Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
PART IV
OPERATIONAL CONTROL
C H A P T E R
IV. Operational Control
14. The Flexible Budget:
Factory Overhead
© The McGraw−Hill
Companies, 2008
F O U R T E E N
The Flexible Budget:
Factory Overhead
After studying this chapter, you should be able to . . .
1. Distinguish between the product costing and control purposes of standard costs for factory
overhead
2. Calculate and properly interpret standard cost variances for factory overhead using traditional
approaches
3. Record factory overhead costs and associated standard cost variances
4. Apply standard costs to service organizations
5. Analyze overhead variances in an activity-based cost (ABC) system
6. Understand decision rules that can be used to guide the variance-investigation decision
“The third quarter was a difficult period for United. Revenue performance suffered significantly
from the operational disruptions we experienced throughout the quarter,” James Goodwin,
United Airlines chairman and chief executive, said.1 United (UAL) suffered from thousands of
labor and weather-related flight cancellations and delays during the third quarter of 2000 while
the airline negotiated a labor contract with its pilots. The earnings per share for the quarter
decreased from a profit of $2.89 the previous year to a loss of $1.29.
UAL’s operating results experienced this drastic change although the decrease in traffic
was only a small percentage of total traffic during the third quarter of 2000. As it is for other
companies with high fixed costs, volume is a critical success factor for UAL. Fluctuations in
traffic volume at UAL often explain the bulk of changes in operating results. UAL constantly
monitors volume-variance data, which measures the effect that deviations in actual volume
(passenger miles) from the budget or planned level have on operating results. The goal to have
minimum disruptions to planned operations and to achieve or exceed the expected operating
level leads airlines to constantly seek to get that last passenger on board through price restructuring or other maneuvers.
Companies with high fixed costs experience wide variations in operating results when
their levels of operation fluctuate. Managers of these organizations monitor business volumes
closely and attempt to reduce fluctuations in business activities. This chapter examines production volume and other overhead-related variances that organizations use to monitor operations to gain better control and improve operating results.
A man should never be ashamed to own that he has been in the wrong, which is but saying in other words,
that he is wiser today than yesterday.
Jonathan Swift
In Chapter 13 we discussed standard costs and standard cost systems, the use of flexible
budgets and standard costs for financial control purposes, and the recording of standard costs
for direct materials and direct labor. In Chapter 14 we continue the discussion of standard
costs and variance analysis, in both traditional and activity-based cost (ABC) systems. In
particular, we focus on standard costs and associated variances for factory overhead. We
550
1
“UAL to Post Loss to 3rd Period, Probably for 4th,” The Wall Street Journal, October 2, 2000, p. A12.
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
Chapter 14
The Flexible Budget: Factory Overhead 551
conclude the chapter with a discussion of approaches that can be used by managers to
determine when, under the management by exception philosophy, standard cost variances
should be investigated.
Standard Overhead Costs: Planning versus Control
LEARNING OBJECTIVE 1
Distinguish between the product
costing and control purposes
of standard costs for factory
overhead.
EXHIBIT 14.1
Variable Factory Overhead:
Product Costing versus
Control
As pointed out in Chapter 13, standard costs can be used alone for control purposes, or they
can be incorporated formally into the accounting records for both product costing and control
purposes. In Chapter 13 we used a flexible budget to calculate various revenue and cost variances and in so doing explain why actual operating income for a period differed from operating income reflected in the master (static) budget. For cost-control purposes, we calculated a
total flexible budget variance and then proceeded to explain this total variance by calculating
a selling price variance, fixed cost variances (for both manufacturing and nonmanufacturing
costs), and a total flexible budget variance for direct manufacturing costs.2 We then broke
down the variance for direct labor and direct materials into a price (rate) component and an
efficiency (quantity) component. The breakdown of the flexible budget variance for factory
overhead was left for Chapter 14. However, before looking at standard cost variances associated with factory overhead, we need to differentiate the product costing and cost-control
purposes of standard costs used for factory overhead costs.
For variable factory overhead costs, that is, those that vary in response to changes in one
or more cost drivers, the underlying model for control and product costing purposes is the
same, as illustrated in Exhibit 14.1. Recall that the Schmidt Machining Company uses direct
labor-hours as the activity variable for applying overhead costs. Other allocation bases, such
as number of machine-hours, could have been used by the company.
The main point is that for both applying variable overhead costs to production (product
costing purpose) and for comparing with actual variable overhead cost (cost-control purpose) identical amounts are used. We reproduce as Exhibit 14.2 the standard cost sheet for the
Schmidt Machinery Company from Chapter 13. As you can see, the standard variable overhead rate per unit is $60 (5 standard direct labor-hours/unit $12 standard variable overhead
cost per direct labor-hour). It is this amount that is charged to production for the period (product costing purpose) and that is used in the flexible budget (cost-control purpose) in Exhibit
13.8. In short, the graph depicted in Exhibit 14.1 for variable overhead cost is similar in form
to what we could have prepared in Chapter 13 for either direct materials cost or direct labor
cost. This makes sense because all three are variable costs.
The situation for fixed costs, however, is different, as reflected in the graph presented as
Exhibit 14.3. For cost-control purposes, we see that budgeted (lump-sum) fixed overhead
costs are used—see the horizontal line in Exhibit 14.3. At the end of the period, this budgeted amount is compared to actual fixed overhead cost incurred. The resulting difference is
called a spending variance. The spending variance for fixed overhead, along with the spending
Variable
Overhead
Cost
Product Costing and
Control SQ SP
LaborHours
Legend: SQ Standard allowed labor-hours for units produced
SP Standard variable overhead cost per labor-hour
2
As you recall, in order to explain the total master (static) budget variance for the period, we also calculated a sales-volume
variance. Further analysis of this variance is covered in chapter 15.
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
552 Part Four Operational Control
EXHIBIT 14.2
SCHMIDT MACHINERY COMPANY
Standard Cost Sheet
(reproduction of
EXHIBIT 13.2)
Standard Cost Sheet
Product Number: XV–1
Description
Direct materials
Aluminum
PVC
Direct labor
Factory overhead (based
on 5,000 direct labor-hours)
Variable
Fixed
Standard cost per unit
EXHIBIT 14.3
Fixed Factory Overhead
Costs: Product Costing versus
Control
Fixed
Overhead
Cost
Quantity
Unit Cost
Subtotal
4 pounds
1 pound
5 hours
$25
40
40
$100
40
12
24
60
120
5 hours
5 hours
Total
$140
200
180
$520
Product Costing: Standard
Fixed Overhead Applied (SQ SP)
Control Budget
(Lump-Sum)
Denominator
Volume
LaborHours
Legend: SQ Standard allowed labor-hours for units produced
SP Standard variable overhead cost per labor-hour
Denominator volume Number of labor-hours used to determine the fixed
overhead application rate
variance for nonmanufacturing fixed costs, is used to explain a portion of the total master
budget variance for the period, as we did in Chapter 13.
For product costing purposes, however, we must “unitize” fixed overhead costs. As indicated in Exhibit 14.3, for product costing purposes we treat fixed overhead costs as if they
were variable costs. In the Schmidt Machinery Company case, the standard fixed overhead
rate per unit produced is $120 (i.e., 5 standard direct labor-hours per unit $24 standard fixed
overhead cost per unit). Note, from Exhibit 14.2, that this $120 per-unit cost allocation rate is
predicated on an output level of 1,000 units (5,000 direct labor-hours/5 standard direct labor hours per unit), an amount we call the denominator volume.
Variance Analysis for Factory Overhead Costs
LEARNING OBJECTIVE 2
Calculate and properly interpret
standard cost variances for
factory overhead costs using
traditional approaches.
We assume that Schmidt Machinery Company uses a standard cost system. Thus, at the end
of each period the accountant for the company prepares an analysis of the total standard cost
variance for both variable and fixed overhead costs. In each case, the goal will be to explain
the difference between the actual cost incurred and the cost charged to production (units produced) for the period. As shown later, these variances are recorded at the end of the period in
separate variance accounts.
For product costing purposes, the total overhead variance for the period (also called the
total under/overapplied overhead) is equal to the difference between actual overhead cost incurred and the standard overhead cost applied to production (units produced). For Schmidt,
the total overhead variance for October 2007 is $30,880U, as follows:
Total overhead variance Total actual overhead Total applied overhead
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
Chapter 14
The Flexible Budget: Factory Overhead 553
(Total variable overhead Total fixed overhead) (Total overhead application rate Standard hours allowed for this period’s production)
($40,630 $130,650) [$36/hour (780 units 5 hours/units)]
$171,280 $140,400 $30,880U (i.e., $30,880 underapplied overhead)
Of course, the total overhead variance for the period can be broken down into a total variable
overhead variance. In turn, each of these variances can be further broken down, as explained
below.
Variable Overhead Cost Analysis
The total variable overhead
variance
is the difference between
actual variable overhead cost
incurred and the standard
variable overhead cost applied to
production; also called over- or
underapplied variable overhead
for the period.
Variable overhead spending
variance
is the difference between actual
variable overhead cost incurred
and the flexible budget for
variable overhead based on
inputs for the period (e.g., actual
labor-hours worked).
Variable overhead efficiency
variance
is the difference between the
flexible budget for variable
overhead based on inputs (e.g.,
actual labor-hours worked) and
the flexible budget for variable
overhead based on outputs (i.e.,
standard allowed labor-hours for
units produced).
EXHIBIT 14.4
Schmidt Machinery Company
Variance Analysis: Variable
Factory Overhead
We provide in Exhibit 14.4 a graphical representation of the process used to decompose the total
variable overhead variance for the period. As indicated in Exhibit 13.8, this variance for the
Schmidt Machinery Company in October 2007 is $6,170F, which is the difference between actual variable overhead costs incurred ($40,630) and the standard variable overhead costs charged to
production during October [$46,800 = (780 units 5 standard labor-hours per unit) $12 standard variable overhead cost per labor-hour]. Note that these figures are obtained from Exhibit 13.8.
Note, too, that this total variance, from a product costing standpoint, could be called total over/
underapplied variable overhead cost for the period, a point consistent with Exhibit 14.1. Because in October the actual variable overhead costs were less than the variable overhead costs
assigned to production, we call the $6,170 figure overapplied variable overhead.
Cost Control: Breakdown of the Total Variable Overhead Variance
We see from Exhibit 14.4 that the total variable overhead variance for a period ($6,170F in
our example) can be broken down into a variable overhead spending variance and a variable
overhead efficiency variance, as follows:
Variable overhead spending variance = Actual variable overhead − Budgeted variable overhead
based on inputs (e.g., actual labor-hours worked)
= ( AQ AP) − ( AQ SP)
= AQ ( AP − SP)
From Exhibit 13.8 we see that the Schmidt Machinery Company used 3,510 labor-hours in
October 2007 to produce 780 units; total variable overhead cost for the month was $40,630.
Based on a standard variable overhead cost per direct labor-hour of $12 and an actual variable
overhead rate of $11.5755 per labor-hour, the variable overhead spending variance is calculated as follows:
= $40,630 − ( 3,510 hours $12 / hour )
= $40,630 − $42,120 = $1,490F
Applied Overhead Flexible Budget Based
on Output (SQ SP)
Variable
Overhead Cost
(SQ SP)
(AQ SP)
(AQ AP)
Efficiency
Variance
(F)
Spending
Variance
(F)
(AQ)
(SQ)
Total
Variable
Overhead
Variance
(F)
LaborHours
Legend: SQ Standard direct labor-hours allowed for units produced 5 780 3,900 hours
SP Standard variable overhead cost per labor-hour $12
AQ Actual labor-hours worked 3,510 hours
AP Actual variable overhead cost per labor-hour worked $11.5755 (rounded)
Total variable overhead variance Spending variance Efficiency variance
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
14. The Flexible Budget:
Factory Overhead
© The McGraw−Hill
Companies, 2008
554 Part Four Operational Control
Or
= 3,510 labor-hours × ($11.5755 − $12 )/ labor-hourr = $1,490F( rounded )
Variable overhead efficiency variance = Budgetted variable overhead based on inputs − Standard
variable overhead applied to production
= ( AQ SP) − (SQ SP)
= SP ( AQ − SQ)
As implied by the graph in Exhibit 14.1, the amount of standard overhead cost applied to
production (product costing purpose) and the flexible budget based on output (cost-control
purpose) are for variable overhead always equal.
