter 3.
Behavioral Problems Associated With Direct Material Variances
In attempting to achieve favorable price variances, purchasing agents may purchase larger quantities of materials than needed to obtain quantity discounts. Too much emphasis on shopping around for the lowest price can also result in a lack of emphasis on quality (i.e., quality of conformance), excess inventory and an excessive number of vendors. On the other hand, too much emphasis on quantity variances at either the department or plant level can motivate production managers to push defective products to the next department, division, or to marketing. Of course this is inconsistent with the JIT concepts of demand pull, quality at the source (jidoka) and cross functional cooperation.
Main Disadvantage of the Traditional Analysis
The main disadvantage of the traditional variance analysis illustrated above is that only two of the aspects associated with total materials costs are included. As indicated in Chapter 8, overall materials costs include the costs of ordering, receiving, inspecting, unpacking, moving, storing, scheduling, reworking and returning defective materials to vendors, as well as the costs associated with price and quantity used. Therefore, from the lean enterprise perspective, the traditional analysis is too narrow and focuses on the wrong measurements. JIT advocates argue that the analysis should focus on the overall cost of materials and several non financial measurements to optimize the system, not the performance measurement for any particular function, department or subsystem.
The following symbols are used to illustrate how direct labor costs are recorded and analyzed in standard costing.
AR = Actual rate per hour.
SR = Standard rate per hour.
AHU = Actual direct labor hours used.
SHA = Standard direct labor hours allowed for the good output. Good units produced multiplied by the standard hours per unit.
EXAMPLE 10-2
This example extends the Expando Company illustration to include direct labor. The information needed to record and analyze direct labor cost is given below.
Standard direct labor rate per hour = $15
Standard direct labor hours allowed per unit = .4
Actual direct labor used = 4,100 hours at $15.15 per hour.
Units of output produced = 10,000
T-account Approach
Direct labor cost is recorded and analyzed in the manner illustrated in Exhibit 10-10. The entries and variance analysis for direct labor are very similar to the analysis of direct material costs under method 2, although the account titles and terminology are different. Actual direct labor costs of $62,115 are charged to the payroll clearing account and the liabilities for wages & salaries payable and the various withholding accounts are credited. Indirect labor costs and the details for withholding (e.g., federal and state income taxes and FICA) are ignored in this example to keep it simple.
Standard labor costs of $60,000 are charged to work in process based on 4,000 standard hours allowed (.4 hours per unit multiplied by 10,000 units) and a standard rate of $15 per hour. The credit to the payroll account is $62,115 since the actual direct labor cost just flow though the account. The difference between the debit to WIP and the credit to the factory payroll account represents the total direct labor cost variance. Therefore, the direct labor rate (or price) and efficiency (or quantity) variances must be calculated to complete the entry. Alternative equations are provided below for this purpose.
Equation Approach
The variances needed to complete the entries in Exhibit 10-10 can be calculated in two ways.
Direct Labor Rate Variance = (AR)(AHU) - (SR)(AHU) or (AR-SR)(AHU)
Direct Labor Efficiency Variance = (SR)(AHU) - (SR)(SHA) or (AHU-SHA)(SR)
The shorter form of each equation is used to obtain the variances in Exhibit 10-10. Since the company paid 15 cents more per hour than the standard allowed, the $615 rate variance is unfavorable. The efficiency variance is also unfavorable because 100 additional hours were used above the 4,000 standard hours allowed.
Journal Entries
The general journal entries to record the direct labor costs are presented in Exhibit 10-11. The first entry combines wages & salaries payable with the withhold accounts to simplify the example.
| EXHIBIT 10-11 Journal Entries to Record Direct Labor Costs |
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| Entry to record the payroll | Factory Payroll | 62,115 | |
| Wages & Salaries payable & withholding accounts | 62,115 | ||
| Entry to record direct labor usage | Work in Process | 60,000 | |
| DL rate variance | 615 | ||
| DL Efficiency variance | 1,500 | ||
| Factory Payroll | 62,115 | ||
Flexible Budget Diagram
The diagram in Exhibit 10-12 emphasizes the flexible budgets involved in the direct labor variance analysis.
Two flexible budgets are used to analyze direct labor costs, but one of them is the standard costs charged to work in process (D). The key is the flexible budget based on actual hours used (B) because it is used to separate the total variance of $2,115 into two parts, i.e., the rate and efficiency variances.
The Graphic Approach
The graphic illustration presented in Figure 10-3 emphasizes the two flexible budgets involved. Although this is the same approach referred to as Method 2 for direct material, the method is not subject to the same disadvantages discussed above for direct material. The reason is that the quantity of direct labor purchased is the same as the quantity of direct labor used, i.e., A = A'. Therefore, the flexible budgets based on the quantities purchased and used are the same as indicated by points B and C on the graph.
Direct Labor Variance Causes and Tradeoffs
A conceptual view of direct labor cost drivers is presented in Exhibit 10-13. Although a large number of labor rate and efficiency variances are likely to be caused by random variations, there are a number of other possibilities. The supply and demand for labor is always a factor in determining labor rates as well as the education, training and experience required to perform the work, the geographic location of the company and the rates negotiated by union contract. Changes in any of these factors that were not considered in establishing the standards can cause rate variances. In addition, where average rates are used for groups of workers, direct labor rate variances result when the actual mix of workers is different from the mix used to establish the standard rate. For example, higher or lower paid workers might be used in cases where there is a shortage of production workers with the required skills.
Labor quantities (hours) are driven by product diversity, production volume, labor productivity, or efficiency and labor mix. The effects of variations in product diversity (size and complexity) are reflected in the standard quantities allowed. Variations in production volume are accounted for by using flexible budgets in the efficiency variance calculations. Therefore, the main causes of labor efficiency variances are labor productivity and labor mix.
Efficiency variances occur when direct labor takes more (or less) time to produce the good output than the standard allows. Of course this can occur because the standards are either too tight or too loose. Unfavorable efficiency variances can occur when new inexperienced workers begin work, or when workers are not well motivated or poorly trained. Low quality material, inadequate equipment and equipment maintenance can also cause an excessive amount of labor time. In addition, direct labor efficiency variances are also influenced when the labor mix is different and individual rates, rather than average rates, are used in the variance calculations.4
There are also some tradeoffs between the direct labor rate and efficiency variances that can lead to behavioral conflicts. For example, poor hiring and training by the human resource function, can cause unfavorable labor efficiency variances that are used in the evaluation of production supervisors.
