Allocating Joint Costs and Allocating Joint Costs
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Learning Objectives
After studying Chapter 5, you will be able to:
Use three different methods to allocate joint product costs, and explain how to handle situations involving byproducts and scrap.
Recast absorption costing income statements into variable costing income statements, reconcile the differences between the two net incomes, and understand arguments supporting both approaches.
5 Joint Cost Allocation and Variable andAbsorption Costing
AndreyPopov/iStockphoto/Thinkstock
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Should We Hide the Joint Cost Assigned to Hides?
Toco Hills Meat Packers handles the slaughtering, processing, packaging, and distribution of cattle. Dianne Leader, the company’s President, has just received the �irst quarter �inancial statements from her Vice-President and Controller, Bruce Berger. She immediately sees that while pro�its from the various meat products are up from the previous quarter, the pro�its from hides are down considerably. She calls Bruce and asks, “Can you tell me why costs for the hides appear to be so high?” Bruce responds, “No, but I’ll look into it and get an answer for you by tomorrow at this time.”
Like clockwork, Bruce knocks on the President’s door, enters, and hands Dianne a one-page report. “Ah, the joint cost allocation to hides seems to be out of line,” Dianne says with a frown. “You know,” Dianne tells Bruce, “if I had to bet on it, I’d wager some big bucks that you changed the way joint costs are assigned to our products.”
Indeed, the way joint costs are assigned to joint products that are produced by a company can greatly affect the reported pro�its from the various products. So, how should these costs be assigned?
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5.1 Joint Cost Allocation Production processes can sometimes spawn multiple products from common inputs and processing. These are called joint products. An example is a re�inery where crude oil is processed into joint products of gasoline, heating oil, and motor oil. The costs of materials and processing up until individual products are identi�iable are referred to as joint costs. This point at which the individual products become identi�iable is known as the split-off point. Until this point, the common input is a single product. The joint costs are allocated to the joint products for some product costing purposes such as external �inancial statement presentation and product pricing. In previous chapters, we have allocated costs using cost drivers that measure inputs such as labor hours or machine hours. However, input measures are not feasible for allocating joint costs since the joint products are not individually distinguishable until the split-off point, and hence, one cannot identify the amount of input associated with each product that emerges at the split-off point. Three common joint cost allocation methods—all based on outputs—are discussed next.
Physical Measures of Output
Physical measures of output re�lect some quanti�iable physical characteristics of the joint products. Examples include number of units, weight, liquid volume, and length. The joint costs would be allocated in proportion to each product’s output measure. Consider the Vexler Mining Company, which mines ore, and after separating the ore in a smelter, sells the individual outputs to jewelry and industrial manufacturers. Suppose that $400,000 in materials, labor, and overhead was incurred to mine a total of 100,000 ounces of the following three metals:
Mineral Amount
Gold 10,000 ounces
Silver 20,000 ounces
Copper 70,000 ounces
100,000 ounces
The joint cost allocations are made by multiplying the ratio of the metal’s output to the 100,000 total and multiplying the ratio by the $400,000 joint cost, as follows:
Allocation to gold: (10,000 ÷ 100,000) × $400,000 = $40,000
Allocation to silver: (20,000 ÷ 100,000) × $400,000 = $80,000
Allocation to copper: (70,000 ÷ 100,000) × $400,000 = $280,000
Note that the sum of these three allocated costs equals the $400,000 total joint cost. This method is generally simple to use, but has two potential major drawbacks. First, the outputs may have different units of measure. For instance, consider a petroleum re�inery that produces gasoline and paraf�in from a joint process. A common measure for gasoline, a liquid, would be gallons; for paraf�in, a solid, a common measure would be pounds.
A second limitation is that physical measures may be unrelated to the pro�itability of the joint products. Why is this an important consideration? The reason relates to why joint costs are incurred. Since joint costs are incurred because of the value that will be received from selling the joint products, the
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allocation of these joint costs should be related to the products’ values. For Vexler Mining Company, 70% of the joint cost was allocated to copper. Suppose, however, that gold accounts for 90% of the three metals’ total revenues. Clearly, the gold is what motivates Vexler to spend $400,000 to mine the ore, yet it receives only 10% (10,000 ÷ 100,000) of the joint costs, while copper is charged with seven times as much.
Relative Sales Value
The relative sales value (RSV) approach allocates joint costs in proportion to the joint products’ total sales values at the split-off point. Assume the following sales values for Vexler Mining Company’s joint products:
Mineral Sales Values
Gold $500,000
Silver 200,000
Copper 100,000
$800,000
Under the RSV method, the joint cost allocations would be as follows:
Allocation to gold: ($500,000 ÷ $800,000) × $400,000 = $250,000
Allocation to silver: ($200,000 ÷ $800,000) × $400,000 = $100,000
Allocation to copper: ($100,000 ÷ $800,000) × $400,000 = $50,000
Note that the sum of these three allocated costs equals the $400,000 total joint cost.
Net Realizable Value
A potential problem with the RSV approach is that sales prices at the split-off point may not be readily available. Moreover, there might not even be a market for one or more of the joint products at the split- off point. Further processing may be necessary to sell some products. The net realizable value (NRV) method uses approximations of sales values at the split-off point. NRV is the total sales revenue of the product in its �inal form less any separable costs. The latter consist of costs incurred after the split-off point, and as such, can be traced to the individual products. Separable costs include processing costs, selling costs, and disposal costs.
Suppose that after Vexler Mining Company smelts its ore, it incurs some costs to get the metals ready for sale to manufacturers. These separable costs, the products’ revenues, and the resulting NRVs are as follows:
Mineral Separable Costs Revenues NRV
Gold $10,000 $550,000 $540,000
Silver 12,000 252,000 240,000
Copper 15,000 135,000 120,000
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Mineral Separable Costs Revenues NRV
$900,000
For the NRV method, the joint cost allocations would be as follows:
Allocation to gold: ($540,000 ÷ $900,000) × $400,000 = $240,000
Allocation to silver: ($240,000 ÷ $900,000) × $400,000 = $106,667
Allocation to copper: ($120,000 ÷ $900,000) × $400,000 = $53,333
Note that the sum of these three allocated costs equals the $400,000 total joint cost. Occasionally, a situation may arise where a product’s NRV is negative. When this happens, none of the joint cost should be allocated to that product. The total joint cost would just be allocated to the products having positive NRVs.
The following table summarizes the joint cost allocations for all three methods:
Mineral Physical Output RSV NRV
Gold $40,000 $250,000 $240,000
Silver 80,000 100,000 106,667
Copper 280,000 50,000 53,333
$400,000 $400,000 $400,000
Byproducts and Scrap
Byproducts and scrap are products that emerge with joint (main) products but have minor sales value compared to the joint products. Byproducts are often processed after the split-off point, while scrap is usually discarded. The accounting treatment, though, is the same for both byproducts and scrap. Joint costs are not allocated to byproducts or scrap. The rationale for this treatment is that joint costs are incurred to produce the main products—not byproducts or scrap.
Revenue from byproducts or scrap is usually handled in one of two ways:
1. Recognize miscellaneous income from the NRVs of byproducts and scrap. 2. Deduct the NRVs of byproducts and scrap from the joint costs that are allocated to the main
products.
The rationale for the second approach builds on the argument we mentioned for not allocating joint costs to byproducts or scrap. That is, the joint production process is undertaken for the pro�its to be earned from main products—not byproducts or scrap. Therefore, no pro�it should be recognized on byproducts or scrap. In effect, the second method shifts any pro�it (NRV) on byproducts and scrap to the main products by reducing the joint costs assigned to the main products.
As an example, suppose that sulphur is a byproduct at Vexler Mining Company. Recall that with the RSV method, we had the following RSVs for the three joint products:
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Mineral Sales valuesMineral Sales values
Gold $500,000
Silver 200,000
Copper 100,000
$800,000
Suppose now that sulphur could be sold at the split-off point for $8,000 after incurring separable costs of $2,000. With the miscellaneous income approach, $6,000 ($8,000 – $2,000) in miscellaneous income would appear on Vexler’s income statement from the sale of sulphur. Under the alternate approach, joint costs of $394,000 ($400,000 – $6,000) would be allocated to the main products in proportion to just the main products’ total sales values, as follows:
Allocation to gold: ($500,000 ÷ $800,000) × $394,000 = $246,250
Allocation to silver: ($200,000 ÷ $800,000) × $394,000 = $98,500
Allocation to copper: ($100,000 ÷ $800,000) × $394,000 = $49,250
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5.2 Variable and Absorption Costing Variable costing (also known as direct costing) is an approach to product costing that assigns only variable manufacturing costs (direct materials, direct labor, and variable factory overhead) to items produced. Thus, inventoriable costs are limited to the variable manufacturing costs, and period costs include all �ixed costs and variable nonmanufacturing costs. Absorption costing (also known as full costing), the method typically used for external income statement reporting, allocates all manufacturing costs (variable and �ixed) to products. This section compares these two costing methods.
Contemporary Practice 5.1: Usage of Variable Costing
In a survey of 148 German and 130 U.S. companies in a cross section of industries, far more German companies labeled their costing system as variable costing—52% versus 21%. The director of cost accounting and internal audit at Cliffstar remarked, “We like variable costing because it doesn’t ‘muddy up’ the waters with less controllable �ixed overhead.”
Source: Krumwiede, K., & Suessmair, A. (2007, June). Getting down to speci�ics on RCA. Strategic Finance, 51–55.
Variable costing, like absorption costing, can be used in conjunction with actual, normal, or standard costing systems. For simplicity, we will restrict our discussion in this chapter to situations in which actual costing is used.
Characteristics of Variable and Absorption Costing
The two costing methods vary as to the cost elements for product costs, the difference in inventory values, and the difference in pro�its. These differences all result from one basic item—the treatment of �ixed manufacturing costs. Absorption costing includes these costs in product costs while variable costing considers them as period costs to be included with the operating expenses. The following summary contrasts the two costing approaches:
Cost Category Variable Costing Absorption Costing
Direct materials Product Product
Direct labor Product Product
Variable factory overhead Product Product
Fixed factory overhead Period Product
Marketing expenses Period Period
Administrative expenses Period Period
Variable costing typically uses a contribution margin approach as a reporting format. Variable marketing and administrative costs are included in the computation of the contribution margin. However, variable
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marketing and administrative costs are not product costs. While we will portray variable costing income statements using the contribution format, we will use the traditional format for the absorption costing income statements. A comparison of the two approaches appears below:
Variable Costing Absorption Costing
Sales revenue Sales revenue
− Variable cost of goods sold − Cost of goods sold
− Other variable costs = Gross pro�it
= Contribution margin − Other variable costs
− Fixed manufacturing costs − Fixed manufacturing costs
− Fixed nonmanufacturing costs − Fixed nonmanufacturing costs
= Operating income = Operating income
Deciding between variable costing and absorption costing has an impact on inventory values and pro�its because of the variation in the treatment of �ixed factory overhead. Although the pro�it can differ between the two costing methods, pro�it under variable costing is not always higher or lower than absorption costing. The difference between pro�its under the two methods is determined by the relationship of production to sales. Assuming that the �ixed manufacturing costs per unit remain the same from one period to the next, we have three possibilities, as follows:
Net Income
Production units equal sales units AC = VC
Production units greater than sales units (building inventory) AC > VC
Production units less than sales units (liquidating inventory) AC < VC
AC = Absorption costing
VC = Variable costing
The magnitude of any difference in pro�its is a function of the �ixed manufacturing costs per unit and the changes in inventory levels, as we will discuss later.
Comparing Variable Costing and Absorption Costing
Let’s assume that Morris the Florist sells one type of �loral arrangement. In its �irst year, 2018, Morris the Florist produced 100,000 arrangements and sold 75,000 at $25 each. The costs for the year are:
Production Costs (Per Unit):
Materials $3.00
Labor 8.00
Variable overhead 5.00
Fixed overhead ($200,000/100,000 units) 2.00
Marketing and Administrative Costs:
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Variable $1.00 per unit sold
Fixed $150,000
The absorption costing income statement that re�lects these results is as follows:
Absorption Costing Income Statement for the Year Ended December 31, 2018
Sales revenue ($25 × 75,000) $1,875,000
Cost of sales:
Variable ($16 × 75,000) $1,200,000
Fixed ($2 × 75,000) 150,000 1,350,000
Gross pro�it $525,000
Marketing and administrative expenses:
Variable ($1 × 75,000) $75,000
Fixed 150,000 225,000
Net pro�it $300,000
A variable costing income statement would be as follows:
Variable Costing Income Statement for the Year Ended December 31, 2018
Sales revenue ($25 × 75,000) $1,875,000
Variable costs:
Production ($16 × 75,000) $1,200,000
Marketing and administrative ($1 × 75,000) 75,000 1,275,000
Contribution margin $600,000
Fixed costs:
Production $200,000
Marketing and administrative 150,000 350,000
Net pro�it $250,000
Notice that the variable costing pro�it is lower than the pro�it from absorption costing. Why does this happen? The next section answers this question.
Reconciliation of Variable and Absorption Costing
The difference in net pro�it �igures between absorption costing and variable costing is due solely to the treatment of �ixed production costs. Absorption costing includes those costs in the inventory costs; variable costing treats them as expenses to be charged to the period incurred. During any given time period, the amount of �ixed costs in inventory will increase or decrease as production differs from sales. If production is greater than sales (as is the case with Morris the Florist in 2018), �ixed costs in the ending inventory are deferred to future periods under absorption costing. That is, �ixed costs are treated
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as assets by including them as part of inventory, and they will be moved to the income statement as cost of goods sold when sold. Alternatively, all �ixed costs are expensed under variable costing. Therefore, absorption costing will show a higher net pro�it. Conversely, if sales are greater than production, �ixed costs in the beginning inventory are expensed in the current period and added to the �ixed costs incurred during the current period. Therefore, �ixed costs in the income statement under absorption costing are higher than under variable costing, and the result is a lower net pro�it for absorption costing.
In the simpli�ied case in which �ixed overhead costs per unit are the same in beginning and ending inventories, the difference in net pro�its is exactly equal to the change in inventory units times the �ixed overhead rate per unit. For Morris the Florist, the change in inventory is:
Units produced 100,000
Units sold 75,000
Increase in inventory 25,000
Using a �ixed overhead rate of $2 per unit, the difference in net pro�its is: $2 × 25,000 units = $50,000. Let’s check this result:
Absorption costing net pro�it $300,000
Variable costing net pro�it 250,000
Difference $50,000
When the �ixed overhead rates are different in beginning and ending inventories, the reconciliation of net pro�it �igures is performed as follows:
Absorption costing net pro�it
+ Fixed overhead in beginning inventory
– Fixed overhead in ending inventory
= Variable costing net pro�it
To illustrate, suppose that in 2019, Morris the Florist produces 80,000 �loral arrangements and sells 100,000. We will presume the same total �ixed costs, unit variable costs, and selling price as in 2018. Morris the Florist uses a FIFO cost �low. As a result, the �ixed overhead per unit produced during 2019 is $2.50 ($200,000/80,000).