The standard labor-hours per unit is 5. Thus, the variable overhead efficiency variance for
October 2007 is:
= $42,120 − [(780 units 5 hours / unit)$12 / hour ]
= $42,120 − $46,800 = $4,680F
Or
= $12.00 / hour ( 3,510 − 3, 900) hours = $4,680F
Interpretation and Implications of Variable Overhead Variances
In traditional accounting systems, such as the system used by Schmidt Machinery Company,
only a single activity variable (e.g., direct labor-hours or machine-hours) is used to assign factory overhead costs to outputs. Further, as illustrated above, traditional systems use this single
activity variable for cost-control purposes. That is, the flexible budget for such companies is
based on a single, usually volume-related, activity variable. This simple approach requires
careful interpretation of the resulting standard cost variances for variable overhead. While the
formulas for these variances may look the same as those covered in Chapter 13 for direct labor
and direct materials costs, the meaning and interpretation of these variances is not the same.
In short, the imperfect relationship between variable factory overhead costs and the chosen
activity variable (e.g., direct labor-hours) that a company uses to allocate these costs to outputs
requires careful interpretation of variable overhead variances.
Variable Overhead Spending Variance
This variance is attributable to actual spending for variable overhead items per unit of the activity variable being different from standard. In the Schmidt Machinery Company example for
October 2007, the budgeted spending for variable overhead cost per direct labor-hour worked
is $12. The actual variable overhead cost per direct labor-hour was approximately $11.5755
($40,630/3,510 hours). Thus, spending for variable overhead during the period per direct labor hour worked was less than standard and for this reason the resulting variable overhead spending variance for the period ($1,490) is labeled “favorable.” The key to understanding this is to
remember that the variable overhead application rate refers to the standard variable overhead
cost per unit of the activity variable used for product costing purposes and for constructing the
flexible budget for cost-control purposes.
What can be done once the spending variance for variable overhead is calculated at the end
of the period? We deal with this question more fully in the Appendix to this chapter. However,
at this point you should recognize that if the variable overhead spending variance is considered
“material” or “significant” a follow-up analysis of individual variable overhead items is required.
Essentially, managers of the Schmidt Machinery Company may want to know why spending for
variable overhead items per labor-hour worked during the period was different from expectations. To answer this question, a follow-up analysis of each variable overhead cost is required.
Perhaps the clearest example pertains to electricity costs for the factory. The electricity bill
each month is a function of both quantity of kilowatt hours consumed and the price paid per
kilowatt hour. Thus, if there is a spending variance for factory electric costs for the period, this
variance could be decomposed into price and efficiency components in exactly the same way
as in Chapter 13 where we decomposed the total direct labor or direct materials flexible budget
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
Chapter 14
The Flexible Budget: Factory Overhead 555
variance for the period into price (rate) and efficiency (quantity) components. Note, however,
that such refinement is not typically done in practice. To do so suggests the need for a more
sophisticated accounting system, such as an activity-based costing (ABC) system—a topic we
cover later in this chapter.
Variable Overhead Efficiency Variance
Care needs to be exercised when interpreting this variance. Simply put, the variable overhead
efficiency variance refers to the effect of efficiency or inefficiency in the use of the activity
variable used to apply variable overhead. In the case of Schmidt Machinery Company, this
variable is direct labor-hours. Thus, to the extent that the incurrence of variable overhead cost
for Schmidt is related to the number of direct labor-hours worked and the company during a
given period uses a nonstandard amount of labor-hours, it will incur both a direct labor efficiency variance (Chapter 13) and a variable overhead efficiency variance. For October 2007,
Schmidt used 3,510 direct labor-hours to produce 780 units of output. The standard laborhours allowed for this level of output was 3,900 hours (780 units 5 hours per unit). Thus, the
company worked 390 fewer hours than standard for the period. If variable overhead is incurred
at the rate of $12 per labor-hour worked, then this 390-hour saving would translate to a savings
of $4,680 of variable overhead costs.
The variable overhead efficiency variance is therefore related to efficiency or inefficiency
in the use of whatever activity variable is used to apply variable overhead for product costing
purposes (and for constructing the flexible budget for cost-control purposes). This reinforces
the need to choose the proper activity variable for allocating variable overhead costs. Also,
whoever is responsible for controlling the use of this activity variable would be responsible for
controlling the variable overhead efficiency variance. In the case of the Schmidt Machinery
Company, this would most likely be the production supervisor.
Fixed Overhead Cost Analysis
The total fixed overhead
variance
is the difference between the
actual fixed overhead cost and
the fixed overhead cost applied to
production based on a standard
fixed overhead application rate;
also called over- or underapplied
fixed overhead for the period.
We provide in Exhibit 14.5 a graphical representation of the process used to decompose
the total fixed overhead variance for the Schmidt Machinery Company, October 2007. For
product costing purposes, the total variance is $37,050U, which is the difference between
actual fixed overhead costs incurred ($130,650, assumed) and the standard fixed overhead
costs charged to production during October ($93,600 = 780 units 5 standard labor-hours
per unit $24 standard fixed overhead per labor-hour—see Exhibit 14.2). Note, too, that this
total variance, from a product costing standpoint, could be called total over- or underapplied
fixed overhead cost for the period. Because for the month of October the actual fixed overhead
costs were greater than the fixed overhead costs assigned to production, we call the $37,050
figure underapplied fixed overhead.
EXHIBIT 14.5
Schmidt Machinery Company
Variance Analysis: Fixed
Factory Overhead
Actual Fixed
Overhead
Budgeted
Fixed
Overhead
Applied
Fixed
Overhead
Standard Fixed Overhead
Applied (SQ SP)
Spending
Variance (U)
Production
Volume
Variance (U)
(SQ)
Denominator
Volume
Total
Variance
(U)
LaborHours
Legend: SQ Standard labor-hours allowed for units produced 5 780 3,900 hours
SP Standard fixed overhead cost per labor-hour $24
Denominator volume Number of labor-hours used to determine the fixed
overhead application rate 5,000 (assumed)
Budgeted fixed overhead $120,000 (assumed)
Total fixed overhead variance Spending variance Production volume
variance
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
REAL-WORLD FOCUS
14. The Flexible Budget:
Factory Overhead
© The McGraw−Hill
Companies, 2008
Using the “Cost of Unused Capacity” to Optimize Product Mix
As we have seen, ABC systems attempt to associate activity costs
with cost objects (products, services, etc.). Can recent thinking regarding ABC system design facilitate product-mix decisions? This is
precisely the question addressed recently by Baxendale et al. (2005)
in a field study conducted at a 70-unit retirement and assisted living
facility. The facility had 10 two-bedroom units, 41 one-bedroom units,
and 19 studio units and delivered four levels of care: short-term (i.e.,
temporary) care, care-free living, semi-assisted living, and assisted
living. The combination of unit-type and care-type resulted in a total
of nine cost objects (e.g., assisted living, one-bedroom unit = 1 cost
object).
Given the nature of care, labor-hours (of different types) were
used as the activity variables for the ABC system. A key objective of
the study was to determine for each of the seven major activities the
amount of unused capacity. To do this, the authors had to estimate
the monthly practical capacity of each activity. For each of the seven
major activities the authors then estimated the intensity of usage factor for each of the nine cost objects. Activity costs and the cost of
unused capacity for each of the nine activities could then be determined. The authors next constructed a monthly income statement by
service offering.
Data from the monthly income statement plus a set of constraints
(e.g., total number of two-bedroom units available) allowed the authors to develop a computer model for determining the optimal shortterm product mix for the facility. This model was executed using the
Solver function in Excel and relied crucially on the availability of the
cost of unused capacity for each of the seven activities.
In short, the practical capacity data and ABC data regarding costs
associated with each service activity were combined in a computer program that provided the owners of the facility with information
that could be used to support a coordinated marketing and processimprovement effort. Appropriate decisions in this regard had the potential of making a significant improvement to monthly operating income.
Source: S. J. Baxendale, M. Gupta, and P. S. Rau, “Profit Enhancement Using
an ABC Model,” Management Accounting Quarterly 6, no. 2 (Winter 2005),
pp. 20.
The Production Volume (Denominator) Variance
In Chapter 13, we assumed that product cost was defined as variable manufacturing cost (Direct labor + Direct materials + Variable factory overhead). For federal income tax and GAAP
purposes, however, companies must report inventories on a full (absorption) cost basis. This
means that each unit produced, in addition to variable manufacturing costs, must absorb a
share of fixed factory overhead costs. As noted earlier, this requires that fixed overhead costs
be “unitized” for product costing purposes, a four-step process described below.
Fixed overhead application rate
is a term used for product
costing purposes; the rate at
which fixed overhead is charged
to production per unit of activity
(or output).
Denominator activity level
(denominator volume)
is the output (activity) level used
to calculate the predetermined
fixed overhead application rate;
generally defined as practical
capacity.
Theoretical capacity
is a measure of capacity (output
or activity) that assumes 100%
efficiency; maximum possible
output (or activity).
Practical capacity
is theoretical capacity reduced
by normal output losses due
to personal time, normal
maintenance, etc.
Step 1: Budgeted Total Fixed Factory Overhead Fixed factory overhead costs, by definition, do not vary in the short run in response to changes in output or activity. As such, these
costs are often referred to as capacity-related manufacturing costs. Thus, once an organization
has determined its capacity for an upcoming period (e.g., one year), it constructs a budget
for capacity-related costs. In the case of Schmidt Machinery Company, the capacity-related
manufacturing costs are estimated at $120,000 per month.
Step 2: Choose an Appropriate Activity Measure for Applying Fixed Factory Overhead For
product costing purposes, capacity-related manufacturing costs are assigned to outputs based
on one or more activity measures (machine-hours, labor-hours, etc.). Usually, this is the same
activity measure used to apply variable overhead costs to outputs. The Schmidt Machinery
Company uses direct labor-hours as the activity measure for assigning fixed overhead to production (output).
Step 3: Choose a Denominator Activity Level In order to unitize fixed overhead costs for
product costing purposes, we must choose some level of output (activity) over which the
budgeted fixed costs for the period can be spread. The Schmidt Machinery Company uses
5,000 direct labor-hours per month (i.e., 1,000 units 5 direct labor-hours per unit) as the
denominator activity level. The general term used to describe the level of output (activity)
used to establish the standard fixed overhead application rate is denominator activity level or
denominator volume. Several alternatives exist for defining the denominator activity level:
two “supply-based” alternatives and two “demand-based” alternatives.
Supply-Based Definitions of Capacity The denominator activity level can be defined in
terms of output capacity supplied. In this regard it is useful to think in terms of two alternatives: theoretical capacity (the maximum level of activity or output based on available capacity), or practical capacity (theoretical capacity reduced by normal employee breaks, machine
downtime for maintenance, and other “expected” loss of output). As a rough rule of thumb,
you might think of practical capacity as being defined operationally as somewhere in the
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
REAL-WORLD FOCUS
14. The Flexible Budget:
Factory Overhead
© The McGraw−Hill
Companies, 2008
Survey Evidence: Factors Related to Successful
Implementation of Stretch Targets
To stay competitive in an increasingly competitive environment, organizations today are exploring a variety of control mechanisms, including the use of “stretch targets” for motivation and control purposes.
