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C H A P T E R F I F T E E N

Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management After studying this chapter, you should be able to . . .

1. Distinguish between the product-costing and control purposes of standard costs for manufacturing overhead

2. Calculate and properly interpret standard cost variances for manufacturing overhead using flexible budgets

3. Record overhead costs and associated standard cost variances

4. Apply standard costs to service organizations

5. Analyze overhead variances in an activity-based cost (ABC) system

6. Understand decision rules that can be used to guide the variance-investigation decision

The third quarter was a difficult period for United. Revenue performance suffered sig-nificantly from the operational disruptions we experienced throughout the quarter, James Goodwin, United Airlines chairman and chief executive, said. 1 United (UAL) suffered from thousands of labor and weather-related flight cancellations and delays during the third quarter of 2000 while the airline negotiated a labor contract with its pilots. The earnings per share for the quarter decreased from a profit of $2.89 the previous year to a loss of $1.29.

UALs operating results experienced this drastic change although the decrease in traffic was only a small percentage of total traffic during the third quarter of 2000. As it is for other companies with high fixed costs (i.e., high degrees of operating leverage), volume is a criti-cal success factor for UAL. Fluctuations in traffic volume at UAL often explain the bulk of changes in operating results. UAL constantly monitors volume-variance data, which measures the effect on operating results of differences between actual volume (passenger miles) and budgeted volume.

Companies with high fixed costs experience wide variations in operating results in response to changes in output volume. Managers of these organizations monitor business volumes closely and attempt to reduce fluctuations in business activities. Continuing the discussion from Chapter 14, in this chapter we examine production volume and other indirect-cost vari-ances that organizations use to monitor short-term financial performance. We expand the dis-cussion of standard costs, flexible budgets, and variance analysis and apply these concepts to both traditional and ABC systems. Chapter 15 deals as well with recording standard overhead costs and with the end-of-period disposition of standard cost variances. We also consider in

1 UAL to Post Loss to 3rd Period, Probably for 4th, The Wall Street Journal, October 2, 2000, p. A12.

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646 Part Three Operational-Level Control

this chapter the use and importance of nonfinancial performance measures as part of a com-prehensive management accounting and control system. Finally, we provide a discussion of resource-capacity management, an area of strategic importance to many organizations today.

Standard Overhead Costs: Planning versus Control

As pointed out in Chapter 14, standard costs can be used alone for control purposes, or they can be incorporated formally into the accounting records for both product-costing and control purposes. In Chapter 14 we used a flexible budget at the end of the period to calculate various revenue and cost variances, which helped explain why actual operating income for the period differed from operating income reflected in the master (static) budget. For cost-control pur-poses, we calculated a total flexible-budget variance and then proceeded to explain this total variance by calculating a selling price variance, fixed cost variances (for both manufacturing and nonmanufacturing costs), and a total flexible-budget variance for direct manufacturing costs. 2 We then subdivided the variance for direct labor and direct materials into price and efficiency components. The breakdown of the flexible-budget variance for factory overhead was left for Chapter 15. However, before looking at standard cost variances associated with manufacturing (factory) overhead, we need to differentiate the product-costing and cost-control purposes of standard costs used for factory overhead.

For variable factory overhead the underlying model for cost-control and product-costing purposes is the same, as illustrated in Exhibit 15.1 . Recall that the Schmidt Machining Com-pany uses direct labor hours as the activity variable for applying overhead costs. Other alloca-tion bases, such as number of machine hours, could have been used by the company.

We reproduce as Exhibit 15.2 the manufacturing cost portion of the standard cost sheet for the Schmidt Machinery Company presented in Chapter 14. As you can see, the standard vari-able overhead rate per unit is $60 (5 standard direct labor hours/unit $12 standard variable overhead cost per direct labor hour). It is this amount that is charged to production for the period (product-costing purpose) and that is used in the flexible budget (cost-control purpose) in Exhibit 14.7. In short, the graph depicted in Exhibit 15.1 for variable overhead cost is simi-lar in form to what we could have prepared in Chapter 14 for either direct materials cost or direct labor cost. This makes sense because all three are variable costs.

The situation for fixed costs, however, is different, as reflected in the graph presented as Exhibit 15.3 . For cost-control purposes, we see that budgeted (lump-sum) fixed overhead

2 As you recall, in order to explain the total operating-income variance for the period, we also calculated a sales-volume variance. Further analysis of this variance is covered in Chapter 16. Please refer back to Exhibit 14.15 for a summary of the variance-decomposition process used by Schmidt each period to explain the total operating-income variance for the period.

LEARNING OBJECTIVE 1Distinguish between the product-costing and control purposes of standard costs for manufacturing overhead.

LEARNING OBJECTIVE 1Distinguish between the product-costing and control purposes of standard costs for manufacturing overhead.

VariableOverhead

Cost Product Costing and Cost Control SQ SP

LaborHours

Legend: SQ Standard allowed labor hours for units producedSP Standard variable overhead cost per labor hour

EXHIBIT 15.1 Variable Manufacturing Overhead: Product-Costing versus Control Purposes



Chapter 15 Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management 647

costs are usedsee the horizontal line in Exhibit 15.3 . At the end of the period, this budgeted amount is compared to the actual fixed overhead cost incurred. The resulting difference is called a spending variance. The spending variance for fixed overhead, along with the spend-ing variance for nonmanufacturing fixed costs, is used to explain a portion of the total master budget variance for the period (see Exhibit 14.15).

For product-costing purposes, however, we must unitize fixed overhead costs. 3 As indi-cated in Exhibit 15.3 , for product-costing purposes we treat fixed overhead costs as if they were variable costs. In the Schmidt Machinery Company case, the standard fixed overhead rate per unit produced is $120 (i.e., 5 standard direct labor hours per unit $24 standard fixed overhead cost per hour). Thus, budgeted fixed overhead for the month was $120,000 (i.e., $120/unit 1,000 units).

3 This holds for what is called the absorption or full-cost approach to product costing, which is currently required for external reporting, and for income-tax purposes in the United States. An alternative product-costing approach called variable costing treats fixed production costs as period costs. Variable costing is covered in Chapter 18. Income tax rules regarding inventory valuation are contained in IRC Section 263 (Uniform Capitalization Rules). Treasury Regulation 1.263 indicates that indirect (manufacturing) costs be reasonably allocated to outputs.

Product-Costing: Standard Fixed Overhead Applied (SQ SP)

Labor Hours

Control Budget(Lump-Sum Amount)

FixedOverhead

Cost

DenominatorVolume

Legend: SQ Standard allowed labor hours for units producedSP Standard variable overhead cost per labor hourDenominator volume Number of labor hours used to determine the fixed

overhead application rate

EXHIBIT 15.3 Fixed Manufacturing Overhead Costs: Product Costing versus Control

EXHIBIT 15.2 Standard Manufacturing Cost Sheet (partial reproduction of EXHIBIT 14.5)

SCHMIDT MACHINERY COMPANYStandard Manufacturing Cost Sheet

Product: XV1

Descriptions Quantity Unit Cost Subtotal Total

Direct materials: Aluminum 4 pounds $25 $100 PVC 1 pound 40 40Direct labor 5 hours 40 200Variable factory overhead 5 hours 12 60 Total variable manufacturing cost $400Fixed factory overhead 5 hours 24 120 180

Standard manufacturing cost per unit $520




Variance Analysis for Manufacturing Overhead Costs

We assume that Schmidt Machinery Company uses a standard cost system. Thus, at the end of each period the accountant for the company prepares an analysis of the total standard cost variance for both variable and fixed overhead costs. In each case, the goal will be to explain the difference between the actual cost incurred and the cost charged to production (units pro-duced) for the period. As shown later, these variances are recorded at the end of the period in separate variance accounts.

For product-costing purposes, the total overhead variance for the period (also called the total under/overapplied overhead) is equal to the difference between actual overhead cost incurred and the standard overhead cost applied to production. For Schmidt, the total over-head variance for October 2010 is $30,880U, as follows:

Total overhead variance Total actual overh eead Total applied overhead

Total variable

( overhead Total fixed overhead Total ove ) ( rrhead application rate

Standard hours allo

wwed for this period's production)

($ , 40 630 $ , ) [$ (130 650 36 780 5/hour units hours/uniits

i.e.,

)]

$ , $ , ( $ 171 280 140 400 3$30,880U 00 880, )applied overheadunder

As explained below, the total overhead variance for the period can be subdivided into a set of variable overhead cost variances and a set of fixed overhead cost variances.