The 2019 absorption costing income statement would be as follows:
Absorption Costing Income Statement for the Year Ended December 31, 2019
Sales revenue ($25 × 100,000) $2,500,000
Cost of sales:
Variable ($16 × 100,000) $1,600,000
Fixed [($2 × 25,000) + ($2.50 × 75,000)] 237,500 1,837,500
Gross pro�it $ 662,500
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Absorption Costing Income Statement for the Year Ended December 31, 2019
Marketing and administrative expenses:
Variable ($1 × 100,000) $100,000
Fixed 150,000 250,000
Net pro�it $412,500
Note that the �ixed portion of cost of sales is consistent with the FIFO cost �low assumption. The �irst 25,000 units come from 2018 production, which had a unit cost of $2 for �ixed overhead; the remaining 75,000 units come from 2019 production, which had a unit cost of $2.50 for �ixed overhead.
The 2019 variable costing income statement would be as follows:
Variable Costing Income Statement for the Year Ended December 31, 2019
Sales revenue ($25 × 100,000) $2,500,000
Variable costs:
Production ($16 × 100,000) $1,600,000
Marketing and administrative ($1 × 100,000) 100,000 1,700,000
Contribution margin $ 800,000
Fixed costs:
Production $200,000
Marketing and administrative 150,000 350,000
Net pro�it $450,000
We reconcile the 2019 net pro�its as follows:
Absorption costing net pro�it $412,500
+ Fixed overhead in beginning inventory ($2 × 25,000) 50,000
– Fixed overhead in ending inventory ($2.50 × 5,000) (12,500)
= Variable costing net pro�it $450,000
The reconciliation of net pro�its between the two costing methods is independent of inventory cost �low assumptions. A company can use FIFO, LIFO, or some average cost method; the reconciliation of net pro�its follows the same procedures.
Another observation about the difference between the two methods relates to the pro�it patterns over time with respect to production and sales strategies. Let’s consider the case of a constant production schedule over time while sales �luctuate each period. The absorption costing net income will �luctuate up and down with sales, but the constant production will have a leveling effect on the swings. The peaks will not be as high nor as low as the corresponding sales changes. Variable costing net income, on the other hand, will have swings that match those of sales, in both direction and relative magnitude. For the situation where production �luctuates while sales remain rather constant, a different picture appears.
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Absorption costing net income will �luctuate with production, in both direction and relative magnitude. Variable costing net income will remain constant, corresponding with sales levels.
While absorption and variable costing methods yield different pro�it �igures during periods when units sold do not equal units produced, these are timing differences. If over the course of several time periods, aggregate production equals aggregate sales, then the aggregate pro�its will be the same for both costing methods despite differences in pro�its during speci�ic periods.
Arguments for Either Costing Method
Neither variable costing nor absorption costing is correct or incorrect. Their usefulness correlates with management’s attitudes and with philosophies of organizational behavior. Some companies will �ind variable costing extremely useful, while other companies will �ind it less meaningful. Any manager can make a valid case for either variable or absorption costing. The primary arguments, for and against, are discussed next.
Short Term Versus Long Term. Those who favor variable costing—let’s call them the “variable costers”—believe it focuses on the short-term consequences of accounting and is more realistic of the way managers make decisions. Those who favor absorption costing—let’s call them the “absorption costers”—assume that long-run performance is more important and that absorption costing more appropriately re�lects long-term consequences.
Unethical Behavior By Managers. Variable costers assume that managers can easily adapt to a new accounting method with little additional cost. They further argue that managers will be rewarded for playing games with absorption costing reports. They speci�ically refer to a manager’s ability to manipulate net pro�it by increasing or decreasing inventory levels that are valued under absorption costing. As we have seen, in�lating inventories reduces current period expenses with absorption costing and reducing inventories would increase current period expenses with absorption costing. Managers’ evaluations and bonuses that are based on net pro�its can therefore be impacted by these actions relating to inventories. The absorption costers admit that occasional short-term decisions (e.g., amount of ending inventory to hold) will be made incorrectly. However, over the long term, the mistakes will be more obvious, and the “games” will be discovered by competent superiors. Absorption costers might assert that unethical managers cannot be suddenly rehabilitated by a change in accounting methods.
Variable Versus Fixed Costs. Variable costers believe that costs can be easily and meaningfully divided into variable and �ixed categories and that using a contribution margin is much more useful for planning and decision making and for control and performance evaluation. Since absorption costing is primarily for external reporting purposes, absorption costers do not see this distinction as meaningful for reports. They will also argue that managers can still make the cost behavior distinctions for internal purposes. They also point out that the variable/�ixed split is not easily made in practice.
External Versus Internal Reports. Financial statement reporting using generally accepted accounting principles, as well as tax reporting for the Internal Revenue Service, require absorption costing. Variable costers argue that allowing external reporting requirements to dominate how useful and meaningful information should be reported is not a valid philosophy for competent management. Since information should be geared to the needs of management, external requirements should not drive the internal accounting system. Absorption costers argue that to have one set of requirements for external reporting and another set for internal reporting gives managers con�licting and inconsistent information. It also forges an image that the company is hiding something in the two approaches.
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Effects of New Manufacturing Environments
Since the major variation between the two methods is the treatment of �ixed costs as product or period costs, the difference in net pro�its disappears when little or no inventory of work in process or �inished goods exists. For companies implementing JIT production procedures, inventories will be eliminated or substantially reduced. Hence, the particular costing method chosen loses signi�icance in this environment. Also, this controversy is irrelevant to service organizations that do not carry inventories.
In automated production environments, whether JIT or not, the bulk of labor and factory overhead costs is �ixed. Variable costs represent a low percentage of total manufacturing costs. In these environments, therefore, variable costing loses much of its appeal because the product cost will be a small fraction of the total manufacturing cost.
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Summary & Resources
Chapter Summary Joint costs are allocated to joint products using either physical measures of output, the relative sales value method, or the net realizable value method. No joint costs are allocated to byproducts or scrap, and their net realizable values are either treated as miscellaneous income or as deductions from the costs allocated to the main products.
Variable costing includes only variable manufacturing costs as an element of product cost. The traditional method of income statement preparation is called absorption costing. It includes �ixed manufacturing costs as an element of product cost. As a result of this difference, net pro�it under the two methods will not necessarily be the same. Anytime production exceeds sales, absorption costing yields a higher net pro�it; when sales exceeds production, variable costing yields a higher net pro�it. The arguments for and against using either costing method apply to individual situations and management philosophy. Neither method is inherently correct or incorrect.
Key Terms
absorption costing A product costing method that allocates all manufacturing costs (variable and �ixed) to products.
byproducts Products produced from a joint manufacturing process that have minor sales value and are typically processed further beyond the split-off point.
direct costing A product costing method that allocates only variable manufacturing costs to items produced.
full costing A product costing method that allocates all manufacturing costs (variable and �ixed) to products.
joint costs The costs of materials and processing common to the production of multiple products that emerge from the joint production process.
joint products The products that emerge from a process where there are common inputs so that the individual products are initially indistinguishable.
net realizable value (NRV) The total sales revenue from the �inal product less its total separable costs.
relative sales value (RSV) An approach that allocates joint costs based on revenues that can be received from selling the products at the split-off point.
scrap
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Products produced from a joint manufacturing process that have minor sales value and are not processed further beyond the split-off point.
separable costs Costs incurred beyond the split-off point.
split-off point The point in the joint production process at which the individual products can be identi�ied.
variable costing A product costing method that allocates only variable manufacturing costs to items produced.
Problem for Review Ludwig’s Plumbing Products purchases raw materials and processes them into more re�ined products. In July, Ludwig’s purchased raw materials for $40,000. Conversion costs of $60,000 were incurred up to the split-off point, at which time two salable products were produced: Product A and Product B. Product B can be further processed into Product C. The July production and sales data were:
Production Sales Sales Price
Product A 1,200 tons 1,200 tons $50 per ton
Product B 800 tons
Product C 500 tons 500 tons $200 per ton
All 800 tons of Product B were further processed, at an incremental cost of $20,000, to yield 500 tons of Product C. There were no byproducts or scrap from this further processing of Product B.
There is an active market for Product B. Ludwig’s could have sold all of its July production of Product B for $75 per ton.
Questions:
1. Allocate the joint costs using the relative sales value method. 2. Allocate the joint costs using the physical measures method. 3. Allocate the joint costs using the net realizable value method.
Solution:
1. RSV method:
RSV of Product A = 1,200 × $50 = $60,000
RSV of Product B = 800 × $75 = $60,000
The total joint cost of $100,000 ($40,000 + $60,000) would be allocated equally to each of Products A and B (i.e., $50,000 to each).
2. Physical measures method:
Allocation to Product A = (1,200 / 2,000) × $100,000 = $60,000
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Allocation to Product B = (800 / 2,000) × $100,000 = $40,000
3. NRV method:
NRV of Product A = 1,200 × $50 = $60,000
NRV of Product B = (500 × $200) – $20,000 = $80,000
Allocation to Product A = ($60,000 / $140,000) × $100,000 = $42,857
Allocation to Product B = ($80,000 / $140,000) × $100,000 = $57,143
Questions for Review and Discussion 1. What are the two criticisms of allocating joint costs based on physical measures of output? 2. Explain the practical problem that sometimes prevents the use of the relative sales value method. 3. Differentiate between variable costing and absorption costing. 4. How is it possible to increase net pro�it using absorption costing when sales are not increasing? 5. A company had a highly labor-intensive manufacturing process. Recently it implemented robotics
and a number of other technological changes that made the process capital intensive. What impact would these changes make on the inventory valuations for variable costing and for absorption costing?
Exercises 5-1. Joint Costs Allocated to Services. Randy Gold & Associates, a CPA �irm, provides audit, tax, and consulting services. The �irm spent $800 recruiting a particular client, George Gottlieb, who contracted for all three services after a round of golf, a sumptuous meal, and a bottle of �ine wine. After the �irm’s work for Gottlieb was completed, the following information was available:
Service Fees Charged
Traceable Costs
Labor Overhead
Audit $14,000 $5,200 $4,000
Tax 10,000 3,000 2,300
Consulting 22,000 9,100 5,500
Question:
Using the NRV method, allocate the joint cost to the three services.
5-2. Joint Cost Allocations and Ending Inventories. Falk Corporation crushes and re�ines mineral ore into three products in a joint operation. There were no beginning inventories of any products. Joint costs are $420,000, resulting in the production of 20,000 pounds of Adelia, 60,000 pounds of Dalewood, and 100,000 pounds of Bramble. Adelia is processed further at a cost of $100,000, and Dalewood is processed further at a cost of $200,000. Bramble does not require any further processing.
The results for the current year are:
Adelia: 19,000 lbs. sold at $20/lb.
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Dalewood: 58,000 lbs. sold at $6/lb.
Bramble: 95,000 lbs. sold at $1/lb.
Question:
Determine the cost of the ending inventories using the NRV method to allocate joint costs.
5-3. Joint Cost Allocation and Income Statements. Lowenstein Promotions, Inc. produces rock concerts across the country. A recent concert by the Twins was also recorded as a CD. The live concert attracted 9,000 people who paid $35 per ticket, and the CD is projected to sell 26,000 units at $11 each. Joint costs of the concert and CD amounted to $300,000. Separable costs are $2 per ticket and $3 per unit for the CDs.
Questions:
1. Comment on the feasibility of allocating the joint costs based on physical measures. 2. Using the NRV method, compute the amount of joint costs to allocate to the live concert and to
the CDs. 3. Prepare product-line income statements for the live concert and for the CDs.
5-4. Joint Cost Allocation With a Byproduct. Paul Fay Fisheries spent $11,000 to catch 3,000 pounds of tuna, 12,000 pounds of shell�ish, and 500 pounds of various other �ish during July. The tuna was sold to Shinderman Industries for $8,000, and the shell�ish was sold to Lisa’s Diner for $17,000. The other �ish was converted to �ish oil, which is treated as a byproduct. Separable costs amounted to $200 for the �ish oil, which was sold to Jake’s Food Products for $900. Paul Fay Fisheries uses physical output to allocate joint costs.
Questions:
Explain how the NRV from the byproduct would be treated and determine the joint cost allocations for each of the following two alternatives:
1. Miscellaneous income approach 2. Reduction of joint cost approach
5-5. Absorption Costing. Leff Corporation incurred the following costs during the year:
Direct materials $10,000
Direct labor 30,000
Other costs: Variable Fixed
Manufacturing $15,000 $25,000
Marketing 5,000 2,000
Administrative 1,000 6,000
Question:
Under absorption costing, determine the amount that would be classi�ied as product costs.
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5-6. Determining Ending Inventory. Goldie Industries uses an absorption costing system. The following data pertain to June:
Operating income $70,000
Beginning inventory 12,000 units
Fixed overhead application rate $2 per unit (May and June)
Joe Pearl, the owner, has determined that the operating income would be $90,000 under variable costing.
Question:
How many units are in the June ending inventory?
5-7. Inventory and Cost of Goods Sold. Karchava Industries is headquartered in Tbilisi, Republic of Georgia, and has three manufacturing plants near the Black Sea. Nino Aladashvili, the company’s cost accountant, reports the following data for October:
Units: Beginning inventory 135,000
Production ?
Sales 250,000
Ending inventory 142,000
Costs (in lari): Beginning inventory 7,000,000
Variable manufacturing costs 19,000,000
Fixed manufacturing costs 8,000,000
Variable selling & administrative costs 9,000,000
Questions:
1. Compute the unit cost of the inventory produced during October using variable costing. 2. Compute the unit cost of the inventory produced during October using absorption costing. 3. If the company uses absorption costing and assumes a FIFO cost �low, what is the cost of goods
sold for October?
5-8. Variable Costing Income Statement. Nahmias Bee Hives produces honey for sale to various food manufacturers. The income statement for last year, prepared on an absorption costing basis, is as follows:
Number of containers produced and sold 250,000
Sales revenue $2,000,000
Cost of goods sold 1,500,000
Gross pro�it $ 500,000
Operating expenses (includes variable costs of $125,000) 225,000
Pro�it before income taxes $ 275,000
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Income taxes 110,000
Pro�it after income taxes $ 165,000
The �ixed production cost per container of honey was $2.00.