Variance analysis was designed to help management uncover the various problems mentioned above before they become too disruptive to efficient operations. It should be understood however, that if a company does not qualify vendors, and lacks strong hiring, training and preventive maintenance procedures, then the resulting variances are caused by the system and should not be blamed on lower level managers and individual workers. The fact that large unfavorable variances occur does not mean that the system is out of control. It may simply mean that the system is poorly designed. In such cases, reducing the variances requires changing the system.
Behavioral Problems Associated With Labor Variances
Placing too much emphasis on labor rate variances can motivate managers to use less qualified workers than needed, although the resulting unfavorable effect on the efficiency variance is a deterrent to that sort of behavior. However, a more serious problem is that labor efficiency variances tend to promote competitive behavior among lower level managers that can destroy the cooperation needed to optimize the system. Competitive behavior tends to occur when the variances are used to evaluate performance at the departmental level. To generate favorable efficiency variances, production managers are motivated to build excess inventory and push it downstream with little emphasis on quality. Of course this behavior violates the concepts of just-in-time and the theory of constraints. A way to promote cooperation, rather than competitive behavior, is to use variance analysis at the plant level to monitor overall operations, but not as a way to micro manage at the departmental level. At the department level, there are more important measurements that are process oriented rather than financial results oriented. Many of these measurements were discussed in Chapter 8.
In this section and the following section on fixed overhead, we will consider the equation approach first, followed by flexible budget diagrams and graphic illustrations. The T-account approach and the journal entries for overhead costs are presented after all four of the overhead variances have been discussed individually.
The analysis of variable overhead costs in standard costing typically includes two variances, the spending variance and the efficiency variance. The following symbols are used below to help illustrate these measurements.
SVOR = Standard variable overhead rate per direct labor hour.
AHU = Actual direct labor hours used.
SHA = Standard direct labor hours allowed for the good output.
AVO = Actual total variable overhead cost incurred.
EXAMPLE 10-3
A continuation of the Expando Company example is used to illustrate the techniques and concepts. Assume that standard overhead rates are based on 4,800 direct labor hours per month. The variable overhead rate calculation and other relevant data appear below.
SVOR = $144,000 ÷ 4,800 D.L. Hours = $30 per hour
Standard direct labor hours allowed per unit = .4
Standard direct labor hours allowed = (.4)(10,000 units produced) = 4,000
Actual Direct labor hours used = 4,100
Actual total variable overhead cost incurred = $121,500
The Equation Approach
The variable overhead spending variance was introduced in Chapter 4, but to refresh your memory, this variance is calculated as follows:
Variable Overhead Spending Variance5 = AVO - (SVOR)(AHU) = $121,500 - (30)(4,100) = 121,500 - 123,000 = 1,500 favorable
If some other activity measure were used to apply overhead, (e.g., machine hours) then the flexible budget would be based on the actual quantity of that measurement, rather than actual direct labor hours (AHU). The only difference between this illustration and the Chapter 4 illustration is the reference to a standard variable overhead rate (SVOR), as opposed to just a variable overhead rate (VOR) in the normal historical costing illustration in Chapter 4. Since both rates should be based on estimates of what variable overhead costs should be for the denominator activity level chosen, these rates and the spending variance calculations are mechanically and conceptually identical in normal historical costing and standard costing.
The variable overhead efficiency variance represents an estimate of the quantity variance for indirect resources that is caused by efficient or inefficient use of the overhead allocation basis. This is difficult to understand at first, so before we examine this interpretation in more depth, consider how the variance is calculated.
Variable Overhead Efficiency Variance = (SVOR)(AHU) - (SVOR)(SHA) or = (AHU - SHA)(SVOR)
= (30)(4,100) - (30)(4,000) = (4,100 - 4,000)(30) = 123,000 - 120,000 = (100)(30) = $3,000 unfavorable
Some authors refer to this variance as the variable overhead quantity variance, but part of the quantity variance is likely to be included in the spending variance. Therefore, the V.O. efficiency variance is only an estimate of that part of the variable overhead quantity variance caused by the efficient, or inefficient use of the allocation basis. The quantities compared in the calculation are quantities of the allocation basis, (usually direct labor hours) not quantities of the resources represented by the variable overhead costs. If the variations in the activity measure, (in this case direct labor hours) were perfectly correlated (i.e., r2 = 1) to the variations in the indirect resources represented by the variable overhead costs, the efficiency variance would represent an accurate measure of the entire quantity variance for variable overhead. Then, the spending variance would represent an accurate measure of the variable overhead price variance. Since interpreting the overhead variances is confusing, an expanded discussion of the traditional interpretation of these variances is provided later in this chapter.
A Flexible Budget Diagram For Variable Overhead Analysis
The variance analysis for variable overhead is more revealing when presented in a manner that places emphasis on the flexible budgets involved. Consider the diagram in Exhibit 10-14. Since the total variance in variable overhead costs is the difference between the actual costs incurred (A) and standard costs allowed (D), the diagram shows how the flexible budget based on actual hours (B) is used to separate the total $1,500 unfavorable variance into two parts.
The traditional interpretation of the separate variances is as follows. The $3,000 unfavorable efficiency variance represents an attempt to measure the effect of labor inefficiency on variable overhead costs. Since actual direct labor hours were 100 above the standard hours allowed, the efficiency variance is unfavorable. This interpretation is based on the implicit assumption that direct labor activity drives variable overhead costs, or more specifically, causes indirect resources to be used.6
Therefore, it is estimated that $3,000 of additional variable overhead costs, ($30)(100 hours) were incurred because labor required more time to produce the 10,000 units than the standard time allowed. The $1,500 favorable variable overhead spending variance is assumed to include the variance caused by differences between budgeted and actual prices of the indirect resources and any quantity variance in indirect resource usage not caused by direct labor inefficiency. The validity of these interpretations depends on the strength of the relationships between the activity measure, or allocation basis, and the indirect resources. These interpretations are examined below after the graphic approach is presented.
The Graphic Approach
A graphic approach for variable overhead analysis is presented in Figure 10-4. The vertical difference between points A (actual variable overhead costs) and B (flexible budget variable overhead costs based on actual direct labor hours) represents the variable overhead spending variance. The vertical difference between points B and D (standard variable overhead costs) represents the variable overhead efficiency variance. Since direct labor hours used and purchased are equal, A' and C are not needed in the analysis. As you can see from the graph, the variable overhead efficiency variance is the difference between two point estimates, i.e., two points on the flexible budget line.