These targets, one example of which would be the use of maximum
(theoretical) capacity for setting fixed overhead application rates, are
by definition not attainable. However, they are meant to motivate employees to think creatively and to strive for best-in-class performance.
If stretch targets are going to be used successfully in an organization,
due care and consideration are required. Recent survey evidence raises important implementation issues regarding the use of such targets.
MBA students (at two different institutions) were asked whether
the company for which they worked had implemented stretch targets.
In addition, these students were asked to evaluate their company in
terms of the following four factors: management, corporate culture,
performance measurement system/compensation, and information
systems. (Past research has shown all of these to be important to the
successful implementation of new management initiatives.)
Overall, the authors conclude that “in many respects, the organizations represented in this survey do not appear well-positioned for
success with stretch targets.” What can organizations do to better
position themselves to use such targets successfully? The authors
offer recommendations in four categories:
1. Mutual trust—establish a culture of mutual trust between managers and subordinates (e.g., communicate to subordinates that
managers will “go to bat” for them, encourage subordinates to
take reasonable risks).
2. Management paradigms—for example, take steps to ensure that
the process of setting stretch targets is perceived by employees
to be fair (even though the targets themselves may be unachievable), use more of a bottom-up process for setting budgets, and
empower employees to accomplish goals and objectives in a manner they best see fit).
3. Information systems—if possible, provide to employees real-time
feedback regarding whether employee initiatives are successful
in terms of stated objectives; allow employees freer access to
information.
4. Motivation and compensation—capture and report nonfinancial
as well as financial performance data; ensure connection between effort and recognition; and use a combination of financial
and nonfinancial incentives.
Source: C. C. Chen and K. T. Jones, “Are Companies Really Ready for Stretch
Targets?” Management Accounting Quarterly 6, no. 4 (Summer 2005),
pp. 10–18
neighborhood of 80 to 85 percent of theoretical capacity. The important point here is that the
notion of practical capacity is not rigidly defined.
Budgeted capacity utilization
represents planned (forecasted)
output for the coming period,
usually a year.
Normal capacity
represents expected average
demand per year over an
intermediate-term, for example,
the upcoming three to five years.
Demand-Based Definitions of Capacity It is also possible to define capacity in terms
of the demand for the organization’s output. For example, we could use budgeted capacity
utilization (the expected level of activity or output for the upcoming period, usually a year),
or normal capacity (the average level of demand for the company’s product projected over an
intermediate-level number of years into the future, say, three to five years).
Given these choices, which activity level should be chosen when determining the fixed
overhead application rate? The answer is, unfortunately, partly subjective. This is due largely
to the fact that the resulting product-cost information will be used for different reasons, ranging from product-pricing decisions, to performance-evaluation purposes, to tax and external
reporting requirements in accounting.
Note that different definitions of the denominator volume will result in different fixed overhead application rates, different amounts of fixed overhead costs charged to production, and
therefore different amounts for the production volume variance (discussed below). Depending
on how variances are disposed of at the end of the year, the financial statements can be affected
by the choice of denominator activity level.3
Our position is that practical capacity be used as the denominator level for setting the fixed
overhead allocation rate. We maintain this position for several reasons. One, though not necessarily controlling, the use of practical capacity is consistent with current Federal Income Tax
requirements in the United States. Two, relative to budgeted output, the use of practical capacity volume provides more uniform data over time, which facilitates decision-making on the part
of management. (That is, managers do not have to continually reevaluate decisions based on
changing product-cost data over time.) Third, the use of practical capacity in the denominator
3
As explained later in this chapter, there are different ways of disposing of standard cost variances at the end of the year. One of
these methods is to restate cost of goods sold (CGS) and ending inventory amounts to actual costs by recalculating, at year-end,
the actual fixed overhead cost per unit of output. Another approach is to allocate (prorate) variances to the ending inventory and
CGS accounts. Under either of these approaches, the denominator activity level chosen at the beginning of the year for product
costing purposes during the year will have little or no effect on the financial statements for the year. The choice of denominator
volume will, however, affect financial statements when standard cost variances are written off in their entirety to CGS. In short,
in some cases the choice of denominator volume will affect an organization’s financial statements for the year.
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
14. The Flexible Budget:
Factory Overhead
© The McGraw−Hill
Companies, 2008
558 Part Four Operational Control
is logically consistent with the numerator in the fixed overhead rate calculation. That is, the
numerator represents the costs of the capacity supplied and the denominator represents, in
practical terms, the amount of capacity supplied.4 Fourth, and perhaps most important, the
use of practical capacity means that current customers and current production is not burdened
with the cost of unused capacity, which would be the case if budgeted output is less than
practical capacity. From a pricing standpoint, this can help managers avoid the “death-spiral”
effect discussed in Chapter 5 (ABC and ABM). Finally, the resulting production volume variance data (discussed below) can be interpreted, loosely, as the cost of unused capacity. This
information can facilitate decisions by management as to the appropriate supply of capacityrelated resources (and associated costs).
Fixed overhead production
volume variance
is the difference between
budgeted fixed factory overhead
and the standard fixed overhead
applied to production (using the
fixed overhead allocation rate).
Step 4: Calculate the Predetermined Fixed Overhead Application Rate The last step in the
process is to divide budgeted fixed factory overhead for the period by the denominator activity
level. For Schmidt, this calculation results in a rate of $24 per direct labor-hour, as reported in
Exhibit 14.2. Thus, for product costing purposes each unit produced is assigned $120 of fixed
factory overhead.
In summary, for product costing purposes a company must choose an activity level over
which it spreads budgeted fixed manufacturing costs for a given period. If the company actually
operates at the level assumed when the application rate was determined, it will have assigned to
production exactly the budgeted fixed overhead for the period. If, on the other hand, the company
operates at any level of activity other than the denominator activity level, then it will have applied
to production an amount greater or lesser than budgeted fixed overhead. It is this over- or underapplied budgeted fixed overhead that we call the production volume variance for the period.
Refer back to Exhibit 14.5. The line emanating from the origin represents the standard fixed
overhead cost applied to production. The slope of this line is equal to the fixed overhead application rate, which in the case of Schmidt Machinery Company is $24 per hour. You will note that
the only situation where the total fixed overhead applied exactly equals budgeted fixed overhead
is when the output (activity) for the period is 5,000 standard allowed hours (or, equivalently,
1,000 units produced). The production volume variance is therefore defined as the difference
between budgeted fixed factory overhead and the standard fixed overhead applied to production.
For October, this variance for the Schmidt Machinery Company is $26,400U, as follows:
Production volume variance = Budgeted fixed factory overhead − Standard fixed overhead
assigned to production = $120,000 − [(780 units produced 5 hours / unit)$24 per hour]
= $120,000 − $93,600 = $26,400U
Or
= SP (Denominator activity hours SQ)
= $24/ hour [5, 000 (780 units35 hours/ unit)]
= $24 (5, 000 3, 900 hours) = $26, 400U5
Fixed Overhead Spending (Budget) Variance
Fixed overhead spending
(budget) variance
is the difference between
budgeted and actual fixed
overhead costs for a period.
Refer to Exhibit 14.4. We see that, in general, the fixed overhead spending (budget) variance
is defined as the difference between budgeted and actual fixed factory overhead for the period.
For Schmidt Machinery Company, the fixed overhead spending (budget) variance for October
was $10,650U, as follows:
Fixed overhead spending (budget) variance = Actual fixed overhead − Budgeted fixed
overhead = $130, 650 − $120, 000 = $10, 650U
Note that this is the amount reported in the profit-variance report contained in Exhibit 13.13.
4
We note that practical capacity can change over time due to changes in manufacturing layout, improvements in worker
efficiencies, and so on.
5
Given the way costs are applied to outputs under a standard cost system, the production volume variance can also be
calculated as: Standard fixed overhead rate/unit (Denominator volume, in units Actual units produced). In the above
example, we would have: $120/unit (1,000 units 780 units) = $26,400 underapplied. This approach to calculating the
production volume variance would, in fact, be the approach used by a company that produces a single product.
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
Chapter 14
The Flexible Budget: Factory Overhead 559
Interpretation of Fixed Factory Overhead Variances
Production Volume Variance
This variance is an artifact of unitizing fixed factory overhead costs for product costing purposes. As indicated in Exhibit 14.4, in and of itself this variance has no meaning for cost-control
purposes. However, as we indicated earlier in this chapter, if practical capacity is used to establish the fixed overhead application rate, then the production volume variance can be viewed
as a measure of capacity utilization. This is because the variance reflects differences between
planned and actual capacity usage. In short, the reporting of production volume variances
over time provides decision makers with information that can be used to manage spending on
capacity-related resources. For example, consistently reported underapplied fixed factory overhead (i.e., unfavorable production volume variances) may signal the need to reduce spending
on capacity-related costs or motivate action to better utilize the capacity that does exist.
You will note that if the fixed overhead allocation rate were based on expected (budgeted)
output, then the cost of unused capacity would be hidden, that is, charged to the units actually produced during the period. When practical capacity is used to calculate the fixed overhead application rate, the cost of unused capacity becomes visible to management through
the amount and direction of the production volume variance. To avoid misinterpretations, yet
communicate information regarding capacity usage, some companies prefer to report the fixed
overhead production volume variance in physical terms only.
Among the causes of production volume variances are unexpected changes in product demand or problems in manufacturing. This suggests shared responsibility for the production
volume variance. Inadequate sales demand could be the responsibility of marketing, poor
manufacturing performance (e.g., excessive machine downtime) would probably be the responsibility of operating managers, excessive production time due to complexity of product
design could be the responsibility of engineering, and lost production due to scheduling
problems/conflicts would likely be the responsibility of the production scheduling department.
Finally, we note the importance of not placing too much emphasis on individual variances
because such approaches do not recognize the interrelatedness of performance indicators. For
example, a production department in a manufacturing facility can generate a favorable production volume variance by overproducing for the period, that is, producing more units than needed
to meet sales and target ending inventory requirements. Such practice, of course, runs counter to
the JIT philosophy. In this case, a financial performance indicator (production volume variance)
might be accompanied by one or more nonfinancial performance indicators (e.g., inventory turnover or spoilage/obsolescence rates). In other situations, such as the case with labor and materials variances discussed in Chapter 13, individual standard cost variances might be reported in
conjunction with one or more related variances. For example, the labor efficiency variance might
be interpreted in conjunction with the labor rate variance. The overall goal is to achieve organizationwide efficiency, what in the technical literature is referred to as global optimization.
Fixed Factory Overhead Spending (Budget) Variance
Fixed factory overhead spending variances typically arise when the budget procedure for the
organization failed to anticipate or incorporate changes in fixed factory overhead costs. For
example, a budget that inadvertently neglected scheduled raises for factory managers, changes
in property taxes on factory buildings and equipment, or purchases of new equipment create
unfavorable spending variances.
Unfavorable fixed overhead spending variances can also result from excessive spending
due to improper or inadequate cost controls. Events such as emergency repairs, impromptu replacement of equipment, or the addition of production supervisors for an unscheduled second
shift all would result in unfavorable fixed overhead spending variances for the period.
If management feels that the total fixed overhead spending variance is significant, it would
likely ask for details regarding spending on individual line-items in the fixed overhead budget
(production supervisor salaries, equipment maintenance and repairs, property taxes, etc.).