Question:
Revise the income statement on a variable costing basis.
5-9. Comparing Operating Pro�its. Mark Silber & Associates produces a product selling for $7 per unit; 100,000 units were produced and 80,000 units were sold during the year. The company had no inventory at the beginning of the year. Data for the year were as follows:
Fixed Costs Variable Costs
Direct materials 0 $1.50 per unit produced
Direct labor 0 $1.00 per unit produced
Factory overhead $150,000 $0.50 per unit produced
Administrative $80,000 $0.50 per unit sold
Questions:
1. What is the operating pro�it using variable costing? 2. What is the operating pro�it using absorption costing?
Problems 5-10. Joint Cost Allocation Using NRV. Capland Advertising Agency produced television and magazine ads for a client, Sharfstein Enterprises. The ads were developed with a common theme, and in so doing, $49,000 in joint costs were incurred. Separable costs totaled $60,000 for the TV ads and $20,000 for the magazine ads. The agency received $95,000 in fees for the TV ads and $42,000 for the magazine ads.
Question:
Allocate the joint costs using the net realizable value method.
5-11. Joint Cost Allocation and Inventory Costs. Jerry’s Wine Garden produces three wine products (Red, White, and Rose) as the result of initial joint processing plus separable processing after the split-off point. Records for July show the following:
Red White Rose Total
Materials used — — — $150,000
Direct labor 70,000
Production overhead cost — — — 100,000
Separable processing costs $50,000 $80,000 $70,000 —
Bottles produced 6,000 12,000 6,250 —
Bottles sold 4,000 9,000 4,250 —
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Red White Rose Total
Sales price $50.00 $37.50 $40.00
Question:
Compute the total cost of the ending inventory for each product, assuming no beginning inventory and using the NRV method for joint cost allocation.
5-12. Determination of Joint Cost. Habif Co. produces products ALPHA and BETA from a joint manufacturing process. For ALPHA, 4,000 units were produced having a sales value at the split-off point of $15,000. If ALPHA were processed further, the additional costs would be $3,000 and the sales value would be $20,000. For BETA, 2,000 units were produced having a sales value at the split-off point of $10,000. If BETA were processed further, the additional costs would be $1,000 and the sales value would be $12,000. Joint costs allocated to ALPHA amounted to $9,000.
Questions:
1. If the relative sales value approach were used, what would be the amount of total joint product costs?
2. If the net realizable value approach were used, what would be the amount of total joint product costs?
3. If the physical measures approach were used, what would be the amount of total joint product costs?
5-13. Determination of Sales Value at Split-Off. Ripans Industries manufactures three products from a joint process: X, Y, and Z. The following information is provided by the plant manager, Rick Halpern:
Product X Product Y Product Z Total
Units produced 4,000 2,000 1,000 7,000
Joint cost $36,000 ? ? $60,000
Sales value at split-off ? ? $15,000 $100,000
Separable costs $7,000 $5,000 $12,000 $24,000
Sales value of �inal product $75,000 $30,000 $20,000 $125,000
Joint costs are allocated using the relative sales value method.
Question:
Calculate the sales value at the split-off point for Product X.
5-14. Operating Incomes for Two Periods. Schumer Motors manufactures cars and sells them for $24,000 each. The controller, Dick Peppy, provided the following data for November and December:
November December
Number of cars:
Beginning inventory 0 ?
Production 500 400
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November December
Sales 350 520
Variable costs:
Mfg. cost per car produced $10,000 $10,000
Marketing cost per car sold $3,000 $3,000
Fixed costs:
Mfg. costs $2,000,000 $2,000,000
Marketing costs $600,000 $600,000
Questions:
1. Calculate operating income for November using: a. Variable costing b. Absorption costing
2. Assuming a LIFO cost �low, calculate operating income for December using: a. Variable costing b. Absorption costing
5-15. Variable and Absorption Costing and Pro�it at the Break-Even Point. The President of Robbins Supply Company, Trudy Raymond, is surprised to learn that the company earned a pro�it in 2019 even though sales were at the break-even point (before considering non-production costs).
“When we were going over the budget for 2019,” she said, “I was told that we would have a poor year and could expect to break even with sales of only 206,000 units. Now, I �ind that we earned a modest pretax pro�it with sales of 206,000 units, although selling prices and costs were as budgeted. I am not complaining about a pro�it, mind you, but I can’t understand how a pro�it can be made when operating at the break-even point.”
Data pertaining to 2019 are as follows:
Unit selling price $35
Unit variable cost 20
Unit contribution margin $15
$3,090,000 (�ixed production cost) / $15 (unit contribution margin) = 206,000 units break even
Fixed production costs are applied to products at $10 per unit. The inventory of �inished goods was 30,000 units on January 1, 2019, and 133,000 units on December 31, 2019. The marketing and administrative expenses were �ixed in the amount of $90,000.
Questions:
1. Prepare an income statement for 2019 using absorption costing. 2. Prepare an income statement for 2019 using variable costing.
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3. Explain to the President how a pro�it was made when using absorption costing even though sales were at the break-even point.
4. Explain whether the absorption costing income statement or the variable costing income statement gives the more realistic results.
5-16. Conversion of Absorption Costing to Variable Costing. Yaffe Electrical Supply Company manufactures electric switches and timing devices in three operating divisions: Utility, Household, and Commercial. An income statement, showing the results for each division, is given for 2018. The company had total �ixed manufacturing overhead of $8,900,000. Inventories were increased during the year in anticipation of more sales volume in 2019.
Yaffe Electrical Supply Company income Statement for the Year 2018 (in Thousands)
Utility Household Commercial Total
Net sales $6,200 $5,150 $6,300 $17,650
Costs of goods sold:
Inventory, beginning $540 $240 $150 $930
Production cost 5,400 4,000 4,200 13,600
Cost of goods available for sale $5,940 $4,240 $4,350 $14,530
Less inventory, ending 900 640 900 2,440
Cost of goods sold $5,040 $3,600 $3,450 $12,090
Manufacturing pro�it $1,160 $1,550 $2,850 $5,560
The Plant Controller, Jennifer Barry, believes that pro�its may be higher than they would be otherwise because of �ixed costs being carried over to the next year as a part of inventory. She would like to have the statement revised to a variable costing basis and would like to know the manufacturing contribution margin for each division.
Additional analyses show the units and unit variable costs as follows. There are no partially completed units.
Utility Household Commercial
Units in beginning inventory 30,000 15,000 10,000
Units produced 300,000 250,000 280,000
Units in ending inventory 50,000 40,000 60,000
Unit variable manufacturing cost $6 $6 $5
Questions:
1. Prepare an income statement on a variable costing basis that shows a contribution margin and direct pro�its by division and in total.
2. Prepare a reconciliation between the variable costing and absorption costing income statements. This reconciliation should show results by division and in total.
3. How much of the �ixed cost was carried over to 2019 as a part of ending inventory cost for each division?
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5-17. Conversion of Absorption Costing to Variable Costing. Grinzaid Pet Shops purchase a variety of household pets (mostly dogs), and they also breed their own pets, for sale to customers. The following income statement for July 2019 was prepared by the Corporate Controller, Sam Marks, using absorption costing:
Sales (200 pets) $22,000
Cost of sales:
July 1 inventory $5,000
Breeding and purchase costs 10,000
July 31 inventory (2,500) 12,500
Gross pro�it $9,500
Fixed selling and administrative expenses 3,700
Operating income $5,800
During 2019, the average unit variable costs have not changed, and �ixed “production” overhead has remained at $2,000 per month. During July, 160 pets were either born or purchased by the store owner, Lisa Marks. Assume that all inventories of pets are “�inished”—there is no beginning or ending “work in process.”
Questions:
1. Prepare an income statement for July using variable costing. 2. Reconcile the absorption and variable costing operating incomes.
Case: Strazynski Cosmetics
Strazynski Cosmetics has four manufacturing plants where it processes a chemical, Idov, into three products. The process works in such a way that Idov is broken down into a high-grade facial cleanser (FC) and a low-grade chemical. The low-grade chemical is then processed into a liquid bath soap (LBS) and a moisturizing skin cream (MSC). All three products are sold to wholesalers that distribute them to retailers, hospitals, and various other institutions.
Strazynski Cosmetics used 12,000 gallons of Idov last month. It cost $300,000 in materials, labor, and overhead to procure Idov and turn it into the FC and low-grade chemical. The total cost of producing LBS and MSC from the low-grade chemical was $70,000. The breakdown of production for the month was as follows:
FC 10,000 ounces
LBS 20,000 ounces
MSC 50,000 ounces
The sales price of FC is $40 an ounce; of LBS, $10 an ounce; and of MSC, $1 an ounce. Additional processing and selling costs, entirely separate and traceable to each product,
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amounted to $20,000 for FC, $160,000 for LBS, and $40,000 for MSC.
When joint costs are allocated, the net realizable value method is used. There were no beginning or ending inventories in any of the four manufacturing plants. All of the production was sold during the month.
Question:
Prepare product line income statements (absorption costing) through gross pro�it for each of the three products.
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Learning Objectives
After studying Chapter 8, you will be able to:
Explain the signi�icance of pro�it analysis for an organization.
Describe the major characteristics and conditions of a standard cost system.
Understand the information contained in a standard cost sheet.
Compute materials price and usage variances, and identify potential causes of such variances.
Compute labor rate and ef�iciency variances, and identify potential causes of such variances.
Explain the major considerations that are the basis of standard costs for overhead and compute budget variances and capacity variances for overhead.
8 Cost Control Through Standard Costs
nd3000/iStock/Thinkstock
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Explain why the capacity variance is related only to �ixed overhead costs.
Understand issues relating to variance investigation and disposal of variances.
Explain how standard costs can be used in various different settings.
Describe ethical considerations relating to standards and variances.
Where Do I Start With Standard Costs?
Jean-Claude Recca, President of Rue de Lorraine, a chain of fast-food restaurants in central France, just returned from a reunion of his INSEAD graduating class. During the day of activities in the Riviera, he talked with several of his classmates who have become extremely successful in various businesses. One of those classmates suggested to Jean-Claude that adoption of a standard cost system eliminated most of her �irm’s unacceptable scrap and spoilage, caused an examination of nonvalue-added activities, and substantially reduced several inef�icient operations.
Jean-Claude did not know whether his restaurant chain would really bene�it from a standard cost system. He wondered: If he makes the change, which costs should be put on standards? How does he set up standards? When do variances mean something? Isn’t a standard cost system expensive to use? Isn’t it a pain in the derriere? Wouldn’t a tight budget do the same thing?
These questions were more than Jean-Claude could consider. He decided to bounce the idea of standard costs off his controller.
In measuring success in any undertaking, a comparison is usually made between actual performance and expected performance. Any difference is a variance. A manager is then left with the responsibility to explain the what, why, and how of the variance. In doing so, the manager must understand the in�luence of key variables on the actual results, focus on areas that deserve more detailed investigation, and determine changes that must be made in future planning and control. This chapter introduces the concept of pro�it analysis and then concentrates on variances associated with a standard cost system for direct materials, direct labor, and factory overhead.
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8.1 Pro�it Analysis Pro�it is an overall measure of how well an organization is doing. A pro�it variance then is the difference between the actual net income and the planned net income for the same period. The causes of such a variance are related to the various elements that make up net income: revenues, cost of goods sold, and operating expenses. The following table shows a disaggregation of the pro�it variance into more detailed elements.
Actual Budget Variance
Revenues $385,000 $365,000 $20,000 Favorable
Cost of goods sold 282,500 227,250 55,250 Unfavorable
Gross margin $102,500 $137,750 $35,250 Unfavorable
Operating expenses 81,250 90,000 8,750 Favorable
Net income $21,250 $47,750 $26,500 Unfavorable
To have a variance, a baseline with which to compare actual results is necessary. Common baselines are results of a prior month or year, a budget, a �lexible budget, or a standard. The analysis of a pro�it variance necessarily looks at each signi�icant area in the income statement, and each area has a baseline that management feels is appropriate for the circumstances. The analysis then looks at causes of variation from the baseline.
The cost of goods sold, comprised of the cost of materials, labor, and factory overhead, is generally the most signi�icant cost in the income statement. Consequently, companies expend great effort to manage and control these costs. Managers can easily cite examples of how small savings on a unit basis—or on a single operation or task performed—add many dollars to pro�it. Analysis of cost variances helps managers to �ind cost savings.
Cost variances are often based on comparisons between actual and standard costs. Besides cost control, cost variances are also used to evaluate the performance of managers who are responsible for particular costs. For example, a plant manager might examine materials, labor, and overhead cost variances in the grinding department to evaluate the performance of the grinding department manager.
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8.2 The Use of Standards Standard costs are appropriate where an organization has standard products, services, or repetitive operations, and where management controls the factors comprising a standard cost.
De�inition of Standard Costs
A standard cost for a product is the amount that management believes one unit of product should cost and consists of a price standard (a generic term indicating price for materials, rate for labor, and rate for factory overhead) and a quantity standard (a generic term indicating quantity for materials, time for labor, and activity or volume for factory overhead). Setting standards for price and quantity involves management judgments, industrial engineering studies, work measurement studies, vendor analyses, union bargaining, as well as a number of other techniques.
Standards are generally stated on a per-unit basis: per unit of quantity, per unit of time, per unit of activity, or per unit of product. Once set, these standards remain unchanged as long as no changes occur in operating methods, in factors that in�luence quantities, or in unit prices of materials, labor, and factory overhead.
Advantages of Standards
A standard cost system presents many advantages to an organization. Although the primary purpose has always been cost control, properly set standards have many other advantages. This section covers �ive major advantages of standard costs.
Cost Control. Cost control is comparing actual performance with the standard performance, analyzing variances to identify controllable causes, and taking action to correct or adjust future planning and control. As discussed later in this chapter, costs can change for at least four reasons: (1) changes in levels of prices or rates, (2) changes in ef�iciency, (3) changes in activity or volume, and (4) changes in the product mix. Variance analysis must identify these changes as well as the managers responsible for these differences so that adjustments can be made to the standards or that good performance can be rewarded.
Standard cost accounting follows the principle of management by exception. Actual results that correspond closely to the standards require little attention. The exceptions, however, are scrutinized. Management by exception can be desirable because it highlights only those weak areas that require management’s attention. However, a behavioral effect can occur when management by exception is applied to people. If a worker is ignored when operating according to the standard and is noticed only when something is wrong, the worker may become resentful and perform less satisfactorily. While it may be argued that the worker is being paid to operate at standard, the human factor cannot be ignored. Without recognition, the worker becomes discontented; this discontentment may spread throughout the organization with a loss of both morale and productivity.