Variable Overhead Cost Analysis We provide in Exhibit 15.4 a graphical representation of the process used to decompose the total variable overhead variance for the period. As indicated in Exhibit 14.8, this variance for the Schmidt Machinery Company in October 2010 is $6,170F, which is the difference between actual variable overhead costs incurred ($40,630) and the standard variable overhead costs charged to production during October [$46,800 (780 units 5 standard labor hours per unit) $12 standard variable overhead cost per labor hour]. Note that these figures are obtained from Exhibit 14.8. Note, too, that this total variance, from a product-costing stand-point, could be called total over/underapplied variable overhead cost for the period, a point consistent with Exhibit 15.1 . Because in October the actual variable overhead costs were less than the variable overhead costs assigned to production, we call the $6,170 figure over applied variable overhead.

LEARNING OBJECTIVE 2Calculate and properly interpret standard cost variances for manufacturing overhead using flexible budgets.

LEARNING OBJECTIVE 2Calculate and properly interpret standard cost variances for manufacturing overhead using flexible budgets.

The total variable overhead varianceis the difference between actual variable overhead cost incurred and the standard variable overhead cost applied to production; also called over- or underapplied variable overhead for the period.

The total variable overhead varianceis the difference between actual variable overhead cost incurred and the standard variable overhead cost applied to production; also called over- or underapplied variable overhead for the period.

LaborHours

(SQ)(AQ)

VariableOverhead Cost

Spending Variance

(F)

Efficiency Variance

(F)

Applied Variable Overhead Flexible Budget Basedon Output (SQ SP)

TotalVariable

OverheadVariance

(F)(AQ SP)

(SQ SP)

(AQ AP)

Legend: SQ Standard direct labor hours allowed for units produced 5 780 3,900 hoursSP Standard variable overhead cost per labor hour $12 (see Exhibit 15.2)AQ Actual labor hours worked 3,510 hoursAP Actual variable overhead cost per labor hour worked $11.5755 (rounded)Total variable overhead variance Spending variance Efficiency variance

EXHIBIT 15.4 Schmidt Machinery Company Variance Analysis: Variable Manufacturing Overhead




Cost Control: Breakdown of the Total Variable Overhead Variance

We see from Exhibit 15.4 that the total variable overhead variance for a period ($6,170F in our example) can be broken down into a variable overhead spending variance and a variable overhead efficiency variance, as follows:

Variable overheadspending variance

Actual vvariable overhead variable overhe Budgeted aadbased on inputs (e.g., actual labor hourss worked)AQ AP AQ SP

AQ AP SP

( ) ( )

( )

From Exhibit 14.8 we see that Schmidt used 3,510 labor hours in October 2010 to produce 780 units; total variable overhead cost for the month was $40,630. Based on a standard variable overhead cost per direct labor hour of $12 and an actual variable overhead rate of $11.5755 per labor hour ($40,630/3,510 hours), the variable overhead spending variance is calculated as follows:

$ , ( , $ )

$ , $

40 630 3 510 12

40 630 42

hours /hour

,,120 $1, 490F

Or

3 510 11 5755 12, ($ . $ )labor hours /labor hourr rounded $1, 490F ( )

Next, we calculate the variable overhead efficiency variance, as follows:

Variable overheadefficiency variance

Budgetted variable overheadbased on inputs

Stan ddard variable overheadto productionapplied

AQ SP SQ SP

SP AQ SQ

( ) ( )

( )

As implied by the graph in Exhibit 15.1 , the amount of standard overhead cost applied to pro-duction (product-costing purpose) and the flexible budget based on output (cost-control pur-pose) for variable overhead are always equal. Thus, the second term on the right-hand side of the above equation could have been expressed as budgeted variable overhead based on outputs.

The standard for direct labor is 5 hours per unit. Thus, the variable overhead efficiency variance for October 2010 is:

$ , [( ) $42 120 780 5 12units hours/unit /hour]]

$ , $ , 42 120 46 800 $4,680F Or

$ . ( , , )12 00 3 510 3 900/hour hours $4,680F

Interpretation and Implications of Variable Overhead Variances In traditional accounting systems, such as the system used by Schmidt Machinery Company, only a single activity variable (e.g., direct labor hours or machine hours) is used to assign manufacturing overhead costs to outputs. Further, as illustrated above, traditional systems use this single activity variable for cost-control purposes. That is, the flexible budget for such companies is based on a single, usually volume-related, activity variable. This simple approach requires careful interpretation of the resulting standard cost variances for variable overhead. While the formulas for these variances may look the same as those covered in Chapter 14 for direct labor and direct materials costs, the meaning and interpretation of these variances is not the same. In short, the imperfect relationship between variable factory overhead costs and the chosen activity variable (e.g., direct labor hours) that a company uses to allocate these costs to outputs requires careful interpretation of variable overhead variances.

Variable Overhead Spending Variance

This variance is attributable to actual spending for variable overhead items per unit of the activity variable being different from standard. In the Schmidt Machinery Company example for October 2010, the budgeted spending for variable overhead cost

Variable overhead spending varianceis the difference between actual variable overhead cost incurred and the flexible budget for variable overhead based on inputs for the period (e.g., actual labor hours worked).

Variable overhead spending varianceis the difference between actual variable overhead cost incurred and the flexible budget for variable overhead based on inputs for the period (e.g., actual labor hours worked).

Variable overhead efficiency varianceis the difference between the flexible budget for variable overhead based on inputs (e.g., actual labor hours worked) and the flexible budget for variable overhead based on outputs (i.e., standard allowed labor hours for units produced).

Variable overhead efficiency varianceis the difference between the flexible budget for variable overhead based on inputs (e.g., actual labor hours worked) and the flexible budget for variable overhead based on outputs (i.e., standard allowed labor hours for units produced).




per direct labor hour is $12. The actual variable overhead cost per direct labor hour was approximately $11.5755 ($40,630/3,510 hours). Thus, spending for variable overhead during the period per direct labor hour worked was less than standard; for this reason the resulting variable overhead spending variance for the period ($1,490) is labeled favorable. The key to understanding this is to remember that the variable overhead application rate refers to the standard variable overhead cost per unit of the activity variable used for product-costing pur-poses and for constructing the flexible budget for cost-control purposes.

If the variable overhead spending variance is considered material or significant, a follow-up analysis of individual variable overhead items is indicated. Essentially, managers of the Schmidt Machinery Company may want to know why spending for variable overhead items per labor hour worked during the period was different from expectations. To answer this question, a follow-up analysis of each variable overhead cost is required.

Perhaps the clearest example pertains to electricity costs for the factory. The electricity bill each month is a function of both quantity of kilowatt hours consumed and the price paid per kilowatt hour. Thus, if there is a spending variance for factory electric costs for the period, this variance could be broken down into price and efficiency components in exactly the same way in Chapter 14 where we subdivided the total direct labor or direct materials flexible-budget variance for the period into price (rate) and efficiency (quantity) components.

Variable Overhead Efficiency Variance

Care needs to be exercised when interpreting this variance. Simply put, the variable overhead efficiency variance reflects efficiency or inefficiency in the use of the activity variable used to apply variable overhead costs to products. In the case of Schmidt Machinery Company, this variable is direct labor hours. Thus, to the extent that the incurrence of variable overhead cost for Schmidt is related to the number of direct labor hours worked and the company dur-ing a given period uses a nonstandard amount of labor hours, it will incur both a direct labor efficiency variance (Chapter 14) and a variable overhead efficiency variance (Chapter 15). For October 2010, Schmidt used 3,510 direct labor hours to produce 780 units of output. The standard labor hours allowed for this level of output was 3,900 hours (780 units 5 hours per unit). Thus, the company worked 390 fewer hours than standard for the period. If variable overhead is incurred at the rate of $12 per labor hour worked, then this 390-hour saving would translate to a savings of $4,680 of variable overhead costs.

The variable overhead efficiency variance is therefore related to efficiency or inefficiency in the use of whatever activity variable is used to apply variable overhead for product-costing purposes (and for constructing the flexible budget for cost-control purposes). This reinforces the need to choose the proper activity variable for allocating variable overhead costs. Also, whoever is responsible for controlling the use of this activity variable would be responsible for controlling the variable overhead efficiency variance. In the case of the Schmidt Machin-ery Company, this would most likely be the production supervisor.