Alternative Analyses of Factory Overhead Variances
In the discussion above, we separated the total variable overhead variance and the total fixed
overhead variance each into two components. Such an analysis is referred to as a four-variance
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
560 Part Four Operational Control
EXHIBIT 14.6
General Model: Four-Way
Analysis of Total Factory
Overhead Variance
(A)
(B)
(C)
(D)
Cost Incurred
Flexible Budget
Based on
Inputs
Flexible Budget
Based on
Output
Standard
Overhead
Applied
Actual quantity of the
activity for applying
variable overhead
Standard variable
overhead rate
Total standard quantity
of the activity for applying
variable overhead for
the units manufactured
Standard variable
overhead rate
Variable Overhead
Amount spent
Variable factory overhead Variable factory overhead
spending variance
efficiency variance
Fixed Overhead
Amount spent
Fixed overhead budget (spending) variance
Budgeted
(Lump-Sum)
amount
Total standard quantity
of the activity for
applying overhead to
the units manufactured
Standard fixed
overhead rate
Production volume variance
analysis of factory overhead. A general model for performing a four-variance analysis, which
combines Exhibits 14.4 and 14.5, is given as Exhibit 14.6. Not all companies, however, want
or need to analyze factory overhead costs in this level of detail. Furthermore, a company’s
chart of accounts may not separate variable and fixed factory overhead costs. In the following
sections we discuss alternative, less-detailed, ways to analyze factory overhead variances.
Three-Variance Decomposition of the Total Factory Overhead Variance
The three-variance analysis of factory overhead separates the total overhead variance into three
components: total spending variance, variable overhead efficiency variance, and fixed overhead
production volume variance. That is, in a three-variance analysis, the variable overhead spending variance and the fixed overhead spending variance are combined into a single overhead
spending variance. Thus, the total overhead variance for the period, $30,880U, can be decomposed into a total spending variance, $9,160U ($10,650 unfavorable fixed overhead spending
variance + $1,490 favorable variable overhead spending variance), plus favorable variable overhead efficiency variance, $4,680, plus an unfavorable production volume variance of $26,400.
Two-Variance Decomposition of the Total Factory Overhead Variance
The total flexible budget
variance for overhead
is equal to the difference
between the actual factory
overhead for a period and the
flexible budget for overhead
based on output.
Companies that do not separate fixed from variable overhead costs for product costing purposes perform what is called a two-variance analysis of the total overhead variance. That is,
the total overhead variance for the period is broken down into a total flexible budget variance
for overhead and a production volume variance (which pertains only to the product costing
purpose of standard costing, as described above).
For the Schmidt Machinery Company, the total overhead variance in October, as before, is
$30,880U. This variance is broken down as follows:
Flexible budget variance
= Actual factory overhead − Flexible budget for factory overhead based on output
(i.e., based on allowed hours for units produced)
= (Actual fixed overhead + Actual variable overrhead ) − [ Budgeted fixed overhead
+ (Standard allowed hours variable overhead rate per hour)]
= ($130, 650 + $40, 630) − [$120, 000 + ($12.00// hr. 3, 900 hrs.)]
= $171, 280 − $166, 800 = $4, 480U
U
Note that $4,480 is the net amount of the two overhead flexible budget variances contained
in Exhibit 13.13: a total variable overhead variance of $6,170F plus a total fixed overhead
variance of $10,650U.
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
Chapter 14
The Flexible Budget: Factory Overhead 561
Production volume variance = Flexible budget for factory overhead based on output − Applied
factory overhead
= $166, 800 − ( 3, 900 hrs. $36.00 / hr.) = $26, 400U
Note that the production volume variance is exactly the same as the amount calculated under
the four-variance and the three-variance breakdown.
Summary of Factory Overhead Variances
Exhibit 14.7 provides a summary of the various approaches to the analysis of overhead variances. In each case, the total variance to be explained for the Schmidt Machinery Company for
October 2007 is $30,880U. The production volume variance ($26,400U) relates to the product
costing use of standard costs. That is, this variance will occur only if a company uses a standard cost system and defines product cost as full manufacturing cost. The other variances can
be calculated regardless of whether the firm uses a standard cost system. The degree of detail
decreases as we go from the four-variance approach to the two-variance approach. None of
these approaches is inherently good or bad: each has to be judged in terms of implementation
cost versus perceived benefits associated with the resulting variance information.
EXHIBIT 14.7 Schmidt Machinery Company, Overhead Variance Analyses, October 2007
Panel 1: Four-Variance Analysis
Variable
Overhead
Actual
(AQ AP)
Flexible Budget
Based on Inputs
(AQ SP)
Flexible Budget
Based on Outputs
(SQ SP)
Standard Cost
Applied to
Production
(SQ SP)
(3,510 $11.5755)
$40,630
(3,510 $12.00)
$42,120
(3,900 $12.00)
$46,800
(3,900 $12.00)
$46,800
Spending
variance $1,490F
Fixed
Overhead
NA
Efficiency
variance $4,680F
$130,650
$120,000
(3,900 $24.00)
$93,600
$120,000
NA
Spending
variance $10,650U
Production volume
variance $26,400U
Panel 2: Three-Variance Analysis
Flexible Budget
Based on Outputs
Actual
Flexible Budget
Based on Inputs
Variable
Overhead
$40,630
$42,120
$46,800
Fixed
Overhead
Total
$130,650
$171,280
$120,000
$162,120
$120,000
$166,800
Spending
variance $9,160U
Standard Cost
Applied to
Production
3,900 hours
$36.00hr.
$140,400
Production volume
variance $26,400U
Efficiency
variance $4,680F
Panel 3: Two-Variance Analysis
Actual
Flexible Budget
Based on Inputs
Flexible Budget
Based on Outputs
Variable
Overhead
$40,630
$46,800
Fixed
Overhead
Total
$130,650
$171,280
$120,000
$166,800
Standard Cost
Applied to
Production
3,900 hours
$36.00hr.
$140,400
Flexible budget
Production volume
variance $4,480U
variance $26,400U
Total factory overhead variance $30,880U
(i.e., under applied overhead $30,880U)
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
562 Part Four Operational Control
Before leaving this discussion, it is important to point out some alternative terminology
for the variances to which we referred in the preceding sections. When standard costs are
incorporated formally into the accounting records (that is, when a standard cost system is
used), we have already indicated that the total overhead variance for the period can also be
referred to as total over- or underapplied overhead. Also, note that the production volume
variance (which arises only when a standard cost system is used) is also referred to as the
capacity variance, the idle-capacity variance, the denominator-level variance, the outputlevel overhead variance, or simply, the denominator variance. The spending variance for
variable overhead is sometimes referred to as a price variance or a budget variance. The total
flexible budget variance for overhead (and by extension the total flexible budget variance
for fixed overhead and the total flexible budget variance for variable overhead) is sometimes
referred to as a controllable variance. This latter term is more descriptive of the use of
standard costs and related variances for cost-control purposes. For this reason, the production
volume variance is sometimes referred to as the noncontrollable overhead variance. The
important point is that, unfortunately, this is an area where the terminology is not standard.
Therefore, you need to keep the above-listed alternatives in mind in any given situation.
Recording Standard Factory Overhead Costs
LEARNING OBJECTIVE 3
Journal Entries and Variances for Factory Overhead Costs
Record factory overhead costs
and associated standard cost
variances.
As noted above and in Chapter 13, a standard cost system incorporates standard product costs
in the formal accounting records (raw materials, WIP inventory, finished goods inventory, and
cost of goods sold). As in the case of direct materials and direct labor, the standard overhead
cost of the output of the period is charged to production, while actual overhead costs are
recorded separately, in descriptive accounts such as Utilities Payable, Accumulated Depreciation, and Salaries Payable.
Assume that for October 2007, the Schmidt Machinery Company incurred the following
variable overhead costs: utilities, $30,000, and indirect materials, $10,630. These actual overhead costs would be recorded as incurred, in entries such as the following:
Factory Overhead
Utilities Payable
Indirect Materials Inventory
40,630
30,000
10,630
At the end of the month (process cost system) or at the completion of one or more jobs (joborder cost system), the WIP inventory account must be charged for the standard variable overhead cost of the 780 units produced. The standard variable overhead rate is $12 per labor-hour
and the standard number of labor-hours per unit is 5. Thus, for October 2007 the appropriate
journal entry would be:
WIP Inventory [(780 units 5 hrs./unit) $12.00/hr.]
46,800
Factory Overhead
46,800
At this point, you can see that the balance in the Factory Overhead account ($46,800 cr. +
$40,630 dr. = $6,170F) is the total variable overhead variance for the period.
Assume now, for simplicity, that the actual fixed overhead cost for October 2007 consisted
of only two items: $100,000 supervisory salaries plus $30,650 of depreciation expense. The
journal entry to record actual fixed overhead costs for the month would be:
Factory Overhead
Accumulated Depreciation
Salaries Payable
130,650
30,650
100,000
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
Chapter 14
The Flexible Budget: Factory Overhead 563
Recall that the standard fixed overhead rate was $24 per standard labor-hour allowed, or
equivalently, $120 per unit produced (since there are 5 standard labor-hours per unit produced). The journal entry to charge production with standard fixed overhead cost would be:
WIP Inventory [(780 units 5 hrs./unit) $24/hr.]
Factory Overhead
93,600
93,600
Similar to entries we made in Chapter 13 (Appendix A) for direct materials and direct labor,
we would then transfer the standard overhead cost of completed production from WIP Inventory to Finished Goods Inventory, using the following entry:
Finished Goods Inventory ($180/unit 780 units)
WIP Inventory
140,400
140,400
After these entries are posted to the ledger, the Factory Overhead account contains the net overhead balance for the period, $30,880 credit (i.e., net unfavorable variance). The component variances calculated using one of the approaches described above could be calculated and used to
close out the $30,880 credit balance in the Factory Overhead account. Assume that Schmidt Machinery Company uses the four-variance approach for overhead analysis. The appropriate journal entry to record the standard overhead cost variances for October 2007 would be as follows:
Factory Overhead
Variable Overhead Spending Variance
Variable Overhead Efficiency Variance
Production Volume Variance
Fixed Overhead Spending Variance
30,880
1,490
4,680
26,400
10,650
Variance Disposition
For interim purposes (e.g., preparation of monthly or quarterly financial statements), the
standard cost variances calculated in this chapter and in Chapter 13 are typically not disposed
of. That is, the variance accounts are carried forward under the assumption that, over time,
favorable and unfavorable interim variances would offset one another. If interim financial
statements are prepared, the cost variances can be shown in a temporary (i.e., holding) account
awaiting ultimate disposition at the end of the year.
Net Variance Considered Immaterial
At the end of the year, the appropriate treatment for standard cost variances depends on the
size (materiality) of the net variance. Assume, for example, that variance data for Schmidt
from Chapters 13 and 14 relate to the fiscal year, not just the month of October. These cost
variances are as follows:
Variance
Source
Amount
DM purchase price variance
DM quantity variance
DL rate variance
DL efficiency variance
Variable overhead spending variance
Variable overhead efficiency variance
Fixed overhead spending variance
Fixed overhead volume variance
Net standard manufacturing cost variance for the year
Exhibit 13.13
Exhibit 13.13
Exhibit 13.13
Exhibit 13.13
Exhibit 14.7, Panel 1
Exhibit 14.7, Panel 1
Exhibit 14.7, Panel 1
Exhibit 14.7, Panel 1
$ 4,350U
10,350U
7,020U
15,600F
1,490F
4,680F
10,650U
26,400U
$37,000U
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
564 Part Four Operational Control
If the net manufacturing cost variance of $37,000U is not considered by management to be
material, then an appropriate treatment at year-end would be to close all variances to Cost of
Goods Sold. If the net variance is favorable, then it is closed out by crediting (i.e., reducing)
Cost of Goods Sold. If, as in the present case, the net standard cost variance is unfavorable, the
Cost of Goods Sold account is debited (i.e., increased) by the amount of the net variance. The
following journal entry closes out the net unfavorable variance of $37,000:
Cost of Goods Sold
Direct labor efficiency variance
Variable overhead efficiency variance
Variable overhead spending variance
Direct materials purchase price variance
37,000
15,600
4,680
1,490
4,350
Direct materials quantity variance
Direct labor rate variance
Fixed overhead spending variance
Fixed overhead volume variance
10,350
7,020
10,650
26,400
Under the assumption that the results for October represent annual results for the Schmidt
Machinery Company, its condensed income statement for 2007 is reflected in Exhibit 14.8. As
noted above, this treatment of the net variance for the period is appropriate when the amount
involved is considered immaterial, for example when expressed as a percentage of total sales
or total operating income.