Cost Management. Cost management is related to cost control, but here the emphasis is on establishing the level of costs that becomes the benchmark for measuring performance. It can be as simple as decreasing the costs of operations through improved methods and procedures, using better selection of resources (human, materials, and facilities), or eliminating unnecessary (nonvalue-added) activities. As standards are set and periodically reviewed, operations can be analyzed to identify waste and inef�iciency and to eliminate their sources. These reviews can also highlight better than expected
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performance; appreciation will motivate employees to continue looking for better ways to operate. A standard cost system creates an environment in which people become cost conscious, always looking for continuous improvements in the process.
Decision Making. If standards are set at currently attainable levels (a concept discussed later in “The Quality of Standards” section), the standard costs are useful in making many types of decisions. For example, some common decisions involve regular, special order, or transfer pricing; cash planning; whether to sell or process further; and whether to make or buy. When an analysis is used as the basis for setting the standard costs, managers need not perform a new analysis for each decision.
Recordkeeping Costs. A standard cost system saves recordkeeping costs, not during the initial startup, but in the long-run operation of the system. When using actual costs, each item of materials issued from a storeroom has its cost, which came from a speci�ic purchase order. The cost transferred to work in process inventory is calculated using an inventory �low method: speci�ic identi�ication, FIFO, LIFO, moving average, or weighted average. For companies with thousands of different materials categories in stock, identifying costs to move to work in process inventory can be an enormous task. When standard costs are in place, each item in the same materials classi�ication has the same standard cost. Therefore, costs transferred to work in process inventory are the standard cost per unit times the number of units issued. This same process applies to work in process inventory transfers to �inished goods. All inventories have their standard costs, and balances are always stated at standard.
Inventory Valuation. A standard cost system records the same costs for physically identical units of materials and products; an actual cost system can record different costs for physically identical units. Differences between the two costs tend to be waste, inef�iciency, and nonvalue-added activities. Such items, if incurred at all, are period costs and excluded from inventory amounts. They should not be capitalized and deferred in inventory values. Therefore, standards provide a more rational cost in valuing inventories.
Occasionally, differences between actual and standard costs show positive ef�iciencies. Performance has been better than expected. If this situation will continue, the standards are revised. Otherwise, the current standards still provide a rational basis for costing products.
The Quality of Standards
The term standard has no meaning unless we know upon what the standard is based. A standard may be very strict at one extreme or very loose at the other extreme. We broadly classify standards as strict or tight standards, attainable standards, and loose or lax standards.
No easy solution exists as to how standards should be set. The objective, of course, is to obtain the best possible results at the lowest possible cost. Often human behavior becomes the dominant concern in setting standards. A very rigorous standard may motivate some employees to produce exceptional results. On the other hand, a standard that is too strict and cannot be reached may discourage employees and produce only modest results. In setting a level of standards, management must consider the employees, their abilities, their aspirations, and their degree of control over the results of operations.
Strict standards are set at a maximum level of ef�iciency, representing conditions that can seldom, if ever, be attained. They ignore normal materials spoilage and idle labor time due to such factors as machine breakdowns. These standards appear to represent perfection, something few employees will achieve. Although a standard should challenge people, a standard that is virtually unattainable will not
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motivate most employees to do their best and may actually be counterproductive. An employee is more likely to put forth increased effort when feeling successful. In other words, a person’s aspirations increase with success and decrease with failure.
In addition, variances from strict standards have little signi�icance for control purposes. There will never be a favorable variance, only zero or unfavorable variances. In fact, most variances will be large and unfavorable. The question is: “What does such a variance measure?”
Loose standards tend to be based on past performance and represent an average of prior costs. They include all inef�iciency and waste in past operations. Such standards are not likely to motivate employees to higher performance. The very nature of loose standards means less than ef�icient performance. As a result, variances from loose standards are almost always favorable and provide little useful information for cost control. Again, the question is: “What does such a variance measure?”
Attainable standards can be achieved with reasonable effort. Perhaps the standards should be somewhat lower than what can be achieved by earnest effort. With success, the employees gain con�idence and tend to be more productive. For a more experienced group of workers, an exacting standard may serve as a challenge that motivates an employee to higher levels of performance. With less experienced workers, standards may have to be set at a lower level at �irst. As learning takes place, the standards may be raised. Increases in standards should be made with caution and should be accepted by the employees as being fair.
Managers should expect to see favorable and unfavorable variances with an attainable standard. Some employees will meet and exceed the standard with reasonable effort, while others will not meet the standard because of poor performance.
Revising the Standards
Standard costs should be reviewed periodically to see if revisions are necessary to maintain a selected level of quality. Although many factors may combine that determine the best time to review standard costs, they should be reviewed at least once a year. Otherwise, they may not be current. This does not mean waiting until the end of the year. Companies with thousands of items on standards will have a department dedicated to reviewing standards throughout the year.
A key for reviewing standards is to identify changes taking place that outdate existing standards. Changes that typically call for a revision to one or more standard costs include:
1. Increases or decreases in the price levels of speci�ic materials and supplies 2. Changes in personnel payment plans or wage schedules 3. Modi�ications of materials type or speci�ications 4. Acquisitions of new equipment or dispositions of old equipment 5. Modi�ications of operations or procedures 6. Additions or deletions of product lines 7. Expansions or contractions of facilities 8. Changes in management policies that affect the amount of costs and the way costs are
accumulated and identi�ied with activities, operations, and products 9. Increased experience of employees
Management policies can have a signi�icant impact on standard costs. Examples of the most common policy areas are the de�inition of capacity, the classi�ication of fringe bene�its, depreciation methods, and
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capitalization and expense policies. Capacity de�initions in�luence the level of waste and inef�iciency that management will tolerate and the amount of �ixed costs applied to individual units of an operation, task, or product. A rede�inition of capacity can be due to changes in the number of shifts, in hours of operation with given shift schedules, or in demand for the product or service. Fringe bene�its can appear in several ways, any of which can in�luence a product cost signi�icantly. Management can classify any element of fringe bene�it cost as a direct cost of the product, an indirect cost through a labor-related cost pool, an indirect cost through a factory overhead cost pool, or a period cost through a general and administrative cost pool. Management determines which depreciation methods are in use. One common policy is to change from a declining balance method for existing equipment to a straight-line method at about the mid-life point of the asset life. Occasionally, management will change the method applied to new equipment purchased. The criteria for capitalization and expense decisions determine which costs are capitalized as assets and charged to operations through depreciation and amortization and which costs are charged immediately upon incurrence. Any change in the criteria alters the treatment of those costs affected.
Throughout the chapter, we assume that standards are recorded into the formal accounting system. As such, product costing is determined through a standard cost system. Many companies do not follow this practice. Instead, they use standards to determine cost variances for control purposes. Revision of standards is much more critical if the standards are the basis for product costing.
Contemporary Practice 8.1: Setting Standards at a Consumer Packaged Goods Company
“In operations, the standard input costs are based on a set of assumptions that are updated each year during the company’s annual budgeting cycle. To make the input costs as accurate as possible, several divisions within the operations group are involved in developing standards. Updating standard costs begins with analyzing the prior year’s actual costs for each input: direct materials, direct labor, and overhead. Not surprisingly, analyzing input costs becomes highly complex given the large and diverse nature of the company. The analysis includes reviewing dozens of direct material inputs, several levels of labor tied to thousands of employees with various bene�it cost combinations, and many manufacturing locations, which involve multiple facility types and con�igurations. All of these inputs are examined closely for cost ef�iciency and are applied consistently across the company. When the analysis of last year’s input costs is complete, these amounts are adjusted based on known changes related to the current year.”
Source: Dosch, J. & Wilson, J. (2010, August). Process costing and management accounting in today’s business environment. Strategic Finance, 37–43.
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8.3 Standard Cost Sheet Once standards have been set for each cost component (direct materials, direct labor, and manufacturing overhead), the costs are summarized in a standard cost sheet. First, this sheet itemizes each type of direct material used, each direct labor operation employed, and all overhead tasks, operations, processes, and support functions applied to a unit of �inal product. Then, the cost per unit of output for each of these items is determined and displayed. Finally, these unit costs are tallied to obtain a total cost per unit for the �inal product. Standard cost sheets can be extremely lengthy or very simple depending on the product and manufacturing process.
Suppose that Zaner Restaurants, Inc., owner of over 200 Steakout Restaurant franchises, uses a standard cost system in accounting for its daily dinner special, the “Goliath Feast.” The standards currently are as follows:
Component Total Cost of Component Unit Cost
Materials 3 lbs. at $4.00 per pound $12.00
Direct labor .5 hour at $17.00 per hour 8.50
Variable overhead .5 hour at $6.00 per hour 3.00
Fixed overhead .5 hour at $9.00 per hour 4.50
Total cost per meal $28.00
This standard cost sheet gives the total unit cost of each meal produced. For each completed meal, three pounds of direct materials at a total cost of $12 is taken from materials inventory and charged to work in process. Also, $8.50 is charged for direct labor, and a total of $7.50 in overhead costs is applied. Nothing is noted here about the actual costs incurred because all production is carried only at standard cost. Thus, when completed meals are transferred from work in process to �inished goods and later to cost of goods sold, the cost is $28 per meal. The standard cost sheet becomes the basis for all accounting entries related to the cost of the meal.
To explain standards for materials, direct labor, and overhead, we need to know the volume of output and the materials quantities allowed for that volume in order to calculate certain variances. The standard cost sheet lists the allowed amounts. The volume of output will be expressed as units of product or equivalent units, depending on the circumstances in production.
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8.4 Standards for Materials Standards are established for the cost of obtaining materials and for the quantities to be used in production. Managers then compare actual costs against these standards to ascertain variances. Basically, two types of variances exist: price and usage. Different variances may be developed for specialized purposes, but they can always be classi�ied as variations in the price of materials or in the quantities used, or as a combination of price and usage. If the actual cost is greater than the standard cost, the variance is an unfavorable variance; if actual cost is less than the standard cost, the variance is a favorable variance. It should be noted that favorable versus unfavorable does not necessarily imply good versus bad for the overall interests of the company. This will be illustrated in a later section that discusses the interrelationships of price and usage variances.
Materials Price Variance
A materials price variance measures the difference between the prices at which materials are acquired and the prices established in the standards. What is in the standard, how a variance is calculated, and what are potential causes of variances are now explained.
Setting the Price Standard. A standard price is set for each item of materials the company expects to use. The cost elements that make up the standard are a matter of management policy. Although the purchase price is the dominant element, other costs may also be included, such as the cost of insurance for materials in transit, the cost of transporting materials, various cash and trade discounts, and costs of receiving and inspecting materials at the receiving dock. Once management decides on the elements, the next step is assessing prices. The estimation techniques are not discussed here, but common approaches to determining amounts include:
1. Statistical forecasting 2. Knowledge and experience in the particular type of business 3. Weighted average of prices in most recent purchases 4. Prices agreed upon in long-term contracts or purchase commitments
Accounting for a Price Variance. A materials price variance is isolated at the time of purchase. To be able to act upon an excessive variance as soon as possible, management should determine the materials price variance when the materials are purchased rather than waiting until the time the materials are used in production.
The actual quantity of materials purchased is entered in the materials inventory at standard prices. The liability to the supplier is recorded at actual quantities and actual prices. Any difference between the two amounts is recorded as a price variance.
To illustrate, assume that Zaner Restaurants bought 40,000 pounds of materials for $159,200, which is $3.98 per pound. To make the example easier to follow, we will use the following symbols:
AQP = Actual quantity purchased
AP = Actual price
SP = Standard price
MPV = Materials price variance
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The cost �low of actual and standard costs would appear in T-account form as follows:
To calculate the variance without thinking in terms of accounts, the information from the T-accounts can be summarized into convenient formulas.
AP × AQP = $3.98 × 40,000 = $159,200
SP × AQP = $4.00 × 40,000 = $160,000
MPV = (AP – SP) × AQP = –$0.02 × 40,000 = $800 Favorable
Note that the actual quantity is used in all three calculations above. Only the prices differ. A materials price variance can be either favorable or unfavorable when actual costs are compared with standard costs. In this illustration, the materials price variance is favorable because the materials were purchased at a cost below the standard.
Causes of the Price Variance. A variance occurs for any number of reasons. If the variance is signi�icant, we must identify causes. If performance is deemed good, the responsible people should be praised, and, where appropriate, rewarded. If the investigation �inds out-of-control situations, corrections can be made so variations are eliminated in the future. In some cases, outdated standards are being used and need to be adjusted.
Although many causes for variances pertain to any given situation, a list of the common sources is as follows:
1. Fluctuations in market prices 2. Materials substitutions 3. Market shortages or excesses 4. Purchases from vendors other than those offering the terms used in the standard 5. Purchases of higher or lower quality materials 6. Purchases in nonstandard or uneconomical quantities 7. Changes in the mode of transportation 8. Changes in the production schedule that result in rush orders or additional materials 9. Unexpected price increases or decreases
10. Fortunate buys 11. Failure to take cash discounts
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Responsibility for the Price Variance. The purchasing department is usually charged with the responsibility for price variances. If the purchasing function is carried out properly, the standard price should be attainable. When lower prices are paid, a favorable materials price variance is recorded, indicating that the department’s purchases were below the standard cost. Higher prices are re�lected in an unfavorable materials price variance. In some circumstances price variances really should be charged to a production department instead of to the purchasing department. As examples, a rush order may be caused by last-minute production changes, or production people may request a speci�ic brand name for materials rather than allowing the purchasing department to buy by speci�ications.
Periodic reports show how actual prices compare with standard prices for the various types of materials purchased. Reports on price variances may be made as frequently as daily, but will generally be weekly or monthly. They reveal which materials, if any, are responsible for a large part of any total price variation and can help the purchasing department in its search for more economical vendors.
Materials Usage Variance
Materials are put into production, but the actual quantity used may be more or less than speci�ied by the standards. The variation in the quantity of materials is called a materials usage variance. Other names for this type of variance are materials quantity variance, materials use variance, and materials ef�iciency variance.
Setting the Quantity Factor. The quantity factor in a materials standard is based on engineering speci�ications, blueprints and designs, bills of materials, and routings. Combined, these items specify the quality, size, thickness, weight, and any other factors necessary for a good unit of �inal product. Also included in the quantity factor are any desired allowances for normal acceptable waste, scrap, shrinkage, and spoilage that may occur during the manufacturing process.