Fixed Overhead Cost Analysis We provide in Exhibit 15.5 a graphical representation of the process used to decompose the total fixed overhead variance for the Schmidt Machinery Company, October 2010. For product-costing purposes, the total variance is $37,050U, which is the difference between actual fixed overhead costs incurred ($130,650, assumed) and the standard fixed overhead costs charged to production during October ($93,600 780 units 5 standard labor hours per unit $24 standard fixed overhead rate per labor hoursee Exhibit 15.2 ). Note, too, that this total variance, from a product-costing standpoint, could be called total over- or underap-plied fixed overhead cost for the period. When the actual fixed overhead costs are greater than the fixed overhead costs assigned to production, as they were for the month of October, we call the $37,050 figure under applied fixed overhead.

The Production-Volume (Denominator) Variance As noted earlier in footnote 3, for federal income tax and GAAP purposes, companies must report inventories on a full (absorption) cost basis. This means that each unit produced must absorb a share of fixed factory overhead costs in addition to variable manufacturing costs. In

The total fixed overhead varianceis the difference between the actual fixed overhead cost incurred and the fixed overhead cost applied to production based on a standard fixed overhead application rate; also called over- or underapplied fixed overhead for the period.

The total fixed overhead varianceis the difference between the actual fixed overhead cost incurred and the fixed overhead cost applied to production based on a standard fixed overhead application rate; also called over- or underapplied fixed overhead for the period.



651

turn, this requires that fixed overhead costs be unitized for product-costing purposes. The following four-step process can be used for this purpose.

Step 1: Determine budgeted total fixed factory overhead Fixed manufacturing overhead costs, by definition, do not vary in the short run in response to changes in output or activity. As such, these costs are often referred to as capacity-related manufacturing support costs. Thus, once an organization has determined its capacity for an upcoming period (e.g., one year), it constructs a budget for capacity-related costs. In the case of Schmidt Machinery Company, assume that the capacity-related manufacturing costs are estimated at $120,000 per month.

Step 2: Choose an appropriate activity measure for applying fixed factory overhead For product-costing purposes, capacity-related manufacturing costs are assigned to outputs based on one or more activity measures (machine hours, labor hours, etc.). Usually, this is the same activity measure used to apply variable overhead costs to outputs. The Schmidt Machinery Company uses direct labor hours as the activity measure for assigning fixed overhead costs to production (output).

As we saw in Chapter 5, ABC systems attempt to associate activity costs with cost objects (products, services, etc.). Can recent think-ing regarding ABC system design facilitate product-mix decisions? This is precisely the question addressed by Baxendale et al. (2005) in a field study conducted at a 70-unit retirement and assisted-living facility. The facility had 10 two-bedroom units, 41 one-bedroom units, and 19 studio units and delivered four levels of care: short-term (i.e., temporary) care, care-free living, semi-assisted living, and assisted living. The combination of unit-type and care-type resulted in a total of nine cost objects (e.g., an assisted living, one-bedroom unit 1 cost object).

Given the nature of care, labor hours (of different types) were used as the activity variables for the ABC system. A key objective of the study was to determine for each of the seven major activities the amount of unused capacity. To do this, the authors had to estimate

the monthly practical capacity of each activity. For each of the seven major activities the authors then estimated the intensity of usage fac-tor for each of the nine cost objects. Activity costs and the cost of unused capacity for each of the nine activities could then be esti-mated. The authors next constructed a monthly income statement by service offering.

Data from the monthly income statement plus a set of constraints (e.g., total number of two-bedroom units available) allowed the authors to develop a computer model for determining the optimal short-term product mix for the facility. This model was executed using the Solver function in Excel and relied crucially on the availability of the cost of unused capacity for each of the seven activities.

Source: S. J. Baxendale, M. Gupta, and P. S. Rau, Profit Enhancement Using an ABC Model, Management Accounting Quarterly 6, no. 2 (Winter 2005), p. 20.

REAL-WORLD FOCUS Using the Cost of Unused Capacity to Optimize Product Mix

Standard Fixed Overhead Applied (SQ SP)Actual Fixed

Overhead

Budgeted FixedOverheadApplied FixedOverhead

LaborHours

DenominatorVolume

Total Variance

(U)

Spending Variance (U)

Production-Volume Variance (U)

(SQ)

Legend: SQ Standard labor hours allowed for units produced 5 780 3,900 hoursSP Standard fixed overhead cost per labor hour $24 (see Exhibit 15.2)Denominator volume Number of labor hours used to determine the fixed

overhead application rate 5,000 (assumed)Budgeted fixed overhead $120,000 (assumed)Total fixed overhead variance Spending variance Production-volume

variance

EXHIBIT 15.5 Schmidt Machinery Company Variance Analysis: Fixed Manufacturing Overhead



652

Step 3: Choose a denominator activity level In order to unitize fixed overhead costs for product-costing purposes, we must choose some level of output (activity) over which the bud-geted fixed costs for the period can be spread. The Schmidt Machinery Company uses 5,000 direct labor hours per month (i.e., 1,000 units 5 direct labor hours per unit) for this purpose. The general term used to describe the level of output (activity) used to establish the standard fixed overhead application rate is denominator activity level or denominator volume. Several alternatives exist for defining the denominator activity level: two supply-based alternatives, and two demand-based alternatives.

Supply-Based Definitions of Capacity The denominator activity level can be defined in terms of output capacity supplied. In this regard it is useful to think in terms of two alterna-tives: theoretical capacity (the maximum level of activity or output based on available capac-ity), or practical capacity (theoretical capacity reduced by normal employee breaks, machine downtime for maintenance, and other expected loss of output). As a rough rule of thumb, you might think of practical capacity as somewhere in the neighborhood of 80 to 85 percent of theoretical capacity. Thus, the notion of practical capacity is not rigidly defined.

Demand-Based Definitions of Capacity It is also possible to define capacity in terms of the demand for the organizations output. For example, we could use budgeted capacity uti-lization (the expected level of activity or output for the upcoming period, usually a year), or normal capacity (the average level of demand for the companys product projected over an intermediate-level number of years into the future, say, three to five years).

Given these choices, which activity level should be chosen when determining the fixed overhead application rate? The answer is partly subjective. This is due largely to the fact that the resulting product-cost information can be used for different purposes, ranging from product-pricing decisions, to performance-evaluation purposes, to tax and external report-ing requirements in accounting. In terms of the latter, Generally Accepted Accounting Prin-ciples (GAAP) (FASB ASC 330-10-30: Inventory-Overall-Initial Measurement [previously, SFAS No. 151: Inventory CostsAn Amendment of ARB No. 43, Chapter 4]) require that allocation of fixed production overhead to products be based on the normal capacity of the

Fixed overhead application rateis a term used for product-costing purposes; the rate at which fixed overhead is charged to production per unit of activity (or output).

Denominator activity level (denominator volume)is the output (activity) level used to establish the predetermined fixed overhead application rate; generally defined as practical capacity.

Theoretical capacityis a measure of capacity (output or activity) that assumes 100% efficiency; maximum possible output (or activity).

Practical capacityis theoretical capacity reduced by normal output losses due to personal time, normal maintenance, and so on.

Budgeted capacity utilizationrepresents planned (forecasted) output for the coming period, usually a year.

Normal capacityrepresents expected average demand per year over an intermediate-term, for example, the upcoming three to five years.

Fixed overhead application rateis a term used for product-costing purposes; the rate at which fixed overhead is charged to production per unit of activity (or output).

Denominator activity level (denominator volume)is the output (activity) level used to establish the predetermined fixed overhead application rate; generally defined as practical capacity.

Theoretical capacityis a measure of capacity (output or activity) that assumes 100% efficiency; maximum possible output (or activity).

Practical capacityis theoretical capacity reduced by normal output losses due to personal time, normal maintenance, and so on.

Budgeted capacity utilizationrepresents planned (forecasted) output for the coming period, usually a year.

Normal capacityrepresents expected average demand per year over an intermediate-term, for example, the upcoming three to five years.

To stay competitive in an increasingly competitive environment, organizations today are exploring a variety of control mechanisms, including the use of stretch targets. These targets, one example of which would be the use of maximum (theoretical) capacity for setting fixed overhead application rates, are by definition not attainable. How-ever, they are meant to motivate employees to think creatively and to strive for best-in-class performance. If stretch targets are going to be used successfully in an organization, due care and consideration are required. Recent survey evidence raises important implementation issues regarding the use of such targets.