However, some accountants argue that any variance that results from inefficiencies that
could in the judgment of management have been avoided, regardless of amount, should be
written off against Cost of Goods Sold rather than carried forward on the balance sheet as is
the case with the proration method discussed below. Not to do this implies that asset values
reflected on the balance sheet (i.e., inventories) necessarily contain the cost of inefficiencies,
a situation that some accountants would dismiss as improper.
Net Variance Considered Material in Amount
If the net manufacturing cost variance is considered material in amount, the net variance
should be allocated to the Inventory and Cost of Goods Sold (CGS) accounts. This allocation should be based on the relative amount of this period’s standard cost in the end-of-period
balance of each affected account. This means that the direct materials price variance will be
apportioned to five accounts—Materials Inventory, the Materials Quantity Variance, WIP Inventory, Finished Goods Inventory, and CGS—based on the amount of this period’s standard
cost in each account at the end of the period. The direct materials quantity variance would
be allocated only to WIP Inventory, Finished Goods Inventory, and CGS. This is because the
materials efficiency variance occurs after materials are issued to production.
EXHIBIT 14.8
SCHMIDT MACHINERY COMPANY
Annual Income Statement
with Write-Off of the Net
Manufacturing Cost Variance
Income Statement
For 2007
Sales (Exhibit 13.5), at standard selling price
Add: Selling price variance (Exhibit 13.5)
†
$624,000
15,600F
Net sales, at actual selling price
Cost of goods sold (at standard: 780 units 520/unit)
$405,600
$639,600
Add: Net manufacturing cost variance
+ 37,000U†
Total cost of goods sold
Gross margin
Selling and administrative expenses
442,600
$197,000
69,000
Operating income (before disposition of sales volume variance)
$128,000
$50F net variable cost variance (Exhibit 13.6) + $37,050U net fixed cost variance (Exhibit 14.7, panel 1).
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
Chapter 14
The Flexible Budget: Factory Overhead 565
Any labor cost variances and variable overhead variances would be allocated to WIP Inventory, Finished Goods Inventory, and CGS on the basis of the standard labor and standard
variable overhead costs, respectively, in these accounts at year-end. The fixed overhead spending variance should be allocated to four accounts: WIP Inventory, Finished Goods Inventory,
CGS, and the Production Volume Variance. Finally, the Production Volume Variance, if allocated, would be apportioned among WIP Inventory, Finished Goods Inventory, and CGS.
One intent of prorating the net standard cost variance is to adjust all accounts (inventory
and CGS) to approximate actual costs. Certainly, the availability of sophisticated software
and information-processing capabilities today provides the opportunity to make the kinds of
complicated adjustments referred to above. Think, for example, how difficult it might be to
allocate variances if there are hundreds of direct materials and perhaps thousands of products.
Even with available technology, prorating variances at the end of the year would seem to be an
expensive proposition. We note, however, that if the cost variances are the result of inappropriate standards (e.g., outdated standards) or bookkeeping errors, then the variances should be
allocated to ending inventories and CGS.
For this reason, some companies take a simpler approach to the variance-allocation decision. For example, they may use the total end-of-period account balances, rather than this
period’s standard cost in each end-of-period account, to allocate the net manufacturing cost
variance. Other companies, in particular, those that have minimal ending inventories, choose
to write off against CGS the net variance, regardless of its size, because most of the variance
would be allocated to CGS anyway. Thus, the error of not allocating a portion of the variance
to inventories, as well as CGS, is thought to be minimal.
In sum, we emphasize that you are likely to observe various treatments today in practice.6
For the most part, good judgment is needed to justify a particular treatment. Our own feeling
is that, in most cases, the more complex methods of allocating standard cost variances are not
likely to result in appreciably more accurate information for management. Thus, in general we
favor the write-off of the net manufacturing cost variance against CGS of the period.
Standard Costs in Service Organizations
LEARNING OBJECTIVE 4
Apply standard costs to service
organizations.
As noted in Chapter 13, a standard cost system facilitates planning (i.e., budget preparation)
and financial control (through standard cost variance analysis) and aids managers in making
decisions such as product pricing and resource management. These benefits, however, are not
limited to manufacturing firms. All organizations can potentially benefit from the use of a
standard cost system.
In fact, in today’s highly competitive environment, more and more service firms are
recognizing the importance of standard costs in productivity monitoring, quality control,
product-line planning, and other cost-management initiatives. Using standard costs helps
managers to grasp behavioral patterns of cost items, assess and monitor the efficiency and
profitability of their organizations, identify deviations in operations, and target areas in need
of attention.
To best use a standard cost system, an organization must adapt the system to its operating
characteristics and objectives. Objectives are likely to differ for different organizations. Some
general characteristics, however, distinguish a service firm from a manufacturing or merchandising firm. Among these are the absence of significant inventories, the importance of faceto-face interaction with customers, the predominance of fixed costs in the organization’s cost
structure, and the lack of a uniform measure for organizational outputs.
Service outputs cannot be stored for use in a future period, as is the case with manufacturers or merchandisers. Service bays in an automobile repair shop not used today do not increase
6
In fact, as indicated in footnote #3, a third possibility exists for disposing of standard cost variances at the end of the year.
This method, referred to as the “adjusted allocation rate approach,” basically revises all manufacturing cost entries during the
year that were made on the basis of standard costs (as illustrated earlier in this chapter). That is, at the end of the year the
accountant knows what the total overhead costs were and what the actual activity level was for the cost-allocation base. All
costs in the ending inventory and CGS accounts are therefore adjusted to an actual cost basis. The availability of appropriate
technology now makes the use of this method feasible for many companies. However, the method has the distinct disadvantage
of not yielding information regarding the cost of unused capacity.
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
REAL-WORLD FOCUS
14. The Flexible Budget:
Factory Overhead
© The McGraw−Hill
Companies, 2008
Matching Capacity and Demand in the Services
Industry—How Can IT Help?
The process of determining an appropriate level of capacity is one
of the most difficult, yet strategically important, decisions that managers must make. Unused capacity wastes resources; insufficient
capacity incurs various costs, the most important of which are lost
business (opportunity costs) and customer ill-will (and loss of future
business). Capacity-related costs are important to service-sector
entities, particularly those that compete on the basis of customer
service.
One aspect of customer service relates to call centers, which
customers (or potential customers) can access to get service-related
information. The problem with call centers, however, is that incomingcall volumes fluctuate widely during the day and various times of the
week. This complicates efforts to determine the appropriate supply
of call-center capacity. Customers hate long waiting times, so it’s important for companies to promptly pass calls to an appropriate agent.
But that’s hard to do in companies employing thousands of agents in
different places.
However, new technologies, such as upgrades made to call-routing
capabilities, are helping organizations make better capacity-related
decisions. One major US airline found that, in spite of a large investment
in call-distribution technology, agents in a Midwest call center sat idle
while customers waited three minutes or more to speak to identically
skilled agents on the West Coast (see accompanying exhibit).
This company has taken advantage of recent developments in Internet Protocol (IP) telephony and automated-call-distribution technology that radically improve the delivery of the right call to the right agent
at the right time across a number of call centers. A $3 million investment in this new technology allowed the airline to manage calls more
effectively and helped reduce operating costs by 5 percent, or $7 million a year, while improving service to meet their preexisting targets.
Source: Wayne E. Pietraszek and Adesh Ramchandran, “Using IT to Boost
Call-Center Performance,” The McKinsey Quarterly (www.mckinseyquarterly
.com), accessed March 20, 2006. This article was first published in the Spring
2006 issue of McKinsey on IT.
HOLD, PLEASE
Required vs actual call-center capacity for disguised major airline
Actual capacity
Required capacity
Number of agents on duty per
30-minute interval
1,400
1,200
1,000
800
Midwest call center
600
15–20%
slack
capacity
between
400
10% gross
12 pm and 4 pm CST
200
overcapacity
0
6 am
9 am 12 pm 3 pm
6 pm
9 pm 11.30 pm
Central standard time
[CST]
800
10–25% gap from
10 am to 2 pm CST
600
Pacific standard time
[PST]
400
West Coast call center
200
6–9% gross
undercapacity
0
4 am
7 am
10 am
1 pm
4 pm
7 pm 9.30 pm
the number of service bays available tomorrow. Empty airline seats on a flight do not increase
the seats available on the next flight. Vacant hospital beds (i.e., a low patient census) today do
not increase the number of beds available tomorrow. That is, service outputs cannot be generated before they are needed; a service output exists only when a customer exists. In contrast,
a manufacturer can make products for future deliveries. Consequently, the manufacturer will
generally have both a production volume variance and a sales volume variance, as determined
using the methods discussed earlier in this chapter and in Chapter 13. A service organization,
on the other hand, has only the latter variance.
In many service organizations the bulk of expenses are salary costs, salary-related costs,
and support costs. Material costs are incidental expenses. Consequently, labor-related measures such as labor rate and efficiency variances are relatively more important to managers
of service firms. In addition, labor-intensiveness leads service firms to monitor activities and
gauge operating results using labor-based measures.
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14. The Flexible Budget:
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Chapter 14
The Flexible Budget: Factory Overhead 567
Equipment in service organizations enables staff members to perform better service. Thus,
new equipment for a service organization often increases, rather than decreases, its total operating costs. A hospital that adds a piece of equipment, say a state-of-the-art MRI scanner,
improves the quality of treatment it provides; the equipment, however, adds costs to the hospital and ultimately the patients. A multimedia classroom not only improves the quality of
instruction but also increases instructional costs. A simple cost/output ratio often is not a good
efficiency measure in these contexts. Improper use of a cost/output ratio generated by a standard cost system can be detrimental to the ultimate objective of the service organization—to
provide better service to its customers or consumers.
Most costs in a service organization are short-term fixed (i.e., capacity-related) costs. The
bulk of labor costs are for professional personnel who usually are paid a monthly salary. Variations from one period to the next for salaried personnel should be small or nonexistent. Other
overhead costs for these organizations often consist of expenses related to facilities and equipment and are therefore fixed in the short run. Other service sector companies have minimal
labor relative to capacity-related costs. Examples include the airline industry, the shipping
industry, and much of the telecommunications industry. The predominance of capacityrelated costs for such companies increases the importance of monitoring fixed-cost spending
variances.
Furthermore, service organizations have varied measures of output. Exhibit 14.9 lists some
measures of output often used by service organizations. As shown in Exhibit 14.10, hospitals
EXHIBIT 14.9
Output Measures for Selected
Service Organizations
Organization
Output Measure
Airline
Hospital
Hotel
Accounting, legal, and consulting firms
Colleges and universities
Primary and secondary schools
Revenue-producing passenger-miles
Patient-days
Occupancy rate or number of guests
Professional staff hours
Credit hours
Number of students
EXHIBIT 14.10
LANCASTER COUNTY HOSPITAL
Standard Cost Sheet for a
Hospital
Source: Based on Table 14 in Managerial
Cost Accounting for Hospitals (Chicago:
American Hospital Association, 1980), p. 97.