Accounting for a Usage Variance. As materials are used, the work in process account is increased by the standard quantity used multiplied by the standard price. The materials inventory account is decreased by the actual quantity used multiplied by the standard price. Returning to Zaner Restaurants, assume that 31,000 pounds of materials are withdrawn from Materials Inventory for making 10,000 meals. Because the standard cost sheet indicates only three pounds should be used for each meal, the standard quantity of materials that should have been used is 30,000 pounds (3 pounds × 10,000 meals).
For our example, we will use the following symbols:
SP = Standard price
AQU = Actual quantity used
SQ = Standard quantity allowed
MUV = Materials usage variance
The cost �low of actual and standard costs would appear in T-account form as follows:
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To calculate the variance without thinking in terms of accounts, the above information can be summarized into convenient formulas.
SP × AQU = $4.00 × 31,000 = $124,000
SP × SQ = $4.00 × 30,000 = $120,000
MUV = SP × (AQU - SQ) = $4.00 × 1,000 = $4,000 Unfavorable
In the �irst two equations, the standard unit price is used, but the quantities differ. In one case, the actual quantities issued from the storeroom are used. In the other, the standard materials quantity allowed for each meal is used. Because only quantities can differ in the equations, any variation is a usage variance. The variance for Zaner Restaurants is unfavorable because the amount of materials used is greater than the amount called for by the standard.
The following table illustrates the materials costs and variances:
A B C D E F G
AQP × AP A – C = AQP × SP C – E = AQU × SP E – G = SQ × SP
Direct Materials
Price Variance
Increase or Decrease in
Materials Inventory
Direct Materials
Usage Variance
40,000 $159,200 40,000 $160,000 31,000 $124,000 30,000
× $3.98 – $160,000 × $4.00 – $124,000 × $4.00 – $120,000
× $4.00
= $159,200 = $800F = $160,000 = $36,000 = $124,000 = $4,000U = $120,000
Causes of the Usage Variance. What causes a materials usage variance? To answer this question, we look at the elements that make up the quantity standard and the speci�ic situation. Examples of common causes include:
1. Changes in product speci�ications 2. Materials substitutions
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3. Breakage during the handling of materials in movement and processing 4. Improper use of materials by workers 5. Machine settings operating at nonstandard levels 6. Waste 7. Pilferage
Responsibility for the Usage Variance. Ordinarily, materials usage variances are chargeable to production departments. They often arise as a result of wasteful practices in working with materials, or they arise because of products that must be scrapped through faulty production.
Reports on the quantities of materials used are given to the responsible production department supervisor. A production supervisor, for example, may receive daily or weekly summaries showing how the quantities used in the department compare with the standards. At the operating level, managers can directly control the use of materials. Often, reports on variations from standard are for physical quantities only. Managers may not need immediate feedback from a cost report. Daily or weekly cost reports simply tell managers the �inancial magnitude of variations and serve as a reminder that corrections should be made before losses become too great.
Summary reports of actual and standard materials consumption given in dollars, with variances and variance percentages, also go to the plant superintendent at least monthly. If the variances in any department are too large, the superintendent can take steps to reduce them. During the month, of course, the operating managers will watch materials usage; if they have been doing their jobs properly, the accumulated variances for the month should be relatively small.
Contemporary Practice 8.2: Using the Materials Usage Variance to Detect Fraud
“Large purchase orders, coupled with a signi�icant unfavorable material usage (quantity) variance (MUV), could indicate inventory theft via collusion between the purchasing and receiving or delivery departments; materials delivery may be made to an unauthorized location for the bene�it of the purchasing agent or another employee.”
Source: Raiborn, C., Butler, J.B & Zelazny, L. (2013, May/June). Standard cost variances: Potential red �lags of fraud? Cost Management, 16–27.
Interrelationships of Price and Usage Variances
We have treated the materials price and usage variances as though they are independent and unrelated. In many cases, the event that causes one variance also causes the other. For example, assume the purchasing department buys lower-grade materials at a substantially reduced price. This generates a favorable price variance for purchasing. When those materials reach production, they result in a higher than normal waste. This gives the operating supervisors unfavorable usage variances. Keeping the two variances in isolation makes the purchasing agent look good, while the operating supervisors turn in poor performances. In reality, both variances are the responsibility of the purchasing department. If the
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variances net out favorable, the purchasing decision has bene�ited the company. On the other hand, a net unfavorable variance is a loss to the company.
The operating people can also in�luence the price variance. If improperly adjusted machines, for instance, generate a higher than usual waste, more materials may be needed from the storeroom. When a production supervisor requisitions the materials and the storeroom manager realizes suf�icient quantities are not available, a request is made to the purchasing department to order more. To keep the production schedule current, a rush order is issued. The higher prices paid for a rush order will result in an unfavorable price variance.
The warning of these situations is simple: Investigation of variances must not be done in isolation.
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8.5 Standards for Labor We can set standards for direct labor and measure variances from the standards in much the same way as we did for materials. The price factor is called rate; the quantity factor is time. When referring to variations in time, we use the term ef�iciency. The labor rate variance measures the portion of the total labor cost variance caused by the difference between the actual wage rate paid and the standard wage rate. The labor ef�iciency variance measures the portion of the total labor cost variance caused by the difference between the actual hours worked and the standard hours required for production.
When discussing standards for labor, we assume direct labor only. Indirect labor consists of the costs for people working in the production departments but not directly on products, and for the time of direct laborers classi�ied as training time, break time, overtime premium, and idle time. These costs are often distributed from payroll to overhead and become part of overhead standards. Therefore, indirect labor is discussed later as part of overhead.
Setting Rate Standards
Standard cost systems rely on individual labor rates by skill-level classi�ication for better control and accuracy. However, in some cases, standard rates can be set for entire cost centers or departments. Regardless of how it is structured, the underlying wage or salary rate used as the standard rate will be either established through contract negotiations or by the prevailing rates in the location where the work is performed. The details for selecting wage-level classi�ications cover training, education, experience, special physical abilities, and set of task skills.
When setting the standard rates, management must decide whether to use a basic labor rate or a “loaded” labor rate as the standard. A “loaded” labor rate includes labor-related costs such as overtime premiums, shift premiums, bonuses and incentives, payroll taxes, and fringe bene�its. Those factors not included in the labor rate standard will be included in overhead. Therefore, management will look at the advantages of treating these cost factors as direct costs or as indirect costs. For example, if the company is performing contracted work for the federal government, the company would typically recover more of its costs through the “loaded” standard labor rate.
Setting Time Standards
Time standards are more dif�icult to establish than materials quantity standards. People’s productivity is the basis for setting time standards, and people tend to differ in behavior from one time to the next. Setting time standards involves answering two questions: (1) What operations are performed? and (2) How much time should be spent on each operation for the product or service? The answer to the �irst question is determined by reviewing operations and procedures, process charts, and routing lists. The answer to the second question will be determined from one or more of the following methods:
1. Operation and body movement analysis. (This involves dividing each operation into the elementary body movements such as reaching, pushing, turning over, etc. Published tables of standard times are available for each movement. These standard times are applied to the individual movements and added together for the total standard time per operation.)
2. Time and motion studies conducted by industrial engineers. 3. Averages of past performance, adjusted for anticipated changes. 4. Test runs through the production process for which standards are to be set.
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Accounting for the Rate and Ef�iciency Variances
Unlike materials, labor cannot be purchased and stored until needed. We purchase and use labor at the same time. Therefore, accounting for both variances is combined.
Zaner Restaurants shows a payroll for its direct workers of $90,584 and 5,200 hours. That gives an actual rate of $17.42 per hour. The standard cost sheet shows that each completed meal requires one- half hour of direct labor time. Since 10,000 meals were produced, 5,000 hours should have been worked (.5 hour × 10,000 meals).
For our example, we will use the following symbols:
AR = Actual rate
SR = Standard rate
AH = Actual hours
SH = Standard hours allowed
LRV = Labor rate variance
LEV = Labor ef�iciency variance
The cost �low of actual and standard costs would appear in T-account form as follows:
The labor rate variance is commonly calculated �irst. It results whenever the actual rate paid to a worker differs from the standard rate. Calculating a labor rate variance requires holding the actual hours constant while comparing the difference in rates, as follows:
AR × AH = $17.42 × 5,200 = $90,584
SR × AH = $17.00 × 5,200 = $88,400
LRV = (AR - SR) × AH = $0.42 × 5,200 = $2,184 Unfavorable
The variance is unfavorable because the actual rate exceeds the standard rate.
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The labor ef�iciency variance (also called quantity, time, or usage variance) results when employees’ total actual hours worked differ from the standard. We calculate the variance by holding the rate constant while comparing the difference in hours. The following summarizes this procedure:
SR × AH = $17.00 × 5,200 = $88,400
SR × SH = $17.00 × 5,000 = $85,000
LEV = SR × (AH - SH) = $17.00 × 200 = $3,400 Unfavorable
The variance is unfavorable because the actual hours worked are more than the standard hours allowed for the 10,000 meals produced.
Because the hours are purchased and used at the same time, an alternate approach to calculating the variances can be used:
Actual Cost Inputs at Standard Standard Cost
AR × AH SR × AH SR × SH
$17.42 × 5,200 hours = $90,584 $17.00 × 5,200 hours = $88,400 $17.00 × 5,000 hours = $85,000
Rate variance Ef�iciency variance
$2,184 Unfavorable $3,400 Unfavorable
Causes of Labor Variances
Labor rates are usually set by contract, negotiations, management, or federal laws or regulations. So, why would a labor rate variance occur? Two basic reasons exist. First, labor rates often represent an average for a task, operation, or work center. If a departmental manager shifts workers’ assignments because of sudden changes in personnel requirements or a shortage of personnel, the average rate can easily change depending on how the shift relates to higher-paid or lower-paid workers. A second reason is that standard labor rates may include cost elements beyond the basic labor rate. Any changes in overtime worked, shift differentials, payroll taxes, or fringe bene�its will show up in a labor variance if these elements are part of the standard rate.
Labor ef�iciency relates to how many units are completed per actual hour for each task, operation, or process. Many reasons exist for why productivity varies from the level assumed in the standard time. Some of the common causes of a labor ef�iciency variance include:
1. Use of lower-skilled or higher-skilled workers 2. Effects of a learning curve 3. Use of lower-quality or higher-quality materials 4. Changes in production methods 5. Changes in production scheduling 6. Installation of new equipment 7. Poorly maintained equipment or machine malfunction 8. Delays in routing work, materials, tools, or instructions 9. Insuf�icient training, incorrect instructions, or worker dissatisfaction
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Responsibility for Labor Variances
Labor rate and ef�iciency variances are charged to the department managers who have control over the use of workers. Labor rate variances are often the responsibility of personnel managers who manage hiring, union contracts, and perhaps labor scheduling. Although a labor rate variance is important to understand and control, managers tend to concentrate more on the labor ef�iciency variance because it has a greater impact on capacity utilization and the department’s ability to meet production schedules. Labor ef�iciency is compared by department and by job with established standards. Daily or weekly reports to department managers and the plant superintendent help to locate and solve dif�iculties on a particular job or in a department. Differences between standard costs and actual costs incurred by a job or department may show that a job cannot be handled at the standard labor cost or that a department is not managed properly.
Interrelationships of Variances
As discussed with materials, variances should not be analyzed in isolation from one another. The event that causes one variance can easily be the cause for one or more other variances. Future cost planning and control can be improved when interrelationships among labor variances and between materials and labor variances are identi�ied and understood.
Labor Rate and Ef�iciency Variances. People perform the productive effort; thus, the rate of pay and the time required are related. Because so many relationships can exist between the two factors, only a few examples are cited to aid in identifying what to look for in a speci�ic operation.
Assume a number of employees are in various military reserve units that have been called to active duty. As a short-term solution, a manager has two options: (1) Employ temporary workers or (2) shift other workers internally and add overtime. Using temporary workers may be cheaper or more expensive depending on the situation. They are not as experienced with the equipment, procedures, and processes. They may take more time than the standard allows. Therefore, hiring temporary workers can result in both rate and ef�iciency variances. The second option is to shift existing workers and use overtime. The move will put differently skilled workers on new jobs. The move can create either a favorable or an unfavorable rate variance depending on the mix of workers. Their experience levels may be higher or lower than the speci�ic job requires and can result in an ef�iciency variance. Adding overtime could affect a rate variance, depending on how the company treats the overtime premium. Ef�iciency should not be an issue of overtime unless the workers become less productive through fatigue.
In another case, suppose an employee is having dif�iculties working on a particular machine. The worker is taking more time than standard to complete good units. The manager, trying to keep production on schedule and not lose capacity to inef�iciency, shifts a more skilled, higher-paid worker to the job. The higher-paid worker will yield an unfavorable rate variance but can reduce the unfavorable ef�iciency variance or create a favorable one.
Materials and Labor Variances. Materials and labor variances can also be related to the same source. Assume, for instance, that a purchasing agent made a fortunate buy on a lower-quality grade of materials. The “good buy” yields a favorable materials price variance for purchasing. However, when the materials are used in production, they crumble and create more waste than anticipated. More materials are needed, and an unfavorable materials usage variance arises. A department manager, desiring to minimize the lost time, moves higher-skilled people to the operation where the higher waste occurs. This
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action leads to a labor rate variance and may in�luence the magnitude or the direction of a labor ef�iciency variance.
In another case, a worker starts the shift fatigued and stressed. Lack of concentration results in higher waste, which takes more materials and time. This results in unfavorable materials usage and labor ef�iciency variances. Because more materials are needed, the manager requisitions additional materials from the storeroom. The storekeeper �inds fewer materials available than are now required. Purchasing is asked to place a rush order so that production can proceed with minimum delay. The rush order increases the purchasing costs, causing an unfavorable materials price variance.
The In�luence of Automation
Companies are constantly seeking to automate various aspects or even all aspects of their production. The purpose of this is to increase productivity and quality while keeping unit costs low. With automatic equipment, the need for high-skill levels of direct labor is substantially reduced. Direct labor in such an environment becomes such an insigni�icant element of cost that variances have little meaning.
In some industries, automation may not go beyond a certain point, in which case direct labor will remain a smaller but signi�icant cost element. However, with a great deal of automation, direct labor time becomes more dependent on the speed of a machine operation than on the speed of individual workers. Hence, labor ef�iciency is more related to machine ef�iciency than to employee ef�iciency. Therefore, a labor ef�iciency variance will carry little meaningful information.