Interpreting The Meaning Of The Traditional Variable Overhead Variances
To understand the meaning of the traditional variable overhead variances, it is helpful to consider the conceptual view of factory overhead cost drivers presented in Exhibit 10-15. This exhibit shows that factory overhead, or indirect resource costs are driven by prices and quantities, just like any other costs and these prices and quantities are driven by many other factors, just like any other prices and quantities. The prices of the various indirect resources (e.g., indirect labor, indirect materials, electricity, water) are influenced by the supply and demand for these resources as well as the quality and quantities of the resources purchased. In addition, the geographic location of the company, any vendor services included with a resource and random variations also affect prices. The quantities of indirect resources used are driven by product diversity, production volume, direct labor efficiency and the efficiency of the resource providers. Resource providers include those outside the company, such as vendors, as well as those who provide services inside the company. Inside resource providers include the various departments or functional areas such as materials planning, purchasing, receiving, inspecting, moving, storing, packing and shipping as well as machine setups, engineering, power, heating, cooling, maintenance and housekeeping.
Consider the following three questions: 1) Are the variable overhead spending and efficiency variances equivalent to price and quantity variances? 2) If not, what causes them to be different? and 3) How do they differ from price and quantity variances? The answer to the first question is no, the spending and efficiency variances are not price and quantity variances in the same sense of the terms price and quantity used for direct materials and direct labor. These variances are different from price and quantity variances for two reasons. First, the overhead rates are not individual prices. Instead they are aggregates of many prices and quantities converted into a composite rate per activity measure, e.g., per direct labor hour. Second, these variances are influenced by an unavoidable estimating error caused by ignoring some of the indirect resource quantity drivers illustrated in Exhibit 10-15. More specifically, the effects of product diversity and indirect resource provider efficiency (not related to direct labor or production volume) are ignored, along with the inevitable randomness associated with the use of any resource.
An estimating error occurs when a flexible budget based on the actual inputs of the allocation basis is used to separate the total variable overhead variance into two parts. When this is done, the analyst is implicitly using the actual quantity of one type of resource, (usually actual direct labor hours) to estimate the quantities of the indirect resources such as kilowatt hours of electricity, hours of indirect labor, and quantities of indirect materials. When the estimates differ from the actual quantities consumed (as they always do), an estimating error is included in the analysis. The effect on the spending and efficiency variances caused by this estimating error is the difference between the flexible budget based on the actual quantity of the overhead allocation basis and the flexible budget that would be calculated for this purpose if the actual quantities of the indirect resources were used instead. Although the size and direction of this effect is unknowable in actual practice, the concept is illustrated in Exhibit 10-16.
The traditional spending and efficiency variances are calculated on the left-hand side of Exhibit 10-16 using the flexible budget based on the actual quantity of the allocation basis (B2). Theoretically, the price and quantity variances on the right-hand side of Exhibit 10-16 could be calculated using a flexible budget based on the actual quantities and budgeted prices of the indirect resources (B1). However, these variances cannot be calculated in the traditional analysis because the actual quantities and budgeted prices of each of the indirect resources are simply not available.
Perhaps you are thinking, if the variable overhead variances aren't price and quantity variances, then what are they? Well, that is a good question. The traditional interpretation of the variable overhead spending and efficiency variances is illustrated in Exhibit 10-17. The traditional interpretation is that the spending variance includes the price variance and the part of the quantity variance caused by factors other than the efficiency or inefficiency of the allocation basis, i.e., 1 = 3 + 4 in Exhibit 10-17. However, the part of the quantity variance caused by unknown factors could be fairly large because it includes the effects of random variations, the effects of any non-production volume related cost drivers and any error in estimating the influence of direct labor efficiency on indirect resource consumption. The efficiency variance is interpreted as that part of the quantity variance for variable overhead that is caused by the efficiency or inefficiency of the allocation basis, i.e., that 2 = 5 in Exhibit 10-17.
Although these traditional interpretations are intuitively appealing, the spending and efficiency variances are not precise measures and can be very misleading. This is because there are two invalid assumptions underlying the traditional analysis. One assumption is that production volume and direct labor efficiency are the only significant drivers of indirect resource usage.7 The other assumption is that the cause and effect relationship between the activity measure (allocation basis) and indirect resource consumption is fairly precise. Precise enough so that it accurately measures the effect of the efficiency of the allocation basis on the quantities of indirect resources consumed.
The problem caused by the first assumption can be eliminated by using activity based costing concepts, i.e., using different cost pools and activity measures (both production volume and non production volume) to allocate or trace indirect resource costs to products. However, the problem caused by the second assumption is more troublesome. The choice of an allocation basis (Traditional or ABC) and the resulting overhead rates are not based on an engineered relationship like the relationships between the direct resources (direct material and direct labor) and output. Instead the allocation measurement is usually based on one of the cost behavior techniques discussed in chapter 3, management experience and intuition, or more likely in traditional cost systems, direct labor dollars or hours because they are conveniently captured by the payroll system. The efficiency variance is essentially the difference between two point estimates on a regression line (see Figure 10-4). Sometimes these estimates are overstated and sometimes they are understated. (Remember the standard error of the estimate in Chapter 3). To assume that the difference between two points on a regression line precisely measures the effect of the independent variable on the dependent variable between those two points is not warranted, or supported, by the least squares technique. The result can be very misleading. For example, if the variable overhead efficiency variance substantially overstates, or understates the effect of direct labor inefficiency on indirect resource costs, an offsetting variance amount will automatically appear in the spending variance. This under, or overstatement might easily be misinterpreted, although it is not interpretable at all. Thus, the main point of this discussion is that the traditional analysis can only provide a rough estimate of the nature of the total variance for a particular type of variable overhead. For this reason, it is probably best not to separate the total variable overhead variance into spending and efficiency variances unless the correlation between the allocation basis and the consumption of each type of indirect resource is fairly high.
The analysis of fixed overhead costs also includes two variances, the fixed overhead spending variance and the production volume variance. The fixed overhead spending variance was introduced in Chapter 4 and the planned production volume variance was discussed in Chapter 9. Now we are ready to include these variances in standard costing. The following additional symbols are used to illustrate the analysis of fixed overhead.