Standard Cost Sheet for Pediatrics Floor
Direct Expenses
Salaries and wages
Supervisors
RNs
LPNs
Nursing assistants
Supplies—Inventory
Supplies—noninventory
Pediatrician fees
Other direct expenses
Rate/Price
Amount
$9,000
$ 30.00 per hour
20.00 per hour
13.00 per hour
0.20 per unit
1.3 hours per patient-day
1.7 hours per patient-day
0.9 hour per patient-day
10 units per patient-day
$ 200 per hour
0.5 hour per patient-day
300
250
Transferred Expenses
Housekeeping
$ 10.00 per hour
Laundry
$ 0.50 per pound
48 hours + 0.4 hour per patient day
+ 1.50 hours per patient discharge
500 pounds + 15 pounds per patient-day
+ 30 pounds per discharge + 50 pounds per
surgery
$ 0.16 per hour
242 hours + 3.9 hours per patient-day
$ 6.00 per hour
118 hours + 0.05 hour per patient-day +
1.5 hours per patient discharge
Allocated Expenses
Personnel
Other administrative
and general
Fixed
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Date:
To:
From:
Subject:
14. The Flexible Budget:
Factory Overhead
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How a Hospital Unit Responds to a Performance Report
November 5, 2007
Cynthia DeCamp, Hospital Director
Stan DeVine, Pediatric Unit Manager
Direct expenses, October 2007
Direct Labor Last month, my unit recruited three new RNs at the
entry-level pay scale, replacing two retired RNs who had been with
us for more than 20 years and were at the top of the pay scale. The
average hourly salary for all RNs on the unit was reduced to $34 per
hour, resulting in a favorable labor rate variance. The replacements,
however, increased my RN nursing hours per patient-day to 1.5 hours,
resulting in an unfavorable labor efficiency variance in last month’s
average daily staffing. To compensate for the increased RN staffing,
one LPN was transferred to the Emergency Room, which needs his
help. This resulted in both a favorable rate and efficiency variance
for LPNs. We expect, however, that the favorable rate variance will
be lost in approximately six months when the RNs reach the next pay
level. Therefore, I recommend that plans be made to replace one RN
with one LPN.
For a period of five consecutive days in the middle of the month,
the unit had more than 20 patients and required the use of 48 overtime
hours for the nurse assistants, causing an unfavorable rate and efficiency variance for this group.
Supplies—Inventory Uses of inventory supplies followed the
standard level of 10 items per patient-day. However, two brands were
changed. The purchasing department informs me that the new brands
are less expensive and resulted in a $3,500 savings last month. Furthermore, the new items appear to be better than the previous brands,
and we will continue to use them.
Supplies—Noninventory The unfavorable quantity variance resulted primarily from purchasing items that had been deferred the last
several months. Year-to-date spending on these items, however, still
remains favorable.
Pediatrician Fees The resident pediatrician, Dr. Kiddear, and other
staff were required to provide some overtime night-shift services during
the period that the patient census was more than 20 patients. Overtime
night-shift work is paid at a rate higher than standard, thus causing an
unfavorable price variance. The 48 additional hours for overtime nightshift work were responsible for the unfavorable usage variance.
Source: Adapted from Managerial Cost Accounting for Hospitals (Chicago:
American Hospital Association, 1980), pp. 98–99.
use patient-days to measure output. Colleges and universities use credit-hour production to
show their outputs. However, these output measures seldom are perfect indicators of the outputs
of service organizations. Patients or their families are likely to place different values on the
same number of patient-days, depending on the results of treatments. A patient who is cured
of an illness is likely to be more pleased with the care received than is the family of a patient
who died of the same disease, although the number of patient-days was identical for both. In
addition, the amount and type of work performed by a service organization to complete an
output unit often varies from one client to the next or from one patient-day to another. The
amounts and types of work performed for two patients with identical heart diseases during
their 10-day stays can be vastly different although the number of patient-days is identical and
their illnesses are the same.
Educational institutions seldom use “knowledge learned” as a measure of their output.
Instead, these institutions frequently cite credit-hour production as the measure of their
output. One hundred credit hours of mediocre instruction, however, do not have the same
value as one hundred hours of excellent instruction. Intangible attributes, in addition to
units of output, play dominant roles in determining the value of outputs from a service organization. These characteristics often lead service firms to rely on input-related measures,
such as patient-days and the number of credit hours of instruction, to measure and monitor
operations.
The differences in operating characteristics between service organizations and typical manufacturing firms make it a necessity to modify standard cost systems before applying them to
service organizations.
Overhead Variances in ABC Systems
LEARNING OBJECTIVE 5
Analyze overhead variances in
an activity-based standard cost
system.
The manufacturing environment has evolved over the last few decades and many new
management techniques have been developed during this period to emphasize continual
improvement, total quality management, and managing activities rather than cost. These
emphases have changed product costing, strategic and operational decisions, and cost
determination methods, as discussed in the preceding chapters. They also influence the
ways in which many firms use standard cost systems as management tools, including the
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14. The Flexible Budget:
Factory Overhead
Chapter 14
The Flexible Budget: Factory Overhead 569
preparation of flexible budgets, the selection of evaluation criteria, and the implication of
reported variances.
ABC-Based Flexible Budgets for Control
Because a number of different activities influence factory overhead costs, the accountant
needs to carefully select the activity measure, or measures, that will be used to construct the
flexible budget for control purposes. The Schmidt Machinery Company, as illustrated thus far
in the chapter, uses a single, volume-based activity measure (direct labor-hours) for allocating
overhead costs to outputs.
As described in Chapter 5, more modern cost systems, such as activity-based costing (ABC)
systems, apply manufacturing support (i.e., factory overhead) costs to outputs on the basis of
activities performed for each product produced. That is, ABC attempts to assign manufacturing support costs to products on the basis of the resource demands, or resource consumption,
of each output. To accomplish this, ABC systems use a broader set of activity measures, both
volume-related and non-volume-related, in the cost-allocation process.
Cooper has developed a framework, in the form of a hierarchy, for classifying different
types of activity measures used in ABC systems.7 Cooper’s framework classifies manufacturing support costs as unit-based, batch-based, product-level, or facilities-level. Unit-based
measures are related to output volume and include machine-hours, direct labor-hours, units
of output, and units of raw materials. Batch-level activity measures include the number of
production setups, the number of times materials and parts are moved during the manufacturing process, and the number of receipts of materials. Product-level activity measures typically
relate to engineering support activities and can include things such as number of products,
number of processes, number of engineering change orders (ECOs), and number of schedule
changes. At the top of the cost hierarchy are facilities-level costs, which are related to the
capacity or ability to produce, not to the variety of outputs, the number of batches produced,
or the volume of output.
Exhibit 14.11 illustrates a traditional flexible (control) budget prepared for a company that
applies factory overhead cost to outputs on the basis of standard direct labor-hours. The master
budget in this exhibit is based on a planned output of 3,000 units for the period (1,500 standard
labor-hours). The flexible budget is based on the actual output of the period, 2,000 units (or,
equivalently, 1,000 standard labor-hours). The company in this example spent 1,200 direct
labor-hours to manufacture the 2,000 units. Exhibit 14.12 shows a typical financial report for
manufacturing costs incurred during the period.
By contrast, Exhibit 14.13 illustrates a flexible budget for the period prepared under ABC.
This representation specifies that manufacturing costs are assigned to outputs on the basis of
multiple activity measures. In the present example, three different volume-related activity
EXHIBIT 14.11 Master Budget and Traditional Flexible Budget for Control
Cost Elements
Variable
Fixed
Cost Item
$ 5,000
30,000
75,000
Direct materials
Direct labor
Indirect material
Repair and maintenance
Receiving
Insurance
Setup
$20/unit
30/Direct labor-hours
2/Direct labor-hours
5/Direct labor-hours
Total
7
Flexible Budget for 2,000 Units
(1,000 standard direct labor-hours)
Master Budget for 3,000 Units
(1,500 standard direct labor-hours)
$ 40,000
30,000
2,000
5,000
5,000
30,000
75,000
$ 60,000
45,000
3,000
7,500
5,000
30,000
75,000
$187,000
$225,500
R. Cooper, “Cost Classification in Unit-Based and Activity-Based Manufacturing Cost Systems,” Journal of Cost Management
for the Manufacturing Industry, Fall 1990, pp. 4–14.
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14. The Flexible Budget:
Factory Overhead
570 Part Four Operational Control
EXHIBIT 14.12
Traditional Financial
Performance Report
Direct materials
Direct labor
Indirect materials
Repair and maintenance
Receiving
Insurance
Setup
Total
Actual Cost
Flexible Budget
Based on Output
Flexible
Budget
Variance
$ 50,000
36,000
3,000
6,500
3,000
30,000
50,000
$178,500
$ 40,000
30,000
2,000
5,000
5,000
30,000
75,000
$187,000
$10,000U
6,000U
1,000U
1,500U
2,000F
—
25,000F
$ 8,500F
measures are used (units produced, direct labor-hours, and machine-hours) as well as one nonvolume-related activity (number of production setups). Note that there is a single facility-level
cost, insurance, that essentially has no well-defined activity variable. Because this cost is not
related to volume of output, or number of batches, or number of products, it is allocated to
products using a systematic, but essentially arbitrary, method, such as square feet in the factory devoted to the production of each product.
Compared to the simpler control budget presented in Exhibit 14.11, the ABC-based flexible
budget presented in Exhibit 14.13 likely represents a more accurate representation of the manufacturing costs that should have been incurred for the production of 2,000 units. A performance
report for the period, based on the ABC flexible budget, is presented in Exhibit 14.14.
The total manufacturing cost flexible budget variance for the period, based on a traditional
costing system, is $8,500, favorable (Exhibit 14.12). In contrast, the ABC approach yields a
$17,000 unfavorable variance for the same period (Exhibit 14.14). Exhibit 14.15 compares
these performance reports.
Exhibit 14.15 demonstrates that variances identified using a traditional approach (single
activity for applying factory overhead) can be misleading. Substantial differences are found
in variances for repair and maintenance, receiving, and setups. The traditional approach in
our example considers repair and maintenance a variable cost that varies with direct laborhours. In contrast, the ABC approach identifies repair and maintenance as a mixed cost with
EXHIBIT 14.13 Representation of Manufacturing Costs under an ABC System
Cost Function
Data
Activity Measure
Variable
Fixed
Operating Data
Output
Number of units
Standard Direct labor-hours
Standard Machine-hours
Number of setups
Cost Data
Direct materials
Direct labor
Indirect materials
Repair and maintenance
Receiving
Setup
Insurance
Total
Number of units
Direct labor-hours
Direct labor-hours
Machine-hours
Number of setups
Number of setups
Facility-level
$20/unit
$30/hour, 0.5 hour/unit
$2/direct labor-hour
$0.01/machine-hour
$1,500/setup
$25,000/setup
—
—
—
$ 3,000
500
—
$30,000
Flexible (Control) Budget
Master (Static) Budget
2,000 units
1,000 hours
300,000 hours
2 setups
3,000 units
1,500 hours
450,000 hours
3 setups
$ 40,000
30,000
2,000
6,000
3,500
50,000
30,000
$ 60,000
45,000
3,000
7,500
5,000
75,000
30,000
$161,500
$225,500
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14. The Flexible Budget:
Factory Overhead
Use of ABC for Planning and Control
Destin Brass Products, Inc., located in Destin, Florida, has three
product lines for fluid distribution systems: pumps, valves, and flow
controllers. All products produced by the company are made of highquality brass and are produced on the same manufacturing equipment.