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8.6 Standards for Overhead The factory overhead costs consist of all manufacturing costs that are not classi�ied as direct materials and direct labor. Examples of factory overhead costs include indirect materials and supplies, indirect labor, maintenance and repairs, lubrication, power, factory property taxes and insurance, and depreciation. Service organizations will have similar overhead costs related to providing services.
In a standard cost system, we use a standard overhead rate to apply these costs to products and services. We accumulate the actual overhead costs and compare them to the applied amounts to determine whether the standards were met. Variances from the standard help to direct management’s attention to situations where costs should be controlled more closely, where managers should be praised and rewarded for good performance, or where the standards should be revised.
Development of Overhead Rates
Standard costs for overhead have price and quantity factors, just like direct materials and direct labor. Price is re�lected in one or more overhead rates; quantity is the measure of activity. Price and quantity in this case are closely linked. In developing standard overhead rates, �ive major considerations must be evaluated.
First, which cost elements are included in overhead? We need to identify the individual costs that compose overhead. When certain variances occur, these items will be examined for speci�ic changes.
The second consideration is the measure of activity for relating overhead costs to products. A measure of activity for this purpose represents the factor that best expresses how costs change as volume increases or decreases. As noted in earlier chapters, we refer to the measure of activity as an allocation base or cost driver. Although many factors can in�luence costs, we select a dominant cost driver. The common ones are direct labor hours or costs, machine hours, and units of products. In Chapter 4, we examined activity-based costing and identi�ied other cost drivers that cause costs to be incurred. Our use of the measure of activity is the same as a primary-stage cost driver in those discussions. For standard costs, the appropriate measure must be selected if variances are to provide any meaningful information.
Third, and closely related to the measure of activity, is the concept of capacity and the anticipated volume level for the current period. We discussed several capacity concepts in Chapter 2. The capacity or volume concept selected and the determination of the current period level signi�icantly in�luence overhead rates because of the presence of �ixed costs.
A fourth consideration is cost behavior. The behavior of each cost within overhead is important because management plans and controls variable costs differently than it plans and controls �ixed costs. Consequently, distinguishing variable from �ixed overhead costs aids in analyzing variances for cause and responsibility. Standard cost systems often use dual overhead rates for variable overhead costs and for �ixed overhead costs. In separating the variable and �ixed cost rates, different cost drivers may be used for each cost behavior.
The �ifth consideration is the level at which overhead rates should be set: by task, by machine or labor operation, by activity center, by department, by facility, or overall. For a single product operation, overall rates for variable and �ixed costs are suf�icient. The greater the product and operation diversity, the more likely it is that rates are set for smaller groupings of costs. For our illustration with Zaner
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Restaurants, we assume an overall rate merely to illustrate the concepts. The same considerations will apply should a company compute rates by task, activity center, and so forth.
Flexible Overhead Budgets
As we have noted in previous chapters, a �lexible overhead budget is based on a formula that expresses the budgeted overhead at any point within the relevant range. The formula recognizes that some costs are variable and some are �ixed. The following schedule shows the �lexible overhead budget formula for Zaner Restaurants. We assume here that the measure of activity is direct labor hours.
The �lexible budget cost function is: $49,500 + ($6.00 × number of hours). Since we know that the hours are related to meals prepared in terms of two per hour, we can restate the formula as: $49,500 + ($3.00 × meals prepared). Typically, we would have multiple products using different amounts of direct labor, which would require the use of the basic formula.
Cost Item Fixed Cost Variable Cost per Direct Labor Hour
Indirect materials — $ 1.90
Hourly indirect labor — 1.27
Supervision $ 21,000 —
Repair and maintenance 3,600 1.11
Utilities and occupancy 10,580 1.00
Depreciation 13,800 —
Miscellaneous costs 520 0.72
Totals $ 49,500 $ 6.00
As a sidelight, the overhead rates are also available from these numbers, if we assume a volume of 5,200 direct labor hours or 10,000 meals prepared. For variable costs, the rate is $6.00 per hour or $3.00 per unit (.5 hour × $6.00). The �ixed costs are $9.52 per hour ($49,500 ÷ 5,200 hours) or $4.76 per unit (.5 hour × $9.52).
The signi�icance of the �lexible overhead budget becomes apparent in the next section where we identify variances for overhead costs.
Framework for Two-Way Overhead Variance Analysis
Because different factors give rise to underapplied or overapplied overhead, we need a framework to identify the areas of potential causes of variations. In our framework, we compare actual overhead costs with a �lexible budget and with the applied overhead to arrive at two possible variances: budget variance and capacity variance.
To begin, we need to know the actual overhead costs and the applied overhead costs. We have already seen for Zaner Restaurants that the company produced 10,000 meals during the month. Actual overhead costs for the month are $31,500 variable and $50,000 �ixed. The overhead accounts would then show the following information:
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Actual costs:
Variable $31,500
Fixed 50,000 $ 81,500
Applied costs:
Variable ($3.00 × 10,000 meals) $30,000
Fixed ($4.50 × 10,000 meals) 45,000 75,000
Underapplied $6,500
This information would appear in a T-account as follows:
Manufacturing Overhead
Actual overhead = $81,500
Applied overhead = $75,000
Underapplied overhead = $6,500
Remember, the cost per unit for variable and �ixed overhead is calculated in advance and appears on the standard cost sheet for individual products. Therefore, the rates used in the example are applied directly to actual units or equivalent units of product.
The next step is to compare the actual costs and applied costs with the �lexible budget for 10,000 meals produced. Figure 8.1 summarizes this information. Note that the two-way overhead variance analysis actually produces three variances: variable and �ixed overhead budget variances, plus the �ixed overhead capacity variance.
Figure 8.1: Overhead variances for Zaner Restaurants
Budget Variance. A budget variance is the difference between actual overhead costs and the �lexible budget for actual units produced. It is also called a controllable variance. This variance is deemed
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controllable by the appropriate operating departments. In the foregoing example, the variance is unfavorable; more dollars were spent than were budgeted for 10,000 meals. A more detailed examination of the variance is necessary to identify areas where managers need to take action. One approach for providing greater detail is to show the budget variance by individual cost item with the use of the �lexible overhead cost function, as shown in the following table:
Cost Item Actual
Overhead Flexible Budget for 10,000
Units Budget Variance
Indirect materials $ 10,250 $ 9,500 $ 750 U
Hourly indirect labor 6,250 6,350 100 F
Supervision 21,400 21,000 400 U
Repair and maintenance
9,050 9,150 100 F
Utilities and occupancy 15,930 15,580 350 U
Depreciation 13,800 13,800 0
Miscellaneous costs 4,820 4,120 700 U
Totals $ 81,500 $ 79,500 $ 2,000 U
A number of causes may exist for either a favorable or an unfavorable budget variance. The common causes will fall into one of four categories:
1. Price changes in individual cost components of overhead costs 2. Quantity changes in individual items within overhead cost components, probably in the variable
overhead area 3. Estimation errors in segregating variable and �ixed costs 4. Any overhead costs that are incurred or saved because of inef�icient or ef�icient use of the
underlying activity measure (machine hours or labor hours, for example)
The estimation errors come in two varieties: (1) the inaccuracies in predicting what will occur in the future and (2) the reliability of approximations made in separating overhead costs into variable and �ixed categories. The inef�icient or ef�icient use of activity relates to the fact that in an activity (labor worked, for example) overhead costs are incurred to support that activity. If the activity is inef�icient, overhead costs support inef�iciency. On the other hand, if less activity occurs, lower total overhead costs are incurred to support it. Therefore, ef�icient resource use also saves overhead costs.
Capacity Variance. The capacity variance (also called a volume variance) is the difference between the �lexible budget for the actual units produced and the amounts applied to work in process inventory. In Figure 8.1, because the variable overhead costs are the same in each column, the capacity variance is the difference between the budgeted �ixed overhead and the applied �ixed overhead. Therefore, the capacity variance is the amount of budgeted �ixed overhead not applied (unfavorable) or the amount applied in excess of the budgeted �ixed costs (favorable). A capacity variance, then, occurs when actual production differs from the capacity level used to calculate the standard �ixed overhead rate.
Continuing with the example, we know that �ixed overhead for the month was budgeted at $49,500, and we presume that 5,500 direct labor hours or 11,000 meals constitute a normal level of operation. We �irst compute the hourly overhead rate:
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We then convert the hourly rate to a rate per meal with the following computation:
0.5 hour per unit × $9.00 = $4.50 per meal
We see that the standard overhead rate for costing meals is computed at the normal volume, so in this case it is $4.50 per meal. During the month, Zaner Restaurants produced 10,000 meals. Fixed overhead is costed to the meals by multiplying the standard rate of $4.50 per meal by the 10,000 meals.
$4.50 × 10,000 meals = $45,000 applied
Fixed overhead budget $49,500
Fixed overhead applied 45,000
Capacity variance (unfavorable) $ 4,500
Figure 8.2 illustrates a graphical approach to the capacity variance concept. The diagonal line on the graph represents the amount of �ixed overhead applied for various meal volumes. It rises at the rate of $4.50 per meal and reaches the $49,500 budgeted �ixed overhead level at the normal volume of 11,000 meals. However, the company only produced 10,000 meals. With the rate of $4.50 per meal, only $45,000 of the budgeted �ixed overhead was applied. The difference between the budgeted �ixed overhead and the �ixed overhead applied is the capacity variance, as designated on the vertical scale.
Figure 8.2: Analysis of capacity variance
Earlier we presented the budget variance for individual categories of overhead costs. We could extend the idea to the capacity variance, but we do not gain additional information from further detail. The capacity variance is an overall issue and has little to do with individual costs.
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8.7 Capacity and Control In general, we consider the capacity variance as an item that production departments do not control. The plant produces what marketing identi�ies as the sales requirements. Therefore, the production departments cannot be held responsible if the sales demand exceeds or falls below production at a normal level of plant operation. Other factors, however, may contribute to producing below capacity. Some of these factors are controllable (or somewhat controllable) by production departments. Excessive machine downtime (due to poor maintenance, for example) or inef�icient production scheduling could be problems traceable to production managers. Lack of rapidity in completing tasks due to unskilled workers is a factor that is expected to some degree, but an excess of this condition may also be traceable to one or more production managers.
For Zaner Restaurants, normal volume was de�ined at 5,500 direct labor hours or 11,000 meals. Normal volume, as de�ined in Chapter 2, represents the average level of actual operation over several years. Practical capacity, on the other hand, is the level at which all facilities are used to full extent. Some allowance is made under this de�inition for expected delays because of changes in machine setups, necessary maintenance time, and other interruptions. Hence, practical capacity is less than theoretical maximum capacity, which could be obtained only under ideal conditions.
A comparison of the actual output with the output for practical capacity broadly measures the failure of the facility to operate at the level for which it was designed. Assume, for example, that Zaner Restaurants can reasonably be expected to produce 15,000 meals a month. Yet only 10,000 meals were produced. The idle capacity is de�ined as the difference between the practical capacity and the actual production for a given month. The idle capacity for Zaner Restaurants is determined as follows:
Practical capacity 15,000 meals
Actual production 10,000
Total idle capacity 5,000 meals
The idle capacity can be analyzed further to determine why facility capacity was not used as intended. Assume that the sales budget shows that 12,000 meals were expected to be sold during the month but that orders for only 11,500 meals were received. The differences between practical capacity, sales budget, orders received, and actual production are illustrated as follows:
1. Practical capacity minus sales budget. The difference between the practical capacity and the sales budget for the month requires further investigation. Perhaps the company was overly optimistic and provided too much capacity. Or the Marketing Department may not be obtaining potential available customers. Additional analysis may reveal the nature of the problem and provide a foundation for improvements.
2. Sales budget minus orders received. The difference between the sales budget for the month and the orders received is a measurement of the inability of the Marketing Department to meet
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the budget quota. Perhaps the quota was too high, or the Marketing Department was not suf�iciently aggressive.
3. Orders received minus actual production. The difference between the orders received and actual production re�lects a mixture of idle time and inef�iciency. Suppose that Zaner Restaurants used 5,200 hours to produce 10,000 meals and 5,000 hours were allowed. The 200 hours of inef�iciency, in this case, consumed time that could have been used for production of an additional 400 meals (200 hours ÷ .5 hour per unit). The difference between the orders received and the expected production for the time used (11,500 – 10,400 = 1,100 meals) is a measurement of idle time.
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8.8 Variances When cost variances occur, managers need to know what caused them. Knowing the amount of variance does not disclose the cause(s); rather, investigation is required. However, managers must decide whether the bene�its of investigation and corrective action exceed the related costs. Obviously, a $10 unfavorable materials usage variance from a standard cost of $50,000 would not be worth investigating. But where should the line be drawn?
Ideally, if the costs and bene�its of investigating and correcting can be estimated, these costs and bene�its should be compared in deciding whether to investigate. In practice, however, this is extremely dif�icult. Instead, many companies use simple decision rules based on prescribed dollar limits, such as “investigate any variance over $500.” The main problem with this method is that $500 may be signi�icant when the standard cost is $2,000 but may be insigni�icant when the standard cost is $20,000. Therefore, many companies use a percentage rule, such as “investigate any variance of �ive percent or more.” Some companies use more sophisticated statistical approaches that set limits based on standard deviations from the standard cost. However, most companies do not seem to have formal decision rules; rather, managers are instructed to use “judgment.”
Summary of Standard Cost Variances
We have completed a number of variance computations for the cost elements of production. Figure 8.3 contains a summary of all variances and the methods of calculating them. It also emphasizes that the costs charged to units produced are the standard costs. Therefore, work in process inventory and all subsequent accounts containing product costs will be stated at standard. Notice that costs on the far left side are all actual costs, while costs on the far right side are standard costs. If dollar amounts become smaller as we move from left to right, we experience unfavorable variances. If amounts become larger, we experience favorable variances.
Figure 8.3: Summary of standard cost variances
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Disposition of Variances
In our discussion of materials and labor variances, we set up separate variance accounts. Overhead variances, although identi�ied separately in worksheet analysis, are combined in the underapplied or overapplied amounts. At the end of each period, variance accounts must be closed. Where do these variances go? As a practical matter, all standard cost variances eventually go to cost of goods sold. The most common practice is to close the variance accounts directly to cost of goods sold, thus treating them as period costs. Occasionally, if the variances are signi�icant in amount, they will be prorated to cost of goods sold and to the appropriate materials, work in process, and �inished goods inventories. We assume here that variances are closed to the cost of goods sold account.