SFOR = Standard fixed overhead rate per direct labor hour.
AFO = Actual total fixed overhead.
DH = Denominator hours, i.e., the number of hours used as a basis for the overhead rate calculations.
BFO = (SFOR)(DH) = Budgeted fixed overhead.
EXAMPLE 10-4
This example extends the Expando Company illustration to include fixed overhead. Assume that the standard fixed overhead rate is based on 4,800 direct labor hours per month. The fixed overhead rate calculation and other relevant data appear below.
SFOR = $240,000 ÷ 4,800 D.L. Hours = $50 per hour
Standard direct labor hours allowed = (.4 per hour)(10,000 produced) = 4,000
Actual Direct labor hours used = 4,100 and Actual total fixed overhead cost incurred = $242,500.
Equation Approach
The fixed overhead spending variance is calculated by comparing the actual fixed overhead costs with the budgeted fixed overhead costs as follows:
Fixed Overhead Spending Variance = Actual Total Fixed overhead - Original Fixed Overhead Budgeted
= AFO - (DH)(SFOR) = 242,500 - (4,800)(50) = 242,500 - 240,000 = $2,500 unfavorable
Remember that budgeted fixed overhead costs are the same for all activity levels. The total amount is frequently a given in standard cost problems, but in some situations you may need to divide the annual amount by 12 to arrive at a monthly budget, or multiply denominator hours by the fixed overhead rate as shown above. Remember, the rate calculation is:
SFOR = Budgeted Fixed Overhead costs ÷ denominator hours
therefore, if it is not given, you can easily find budgeted fixed overhead as shown above, i.e., (DH)(SFOR).
This variance was also introduced in Chapter 4 since it can be calculated in normal historical costing. It measures any price and quantity differences between actual and budgeted prices and actual and budgeted quantities for the various types of resources represented by the fixed overhead costs. Notice that the meaning of the fixed overhead spending variance is different from the meaning of the variable overhead spending variance. The fixed overhead spending variance does not include an estimating error because the analysis does not include as estimate of the actual quantities of fixed resources consumed. However, it does include a variance resulting from any variation in the quantities of the resources represented in the fixed overhead costs. For example, a quantity effect occurs when a salaried employee resigns during the period, and when there are increases or decreases in the company's fixed assets during the period.
Production Volume Variance
The planned production volume variance was introduced in Chapter 9. This section introduces the actual production volume variance. Remember that the planned production volume variance is based on the difference between denominator hours and the standard (or budgeted) hours allowed for the budgeted units to be produced. The actual production volume variance is very similar, but it is based on the difference between denominator hours and standard hours allowed for the actual units produced. For the Expando Company example, the variance is as follows:
Production Volume Variance = Budgeted Fixed Overhead costs - Standard Fixed Overhead costs
= (SFOR)(DH) - (SFOR)(SHA) or (DH-SHA)(SFOR)
= (50)(4,800) - (50)(4,000) or (4,800 - 4,000)(50)
= 240,000 - 200,000 or (800)(50) = $40,000 unfavorable
The variance is unfavorable, as in this case, if standard fixed overhead costs are less than budgeted. Actual production was 800 hours below the average monthly denominator level. Therefore, the variance represents the cost of unused capacity and under-utilizing capacity is viewed as unfavorable.
The production volume variance is similar to the idle capacity variance introduced in Chapter 4. They are both measures of capacity utilization. The production volume variance measures the variance caused by the difference between the denominator output level, i.e., capacity used to calculate the overhead rates, and the output level actually achieved. If unit data are available, it may also be calculated in the following manner.
Alternative Calculation for the Production Volume Variance
Production Volume Variance = (Denominator units - Actual units)(Fixed overhead per unit)
= (12,000 - 10,000)(20) = (2,000)(20) = $40,000 unfavorable
The difference between the idle capacity variance and the production volume variance is in how the actual capacity level is measured. The idle capacity variance uses actual direct labor hours as a measure of capacity utilization, while the production volume variance uses standard direct labor hours. The difference is that using standard hours is equivalent to using actual units of output in the calculation which excludes the effect of direct labor efficiency.8 The production volume variance is a better measurement if the plant facilities represent the main capacity constraint, (e.g., a bottleneck machine) as opposed to the number of direct labor hours available. An alternative approach is presented in Appendix 10-1 using the idle capacity variance.
Controllability of the Variances
The production volume variance is considered to be uncontrollable for the same reason the idle capacity variance is considered to be uncontrollable. Recall that control refers to the ability to influence actual costs. But, neither the idle capacity variance or the production volume variance calculations involve actual costs. They merely represent more or less applied fixed overhead costs than budgeted fixed overhead costs. Both variances occur because of the attempt to match cost against benefits and obtain the advantages of using a predetermined overhead rate, e.g., normalizing unit overhead cost and more timely costing and pricing. The main purpose of calculating either of these variances is to remove them from the total overhead variance, so that the other parts, i.e., the controllable variances, can be isolated for further evaluation and possible investigation.
Diagram Of Fixed Overhead Variances
A diagram approach may also be used for fixed overhead variance analysis, although a flexible budget is not involved. Consider the analysis presented in Exhibit 10-18.
The original static budget for fixed overhead (B) is used to separate the $42,500 total variance in fixed overhead costs into two parts, spending and production volume, or controllable and uncontrollable. Denominator hours are used in the budget calculation to find the static budgeted fixed overhead amount if it is not otherwise available. But remember, budgeted fixed costs are not flexible, thus a flexible budget calculation for fixed overhead is not appropriate.
The Graphic Approach For Fixed Overhead
A graphic approach for fixed overhead analysis is presented in Figure 10-5. This graph not only provides a way to illustrate fixed overhead variance analysis in a standard cost system, but more importantly, it provides a way to emphasize the difference between budgeted costs and standard costs. Budgeted fixed costs are represented by a horizontal line which indicates that budgeted fixed overhead costs do not change as the level of production changes. However, the standard fixed overhead cost line is up-sloping which shows that standard costs increase as production increases. This is because fixed overhead is treated as a variable cost when applied to the units produced, i.e., for inventory valuation purposes.