What can organizations do to better position themselves to use stretch targets successfully? The authors offer recommendations in four categories:

1. Mutual trustestablish a culture of mutual trust between man-agers and subordinates (e.g., communicate to subordinates that managers will go to bat for them, encourage subordinates to take reasonable risks).

2. Management paradigmsfor example, take steps to ensure that the process of setting stretch targets is perceived by employees to be fair (even though the targets themselves may be unachiev-able), use more of a bottom-up process for setting budgets, and empower employees to accomplish goals and objectives in a manner they best see fit.

3. Information systemsif possible, provide to employees real-time feedback regarding whether employee initiatives are successful in terms of stated objectives; allow employees freer access to information.

4. Motivation and compensationcapture and report nonfinan-cial as well as financial performance data; ensure connection between effort and recognition; and use a combination of finan-cial and nonfinancial incentives.

Source: C. C. Chen and K. T. Jones, Are Companies Really Ready for Stretch Targets? Management Accounting Quarterly 6, no. 4 (Summer 2005), pp. 1018.

REAL-WORLD FOCUS Survey Evidence: Factors Related to Successful Implementation of Stretch Targets




production facilities. According to FASB ASC 330-10-30, normal capacity is the production expected to be achieved over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. According to this financial-reporting standard, some variation in production levels from period to period is expected and establishes the range of normal capacity. As noted in footnote 3, current income-tax requirements specify only that methods used to allocate indirect costs to inventory should result in reasonable allocations across outputs. Additional guidance for income-tax purposes regarding the use of alternative denominator-volume levels for determining income under the absorption-costing approach is given in Treasury Regulation Section 1.471-11: Inventories of Manufacturers.

Note that different definitions of the denominator volume will result in different fixed overhead application rates, different amounts of fixed overhead costs charged to produc-tion, and therefore different amounts for the production-volume variance (discussed below). Depending on how variances are disposed of at the end of the year, the financial statements can be affected by the choice of denominator activity level. 4

Our position is that for internal reporting purposes practical capacity be used as the denom-inator level for setting the fixed overhead allocation rate. We maintain this position for several reasons. One, though not necessarily controlling, the use of practical capacity is consistent with current Federal income tax requirements in the United States. Two, relative to budgeted output, the use of practical capacity volume provides more uniform data over time, which facilitates decision making on the part of management. (That is, managers do not have to continually reevaluate decisions based on changing product-cost data over time.) Third, the use of practical capacity in the denominator is logically consistent with the numerator in the fixed overhead rate calculation. That is, the numerator represents the costs of the capacity supplied and the denominator represents, in practical terms, the amount of capacity supplied. 5 Fourth, and perhaps most important, the use of practical capacity means that current customers and current production will not be burdened with the cost of unused capacity, which would be the case if budgeted output were used and budgeted output is less than practical capacity. From a pricing standpoint, this can help managers avoid the so-called death-spiral effect discussed in Chapter 5 (ABC and ABM). Finally, the resulting production-volume variance data (discussed below) can be interpreted, loosely, as the cost of unused capacity and therefore can be used for resource-capacity planning purposes. This information can facilitate decisions by manage-ment as to the appropriate supply of capacity-related resources (and associated costs).

Step 4: Calculate the predetermined fixed overhead application rate The last step in the process is to divide budgeted fixed factory overhead for the period by the denominator activity level. For Schmidt, this calculation results in a rate of $24 per direct labor hour, as reported in Exhibit 15.2 . Thus, for product-costing purposes each unit produced is assigned $120 of fixed factory overhead (i.e., $24/hour 5 hours).

In summary, for product-costing purposes a company must choose an activity level over which it spreads budgeted fixed manufacturing costs for a given period. If the company actu-ally operates at the level assumed when the application rate was determined, it will have assigned to production an amount exactly equal to the budgeted fixed overhead for the period. If, on the other hand, the company operates at any level of activity other than the denominator activity level, then it will have applied to production an amount greater or lesser than bud-geted fixed overhead. It is this over- or underapplied budgeted fixed overhead that we call the production-volume variance for the period.

4 As explained later in this chapter, there are different ways of disposing of standard cost variances at the end of the year. One of these methods is to restate cost of goods sold (CGS) and ending inventory amounts to actual costs by recalculating, at year-end, the actual fixed overhead cost per unit of output. Another approach is to allocate (prorate) variances to the ending inventory and CGS accounts. Under either of these approaches, the denominator activity level chosen at the beginning of the year for product-costing purposes during the year will have little or no effect on the financial statements for the year. The choice of denominator volume will, however, affect financial statements when standard cost variances are written off in their entirety to CGS. In short, in some cases the choice of denominator volume will affect an organizations financial statements for the year. 5 We note that practical capacity can change over time due to changes in manufacturing layout, improvements in worker efficiencies, and so on.

FASB ASC 330-10-30Provide financial-reporting guidance regarding the determination of overhead allocation rates and the treatment of abnormal idle-capacity variances.

FASB ASC 330-10-30Provide financial-reporting guidance regarding the determination of overhead allocation rates and the treatment of abnormal idle-capacity variances.

Resource-capacity planningrefers to ensuring adequate but not excessive supply of capacity-related resources.

Resource-capacity planningrefers to ensuring adequate but not excessive supply of capacity-related resources.

Fixed overhead production-volume varianceis the difference between budgeted fixed overhead for the period and the standard fixed overhead applied to production (using the fixed overhead allocation rate).

Fixed overhead production-volume varianceis the difference between budgeted fixed overhead for the period and the standard fixed overhead applied to production (using the fixed overhead allocation rate).



654

Refer back to Exhibit 15.5 . The line emanating from the origin represents the standard fixed overhead cost applied to production. The slope of this line is equal to the fixed over-head application rate, which in the case of Schmidt Machinery Company is $24 per hour (or, $120/unit). You will note that the only situation where the total fixed overhead applied exactly equals budgeted fixed overhead is when the output (activity) for the period is 5,000 standard allowed hours (or, equivalently, 1,000 units produced). The production-volume variance is therefore defined as the difference between budgeted fixed factory overhead cost and the standard fixed overhead cost applied to production. For October, this variance for the Schmidt Machinery Company is $26,400U, as follows:

Production-volume variance Budgeted fixed f aactory overhead cost Standard

fixed overhea

dd cost assigned to production

$ , [(120 000 7800

5 24

units produced

hours/unit per hou ) $ rr]

$ , $ , 120 000 93 600 $26, 400U

Or6

SP Denominator activity hours SQ

/hou

( )

$24 rr units hours/unit

[ , ( )]

$ ( ,

5 000 780 5

24 5 0000 3 900 6 , )hours $26, 400U

Fixed Overhead Spending (Budget) Variance

Refer to Exhibit 15.5 . We see that, in general, the fixed overhead spending (budget) vari-ance is defined as the difference between budgeted and actual fixed factory overhead for the period. For Schmidt Machinery Company, the fixed overhead spending (budget) variance for October was $10,650U, as follows:

Fixed overhead spending variance Actual fix eed overhead Budgeted fixed overhead

$1330 650 120 000, $ ,

$10,650U

Note that this is the amount reported in the profit-variance report contained in Exhibits 14.15 and 15.7. 6 Given the way costs are applied to outputs under a standard cost system, the production-volume variance can also be calculated as: Standard fixed overhead rate/unit (Denominator volume, in units Actual units produced). In the above example, we would have: $120/unit (1,000 units 780 units) $26,400 underapplied. This approach to calculating the production-volume variance would, in fact, be the approach used by a company that produces a single product.

Fixed overhead spending (budget) varianceis the difference between budgeted and actual fixed factory overhead costs for a period.

Fixed overhead spending (budget) varianceis the difference between budgeted and actual fixed factory overhead costs for a period.

Because automobile manufacturers face high degrees of operating leverage (i.e., relatively high levels of capacity-related costs), volume of output is critical to financial success. Further, the ability to quickly adapt production facilities to changes in consumer demand can lead to competitive advantage for an automaker. Smart players in this mar-ket are therefore making significant investments in what are called flexible manufacturing plants, which enable a company to quickly shift outputs and therefore maintain adequate use of available capac-ity. Honda alone has, over the past 10 years, invested over $400 million to convert its East Liberty, Ohio, plant to a flexible manufacturing facil-ity that relies heavily on the use of advanced robotics, which enables

the company to reduce setup and changeover costs (and time). How does Honda benefit? When gas prices are relatively low, the company can almost seamlessly switch production to large vehicles, such as its Ridgeline pickup truck. When gas prices are high, that same pro-ductive capacity can be easily converted to the production of smaller, more fuel-efficient automobiles. This type of production process stands in stark contrast to traditional manufacturing facilities that are configured to produce a significant volume of a single vehicle type.