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8.9 Standard Costs in Different Settings Standard costs are applicable to service organizations, as we have shown with Zaner Restaurants. As with manufacturing companies, the more routine the service organization’s activities, the easier it is to set standards. Generally, though, a service organization’s activities are less routine than those of a manufacturing company. The following list contains examples of service organization activities for which standard costing would be appropriate:
1. Filling prescriptions in a pharmacy 2. Picking orders in a warehouse 3. Preparing food in a restaurant 4. Answering telephones in advertising agencies, airline of�ices, customer service departments, and
computer technical hotlines 5. Processing orders in a mail-order house 6. Calling on customers (by phone or door-to-door)
Standard Costs in Service Organizations
Standard costing in a service setting will tend to emphasize labor and overhead, since materials are usually not a signi�icant item. Notable exceptions, however, would be restaurants and auto repair shops, where food ingredients and car parts, respectively, are sizable cost elements. Calculating standard costs and variances for service organizations is similar to manufacturing companies. The main difference is that in determining standard quantities, the output of a service organization is often not as clear as for a manufacturing company. The following list contains examples of output measures that might be chosen in various service settings:
1. Number of claims processed in an insurance company 2. Number of loan applications processed at a bank 3. Number of deliveries made by a delivery service 4. Number of patients treated in a particular department of a hospital 5. Number of passengers transported by an airline
Standard Costs in a Process Cost System
Standard costs are appropriate for job cost systems or process cost systems. Where we have a process cost system, the equivalent units are calculated using the FIFO method discussed in Chapter 3. Remember that equivalent units can be different for materials, labor, and overhead.
One convenience realized in a standard cost system is the availability of unit costs without the computations we did in Chapter 3. Since standard costs are predetermined, we simply multiply the equivalent units by the appropriate standard costs to determine costs of goods completed and costs of the ending inventory. Except for the use of equivalent units, variance analysis in a process cost system does not differ from the analysis used in a job cost system.
Standard Costs in JIT/CIM Environments
In JIT and computer-integrated manufacturing (CIM) environments, standard cost systems face greater challenges. These environments are often characterized by rapid technological changes in production
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processes and products produced, which make it very dif�icult to set standards that will be relevant for a reasonable time period. Furthermore, the prevalence of short production runs and the need for real- time information require variance reporting on a much more timely basis than the typical monthly or even weekly basis.
Companies with JIT/CIM environments are increasingly turning to a philosophy of continuous improvement. With this approach, the focus is more on trends of variances rather than their magnitudes.
Generally, fewer types of cost variances are computed in JIT/CIM environments. Since JIT/CIM companies tend to be highly automated, direct labor variances are of little or no relevance. Also, materials price variances have little relevance because JIT companies usually have long-term contracts with a small number of suppliers.
In many companies with JIT/CIM processes, cost variances are being supplemented or, in some cases, replaced by non�inancial measures of performance. We discuss these types of measures in Chapter 12.
Target Costing and Kaizen Cost Targets
Recognizing that most costs of production are determined when products are developed and designed, many companies are turning to a technique developed by Japanese companies known as target costing. After a target selling price and a target pro�it are established, an allowable cost consistent with these targets is obtained for the product. The company then designs the product and sets cost standards based on the allowable (target) cost. To promote continuous improvement, these cost targets, known as kaizen cost targets, are reduced in each successive period. Target costing and kaizen cost targets are discussed more fully in Chapter 12.
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8.10 Ethical Considerations Because cost variances are used to evaluate performance of cost center managers, there may be temptation to compromise ethics. This might happen in the standard-setting process or in reporting actual costs. A manager who has input in setting standards might deliberately provide inaccurate information in an attempt to produce loose standards. Likewise, a manager who plays a role in gathering or reporting actual costs might intentionally distort actual data. Top management should be aware that performance evaluation based on cost variances can produce these behaviors. Cost center managers must guard against compromising their integrity for a possible short-term gain.
A more subtle form of unethical behavior results when managers avoid doing their best for fear of causing the standards to be tightened. A manager might believe that cost decreases in the current period are unlikely to be replicated due to some unique conditions. In that case, the manager should prepare a convincing argument to upper management not to revise standards signi�icantly. Upper management can alleviate these types of problems by not automatically adjusting the cost standard by the full amount of cost reduction. For instance, if the production manager knows that any cost reduction will cause next period’s cost standards to decrease by only 50% of the cost reduction, the manager would tend to put more effort into cutting costs than if the standards were to be adjusted by the full cost reduction.
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Summary & Resources
Chapter Summary When actual performance varies from expectations, explanations for the differences are sought. Once causes of variations are identi�ied, changes can be made through the planning process or control mechanisms. One aid to the analysis is the use of a standard cost system for costs that ultimately �low into cost of goods sold. Standard cost systems operate effectively in situations where standardized products or standardized operations exist. Although the primary advantage of such a system is cost control, several other advantages can also be achieved: cost management, improved decision making, savings in recordkeeping costs, and more rational inventory valuation.
A standard cost consists of a price factor and a quantity factor. The quality of a standard is expressed as strict, attainable, or loose. The preferred standard for all purposes is one that is current and attainable. A standard cost sheet is a basic element of the standard cost system. Here the standard quantities and prices are stated for direct materials, direct labor, and all overhead. The standard cost sheet gives the total unit cost that is attached to a completed unit of a given product.
Materials standards are set after considering the purchase price and other dollar amounts to be included and after determining the quantities needed for the intended operations. A materials price variance occurs anytime the actual price differs from the standard price. The variance is calculated as the actual quantity purchased times the difference between the actual price and the standard price. A materials usage variance is caused by using more or less materials than set by the standard. This variance is calculated as the standard price times the difference between the actual quantity used and the standard quantity allowed. Price variances are generally the responsibility of the purchasing department while usage variances are generally the responsibility of production department managers.
In establishing labor standards, management looks at what operations are performed, how much time should be spent in each operation, what labor skills are needed to perform the operations, and what rate should be paid. The standard labor rate is the base rate of pay plus any other costs associated with labor that management chooses to include. A labor rate variance occurs any time the actual rate differs from the standard rate. The variance is the actual hours worked times the difference between the actual rate and the standard rate. A labor ef�iciency variance is caused by using more or less time than the standard speci�ies. This variance is calculated as standard rate times the difference between actual hours worked and the standard hours allowed. Both variances generally are the responsibility of production department managers.
Standards for overhead are set after considering �ive important factors: the cost elements to include in the standards, the measure of activity that best relates the costs to the work done, the capacity concept for the selected measure of activity, the cost behavior of each element of overhead cost, and the rate structure, whether by task, operation, process, department, or overall. During any period, the actual overhead cost can differ from the overhead applied to products. To understand the signi�icance of the underapplied or overapplied amounts, we calculate a budget variance and a capacity variance. A budget variance is the difference between actual overhead costs incurred and the �lexible budget for the actual number of units produced. It represents those overhead cost elements over which department managers have control. The capacity variance is the difference between the �lexible budget for the actual units produced and the amounts applied to products. This variance consists only of �ixed overhead costs and represents the amount by which actual production differs from planned capacity.
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Key Terms
attainable standards Standards that can be achieved with reasonable effort.
budget variance The difference between actual overhead costs and the �lexible budget for actual units produced.
capacity variance The difference between the budgeted �ixed overhead and the �ixed overhead costed to products by the use of the predetermined �ixed overhead rate.
controllable variance The difference between actual overhead costs and the �lexible budget for actual units produced.
cost control Comparing actual performance with the standard performance, analyzing variances to identify controllable causes, and taking action to correct or adjust future planning and control.
favorable variance Actual cost is less than the standard cost.
�lexible overhead budget A budget based on a formula that expresses the budgeted overhead costs at any point within the relevant range.
idle capacity The difference between the practical capacity and the actual production for a given period.
kaizen cost targets Cost targets that are set at the last period’s actual level with the intent to reduce these costs.
labor ef�iciency variance The difference between the actual and standard time required for production multiplied by the standard labor rate.
labor rate variance The difference between the actual and standard labor rates multiplied by the actual hours worked.
loose standards Standards that can be achieved with very little effort.
management by exception A philosophy of emphasizing the exception, highlighting only areas that deviate from the plan and that require management’s attention.
materials price variance The difference between the actual and standard materials prices multiplied by the actual quantity of materials.
materials usage variance
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The difference between the actual and standard quantity of materials multiplied by the standard materials price.
measure of activity The factor that best expresses how costs change as volume changes.
price standard A generic term that means a standard price for materials, rate for labor, and rate for factory overhead.
quantity standard A generic term that means a standard quantity for materials, time for labor, and activity or volume for factory overhead.
standard cost The combination of a price standard and a quantity standard.
standard cost sheet A summary of the cost for each category of direct materials used; the cost of each direct labor operation employed; and the cost of all overhead tasks, operations, processes, and support functions applied to a unit of �inal product.
strict standards Standards set at a maximum level of ef�iciency, representing conditions that are very dif�icult to attain.
target costing A cost target set by subtracting the desired pro�it from the target selling price.
unfavorable variance Actual cost is greater than the standard cost.
Problem for Review Glusman Of�ice Furniture is a well-known supplier of quality of�ice furniture. It is currently setting up a standard cost system for its products. One product is the Home Of�ice Workstation for those who operate a business in their homes. The production process for this workstation involves four departments: Cutting, Assembly, Staining, and Finishing. Materials, labor, and overhead costs are accumulated by department.
Raw materials include lumber, stain, drawer handles and �ixtures, screws, dowels, and glue. Each workstation requires 64 feet of lumber at $1.60 per foot. Drawer handles and other drawer �ixtures are $16.80 per workstation. Stain required is 0.8 gallons at $16.70 per gallon. Screws, dowels, and glue are included in the overhead costs of the Assembly Department. Lumber enters the process in the Cutting Department; drawer handles and other drawer �ixtures, in the Assembly Department; and stain, in the Staining Department.
Direct labor occurs in Cutting, Assembly, and Finishing. Cutting requires 30 minutes per workstation with labor cost at $19.50 per hour. Assembly requires two hours per workstation with a labor cost of $21.60 per hour. Finishing requires 20 minutes with a labor cost of $17.70 per hour. Staining is an automated department and has no direct labor.
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Factory overhead is applied to workstations by department on the basis of direct labor hours in the three departments with direct labor. Cutting is $10 per hour, Assembly is $9.50 per hour, and Finishing is $9 per hour. The Staining Department overhead is applied on the basis of machine time, and the rate is $18 per machine hour. Each workstation requires one-fourth of an hour of machine time.
Question:
Prepare a standard cost sheet that shows all of the elements of cost for a completed workstation. For convenience, identify the cost elements by department.
Solution:
Standard cost sheet for completed workstation:
Direct materials:
Lumber (64 feet at $1.60) $102.40
Drawer handles and �ixtures 16.80
Stain (0.8 gallons at $16.70) 13.36 $132.56
Direct labor:
Cutting (0.5 hour at $19.50) $9.75
Assembly (2 hours at $21.60) 43.20
Finishing (1/3 hour at $17.70) 5.90 58.85
Factory overhead:
Cutting (0.5 hour at $10.00) $5.00
Assembly (2 hours at $9.50) 19.00
Staining (1/4 hours at $18.00) 4.50
Finishing (1/3 hour at $9.00) 3.00 31.50
Total standard cost per workstation $222.91
Questions for Review and Discussion 1. Under what conditions will a standard cost system work best? 2. De�ine a standard cost. Explain what constitutes the components of a standard cost. 3. Point out advantages and disadvantages of following the principle of management by exception. 4. Which level of standard (tight, attainable, or loose) will give the lowest standard cost per unit?
Explain. 5. A standard cost sheet is a key component of a standard cost system. Describe a standard cost
sheet and explain why it is signi�icant. 6. In purchasing materials, what amounts are recorded in Accounts Payable and what amounts in
Materials Inventory? What happens to the difference? 7. Describe �ive potential causes of a materials price variance. 8. List and explain �ive potential causes of materials usage variances. 9. Explain how the purchase of materials at less than the standard price may have an adverse effect
on other production variances.
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10. List �ive causes of a labor rate variance. 11. List �ive causes of a labor ef�iciency variance. 12. Give an example of how labor variances and materials variances are related. 13. Explain brie�ly how underapplied or overapplied overhead can be analyzed into a budget
variance and a capacity variance. 14. De�ine a capacity variance and explain why it consists solely of �ixed overhead costs. 15. What is the primary difference between using standard costs in a job cost system and a process
cost system?
Exercises 8-1. Standard Cost Sheet. Arnovitz Enterprises manufactures special electronic equipment and parts. It has adopted a standard cost system with separate standards for each part. A special electronic “black box” has standards set with the following components. Materials include both iron and copper. Each “black box” requires six sheets of iron which cost $7 per sheet and four spools of copper at $3.50 per spool. Four hours of direct labor are needed for producing each box, and the standard rate per hour is $16. Overhead costs are charged to products on the basis of direct labor time. The variable overhead rate is $3 per hour, and the �ixed overhead rate is $2 per hour.
Question:
Prepare a standard cost sheet that shows the standard cost per unit for each “black box.”
8-2. Labor Variances. Marvin & Singer TV Repair Shop �ixed 550 television sets during the year, using 1,447 direct labor hours. Standards state that television sets, on average, should take 2.5 hours to repair. The standard direct labor rate is $19 per hour, while the actual rate averaged $18.60 per hour.
Question:
Compute the labor rate variance and the labor ef�iciency variance.
8-3. Materials Variances – Missing Information. In May, Sobel Equipment Company purchased 50,000 parts at a total cost of $600,000. During the month, 46,000 parts having a standard unit cost of $11 were used in production. The materials usage variance for the month was unfavorable by $33,000. According to the standards, �ive parts should be used for each unit of product.
Questions:
1. Calculate the materials price variance. 2. How many units of product were made? 3. How many units of parts should have been used in production?
8-4. Labor Standards. Four employees each work 38 hours a week in an assembly operation at Goozh Company. Standard production for the week was established at 2,280 assemblies, or at a rate of production of 15 assemblies per labor hour. A time study person, Keith Baker, has observed that it is possible to make 20 assemblies an hour, and this rate has been set as the new standard.
Production data for one week under the new standard are as follows:
Employee Hours Worked Units Assembled
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Employee Hours Worked Units Assembled
1 38 660
2 38 590
3 38 630
4 38 620
The standard labor rate per hour is $12. During this week, an unfavorable materials usage variance due solely to above normal scrap and waste was $2,500. Also, 500 units that had been fully assembled were rejected by Jean Emmer, an inspector.