Observe that the slope of the standard cost line is the standard fixed overhead rate (SFOR). The two lines intersect at the capacity level chosen as the denominator for calculating the standard overhead rates. Standard fixed overhead costs are equal to budgeted fixed overhead costs only when denominator hours (DH) are equal to standard hours allowed (SHA). In that specific case, the production volume variance is zero since SHA=DH, (SHA)(SFOR)=(DH)(SFOR) and, as a result, Points B and D would be in precisely the same place on the graph at the intersection of the two lines. When standard hours allowed are not equal to denominator hours, a production volume variance results and is represented by the vertical difference between Points B and D. In Figure 10-5 the production volume variance is unfavorable because standard hours allowed are less than denominator hours. It is favorable when SHA>DH.
Denominator capacity can be any level of capacity from zero to 100 percent of maximum. The most common capacity levels used are: 1.) planned, i.e., master budget units to be produced, 2.) practical, i.e., the maximum level of production under efficient, but not perfect, operating conditions, and 3.) normal, i.e., a long run average level of production.
The Unplanned Production Volume Variance
The unplanned production volume variance is a more useful measure of capacity utilization than the actual production volume variance because it results from a comparison of planned and actual capacity utilization. Referring back to the Expando Company budget in Chapter 9, recall that the planned production volume variance for March was $19,000 unfavorable. Since the actual variance for March is $40,000 unfavorable, the unplanned variance is $21,000 unfavorable. Although the production volume variance is referred to as uncontrollable, a large unplanned variance may need to be investigated and explained. The unplanned variance above could have been caused by a decrease in the demand for the Company's product, or by various production problems. The calculations are presented in Exhibit 10-18A as a more revealing alternative to the analysis in Exhibit 10-18.
T-account Approach for Factory Overhead
Expando Company's factory overhead costs and the resulting variances are recorded in T-account form in Exhibit 10-19.
Exhibit 10-19 shows three entries. The first entry records the actual factory overhead costs of $364,000 and shows a credit to miscellaneous accounts. The second entry charges the standard (applied) overhead costs of $320,000 to the work in process account. This leaves a debit balance in the factory overhead account of $44,000 that represents an unfavorable total factory overhead variance. The third entry closes the factory overhead account by distributing the variances to the four variance accounts.
Journal Entries
The general journal entries required to record the factory overhead costs are presented in Exhibit 10-20.
| EXHIBIT 10-20 Journal Entries to Record Factory Overhead Costs |
|||
| Entry to record actual overhead costs | Factory Overhead Control | 364,000 | |
| Miscellaneous Accounts* | 364,000 | ||
| Entry to record standard overhead costs | Work in Process | 320,000 | |
| Factory Overhead Control | 320,000 | ||
| Entry to close the control account | VO Efficiency variance | 3,000 | |
| FO Spending variance | 2,500 | ||
| Production volume variance | 40,000 | ||
| VO Spending variance | 1,500 | ||
| Factory Overhead Control | 44,000 | ||
| * e.g., Accounts payable, accumulated depreciation, factory payroll, etc. | |||
Summary Combined Overhead Analysis
All of the overhead variances can be calculated in a combined approach that emphasizes the flexible budgets involved. Exhibit 10-21 illustrates the idea. A four variance approach appears on the right-hand side of the exhibit and a two variance approach appears on the left side. The difference between items 1 and 4 is the total unfavorable variance in factory overhead costs of $44,000. The difference between actual total overhead costs (1) and a flexible budget based on actual direct labor hours (2) is the total spending variance of $1,000 U. This variance can easily be separated into variable and fixed spending variances as illustrated on the right-hand side of the exhibit. The difference between the flexible budget based on actual direct labor hours (2) and a flexible budget based on standard direct labor hours (3) is the variable overhead efficiency variance. Budgeted fixed overhead does not affect the variable overhead efficiency variance calculation because it is the same static amount in both flexible budgets. The difference between the flexible budget based on standard direct labor hours (3) and standard total factory overhead (4) is the production volume variance. Variable overhead does not affect this variance calculation because standard variable overhead in item 4 is the same as the flexible budgeted variable overhead based on standard direct labor hours in item 3.
In the two variance approach on the left-hand side of Exhibit 10-21, the Controllable variance is the difference between actual total overhead (1) and a flexible budget based on standard hours allowed (3). The Controllable variance is a combination of the two spending variances and the VO Efficiency variance. The Uncontrollable variance is just another term for the production volume variance. In addition to the methods above, there are many other ways to analyze the total overhead variance in standard costing. Some additional alternatives are presented in Appendix 10-1.
The methods illustrated in Exhibit 10-21 provide a convenient way to calculate all of the overhead variances at once and a better overall picture of how overhead costs are evaluated. However, be careful with this combined approach. It is important to recognize that a total budget must be calculated in two parts. We cannot multiply fixed overhead per hour by actual or standard hours to arrive at budgeted fixed overhead. Since fixed costs do not vary with the level of productive activity, we must use the amount from the original budget. Remember, if this is not available, we can calculate it by taking 1/12 of the annual fixed overhead budget, or by multiplying denominator hours for one month by the fixed overhead rate.
Potential Behavioral Problems Associated with Overhead Variances
The behavioral problems associated with overhead variances are similar to those associated with the direct labor variances. This is understandable since variable overhead efficiency variances are derived from the direct labor efficiency measurement. As a result, when the variable overhead efficiency variance is used to evaluate individual department managers, it reinforces the temptation to overproduce and to de-emphasize quality. The production volume variance has the same effect since managers can cause the variance to be less unfavorable, or more favorable, by producing more than is needed. A partial solution to this potential behavioral problem, at least as far as the production volume variance is concerned, is to compare the actual production volume variance to the planned production volume variance, i.e., emphasize the unplanned variance rather than the actual variance. This avoids the implication in departmental performance reports that the production managers are somehow responsible for a variance that is planned based on budgeted sales. Of course another solution, as indicated earlier, is to use variance analysis at the plant level to monitor overall operations, but not as a way to micro manage at the departmental level.
Accounting for the Variances at Month and Year End Closing
The variance accounts for materials, labor and overhead may be: 1) closed to the income summary for interim reporting and then reversed, or 2) closed to cost of goods sold, or 3) prorated to the inventory accounts and cost of goods sold at the end of the period. The first alternative is preferable for internal reporting because alternatives 2 and 3 cancel the normalizing and control benefits obtained from using predetermined or standard overhead rates. (This point was discussed in Chapter 4.) Using the first alternative provides the information for monthly and year to date comparisons. For example, the computer program for this chapter shows the variances separately on the income statement below gross profit (See Appendix 10-2). For external reporting purposes, alternatives 2 or 3 should be used, since GAAP and the IRS require actual costs in the external statements. Alternative 3 is preferable when the variances are significant. Then the variances are charged to the inventory accounts and cost of goods sold in proportion to the current period costs remaining in those accounts.