Source: K. Linebaugh, Hondas Flexible Plants Provide Edge, The Wall Street Journal, September 23, 2008, p. B1.

REAL-WORLD FOCUS Managing Capacity Cost through Investments in Flexible Manufacturing



655

Automobile companies have huge investments in plant and equip-ment, which translates to significant amounts of capacity-related costs. Further, existing union contracts essentially have transformed labor costs to short-term fixed costs. Managing excess-capacity costs presents unique challenges when, as is the case for automak-ers, the underlying business is cyclical. Toyota estimates that the total wage cost alone associated with idle plants is $15 million to $20 mil-lion per month. Recently, however, the company changed in dramatic

fashion the manner in which it manages it short-term idle-capacity costs: when business is slack it uses any available downtime to send its employees to training sessions designed to sharpen their job skills, investments that the company hopes will result in better quality and increases in employee productivity.

Source: K. Linebaugh, Idle Workers Busy at Toyota, The Wall Street Jour-nal, October 13, 2008, p. B1.

REAL-WORLD FOCUS Managing the Cost of Idle Capacity at Toyota Motor Corporation

Interpretation of Fixed Overhead Variances

Production (Denominator) Volume Variance

This variance is an artifact of unitizing fixed overhead costs for product-costing purposes. As indicated in Exhibit 15.5 , in and of itself this variance has no meaning for cost-control pur-poses. However, as we indicated earlier in this chapter, if practical capacity is used to estab-lish the fixed overhead application rate, then the production-volume variance can be viewed as a rough measure of capacity utilization. This is because the variance reflects differences between available capacity and actual capacity usage. In short, the reporting of production-volume variances over time provides decision makers with information that can be used to manage spending on capacity-related resources. For example, consistently reported underap-plied fixed overhead (i.e., unfavorable production-volume variances) may signal the need to reduce spending on capacity-related costs or motivate action to better utilize the capacity that does exist.

You will note that if the fixed overhead allocation rate were based on expected (budgeted) output, then the cost of unused capacity would be hidden, that is, charged to the units actu-ally produced during the period. To the extent that selling prices are based on indicated costs and budgeted output is less than practical capacity, the use of budgeted output could lead to successively increasing charges (and, therefore, selling prices) over time, a situation referred to as the death-spiral effect. In this case, fixed overhead costs get allocated over successively lower outputs.

When practical capacity is used to calculate the fixed overhead application rate, the cost of unused capacity becomes visible to management through the amount and direction of the production-volume variance. To avoid misinterpretations, yet communicate information regarding capacity usage, some companies prefer to report the fixed overhead production-volume variance in physical terms only.

Finally, we note the importance of not placing too much emphasis on individual variances because of the interrelatedness of these performance indicators. For example, a production department in a manufacturing facility can generate a favorable production-volume variance by overproducing for the period, that is, producing more units than needed to meet sales and target ending inventory requirements. Such practice, of course, runs counter to the JIT phi-losophy. In this case, a financial performance indicator (production-volume variance) might be accompanied by one or more nonfinancial performance indicators (e.g., inventory turnover or spoilage/obsolescence rates).

Fixed Overhead Spending (Budget) Variance

Fixed overhead spending variances typically arise when the budget procedure for the organi-zation failed to anticipate or incorporate changes in spending for fixed overhead costs. For example, a budget that inadvertently neglected scheduled raises for factory managers, changes in property taxes on factory buildings and equipment, or purchases of new equipment create unfavorable spending variances.

The death-spiral effectis the continual raising of selling prices in an attempt to recover fixed costs, in spite of successive decreases in demand.

The death-spiral effectis the continual raising of selling prices in an attempt to recover fixed costs, in spite of successive decreases in demand.




Unfavorable fixed overhead spending variances can also result from excessive spending due to improper or inadequate cost controls. Events such as emergency repairs, impromptu replacement of equipment, or the addition of production supervisors for an unscheduled second shift all would result in unfavorable fixed overhead spending variances for the period.

Alternative Analyses of Overhead Variances In the discussion above, we separated the total variable overhead variance and the total fixed overhead variance each into two components. Such an analysis is referred to as a four-variance analysis of factory overhead. A general model for performing a four-variance anal-ysis, which combines Exhibits 15.4 and 15.5 , is given as Exhibit 15.6 . Not all companies, however, want or need to analyze factory overhead costs in this level of detail. Furthermore, a companys chart of accounts may not separate total overhead into its fixed and variable components. In the following sections we discuss alternative, less-detailed, ways to analyze overhead variances.

Three-Variance Subdivision of the Total Overhead Variance

The three-variance analysis of manufacturing overhead separates the total overhead variance into three components: total spending variance, variable overhead efficiency variance, and fixed overhead production-volume variance. That is, in a three-variance analysis, the variable overhead spending variance and the fixed overhead spending variance are combined into a single overhead variance. Thus, the total overhead variance for the period, $30,880U, can be subdivided into a total spending variance, $9,160U ($10,650 unfavorable fixed overhead spending variance $1,490 favorable variable overhead spending variance), a favorable var-iable overhead efficiency variance, $4,680, plus an unfavorable production-volume variance of $26,400.

Two-Variance Subdivision of the Total Overhead Variance

Companies that do not separate fixed from variable overhead costs for product-costing purposes perform what is called a two-variance analysis of the total overhead variance. That is, the total overhead variance for the period is broken down into a total flexible-budget variance for overhead

The total flexible-budget variance for overheadis equal to the difference between the actual factory overhead for a period and the flexible budget for overhead based on output.

The total flexible-budget variance for overheadis equal to the difference between the actual factory overhead for a period and the flexible budget for overhead based on output.

EXHIBIT 15.6 General Model: Four-Way Analysis of Total Overhead Variance

(A) (B) (C) (D)

Variable Overhead

Fixed Overhead

Flexible BudgetBased onOutput

Flexible BudgetBased onInputs

StandardOverheadApplied

Variable overheadspending variance

Variable overheadefficiency variance

Total standard quantityof the activity for applying variable overhead to theoutput of the period Standard variableoverhead rate

Actual quantity of theactivity for applying variable overhead Standard variable overhead rateAmount spent

Cost Incurred

Fixed overhead budget (spending) variance Production (denominator)volume variance

Total standard quantityof the activity forapplying overhead to the output of the period Standard fixedoverhead rate

Budgeted(Lump-Sum)

amountAmount spent




and a production-volume variance (which pertains only to the product-costing purpose of standard costing, as described above).

For the Schmidt Machinery Company, the total overhead variance in October, as before, is $30,880U. This variance is broken down as follows:

Flexible-budget variance

Actual factory overhead Flexible budget forr factory overhead based oni.e., b

output( aased on allowed hours for units produced)

((Actual fixed overhead Actual variable ove rrhead Budgeted fixed overheadStandard

) [(

aallowed hours Standard variable overhead r aate per hour)]

($ , $ , ) [$ , 130 650 40 630 120 0000 12 00 3 900

166 8

( . , )]

,

$

$171,280 $

/hr. hrs.

000 $4, 480U

Note that $4,480 is the net amount of the two overhead flexible-budget variances contained in Exhibit 14.15: a total variable overhead variance of $6,170F, plus a total fixed overhead vari-ance of $10,650U.

The second variance in a two-variance breakdown of the total overhead variance ($30,880U) is the production-volume variance, as follows:

Production (denominator)volume variance

Fl eexible budget foroverhead based on output

AApplied factoryoverhead

hr $ , ( ,166 800 3 900 ss. /hr. $ . )36 00 $26, 400U

Note that the production-volume variance is exactly the same as the amount calculated under the four-variance and the three-variance breakdown.

Summary of Overhead Variances Exhibit 15.7 provides a summary of the various approaches to the analysis of overhead vari-ances. In each case, the total variance to be explained for the Schmidt Machinery Company for October 2010 is $30,880U. The production-volume variance ($26,400U) relates to the product-costing use of standard costs. That is, this variance will occur only if a company uses a standard cost system and defines product cost as full manufacturing cost. The other variances can be calculated regardless of whether the firm uses a standard cost system. The degree of detail decreases as we go from the four-variance approach to the two-variance approach. None of these approaches is inherently good or bad: each has to be judged in terms of implementation cost versus perceived benefits associated with the resulting variance information.