However, the products differ significantly in terms of their consumption of manufacturing support resources. The pump line consists of a
more-or-less standardized product with no distinguishing characteristics. Pumps are produced in a single lot per month and are sold to a
single customer; relatively small amounts of engineering support are
needed for this product line. Flow controllers, on the other hand, are
sold to a number of distributors, require high levels of engineering
support, and have many more parts as compared to pumps. The company originally used a single volume-based activity measure (direct
labor dollars) to apply manufacturing overhead costs to each of the
three product lines.
The traditional cost system was replaced by a rudimentary ABC
system and then a slightly more complex ABC system that applied
manufacturing support (i.e., overhead) costs to products on the basis
of a number of volume-based and non-volume-based activities. Indicated manufacturing costs for representative products in each of the
three product lines under each of the three systems differed, and in
some cases by a substantial amount.
One of the functions of the ABC system was to be able to predict
cost incurrence at different activity and output levels. Managers found
out that the cost of the more complex and resource-demanding product was seriously distorted under the traditional and under the simple ABC system. In fact, this product was being “subsidized” by the
overcosting associated with the high-volume product line. Cost distortions under the old system were attributable to the fact that the system
allocated manufacturing support costs using a volume-based activity
measure. The ABC system was better able to budget manufacturing
support costs based on the resource demands that each product line
made on the organization. In turn, this information was used by management for pricing, process design, and cost-control purposes.
Source: William J. Bruns, Jr., Destin Brass Products Co., Harvard Business
School Case #9-190-089.
the variable portion of the cost varying with machine-hours. As a result, the variance of repair
and maintenance decreases from $1,500 unfavorable to $500 unfavorable. The traditional approach considers both receiving and setups as fixed costs while the ABC approach classifies
these two overhead costs as batch-related costs. As illustrated in Exhibit 14.15, the difference
in the net variance between these two approaches is 25,500.
EXHIBIT 14.14 Performance Report Using ABC
Cost Incurred
Flexible (Control) Budget
Flexible
Budget
Variance
$ 50,000
36,000
3,000
6,500
3,000
30,000
50,000
$178,500
$ 40,000 (2,000 units $20 per unit)
30,000 (2,000 units 0.5 hour per unit $30 per hour)
2,000 (1,000 hours $2 per hour)
6,000 [(300,000 machine-hours $0.01 per machine-hour) + $3,000]
3,500 [(2 setups $1,500 per setup) + $500]
30,000 ($30,000 per period)
50,000 (2 setups $25,000 per setup)
$161,500
$10,000U
6,000U
1,000U
500U
500F
—
—
$17,000U
Direct materials
Direct labor
Indirect materials
Repair and maintenance
Receiving
Insurance
Setup
Total
EXHIBIT 14.15
Performance Reports:
Comparison of Traditional and
ABC Approaches
Variance
Direct materials
Direct labor
Indirect materials
Repair and maintenance
Receiving
Insurance
Setup
Total
Traditional
Activity-Based
Difference
$10,000U
6,000U
1,000U
1,500U
2,000F
—
25,000F
$ 8,500F
$10,000U
6,000U
1,000U
500U
500F
—
—
$17,000U
—
—
—
$ 1,000
1,500
—
25,000
$25,500
Blocher−Stout−Cokins−Chen:
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Strategic Emphasis, Fourth
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14. The Flexible Budget:
Factory Overhead
Cost Management in Action
In this and the preceding chapter we abstracted from reality by assuming that production for a period equals sales for the period, that is, that
there was no change in inventory during the period. Although this is
certainly possible, particularly for companies that embrace a JIT philosophy, the assumption is not reasonable for many other companies.
We note, for example, that sales-related variances (discussed in Chapter 13) should logically be based on units sold while manufacturingrelated variances (discussed in Chapters 13 and 14) should be based
on production volume. So, this raises the question of how to account
in the profit-variance model discussed in Chapters 13 and 14 for both
© The McGraw−Hill
Companies, 2008
How Do We Account for Inventory Changes?
planned and unplanned changes in inventory (i.e., for imbalances between production volume and sales volume during a period). This issue
has been addressed in the following article: R. Balakrishnan and G. B.
Sprinkle, “Integrating Profit Variances and Capacity Costing to Provide
Better Managerial Information,” Issues in Accounting Education 17, no.
2 (May 2002), pp. 149–161.
Access the above reading and provide an explanation as to how the
conventional profit-variance report can be expanded to include changes
in inventory, both planned and unplanned. Also, discuss how the resulting
variance information would be useful to managers.
Investigation of Variances
LEARNING OBJECTIVE 6
Understand decision rules
that can be used to guide the
variance-investigation decision.
Identifying and reporting variances are the first steps in reducing variances and improving
operations. An effective standard cost system requires management to respond promptly and
take proper actions to prevent unfavorable variances from recurring. Left uncorrected, variances are likely to repeat period after period. Abuse and waste of resources, falling morale,
and declining performance are common among firms that pay no heed to variances.
Not all variances call for investigation and corrective action, however. The proper response to a variance depends on the type of standard the firm uses, the firm’s expectation,
the magnitude and impact of the variance, and the causes and degree of controllability of the
variance.
Type of Standard
Management may set standards based on a currently attainable standard or an ideal standard.
Proper actions for variances from these two standards differ. A material variance from a currently attainable standard, either favorable or unfavorable, often requires management’s immediate attention.
The same variance from an ideal standard, in contrast, can require no management action beyond noting improvements in operations as indicated by the magnitude and direction
of the variance. As long as the organization is making progress over time toward the ideal
standard, management might not need to take any corrective action, even if the variance
is large.
Expectations of the Organization
Organizations have different expectations on their operations. A company experiencing a crisis needs and demands peak performance from all employees. A struggling firm might need to
attain the established standards in all cases. To survive, the firm is likely to allow no exception
to the standards, even if management adopts ideal standards. In contrast, managers of a highly
profitable firm could be satisfied with making steady progress toward the established standard,
especially when the firm uses an ideal standard. Management would not be overly alarmed by
minor deviations from the standard.
Experience also can affect management’s reaction to a variance. A company in the early
stages of using ideal standards should not be alarmed by small deviations; a firm further along
the path toward ideal standards might see the same amount of deviation as a setback that requires immediate corrective action.
Magnitude, Pattern, and Impact of a Variance
The magnitude of variances and their impact on future operations affect management’s reaction to variances. Rarely do operating results meet the standards exactly. Small variances
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Factory Overhead
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What Effects Does Cell Manufacturing Have on
Factory Overhead?
After almost a century of movement toward mass production, use of
ever larger machinery, and the facility of Henry Ford’s assembly line, the
National Association of Manufacturers found in 1994 that the majority
of factories are now using cell manufacturing. In cell manufacturing,
a small team of workers group around manufacturing equipment and
make entire products. A single cell makes, checks, and even packages
an entire product or component. Each worker performs several tasks,
and every cell is responsible for the quality of its products.
The benefits of manufacturing cells include speed, productivity,
flexibility, and higher quality. After Gore-Tex adopted cell manufacturing at several of its 46 plants, it cut production time in half and delivered 97 percent, as compared to 75 percent, of the products on time.
At both Harley-Davidson and Lexmark, productivity has increased by
25 percent. Harley-Davidson’s cell-based plants have experienced
substantial improvements in quality, despite the fact that the number
of quality inspectors has been cut significantly. Mr. Kathuria, a factory
manager at Harley-Davidson, attributed the success of cells to employee satisfaction. Working on an assembly line allows each worker
to spend only a few seconds on each product. Few workers would
see the finished product. In cells employees see their product from
start to finish.” As Mr. Kathuria says, “they own the serial number.”
However, does cell manufacturing have an effect on factory overheads costs?
Firms adopting cell manufacturing have found their factory overhead costs have decreased both in total and on a per-unit basis.
At Harley-Davidson, the floor space occupied by the factory was
reduced by a third. Gore-Tex decreased the space taken up by the
plant by one-quarter. Factors contributing to the need for less space
are clustering of equipment and decrease or elimination of work-inprocess and finished goods inventories.
Increased productivity further allows the reduced total factory
overhead to be borne by higher volumes and, thus, decreases factory overhead per unit. In 1981, Harley-Davidson took a week to make
a cylinder head and turned over its product only 4.5 times a year. In
1994, it took a two-person cell less than three hours to make a cylinder
head and the firm turned over its stock 40 times a year.
Source: Based on “The Celling Out of America,” The Economist, December
1994, pp. 63–64.
are expected, and most of them need no special attention from management unless a pattern
develops. A persistent but small unfavorable variance might require management’s attention
because its cumulative effect on operating results over time can be quite substantial.
Large variances usually catch the attention of management and receive immediate respones.
The responses, however, might not be warranted. A large variance does not require action if it
is not a result of aberrations of the underlying operations or if it is a one-time occurrence. A
large unfavorable variable overhead efficiency variance identified with direct labor-hours as
the base for applying factory overhead might not indicate runaway factory overhead costs if
the bulk of factory overhead is driven by activities other than direct labor-hours. Similarly, a
large unfavorable direct materials usage variance requires no further action if it is a result of,
for example, a poorly adjusted machine that has since been properly calibrated.
Causes and Controllability
Random variances
are variances beyond the
control of management, either
technically or financially,
and often are considered as
uncontrollable variances.
Systematic variances
are variances that are likely to
recur until corrected.
The causes of variances and the degree to which an organization can control them determine
whether corrective actions are needed. No action is needed if management has no control over
the variance, even if the variance has a significant effect on the firm’s operating results.
The causes of variances and the controllability of variances fall into two categories: random
and systematic. Random variances are beyond the control of management, either technically
or financially, and are often considered as uncontrollable variances. Many standards are point
estimates of a long-term average performance of operations. Small variances in either direction occur in operations, and firms usually cannot benefit from investigating or responding
to them. For example, prices of goods or services acquired in open markets fluctuate with,
among other factors, supply and demand at the time of acquisition and the amount of time
allowed to acquire the goods or services. These variances are essentially random and require
no management action. A firm with a 10 percent excess material usage would most likely not
investigate the variance if the firm chose to purchase the equipment that, on average, had a
spoilage rate of 12 percent and the standard allowed no spoilage.
Systematic variances are persistent and are likely to recur until corrected. They usually are
controllable by management or can be eliminated or reduced through actions of management.
Systematic variances that are material in amount require prompt corrective action.
Among causes for systematic variances are errors in prediction, modeling, measurement,
and implementation. Each of these factors has its own implications regarding the need for
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
574 Part Four Operational Control
EXHIBIT 14.16 Cause of Variance and Indicated Corrective Action
Controllability
Cause
Corrective Action
Example
Uncontrollable (random)
Random error
None
Overtime wages paid to make up time
lost by employees ill with the flu
Materials lost in a fire
Controllable (systematic)
Prediction error
Modeling error
Modify standard-setting
processes
Revise model or modeling process
Measurement error
Adjust accounting procedure
Implementation error
Take proper actions to correct
the causes
Increases in materials prices faster
than expected
Failure to consider learning-curve
effect in estimating product costs
Not allowing for normal materials lost
Bonus attributed to the period paid,
not the period earned
Costs assigned to wrong jobs
Failure to provide proper training
for the task
A prediction error
is a deviation from the
standard because of inaccurate
estimations.
Modeling errors
are failures in not including all
relevant variables or including
wrong or irrelevant variables.
Measurement errors
are uses of incorrect numbers
because of improper or
inaccurate accounting systems or
procedures.
Implementation errors
are deviations from the standard
due to operator errors.
further investigation or proper managerial action to correct the variance. Exhibit 14.16 classifies variances according to controllability, causes, and actions to be taken.