SUMMARY OF THE STANDARD COST CONTROVERSY
The various behavioral problems associated with standard costing have been discussed throughout this chapter. In summary, the main argument against the standard cost control methodology is that it emphasizes financial performance measurements that tend to motivate managers to manage the short term financial results rather than the processes that add value and contribute to the company's long run profitability. The main types of dysfunctional behavior include creating excess direct materials and finished goods inventory, (a push system rather than JIT demand pull system) de-emphasizing quality and promoting competitive behavior among employees and production department managers. From the perspective of the just-in-time and theory of constraints lean enterprise concepts, this behavior creates a great deal of waste and prevents optimizing the company's overall performance.9
In defense of standard costing, one can argue that it provides a powerful planning device (Chapter 9) and macro performance monitoring system (Chapter 10) that allows middle and upper level managers to see the big picture on a periodic basis. If other non-financial performance measurements (Chapter 8) are used to guide and evaluate lower level managers, then standard costing can still play an important role in the overall management of the organization, even in a JIT or TOC environment. From this defense perspective, it is just a matter of developing a balanced system that does not overemphasize any particular aspect of performance. Kaplan and Norton build on this idea using an approach referred to as the balanced scorecard.10 Balanced scorecards are systems that balance the various aspects of performance including financial and non-financial, short term and long term, leading and lagging, and internal and external measurements. (See MAAW's Balanced Scorecard topic for more information).
Perhaps the implementation of the balanced scorecard approach will help resolve the controversy over standard cost control in the long run, but this issue is not likely to be resolved in the near future and it is certainly not a trivial issue. Surveys have indicated that the majority of manufacturing firms use some form of standard costing.11 Therefore, it is important to recognize that where people are involved, performance measurement systems simultaneously measure and influence behavior.
The appendix includes four sections as follows: 1) Standard Process Costing, 2) Material Mix and Yield Variances and 3) Alternative analysis of fixed overhead, and Twelve alternative methods of overhead variance analysis.
1 Standard cost variances have been used for control purposes since around 1900. See Johnson and Kaplan, Relevance Lost: 50-51. (Summary). For a comparison of control models see Onsi, M. 1967. Quantitative models for accounting control. The Accounting Review (April): 321-330. (Onsi compares three control models: 1. The traditional standard cost model illustrated in this chapter, 2. a model based on classical statistics, and 3. a model based on decision theory).
2 Productivity is a measure of output per input. Yield refers to the productivity measure for materials.
3 The effects of material mix differences are discussed in Appendix 10-1.
4 Labor efficiency variances can be separated into two parts to isolate the effects of labor mix and efficiency differences. This analysis is similar to the material mix and yield illustration in Appendix 10-1.
5 Another way to calculate the spending variance is to multiply the difference between the actual and standard variable overhead rates by the actual number of direct labor hours. For the Expando Company example the actual VO rate is $121,500 ÷ 4,100 = 29.63414634. Then (30-29.63414634)(4,100) = $1,500 favorable. This approach is not recommended because of the potential rounding errors and the fact that it requires an additional calculation.
6 This means that direct labor time is assumed to be the primary driver, as opposed to simply being a representative of production volume.
7 Another way to say this using Cooper's ABC cost hierarchy, is that all variable indirect resource costs are assumed to be unit level costs. (See Chapter 7 to review the cost hierarchy concept).
8 If the number of units produced is higher or lower than desired because of labor efficiency, then the effect of labor efficiency is not entirely removed from the production volume variance calculation.
9 There are a number of summaries on the MAAW site related to lean accounting. For example, see the following: Brosnahan, J. P. 2008. Unleash the power of lean accounting. Journal of Accountancy (July): 60-66. (Summary). Maskell, B. H. and B. L. Baggaley. 2006. Lean accounting: What's it all about? Target Magazine 22(1): 35-43. (Note). Pickering, M. 2017. Implementing lean management reporting in lean enterprises. Cost Management (January/February): 28-36. (Summary).
10 Robert S. Kaplan and D. P. Norton. 1996. The Balanced Scorecard: Translating Strategy into Action. Boston: Harvard Business School Press. (Summary).
11 One survey of all manufacturing firms listed on the Compustat tapes indicated that approximately 85% of the companies responding to the survey used standard costing. The companies most important reasons for using standard costing, in the order of importance, were cost control, performance evaluation, inventory valuation, pricing, budgeting and bookkeeping. See Cress and Pettijohn, 1985, A survey of Budget-related planning and control policies and procedures. Journal of Accounting Education (Fall): 61-78.
1. Briefly discuss the two purposes of a standard cost system and compare them to the needs of lower, middle and upper management as well as the Company's needs for external reporting. (See the Introduction and Exhibit 2-4).
2. Does the traditional standard cost system described in this chapter recognize the concept of variability that is the basis of the statistical control chart methodology? Explain. (See the Introduction and the Onsi article mentioned above in footnote 1.
3. What is the difference between a complete standard cost system and a partial system? Explain the advantages of a complete system. (See Exhibits 10-1 and 10-2).
4. Briefly describe the two traditional methods of recording and evaluating direct materials in a standard cost system. (See Exhibits 10-3,
10-5, and Figure 10-1 for the first method and
Exhibits 10-6, 10-8 and Figure
10-2 for the second method).
5. Compare the advantages and disadvantages of the two methods you described in question 4. (See Advantages).
6. What causes material price variances? (See Exhibit 10-9).
7. What causes material quantity variances? (See Exhibit 10-9).
8. Does variance analysis identify these causes of the variances? Explain. (See DM Causes & Tradeoffs and Exhibit 10-9).
9. What are some of the problems or conflicts caused by material price and quantity variances? (See DM Causes & Tradeoffs related to materials related costs and the quality perspective).
10. What are some of the potential behavioral problems caused by material price and quantity variances? (See DM related Behavioral Problems).
11. Why are favorable variances not necessarily good and unfavorable variances not necessarily bad? (See DM related Behavioral Problems).
12. How does the standard cost method of recording and evaluating direct labor differ from the methods for direct material? (See Exhibits 10-10 and 10-12).