Questions:
1. What was the standard labor cost per assembly under the old standard of 15 assemblies per hour?
2. What was the anticipated labor cost per assembly under the new standard of 20 assemblies per hour?
3. What was the actual labor cost per assembly during the week (after deducting the rejected units)?
4. Comment on the new labor standard and possible reasons for the losses.
8-5. Labor Ef�iciency Variance and Ethics. Gold Burgers is a large fast-food restaurant located in Washington and managed by Randee Menashe. Standards indicate that each hamburger cook should make 100 burgers per hour and that the labor rate is $10 per hour. This month, 263,000 burgers were cooked in 2,150 hours.
Questions:
1. What was the labor ef�iciency variance this month? 2. Why might the restaurant manager be tempted to report to top management a smaller variance
than actually occurred?
8-6. Labor Variances – Incomplete Data. Lipis & Glinsky, a consulting �irm, reports the following data related to its labor cost:
Labor ef�iciency variance $7,000 favorable
Total labor cost variance $13,000 unfavorable
Actual wage rate paid $120 per hour
Standard wage rate $110 per hour
Question:
Determine the actual hours worked.
8-7. Materials Price Variance and Finding Unknowns. The Kurland Youth Baseball League has 3,000 baseballs in inventory, which were purchased by the director, Jack Williams, for a total of $6,600. Each baseball game should require a standard usage of �ive baseballs. During July, 330 baseball games were played. The total standard cost allowed for the baseballs amounted to $3,762. There was an unfavorable materials usage variance of $800.
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Questions:
1. Compute the standard price for one baseball. 2. How many baseballs were used in July? (Round to nearest whole number.) 3. Compute the price variance for the baseballs used in July.
8-8. Materials Variances and T-accounts. Rita Pollack & Company has the following data for the month of November:
Materials purchased, 2,600 kilograms $8,580
Materials used in production 1,320 kilograms
Units of product manufactured 17,000
Materials usage variance $384 Unfavorable
Standard price per kilogram $3.20
Questions:
1. Find the standard quantity of materials allowed for the units of product manufactured. 2. Determine the materials price variance. 3. Record the materials costs and variances in T-accounts with Work in Process Inventory as the
�inal account.
8-9. Standard Rate for Direct Labor. Frankel Brothers, Inc. manufactures tennis rackets. During one week in January, the company had a total standard cost for direct labor of $3,600. There was a favorable direct labor ef�iciency variance of $240. The actual amount of direct labor hours worked was 560 hours.
Question:
Compute the standard rate for direct labor.
8-10. Overhead Variance Analysis. A �lexible budget for Mark Fisher’s Tire Service is given in summary form as follows:
Machine hours 60,000 70,000 80,000 90,000
Variable overhead $240,000 $280,000 $320,000 $360,000
Fixed overhead 480,000 480,000 480,000 480,000
Total overhead $720,000 $760,000 $800,000 $840,000
The standard rate of production is six jobs per machine hour, and normal volume has been de�ined at 80,000 machine hours. The company performed 420,000 jobs in 70,000 machine hours. Actual variable overhead was $287,000, and the �ixed overhead was $475,000.
Questions:
1. Compute the amount of underapplied or overapplied overhead. 2. Compute the budget variance. 3. Explain the major causes of a budget variance. 4. Compute the capacity variance.
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5. Cite three possible reasons for the existence of this capacity variance.
8-11. Overhead Variances. Shapiro’s Delivery Service hires drivers to deliver packages in St. Louis. An average standard time to make a delivery has been established as one hour. The of�ice is centrally located, and it takes about as much time to deliver to one location as it does to another. Fixed costs have been budgeted at $240,000 for the year. Under normal conditions, the company expects to make 60,000 deliveries a year. The variable cost has been budgeted at $12 per hour. Last year, the company made 63,000 deliveries in 59,000 hours and incurred total costs of $988,000, including �ixed costs.
Questions:
1. Compute the standard cost of making a delivery. 2. How much overhead costs were charged to deliveries in total during the year? 3. Determine the budget variance. 4. Determine the capacity variance.
Problems 8-12. Standard Cost Sheet – Materials and Labor. An industrial solvent with the brand name Velocidad is produced by Proveedor Chemical Company in Caracas, Venezuela, and sold in 25-liter drums. Data with respect to materials and labor are as follows:
1. A batch of 1,500 liters of Velocidad is made from an input of 1,500 liters each of Destino and Promesa. In the boiling operation, 50% of the volume of both Destino and Promesa is lost through evaporation.
2. At the end of the boiling operation, 2 kilograms of Bono are added to each 1,500-liter batch. (This has no measurable effect on volume.)
3. A worker can process one 25-liter drum in 20 minutes. 4. At the �inal inspection, two 25-liter drums are rejected out of every 10 drums received from the
production line. 5. Standard materials prices and the labor rate (in bolivars) are as follows:
Destino B 200 per liter
Promesa B 150 per liter
Bono B 600 per kilogram
Labor rate B 1,200 per hour
Question:
Prepare a standard cost sheet that shows the standard materials and labor costs for each 25-liter drum of completed product.
8-13. Interrelationship of Materials and Labor Variances. Vicki Kayser, purchasing agent for the western region of Knockout Nail Salons, was pleased to report that she bought 50,000 units (i.e., nails) for $15,000, which was lower than the $22,500 cost at its standard price. The nails also were a lower grade than called for by the standard. Allowing for a normal amount of breakage, an average of 5.2 nails should be used for each hand.
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When these nails were used on customers, breakage was higher than normal. To keep the abnormal breakage to a minimum, the operating manager, Lori Brickman, shifted more skilled workers into the salons where breakage occurred. The standard labor rate was $18 per hour. One half hour is the standard time for putting nails on one hand.
Last month, the salons used 42,000 units and 3,300 hours in doing 6,000 hands. The labor cost was $65,750.
Questions:
1. Compute materials price and materials usage variances. 2. Compute labor rate and labor ef�iciency variances. 3. Combine the four variances to obtain the net effect. Did the purchasing agent save the company
money in buying the nonstandard nails? 4. Which variance amounts would be assigned to the purchasing agent and which would be
assigned to the operating manager? Comment on the interrelationships among the variances here.
8-14. Reconstructing Actual Inputs. Schoen Corporation manufactures a number of different products. Its most pro�itable product comes from a division in Alabama that has the following standard cost sheet:
Materials (2 ounces at $8.50 per ounce) $17
Labor (.5 hour at $12 per hour) 6
Overhead ($18 per labor hour) 9
Total product cost $32
At the end of a recent month, the following variance information was available for the product:
Manufacturing cost variances:
Materials price $7,500 F
Materials usage 8,500 U
Labor rate 5,900 U
Labor ef�iciency 12,000 F
Materials purchases for the month were 300,000 ounces. The division produced 120,000 units, with no work in process inventories at the beginning or end of the month.
Questions:
1. Calculate the actual materials price per ounce. 2. Calculate the number of ounces of materials actually used in production. 3. Calculate the actual number of labor hours worked.
8-15. Materials Variances. The current year budget for Ed Lynn’s Courier Service estimated 153,000 miles to be driven by its couriers based on a forecast of 17,000 deliveries. The standard price of gasoline was set at $2.20 per gallon, and the company expected to drive an average of 22 miles per gallon for its
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deliveries. During the year, 18,480 deliveries were actually made, 165,600 miles were driven, the average price per gallon of gasoline purchased was $2.16, and an average of 24 miles per gallon was achieved for the company’s deliveries.
Question:
Compute the materials price variance and the materials usage variance for the current year.
8-16. Overhead in an Automated Operation. Joe Tate observes, “The nature of costs has changed since Eruv Company installed more automated equipment. At one time, direct labor was an important factor. With automation, direct labor is essentially a �ixed cost with workers monitoring the operation on television screens. Variable overhead cost is lower and is related to hours of machine operation. On the other hand, �ixed cost is much higher than it was in a labor-oriented operation. However, the production line can only move so fast. If it is stepped up, too many pieces are broken.”
Jan Spector, the production manager, says, “We may not obtain much more savings from increases in productivity. Additional savings will have to come by holding down �ixed costs and receiving a large volume of orders.”
Data from last year is as follows:
Variable cost per machine hour $4
Number of standard units of product per machine hour 100
Fixed overhead budget $6,000,000
Normal number of product units produced in a year 60,000,000
Actual hours of operation 500,000
Actual product units produced 58,000,000
Actual overhead cost:
Variable overhead $1,935,000
Fixed overhead $6,030,000
Questions:
1. What was the standard variable overhead cost per product unit and the standard �ixed overhead cost per product unit?
2. How much overhead was applied to production for the year? 3. Determine the following variances:
a. Overhead budget variance. b. Overhead capacity variance.
8-17. Overhead Budget and Capacity Variances. Levene Finance, Inc. specializes in home equity loans. It bases its overhead on the �lexible budget cost function of:
$33,000 + ($2.40 × labor hours)
Normal volume is based on 12,000 labor hours. Standards call for two labor hours per loan processed.
For the current period, the operating results were as follows:
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Actual labor hours worked 11,400
Loans processed 5,800
Actual variable overhead costs $28,460
Actual �ixed overhead costs $31,950
Questions:
1. Calculate the rates for variable and �ixed overhead that would be used to apply overhead to loans.
2. Calculate the underapplied or overapplied overhead for the period. 3. Determine the following variances:
a. Overhead budget variance. b. Overhead capacity variance.
4. How much of the budget variance is due to variable costs and how much to �ixed costs?
8-18. Comprehensive Variance Analysis. Weissmann Company uses a standard cost system and isolates the following six variances for the appropriate departments:
Materials price variance Labor ef�iciency variance
Materials usage variance Overhead budget variance
Labor rate variance Overhead capacity variance
The company uses direct labor as the measure of activity for each of the producing departments.
Question:
For each of the following independent events, indicate which variances would be affected. Brie�ly explain why they would be affected, and indicate whether the effect is favorable or unfavorable. If more than one variance is in�luenced in a given situation, limit your discussion to the two or three most important variances for that situation.
a. Demand exceeded expectation, and the number of units produced during the year was much greater than the number planned.
b. Because of an improperly adjusted machine, more materials were wasted than anticipated. When the department supervisor requisitioned more materials from the storeroom, no materials were there. A rush order for more materials was placed, and the materials arrived by special delivery before the end of the day.
c. A purchasing agent bought substandard materials at a large savings. Because of the lower quality of the materials, more scrap was produced, and an additional employee was hired to assist in the cutting operation.
d. Several customer rush orders were accepted and placed into production. The orders were completed within the standard time allotted; however, overtime was required to meet the customers’ delivery schedules.
e. A new union contract at the beginning of the year required an increase in labor rates. Adjustments to the standard wage rates were made as required at the beginning of the year. During the year, the rate of in�lation in the economy was lower than what was predicted for the contract wage rates.
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f. Due to food poisoning in the plant cafeteria, several highly skilled employees from one department were sick for two days. The department supervisor hired temporary, unskilled production-line workers to substitute for the skilled workers. The wages for the temporary help were less than standard, and the output was also less than standard.
g. Because there were more than the usual machine breakdowns, repair and maintenance personnel used more supplies than called for in the overhead budgets.
h. A brownout caused by the overload of extra power usage in the city resulted in the inability to run machines at full power for four hours during a second shift.
i. A forklift driver inadvertently ran into a large machine, dumping his load and stopping the machine. Several direct labor workers and the machine operator helped clean up the mess and got the machine going again.
j. A new quality control inspector was less strict than policy standards required. Units that should have been reworked were passed over, released to the �inished goods warehouse, and sold to customers.
8-19. Analysis of Overhead Items. Elaine Alexander, administrator of a dialysis clinic in Peyton, New Mexico, has estimated overhead costs for the year at an expected operating level of 6,000 dialyzer machine hours. Past experience indicates a rate of cost variability per hour as follows:
Lubrication $.75
Supplies .30
Power .25
Repairs .50
Maintenance .80
Costs that are �ixed are budgeted as follows:
Supervision $ 4,500
Indirect labor 11,500
Heat and light 3,200
Taxes and insurance 1,600
Depreciation 1,800
During the year, the clinic incurred 5,500 dialyzer machine hours and treated the number of patients that should have been treated in 5,000 dialyzer machine hours. The clinic incurred the following overhead costs:
Lubrication $ 3,900
Supplies 1,700
Power 1,500
Repairs 2,800
Maintenance 4,300
Supervision 4,000
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Indirect labor 12,000
Heat and light 3,200
Taxes and insurance 1,400
Depreciation 1,600
Total $36,400
Questions:
1. Prepare a budget of overhead costs for 5,000 dialyzer machine hours. 2. Compare the actual overhead costs with the budget for 5,000 dialyzer machine hours. Show
budget variances for each item. 3. Explain what factors could cause the budget variance to arise.
Case: Sydney’s Bicycles, Inc.
Sydney’s Bicycles, Inc. is a large manufacturer located in Omaha. Its usual production of bicycles is 10,000 units per year. The company has been a leader in the 21-speed bike industry for several years. However, with increasing competition and a higher public emphasis on quality, the company has been searching for ways to maintain quality and cut costs. Andy Lewis, production planner, suggested that starting at the beginning of 2019 the company invest in higher-quality materials and hire more experienced workers at a slightly higher pay rate.
The company has used a standard cost system for the past �ive years. The current standard costs for one bicycle, based on production of 10,000 units, are as follows:
Materials $ 60
Direct labor (4 hours at $10) 40
Variable overhead (based on labor) 20
Fixed overhead (based on labor) 8
Standard cost per bicycle $128
Jonathan Levin, president, is skeptical about decreasing costs by increasing materials and labor costs. However, after much debate, he agrees to try the changes for one year beginning with January 2019. Because the exact costs of changes were not known at the beginning of 2019, the existing standard costs were retained. Therefore, the changes will be in the variances from standard costs.
During 2019, the company produced only 9,500 bicycles because the marketplace showed a decreasing demand. The following data show the actual results for 2019:
1. Materials costing $617,500 were purchased and used. No usage variance existed, so any differences were due solely to price changes.
2. Direct labor was $249,375 for 23,750 direct labor hours. 3. Actual variable overhead totaled $163,000.
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4. Actual �ixed overhead totaled $80,000.
Mr. Levin was pleased with the results. Even though production was down by 500 bicycles, the difference in costs was signi�icant. He would like to know why.
Questions:
1. Compute all appropriate variances for the following categories: a. Materials b. Labor c. Overhead
2. Explain how any of the variances interrelate (have the same basic cause). 3. Explain which of the variances are controllable. 4. Assuming that the actual cost results for 2019 represent the new standard performance,
calculate the new standard cost per bicycle, showing separately the materials, labor, and overhead components. (Normal production is still based on 10,000 bicycles.)