Prediction errors result from inaccurate estimation of the amounts of variables included in
the standard-setting process. For example, management expected a 5 percent price increase for
a direct material when the price increased 10 percent, or it expected to have adequate $15-perhour workers available when a shortage forced the firm to hire workers at $25 per hour.
Modeling errors result from failing to include all relevant variables or from including wrong
or irrelevant ones in the standard-setting process. For example, a modeling error occurs when a
firm uses as a standard the production rate of experienced workers although most of its workers
are new hires with little or no experience. The unfavorable direct labor efficiency variance that
the firm experiences is a result of modeling error, not of inefficient operations. The standard of
making 100 gallons of output from every 100 gallons of input material is a modeling error when
the manufacturing process has a 5 percent normal evaporation rate. Corrective actions for both
prediction and modeling errors require the firm to change its standard and the standard-setting
process.
Measurement errors are uses of incorrect numbers because of improper or inaccurate accounting systems or procedures. Including bonuses for extraordinary productivity as a cost of
the period in which the bonuses are paid rather than the period in which they are earned is a
measurement error. Charging overhead incurred for setups based on direct production laborhours rather than the number of setups is a measurement error. Corrective actions for measurement errors include redesigning the firm’s accounting system or procedures.
Failure to correct prediction, modeling, or measurement errors would, in the long term,
frustrate employees and lead them to focus on showing the best reported results, even at the
expense of improving the firm’s performance. Employees of firms using standard cost systems
that have uncorrected prediction, modeling, or measurement errors often lose confidence in
accounting reports.
Implementation errors are deviations from the standard due to operator errors. Unfavorable
materials usage variances from using materials of lesser quality than those specified by the
standard are implementation errors. The direct labor rate or efficiency variance in an operation
that assigned workers with a different skill level than the one called for in the standard is an
implementation error. Setting a cutting machine to cut tubes in lengths of 2 feet 9.7 inches,
instead of 2 feet 10 inches as required, is an implementation error.
Some implementation errors are temporary and disappear in subsequent periods in the
normal course of operations. Other implementation errors could be persistent and reappear
until the firm takes proper corrective action. An incorrectly set cutting machine continues
to manufacture products with wrong lengths until the problem is corrected. Use of wrong
or excessive materials in production, on the other hand, might occur in one or only a few
production runs.
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
Chapter 14
The Flexible Budget: Factory Overhead 575
Control Chart
A statistical control chart
sets control limits using a
statistical procedure.
Managers and employees can use control charts to identify random versus systematic variances.
A control chart plots measures of an activity or event over time; this widely used tool helps
managers identify out-of-control variances. A control chart has a horizontal axis, a vertical
axis, a horizontal line at the level of the desirable characteristic, and one or two additional horizontal lines for the allowable range of variation. The horizontal line represents time intervals,
batch numbers, or production runs. In Exhibit 14.17, the horizontal line denotes months, from
January through December. The vertical line denotes scales for the characteristic of interest,
such as cost incurred. The scale of interest in Exhibit 14.17 is the amount of variance, ranging from $200 favorable to $200 unfavorable. The horizontal line at the level of the desirable
characteristic in Exhibit 14.17 represents conformity with the standard cost ($0 variance). The
two additional horizontal lines in Exhibit 14.17 are the upper and lower limits that indicate the
allowable range of the variance. Management has decided that an favourable variance less than
$150 is acceptable. Variances within the limits are deemed random variances and no further
action is needed unless a pattern emerges.
A control chart enables managers and employees to grasp the size and the trend, if any,
of variances over time. Exhibit 14.17 reflects an upward trend of unfavorable variances in
March through June and repeated in September through December. An alert manager would
very likely monitor the operations closely starting from, say, April or May. If corrective action
were taken in April or May, the upward pattern of unfavorable variances starting in September
might not have occurred. The chart also suggests that the firm tends to have larger unfavorable
variances at the beginning and end of a year. Management needs to examine this phenomenon
and determine whether corrective action is warranted.
It is management’s responsibility to set upper and lower control limits in control charts.
Although the limits in Exhibit 14.17 are equal in distance from the standard cost, they are
not necessarily so. When the control limits are established using a statistical procedure, the
chart is called a statistical control chart. A common practice is to set the control limits at ±3
standard deviations from the standard cost. Assuming that the characteristic of interest has a
normal distribution, a statistical control chart with ±3 standard deviations as the control limits
suggests that the likelihood for an observation to be outside of the control limit if the process
is in control is only 0.13 percent in either direction. For example, assume that the direct labor
efficiency variance in Exhibit 14.17 has a normal distribution and that a $150 variance is three
standard deviations away from the standard cost, then the chance for a variance such as the
ones observed in December or February is only 0.13%—a rare occurrence that is not likely a
result of random cause. Management may need to investigate the reason for the variance.
The chapter Appendix examines a cost-benefit approach to the variance-investigation
decision.
EXHIBIT 14.17
Time-Series Plot: Direct Labor
Efficiency Variance—Finishing
Department
$200U
Dec.
Upper Limit
$150U
Nov.
June
Jan.
May
Apr.
$100U
Oct.
Aug.
July
Sept.
Mar.
$50U
Standard cost
Feb.
$50F
$100F
$150F
Lower Limit
$200F
Month
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
14. The Flexible Budget:
Factory Overhead
© The McGraw−Hill
Companies, 2008
576 Part Four Operational Control
Company Practices
Experienced managers usually have a good intuitive feeling about whether a variance requires further investigation. Others follow a rule of thumb (i.e., heuristic), either in dollar
amounts or in percentage of variation, to determine whether to further investigate variances. Often, the cause for a variance is corrected before the variance is reported. Visual
inspections during operation might alert the operator of a cutting machine that the cuttings
are not square as required. Most likely the operator would have adjusted the alignment that
caused the improper cutting and corrected the problem before the manager received the
variance report. This points to the general need to provide operating personnel with realtime nonfinancial data (e.g., labor-hour or materials consumption) for operational control
purposes.
Summary
Establishing standard variable overhead application rates requires selection of appropriate
activity measures. These rates can be determined using relatively simple procedures (e.g., a
single, volume-related activity measure) or more sophisticated procedures, such as ABC. The
resulting standard-cost data can be used both for product costing purposes and, through their
inclusion in flexible budgets, control purposes.
For control purposes, actual overhead costs (both variable and fixed) are compared to flexible budget costs. A summary of the overhead cost variances realized by the Schmidt Machinery Company for October 2007 is presented in Exhibit 14.18. This exhibit is a variant of the
model presented earlier in Exhibit 14.7. Both exhibits are general in nature and therefore can
be used in a four-variance, a three-variance, and a two-variance approach to decomposing the
total overhead variance for the period. Feel free to use whichever of the two models you find
more appealing.
As indicated in Exhibit 14.18, the total variable overhead variance (also referred to as the
total variable overhead flexible budget variance or the total over- or underapplied variable
overhead for the period) is $6,170F and is calculated as the difference between actual variable
overhead cost for the period and the flexible budget for variable overhead based on output
(i.e., based on allowed activity for the number of units manufactured during the period). Variable overhead spending ($1,490F) and efficiency ($4,680F) variances are components of the
total variable overhead variance. The variable overhead efficiency variance reflects efficiency
or inefficiency in the use of the activity measure used to construct the flexible budget; in the
case of the Schmidt Machinery Company, this activity measure is direct labor-hours. The
spending variance for variable overhead reflects the fact that spending on variable overhead
items, per direct labor-hour, was different from planned spending. As such, this variance reflects both price effects and usage (efficiency) effects. The ability to disentangle these effects,
however, requires detailed information about budgeted prices and budgeted quantities of individual variable overhead items.
Exhibit 14.18 also indicates a total fixed overhead variance for the period of $37,050U.
This variance, which is also called the total over- or underapplied fixed overhead for the
period, can be decomposed into a fixed overhead spending variance ($10,650U) and a production volume variance ($26,400U). The former variance is defined as the difference between
the actual fixed overhead costs and the budgeted (lump-sum) fixed overhead costs for the
period. If management desires, this total variance can be broken down on a line-item basis.
The production volume variance exists only because of the product costing need to assign a
share of fixed overhead costs to each unit produced. To do this, the accountant develops a fixed
overhead allocation rate, which is defined as budgeted fixed overhead costs divided by an assumed level of activity, called the denominator volume. If the denominator volume is defined
as practical capacity, then the resulting production volume variance can be thought of as a
measure of the cost of unused capacity.
You should remember that, in practice, different terms are used to describe the same overhead variance. Thus, you are advised in constructing any performance reports to clearly define
the meaning of each variance contained in the report.
Blocher−Stout−Cokins−Chen:
Cost Management: A
Strategic Emphasis, Fourth
Edition
IV. Operational Control
© The McGraw−Hill
Companies, 2008
14. The Flexible Budget:
Factory Overhead
Chapter 14
EXHIBIT 14.18
Variance Analysis Summary:
Schmidt Machinery Company,
October 2007
The Flexible Budget: Factory Overhead 577
Variable (Factory) Overhead: Standard Cost Variance Analysis—Alternative Format
Actual
Variable Overhead
(AQ AP) $40,630
Applied Variable
Overhead
(SQ SP)
$46,800
Total variable overhead
variance $6,170F
Spending variance
AQ (AP SP)
$1,490F
Flexible Budget
Based on Inputs
(Actual machinehours) (AQ SP) $42,120
Efficiency
variance SP (AQ SQ)
$4,680F
Flexible Budget
Based on Outputs
(Standard machinehours) (SQ SP)
$46,800
$0—These two are
always equal (i.e.,
never a variance here)
Legend: SQ Standard labor-hours allowed for units produced 3,900
AQ Actual labor-hours worked during the period 3,510
SP Standard variable overhead cost $12hour
AP Actual variable overhead cost per labor-hour $11.5755 (rounded)
Total variable overhead variance Spending variance Efficiency variance
Fixed (Factory) Overhead: Standard Cost Variance Analysis—Alternative Format
Actual Fixed
Overhead
$130,650
Spending variance
$10,650U
Total fixed overhead
variance $37,050U
Budgeted Fixed
Overhead (LumpSum) $120,000
Applied Fixed
Overhead (SQ SP)
$93,600
Production volume
variance SP (SQ Denominator volume)
$26,400U
Legend: SQ Standard labor-hours allowed for units produced 3,900 hours
SP Standard fixed overhead cost $24hour
Denominator volume Number of labor-hours used to calculate the predetermined
fixed overhead application rate 1,000 units 5 hoursunit 5,000 hours
Total fixed overhead variance Spending (budget) variance Production
volume variance
A firm can dispose of variances in the income statement of the period in which the variance
occurs by charging them to the cost of goods sold. Alternatively, the firm can prorate the variances among the cost of goods sold, ending work-in-process inventory, and ending finished
goods inventory. For materials price variances, the proration should include the materials ending inventory and materials usage variance.
Uses of standard cost systems are not limited to manufacturing operations; service firms
and other organizations also can benefit from using them. Because operating characteristics of
service firms often differ from those of manufacturing firms, modifications might be needed
and emphases could be different when using standard costs in a service organization. Among
operating characteristics that differ between manufacturing and service organizations are the
absence of output inventory, labor-intensive operations, the predominance of fixed costs, and
the ambiguity of output measures in service organizations.
Changes in manufacturing environments in recent years have motivated changes in cost
systems. Increasingly, companies are using systems with multiple activity measures, both
volume-based and non-volume-based. Flexible budgets based on ABC systems provide more
accurate data for cost-control purposes.
Whether to investigate variances depends on the type of standard the firm uses, the expectations of the firm, the magnitude and impact of variances, and the causes and controllability
of variances. Causes of variances can be random or systematic. Control charts can be used
by managers to isolate random versus non-random variances. The Appendix discusses the
variance-investigation decision under uncertainty.