13. What are some of the causes of unfavorable and favorable direct labor efficiency variances? (See Exhibit 10-13).
14. What are some of the potential conflicts and behavioral problems that can be caused by labor efficiency variances? (See DL related Behavioral Problems).
15. Is the variable overhead spending variance calculated in a standard cost system the same as in normal historical costing? Explain. (See Figure 4-1 and Exhibit 10-14).
16. What does the variable overhead efficiency variance measure, or attempt to measure, i.e., it measures the efficiency of what? (See Figure 10-4).
17. Why can't we calculate a variable overhead efficiency variance in normal historical costing? (See Figure 4-1).
18. If we used machine hours instead of direct labor hours as the overhead allocation basis, could we still calculate a variable overhead efficiency variance? Explain.
19. How is the direct labor efficiency variance related to the variable overhead efficiency variance when direct labor hours are used as the overhead allocation basis? (See Figures 10-3 and 10-4).
20. Is it appropriate, or helpful to management, to think of the variable overhead spending variance as a price variance and the variable overhead efficiency variance as a quantity variance? Why or why not? (See Exhibit 10-16).
21. What is the usual interpretation of the V.O. spending and efficiency variances? (See Exhibit 10-17).
22. What is wrong with the usual interpretation? (See Exhibit 10-17 and related discussion).
23. Is the fixed overhead spending variance the same in normal historical costing and standard costing? (See Figure 4-2 and Exhibit 10-18 or Figure 10-5).
24. How does the production volume variance differ from the idle capacity variance? (See Figure 10-5 and Figure 10-5 Revised, or compare Figure 4-2 with Figure 10-5).
25. Could we calculate a production volume variance in normal historical job order costing? How about normal historical process costing? Explain. (See Figure 4-2).
26. Is a flexible budget needed in all standard cost variance calculations, i.e., for all variances? (See Figure 10-5).
27. How could emphasis on the production volume variance for performance evaluation cause behavioral problems? (See Potential behavioral problems)
28. How could the potential behavioral problem in the last question be reduced, i.e., how could we extend the analysis to reduce the bias? (See Unplanned PVV and Summary).
29. Are standard cost variances useful to lower level management in the plant? Why or why not? (See Exhibit 2-4 second audience).
30. What would you recommend as a better way to monitor the processes in the plant and who do you think should do this? (See Chapter 3 and Chapter 8 for some ideas).
31. Compare the standard cost control methodology to the statistical process control methodology and discuss how you believe each should be used. (See Chapter 3).
32. Summarize the behavioral conflicts associated with standard cost variance analysis. (See Summary).
33. Do you think standard cost variance analysis would be useful in a system designed around the concepts of just-in-time and the theory of constraints? (See the Lessner, Vollmann and Schonberger summaries).
34. How do standard process cost problems differ from the examples in this chapter? (See the Chapter 10 Appendix).
35. When are material mix and yield variances appropriate and what do they show? (See the Chapter 10 Appendix).
PROBLEMS
Micro Company uses a complete standard cost system and produces a single product with standard costs as follows:
| Inputs | Standards | Cost per Unit |
| Direct materials | 10 lbs at $ 3.00 | $30 |
| Direct labor | 3 hours at 8.00 | 24 |
| Variable overhead | 3 hours at 7.00 | 21 |
| Fixed overhead | 3 hours at 20.00 | 60 |
| Total unit cost | $135 |
There were no beginning inventories. During the month 800 units were manufactured and 600 units were sold at a sales price of $200 each. Overhead rates are based on 1,000 units per month or 3,000 standard direct labor hours, i.e., this is the master budget denominator activity level. Overhead is applied on the basis of direct labor hours.
Actual results for the month were as follows:
Direct materials purchased 8,500 lbs at $3.05
Direct materials used 8,200 lbs
Direct labor used 2,500 hours at $8.40
Variable overhead cost incurred $18,000
Fixed overhead cost incurred $62,000
Required:
Calculate the following and indicate if each variance is favorable or unfavorable.
1. The material price variance based on
quantity purchased.
2. The material quantity variance.
3. The debit to work in process for direct materials.
4. The direct labor rate variance.
5. The direct labor efficiency variance.
6. The debit to work in process for direct labor.
7. The variable overhead spending variance.
8. The fixed overhead spending variance.
9. The variable overhead efficiency variance.
10. The production volume variance.
11. Cost of goods sold at standard costs.
12. Gross profit based on standard costs.
13. Which of the variances above are uncontrollable ?
14. You have studied two measures of capacity utilization. Identify them, and indicate which one is the better measurement and why it is better than the other one.
15. You have studied two types of material price variances. Identify them, and indicate which one is the better measurement.
16. List three reasons the measurement you chose in question 15 is better than the other measurement.
Refer to the data in problem 10-1.
Required:
Record the following transactions using general journal entries including the appropriate variances.
1. The purchase of direct materials assuming the material price variance is based on quantity purchased.
2. Actual material used in production.
3. The payroll for direct labor. Assume 20 percent of the payroll is withheld for federal income taxes and FICA.
4. The actual direct labor used in production.
5. Actual factory overhead costs. Credit sundry accounts.
6. Applied factory overhead.
7. The transfer of 800 units to finished goods.
8. Cost of goods sold.
9. Sales.
Calculate the following variances and indicate if each one if favorable or unfavorable.
10. The total variance in factory overhead.
11. The variable overhead spending variance.
12. The fixed overhead spending variance.
13. The variable overhead efficiency variance.
14. The production volume variance.
15. Close the factory overhead account to the variance accounts.
PROBLEM 10-3
Bibb Company uses a complete standard cost system and produces a single product with standard costs as follows: (This is an extension of master budget Problem 9-2)
| Inputs | Standards | Cost per Unit |
| Direct materials | 2 lbs at $ 4.00 | $8 |
| Direct labor | 3 hours at 6.00 | 18 |
| Variable overhead | 3 hours at 9.00 | 27 |
| Fixed overhead | 3 hours at 10.00 | 30 |
| Total unit cost | $83 |
There were no beginning inventories. During the month 2,100 units were manufactured and 1,900 units were sold at a sales price of $160 each. Overhead rates are based on 2,000 units per month or 6,000 standard direct labor hours, i.e., this is the master budget denominator activity level. Overhead is applied on the basis of direct labor hours.