Before leaving this discussion, it is important to point out some alternative terminol-ogy for the variances to which we referred in the preceding sections. When standard costs are incorporated formally into the accounting records (that is, when a standard cost sys-tem is used), we have already indicated that the total overhead variance for the period can also be referred to as total over- or underapplied overhead. Also, note that the production-volume variance is also referred to as the capacity variance, the idle-capacity variance, the denominator-level variance, the output-level overhead variance, or simply, the denominator variance. The spending variance for variable overhead is sometimes referred to as a price variance or a budget variance. The total flexible-budget variance for overhead (and by exten-sion the total flexible-budget variance for fixed overhead and the total flexible-budget vari-ance for variable overhead) is sometimes referred to as a controllable variance. This latter term is more descriptive of the use of standard costs and related variances for cost-control purposes. For this reason, the production-volume variance is sometimes referred to as the noncontrollable overhead variance. The important point is that, unfortunately, this is an area where the terminology is not standard. Therefore, you need to keep the above-listed alterna-tives in mind in any given situation.




Recording Standard Overhead Costs

Journal Entries and Variances for Overhead Costs As noted above and in Chapter 14, a standard cost system incorporates standard product costs in the formal accounting records (raw materials, WIP inventory, finished goods inventory, and cost of goods sold). As in the case of direct materials and direct labor, the standard overhead cost of the output of the period is charged to production, while actual overhead costs are recorded separately, in descriptive accounts such as Utilities Payable, Accumulated Depreciation, and Salaries Payable.

LEARNING OBJECTIVE 3Record overhead costs and associated standard cost variances.

LEARNING OBJECTIVE 3Record overhead costs and associated standard cost variances.

Panel 1: Four-Variance Analysis

Panel 2: Three-Variance Analysis

Panel 3: Two-Variance Analysis

VariableOverhead

ActualFlexible BudgetBased on Inputs

Flexible-budget

Flexible BudgetBased on Outputs

Standard Cost Applied toProduction

FixedOverhead

VariableOverhead

FixedOverhead

(3,510 $11.5755) (3,510 $12.00) (3,900 $12.00) (3,900 $12.00)

$40,630 $42,120

$130,650 $120,000$171,280

$40,630

$130,650$171,280

$162,120

$46,800

$120,000 $36.00hr.3,900 hours

$166,800

$46,800

$120,000$166,800

$140,400

$36.00hr.3,900 hours

$140,400

VariableOverhead

FixedOverhead

Total

Total

Efficiency

Efficiency

Spending

Spending Production-volume

Production-volume

NAvariance $1,490F

variance $9,160U

variance $4,480U variance $26,400U

variance $4,680F variance $26,400U

variance $4,680F

$40,630 $42,120 $46,800 $46,800

Actual(AQ AP)

Flexible BudgetBased on Inputs

(AQ SP)


(SQ SP)

Standard Cost Applied toProduction(SQ SP)

(3,900 $24.00)

Spending Production-volumeNAvariance $10,650U variance $26,400U

$130,650 $120,000 $120,000 $93,600

ActualFlexible BudgetBased on Inputs


Standard Cost Applied toProduction

Total factory overhead variance $30,880U

(i.e., underapplied overhead $30,880U)





Total Variable overhead variance

$6,170F

EXHIBIT 15.7 Schmidt Machinery Company, Overhead Variance Analyses, October 2010




Assume that for October 2010, the Schmidt Machinery Company incurred the following variable overhead costs: utilities, $30,000, and indirect materials, $10,630. These actual over-head costs would be recorded as incurred, in entries such as the following:

Manufacturing Overhead 40,630 Utilities Payable 30,000 Indirect Materials Inventory 10,630

At the end of the month (process cost system) or at the completion of one or more jobs (job-order cost system), the WIP inventory account must be charged for the standard variable over-head cost of the 780 units produced. The standard variable overhead rate is $12 per labor hour and the standard number of labor hours per unit is 5. Thus, for October 2010 the appropriate journal entry would be:

WIP Inventory [(780 units 5 hrs./unit) $12.00/hr.] 46,800 Manufacturing Overhead 46,800

At this point, you can see that the balance in the Factory Overhead account ($46,800 cr. $40,630 dr. $6,170F) is the total variable overhead variance for the period.

Assume now, for simplicity, that the actual fixed overhead cost for October 2010 consisted of only two items: $100,000 supervisory salaries plus $30,650 of depreciation expense. The journal entry to record actual fixed overhead costs for the month would be:

Manufacturing Overhead 130,650 Accumulated Depreciation 30,650 Salaries Payable 100,000

Recall that the standard fixed overhead rate is $24 per standard labor hour allowed, or equivalently, $120 per unit produced (since there are 5 standard labor hours per unit pro-duced). The journal entry to charge production with standard fixed overhead cost would be:

WIP Inventory [(780 units 5 hrs./unit) $24/hr.] 93,600 Manufacturing Overhead 93,600

Similar to entries we made in Chapter 14 for direct materials and direct labor, we would then use the following journal entry to transfer the standard overhead cost of completed production from WIP Inventory to Finished Goods Inventory:

Finished Goods Inventory ($180/unit 780 units) 140,400 WIP Inventory 140,400

After these entries are posted to the ledger, the Manufacturing Overhead account contains the net overhead balance for the period, $30,880 debit (i.e., net unfavorable variance). The com-ponent variances calculated using one of the approaches described above could be calculated and used to close out the $30,880 balance in the Manufacturing Overhead account. Assume that Schmidt Machinery Company uses the four-variance approach for overhead analysis. The appropriate journal entry to record the standard overhead cost variances for October 2010 would be as follows:

Production-Volume Variance 26,400 Fixed Overhead Spending Variance 10,650 Manufacturing Overhead 30,880 Variable Overhead Spending Variance 1,490 Variable Overhead Efficiency Variance 4,680




Variance Disposition For interim purposes (e.g., preparation of monthly or quarterly financial statements), the standard cost variances calculated in this chapter and in Chapter 14 are typically not disposed of. That is, the variance accounts are carried forward on the balance sheet under the assump-tion that, over the course of the year, favorable and unfavorable interim variances will offset one another. If interim financial statements are prepared, the cost variances can be shown in a temporary (i.e., holding) account awaiting ultimate disposition at the end of the year.

At the end of the year, the appropriate treatment for standard cost variances depends on the size (materiality) of the net variance. Assume, for example, that variance data for Schmidt from Chapters 14 and 15 relate to the fiscal year, not just the month of October. These cost variances are as follows:

Variance Source Amount

DM purchase price variance Exhibit 14.15 $ 4,350UDM quantity variance Exhibit 14.15 10,350UDL rate variance Exhibit 14.15 7,020UDL efficiency variance Exhibit 14.15 15,600FVariable overhead spending variance Exhibit 15.7, Panel 1 1,490FVariable overhead efficiency variance Exhibit 15.7, Panel 1 4,680FFixed overhead spending variance Exhibit 15.7, Panel 1 10,650UFixed overhead volume variance Exhibit 15.7, Panel 1 26,400UNet standard manufacturing cost variance for the year $37,000U

Net Variance Considered Immaterial

If the net manufacturing cost variance of $37,000U is not considered to be material, then an appropriate treatment at year-end would be to close all variances to Cost of Goods Sold. If the net variance is favorable, then it is closed out by crediting (i.e., reducing) Cost of Goods Sold. If, as in the present case, the net standard cost variance is unfavorable, the Cost of Goods Sold account is debited (i.e., increased) by the amount of the net variance. The following journal entry closes out the net unfavorable variance of $37,000:

Cost of Goods Sold 37,000 Direct labor efficiency variance 15,600 Variable overhead efficiency variance 4,680 Variable overhead spending variance 1,490 Direct materials purchase price variance 4,350 Direct materials quantity variance 10,350 Direct labor rate variance 7,020 Fixed overhead spending variance 10,650 Fixed overhead volume variance 26,400

EXHIBIT 15.8Annual Income Statement with Write-Off of the Net Manufacturing Cost Variance

SCHMIDT MACHINERY COMPANYIncome Statement

For 2010

Sales (Exhibit 14.4), at standard selling price $624,000

Add: Selling price variance (Exhibit 14.4) 15,600F

Net sales, at actual selling price $639,600Cost of goods sold (at standard: 780 units $520/unit) (Exhibit.15.2) $405,600

Add: Net manufacturing cost variance 37,000U

Total cost of goods sold 442,600

Gross margin $197,000Selling and administrative expenses ($39,000 variable $30,000 fixed) 69,000

Operating income (before disposition of sales-volume variance) $128,000

$50F net variable cost variance (Exhibit 14.8) $37,050U net fixed cost variance ( Exhibit 15.7 , Panel 1; $10,650U fixed overhead spending variance $26,400U production-volume variance).