Actual results for the month were as follows:
Direct materials purchased 4,300 lbs at $4.10
Direct materials used 4,150 lbs
Direct labor used 6,400 hours at $5.95
Variable overhead cost incurred $57,000
Fixed overhead cost incurred $62,000
Required:
Record the following transactions using general journal entries including the appropriate variances.
1. The purchase of direct materials assuming the material price variance is based on quantity purchased.
2. Actual material used in production.
3. The payroll for direct labor. Assume 20 percent of the payroll is withheld for federal income taxes and FICA.
4. The actual direct labor used in production.
5. Actual factory overhead costs. Credit sundry accounts.
6. Applied factory overhead.
7. The transfer of 2,100 units to finished goods.
8. Cost of goods sold.
9. Sales.
Calculate the following variances and note the status of each variance.
10. The variable overhead spending variance.
11. The fixed overhead spending variance.
12. The variable overhead efficiency variance.
13. The production volume variance.
14. What is the amount of the difference between the production volume variance and the idle capacity variance
in this problem and what is it called?
PROBLEM 10-4
This problem is an extension of master budget Problem 9-6, The Microtable Company.
| Inputs | Standards | Cost per Unit |
| Direct materials | 20 board feet at $3.00 | $60 |
| Variable overhead | .1 hour* at 100.00 | 10 |
| Fixed overhead | .1 hour* at 400.00 | 40 |
| Total unit cost | $110 | |
| * Robot (machine) hours. | ||
Overhead rates are based on a capacity level 500 machine hours per month and overhead is applied on the basis of robot (machine) hours. During February 5,050 tables were manufactured and 5,000 were sold at an average sales price of $254 per table.
Actual results for February were as follows:
Direct materials purchased 101,100 board feet at $3.20 per foot.
Direct materials used 101,050 board feet
Machine (robot) hours used 510 hours
Variable overhead costs incurred $52,000
Fixed overhead costs incurred $202,500
Required:
Calculate the following amounts. Then circle the letter of the answer you choose. Show all your supporting calculations next to the question.
1. Assuming material price variances are based on the quantity purchased, the direct material price variance for February is:
a. $20,210 unfavorable b. 20,210 favorable c. 20,220 unfavorable d. 20,220 favorable e. None of these.
2. The direct material quantity variance for February is:
a. $150 unfavorable b. 150 favorable c. 3,150 unfavorable d. 3,150 favorable e. None of these.
3. If direct material price variances were based on quantity used the price variance would be (assume no beginning inventory)
a. $20,210 unfavorable b. 20,210 favorable c. 20,220 unfavorable d. 20,220 favorable e. None of these.
4. The total overhead variance for February is
a. $ 500 unfavorable b. 500 favorable c. 2,000 favorable d. 2,000 unfavorable e. Some other amount.
5. The total variable overhead variance for February is
a. $1,000 unfavorable b. 1,500 unfavorable c. 1,000 favorable d. 1,500 favorable e. None of the above.
6. The fixed overhead spending variance for February is
a. $ 500 unfavorable b. 500 favorable c. 1,500 unfavorable d. 1,500 favorable e. None of these
7. The production volume variance for February
a. $4,000 unfavorable b. Zero c. 2,000 unfavorable d. 2,000 favorable e. It is not possible to calculate this variance without additional facts.
8. The idle capacity variance for February
a. $4,000 unfavorable b. Zero c. 2,000 unfavorable d. 2,000 favorable e. None of these.
9. What is the total amount charged to work in process during February?
a. $555,500 b. 557,650 c. 577,860 d. 578,360 e. Some other amount.
10. What is the cost of goods sold for February stated at standard costs?
a. $555,500 b. 550,000 c. 577,860 d. 578,360 e. Some other amount.
PROBLEM 10-5
Riley Company produces and sells a single product with budgeted or standard unit costs as follows:
| Inputs | Standards | Cost per Unit |
| Direct materials | 2 gallons at $11.00 | $22 |
| Direct labor | 3 hours at 14.00 | 42 |
| Variable overhead | 3 hours at 40.00 | 120 |
| Fixed overhead | 3 hours at 60.00 | 180 |
| Total unit cost | $364 |
Overhead rates are based on a capacity level of 1,000 units (or 3,000 direct labor hours) per month, i.e., this is the master budget denominator activity level. Overhead is applied on the basis of direct labor hours.
During April 1,100 units were manufactured and 1,000 units were sold at a sales price of $610.
Actual results for April were as follows:
Direct materials purchased 2,400 gallons at $10 per gallon
Direct materials used 2,340 gallons
Direct labor used 3,480 hours at $15.20 per hr.
Variable overhead costs incurred $135,600
Fixed overhead costs incurred $183,500
Required:
Record the following transactions with general journal entries.
1. Direct material purchases. Assume material price variances are based on quantity purchased.
2. Direct material used during the month.
3. Direct labor used during the month. Assume the factory payroll has already been recorded.
4. Actual factory overhead costs incurred. Credit misc. accounts.
5. Applied factory overhead.
6. The transfer of completed units to finished goods.
7. Cost of goods sold.
8. Sales.
Calculate the following variances and indicate if each variance is favorable or unfavorable.
9. The total overhead variance.
10. The variable overhead spending variance.
11. The fixed overhead spending variance.
12. The variable overhead efficiency variance.
13. The production volume variance.
14. The controllable (or budget) variance.
15. The idle capacity variance.
16. Calculate the dollar amount of distortion in the idle capacity variance and indicate if it is favorable or unfavorable.
17. What is the total amount of the combined price and quantity variances for variable overhead?
18. What is the total amount of the combined price variances for the indirect resources represented by the variable overhead costs?
PROBLEM 10-6
From Appendix 10-1: Material Mix and Yield Variances
The Wise Co. produces a beverage called Wise-O brain food that expands a person's ability to think. This unique product is sold in 4 ounce bottles and requires two secret ingredients, A and B. The standard prices and quantities allowed for four ounces of Wise-O are as follows:
| Product A | Product B | |
| Standard price per ounce | $5 | $4 |
| Standard quantity per 4 ounce bottle | 2 ounces | 2 ounces |
During a recent accounting period the Company produced 5,000 bottles of Wise-O. The actual quantities of raw materials used were 6,000 ounces of A and 18,000 ounces of B.
Required:
Calculate the following variances and indicate if each variance is favorable or unfavorable:
1. The material quantity variances.
2. The material mix variances,
3. The material yield variances.
4. Explain the meaning of the variances.