Under the assumption that the results for October represent annual results for the Schmidt Machinery Company, its condensed income statement for 2010 is reflected in Exhibit 15.8 . As noted above, this treatment of the net variance for the period is appropriate when the amount involved is considered immaterial.

However, some accountants argue that any variance that results from inefficiencies that could in the judgment of management have been avoided, regardless of amount, should be written off against Cost of Goods Sold rather than carried forward on the balance sheet as is the case with the proration method discussed below. Not to do this implies that asset values reflected on the balance sheet (i.e., inventories) necessarily contain the cost of inefficiencies, a situation that some accountants would dismiss as improper.

Net Variance Considered Material in Amount

If the net manufacturing cost variance is considered material in amount, the net variance should be allocated to the Inventory and Cost of Goods Sold (CGS) accounts. This allocation should be based on the relative amount of this periods standard cost in the end-of-period balance of each affected account. This means that the direct materials price variance from Chapter 14 will be apportioned to five accountsMaterials Inventory, the Materials Quantity Variance, WIP Inventory, Finished Goods Inventory, and CGSbased on the amount of this periods standard cost in each account at the end of the period. The direct materials quantity variance would be allocated only to WIP Inventory, Finished Goods Inventory, and CGS. This is because the materials efficiency variance occurs after materials are issued to production.

Note that, as a practical matter, some companies allocate the price variance only to ending inventory and CGS accounts. This is, in fact, standard practice for problems on the Uniform CPA exam.

Any labor-cost variances and variable overhead variances would be allocated to WIP Inven-tory, Finished Goods Inventory, and CGS on the basis of this periods standard labor and standard variable overhead costs, respectively, in these accounts at year-end. The fixed overhead spending variance should be allocated to four accounts: WIP Inventory, Finished Goods Inventory, CGS, and the Production-Volume Variance. The Production-Volume Variance, if allocated, would be apportioned among WIP Inventory, Finished Goods Inventory, and CGS. Finally, we note that for external reporting purposes, accountants need to follow the provisions of Generally Accepted Accounting Principles, which specifies that abnormal amounts of idle facility expense should be recognized as current-period charges and not capitalized as part of inventory cost. One impli-cation of this reporting requirement is that the amount of fixed overhead allocated to each unit of production is not increased as a consequence of abnormally low production or an idle plant.

Some companies take a simpler approach to the variance-allocation decision. For example, they may use the total end-of-period account balances, rather than this periods standard cost in each end-of-period account, to allocate the net manufacturing cost variance. Other com-panies, in particular those that have minimal ending inventories, choose to write off against CGS the net variance, regardless of its size, because most of the variance would be allocated to CGS anyway. Thus, the error of not allocating a portion of the variance to inventories, as well as CGS, is thought to be minimal.

The Effects on Absorption Costing Income of Denominator-Level Choice in Allocating Fixed Overhead Before leaving this section, we discuss one additional topic, principally because it deals with the issue of managing earnings through the selection of the denominator level used to establish the fixed-overhead application rate. We noted earlier in this chapter that alternative denomina-tor-volume levels lead to different (fixed) overhead application rates, which in turn lead to dif-ferent product costs, and ultimately to different levels of the production-volume variance. The accounting disposition of the production-volume variance essentially provides management with an opportunity to smooth, or manage, income as determined under absorption costing.

Under absorption (i.e., full) costing, a portion of fixed manufacturing overhead costs are either absorbed into or released from inventory, depending on the relationship between pro-duction volume and sales volume during the period. For example, for a given level of sales, the production of extra units shifts fixed overhead costs to the balance sheet (inventory) so that reported profit increases with increases in production. The opposite is true if inventory is

Managing earningsrefers to the manipulation of reported income.

Managing earningsrefers to the manipulation of reported income.




decreasing. For a given level of sales, decreases in production requires not only this periods fixed overhead to be released as an expense on the income statement, it also implies the release of some previously capitalized fixed overhead costs (from inventory). Thus, for a given level of sales, absorption-costing income decreases as production decreases.

Note, however, a key point: the amount of fixed overhead costs absorbed or released is affected by the denominator level chosen for the predetermined overhead rate. Thus, the effect of a change in inventory can be intensified or reduced based on how the production-volume variance is disposed of at the end of the period. Specifically, this ability to affect reported income is confined to the situation where the production-volume variance is written off entirely to cost of goods sold (CGS), as follows:

If inventory is increasing, choosing a lower denominator-volume level will enhance the increase in absorption costing income due to the deferral of fixed overhead in inventory.

If inventory is decreasing, choosing a higher denominator level will moderate the decrease in absorption-costing income due to the release of fixed overhead into CGS.

Thus, it is through the interaction of how the fixed overhead rate is set and how the result-ing production-volume variance is accounted for that provides management an opportunity to manage earnings under absorption costing. The above points suggest that managers can increase short-run operating income by: (1) choosing larger denominator levels if they expect inventory to decrease, or (2) choosing smaller denominator levels if they expect inventory to increase. Note, however, that if the production-volume variance is prorated based on the units creating the variance, then the denominator-level choice has no effect on absorption-costing income. This is because prorating this variance effectively changes the budgeted overhead application rate to the actual overhead application rate.

Standard Costs in Service Organizations

As noted in Chapter 14, a standard cost system facilitates planning (i.e., budget preparation) and financial control (through standard-cost variance analysis) and aids managers in making decisions such as product pricing and resource management. These benefits, however, are not limited to manufacturing companies. All organizations can potentially benefit from the use of a standard cost system.

Most costs in a service organization are short-term fixed (i.e., capacity-related) costs. The bulk of labor costs are for professional personnel who usually are paid a monthly salary. Variations from one period to the next for salaried personnel should be small or nonexistent. Other overhead costs for these organizations often consist of expenses related to facilities and equipment and are therefore fixed in the short run. Other service-sector companies have minimal labor relative to capacity-related costs. Examples include the airline industry, the shipping industry, and much of the telecommunications industry. The predominance of capac-ity-related costs for such companies increases the importance of monitoring fixed-cost spend-ing variances and idle-capacity variances.

Furthermore, service organizations have varied measures of output. Exhibit 15.9 lists some measures of output often used by service organizations. As shown in Exhibit 15.10 , hospitals use patient-days to measure output. Colleges and universities use credit-hour pro-duction to show their outputs. However, these output measures seldom are perfect indicators of the outputs of service organizations. Patients or their families are likely to place different values on the same number of patient-days, depending on the results of treatments. A patient

LEARNING OBJECTIVE 4Apply standard costs to service organizations.

LEARNING OBJECTIVE 4Apply standard costs to service organizations.

Organization Output Measure

Airline Revenue-producing passenger milesHospital Patient daysHotel Occupancy rate or number of guestsAccounting, legal, and consulting firms Professional staff hoursColleges and universities Credit hoursPrimary and secondary schools Number of students

EXHIBIT 15.9 Output Measures for Selected Service Organizations



663

who is cured of an illness is likely to be more pleased with the care received than is the family of a patient who died of the same disease, although the number of patient-days was identi-cal for both. In addition, the amount and type of work performed by a service organization to complete an output unit often varies from one client to the next or from one patient-day to another. The amounts and types of work performed for two patients with identical heart diseases during their 10-day stays can be vastly different although the number of patient-days is identical and their illnesses are the same.

The process of determining an appropriate level of capacity is one of the most strategically important decisions that managers must make. Unused capacity wastes resources; insufficient capacity incurs various costs, the most important of which are lost busi-ness (opportunity costs) and customer ill-will (and loss of future business). Capacity-related costs are important to service-sector entities, particularly those that compete on the basis of customer service.

One aspect of customer service relates to call centers, which customers (or potential customers) can access to get service-related information. The problem with call centers, however, is that incom-ing-call volumes fluctuate widely during the day and various times of the week. This complicates efforts to determine the appropriate supply of call-center capacity. Customers hate long waiting times, so its important for companies to promptly pass calls to an appropriate agent. But thats hard to do in companies employing thousands of agents in different places.

However, new technologies, such as upgrades made to call-routing capabilities, are helping organizations make better capacity-related decisions. One major US airline found that, in spite of a large invest-ment in call-distribution technology, agents in a Midwest call center sat idle while customers waited three minutes or more to speak to identically skilled agents on the West Coast.

This company has taken advantage of recent developments in Inter-net Protocol (IP) telephony and automated-call-distribution technology that radically improve the delivery of the right call to the right agent at the right time across a number of call centers. A $3 million investment in this new technology allowed the airline to manage calls more effec-tively and helped reduce operating costs by 5 percent, or $7 million a year, while improving service to meet their preexisting targets.

Source: Wayne E. Pietraszek and Adesh Ramchandran, Using IT to Boost Call-Center Performance, The McKinsey Quarterly (www.mckinseyquarterly.com, accessed March 20, 2006). This article was first published in the Spring 2006 issue of McKinsey on IT.

REAL-WORLD FOCUS Matching Capacity and Demand in the Services IndustryHow Can IT Help?

LANCASTER COUNTY HOSPITALStandard Cost Sheet for Pediatrics Floor

Direct Expenses Rate/Price Amount Fixed

Salaries and wages: Supervisors $9,000 RNs $ 30.00 per hour 1.3 hours per patient-day LPNs 20.00 per hour 1.7 hours per patient-day Nursing assistants 13.00 per hour 0.9 hour per patient-day SuppliesInventory 0.20 per unit 10 units per patient-day Suppliesnoninventory 300Pediatrician fees $ 200 per hour 0.5 hour per patient-day Other direct expenses 250

Transferred Expenses

Housekeeping $ 10.00 per hour 48 hours 0.4 hour per patient-day 1.50 hours per patient dischargeLaundry $ 0.50 per pound 500 pounds 15 pounds per patient-day 30 pounds per discharge 50 pounds per surgery

Allocated Expenses

Personnel $ 0.16 per hour 242 hours 3.9 hours per patient-dayOther administrative and general $ 6.00 per hour 118 hours 0.05 hour per patient-day 1.5 hours per patient discharge

EXHIBIT 15.10Standard Cost Sheet for a Hospital

Source: Based on Table 14 in Managerial Cost Accounting for Hospitals (Chicago: American Hospital Association, 1980), p. 97.




The differences in operating characteristics between service organizations and typical manufacturing companies make it a necessity to modify standard cost systems before apply-ing them to service organizations.

Overhead Cost Variances in ABC Systems

The manufacturing environment has evolved over the last few decades and many new manage-ment techniques have been developed during this period to emphasize continual improvement, total quality management, and managing activities rather than cost. These emphases have changed product costing, strategic and operational decisions, and cost-determination methods, as discussed in the preceding chapters. They also influence the ways in which many firms use standard cost systems as management tools, including the preparation of flexible budgets, the selection of performance-evaluation criteria, and the implication of reported variances.

ABC-Based Flexible Budgets for Control Because a number of different activities influence factory overhead costs, the accountant needs to carefully select the activity measure, or measures, that will be used to construct the flexible budget for control purposes. The Schmidt Machinery Company, as illustrated thus far in the chapter, uses a single, volume-based activity measure (direct labor hours) for allocating overhead costs to outputs and for determining standard cost variances for control purposes.

As described in Chapter 5, more modern cost systems, such as activity-based costing (ABC) systems, apply manufacturing support (i.e., factory overhead) costs to outputs on the basis of activities performed for each product produced. That is, ABC attempts to assign manufactur-ing support costs to products on the basis of the resource demands, or resource consumption, of each output. To accomplish this, ABC systems use a broader set of activity measures, both volume-related and non-volume-related, in the cost-allocation process.

Cooper has developed a framework, in the form of a hierarchy, for classifying different types of activity measures used in ABC systems. 7 Coopers framework classifies manufac-turing support costs as unit-based, batch-level, product-level, or facilities-level. Unit-based measures are related to output volume and include machine hours, direct labor hours, units of output, and units of raw materials. Batch-level activity measures include the number of production setups, the number of times materials and parts are moved during the manufactur-ing process, and the number of receipts of materials. Product-level activity measures typically relate to engineering support activities and can include things such as number of products, number of processes, number of engineering change orders (ECOs), and number of schedule changes. At the top of the cost hierarchy are facilities-level costs, which are related to the capacity or ability to produce, not to the variety of outputs, the number of batches produced, or the volume of output.

Exhibit 15.11 illustrates a traditional flexible (control) budget prepared for a company that applies factory overhead cost to outputs on the basis of standard direct labor hours, similar in nature to the example discussed thus far in this chapter. The master budget in this exhibit is based on a planned output of 3,000 units for the period (1,500 standard labor hours). The flexible budget is based on the actual output of the period, 2,000 units (or, equivalently, 1,000 standard labor hours). The company in this example spent 1,200 direct labor hours to manu-facture the 2,000 units. Exhibit 15.12 shows a typical financial report for manufacturing costs incurred during the period.

By contrast, Exhibit 15.13 illustrates a flexible budget for the period prepared under ABC. This representation specifies that manufacturing costs are assigned to outputs on the basis of multiple activity measures. In the present example, three different volume-related activ-ity measures are used (units produced, direct labor hours, and machine hours) as well as one non-volume-related activity (number of production setups). Note that there is a single facility-level cost, insurance, that essentially has no well-defined activity variable. Because this cost is not related to volume of output, or number of batches, or number of products, it is allocated

7 R. Cooper, Cost Classification in Unit-Based and Activity-Based Manufacturing Cost Systems, Journal of Cost Management for the Manufacturing Industry, Fall 1990, pp. 414.

LEARNING OBJECTIVE 5Analyze overhead variances in an activity-based cost (ABC) system.

LEARNING OBJECTIVE 5Analyze overhead variances in an activity-based cost (ABC) system.




to products using a systematic, but essentially arbitrary, method, such as square feet in the fac-tory devoted to the production of each product.

Compared to the simpler control budget presented in Exhibit 15.11 , the ABC-based flexible budget presented in Exhibit 15.13 provides more accurate representation of the manufacturing costs that should have been incurred for the production of 2,000 units. A financial-performance report for the period, based on the ABC flexible budget, is presented in Exhibit 15.14 .

EXHIBIT 15.11 Master Budget and Traditional Flexible Budget for Control

Cost Elements

Variable Fixed Cost Item Flexible Budget for 2,000 Units Master Budget for 3,000 Units

(1,000 standard direct labor hours) (1,500 standard direct labor hours)

$20/unit Direct materials $ 40,000 $ 60,000 30/Direct labor hour Direct labor 30,000 45,000 2/Direct labor hour Indirect material 2,000 3,000 5/Direct labor hour Repair and maintenance 5,000 7,500 $ 5,000 Receiving 5,000 5,000 30,000 Insurance 30,000 30,000 75,000 Setup 75,000 75,000

Total $187,000 $225,500

EXHIBIT 15.13 Representation of Manufacturing Costs under an ABC System

Cost Function

Data Activity Measure Variable Fixed Flexible (Control) Budget Master (Static) Budget

Operating DataOutput Number of units 2,000 units 3,000 unitsStandard Direct labor hours 1,000 hours 1,500 hoursStandard Machine hours 300,000 hours 450,000 hoursNumber of setups 2 setups 3 setups

Cost DataDirect materials Number of units $20/unit $ 40,000 $ 60,000Direct labor Direct labor hours $30/hour, 0.5 hour/unit 30,000 45,000Indirect materials Direct labor hours $2/direct labor hour 2,000 3,000Repair and maintenance Machine hours $0.01/machine hour $ 3,000 6,000 7,500Receiving Number of setups $1,500/setup 500 3,500 5,000Setup Number of setups $25,000/setup 50,000 75,000Insurance Facility-level $30,000 30,000 30,000

Total $161,500 $225,500

EXHIBIT 15.12 Traditional Financial Performance Report

Flexible Generally Accepted Accounting Principles, Flexible Budget Budget Actual Cost Based on Output Variance

Direct materials $ 50,000 $ 40,000 $10,000UDirect labor 36,000 30,000 6,000UIndirect materials 3,000 2,000 1,000URepair and maintenance 6,500 5,000 1,500UReceiving 3,000 5,000 2,000FInsurance 30,000 30,000 Setup 50,000 75,000 25,000F

Total $178,500 $187,000 $ 8,500F



666

The total manufacturing cost flexible-budget variance for the period, based on a traditional costing system, is $8,500, favorable ( Exhibit 15.12 ). In contrast, the ABC approach yields a $17,000 unfavorable variance for the same period ( Exhibit 15.14 ). Exhibit

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