Technical: FMAF and IMPM
Question Time Again
Grahame Steven
Ask a Simple Question (published in December 2003) argued that students
would find it easier to calculate variances if they understood why variances
are calculated instead of trying to memorise formula. This article will use the
example contained in Ask a Simple Question to demonstrate the impact of
absorption costing on variance analysis.
In order to calculate absorption costing variances, it is essential to recognise
that absorption and marginal costing treat factory overheads very differently.
Marginal costing charges factory overheads to the profit and loss account
when products are made ie they are a period cost. Absorption costing charges
factory overheads to the profit and loss account when products are sold ie
they are a product cost. Factory overheads consequently follow the product in
an absorption costing system. Firstly to stock, then to the profit and loss
account when the products are sold: this month, next month, etc.
Tables 1, 2, 3 and 4 contain the budget data, actual data, absorption and
marginal cost reconciliations for PPL. Please refer to these tables when
reading this article.
The starting point for an absorption costing variance analysis is the calculation
of the budget overhead absorption rate for PPL since factory overheads are a
product cost ie £2.50 per item. PPL is consequently valued at £9.20 per item
under absorption costing instead of £6.70 under marginal costing.
How does this affect the variance analysis? Firstly, the sales volume variance
is valued at gross profit margin, not contribution. Secondly, an additional
variance, fixed production overhead volume variance, is calculated. All other
variances remain the same since they are not affected by the treatment of
factory overheads.
The sales volume variance is calculated to determine if total gross profit was
higher or lower than expected. Did PPL sell more or less products than
expected? Answer: 40 less. What was the impact on PPL’s profits? Answer:
£112 adverse ie 40 x (£12.00 less £9.20). Standard price and standard cost is
used since the other variances in the reconciliation highlight price, cost, and
usage fluctuations from standard.
The fixed production overhead volume variance is calculated to determine if
budget factory overheads were charged to more or less finished goods than
expected. A favourable variance is produced when actual production is
greater than budget since budget factory overheads were charged to more
goods than expected. An adverse variance is produced when actual
production is less than budget since budget factory overheads were charged
to fewer goods than expected.
Did PPL make more or less goods than expected? Answer: 50 more. The total
variance is £125 since the quantity variance is valued at the budget overhead
absorption rate of £2.50. Please note that while in this example this variance
has been released to the profit and loss account, in practice, it might not be
released until the goods are sold.
The profit reported under absorption costing is £2,783 and the profit reported
under marginal costing is £2,558. A difference of £225. So why does this
occur? The difference is due to stock movement. Stock has increased by 90
units since production (1,050 units) was greater than sales (960 units). The
profit reported by absorption costing is greater since the factory overheads
associated with the stock increase have not been charged to the profit and
loss account as they are still in stock ie 90 x £2.50 (£225). Marginal costing,
on the other hand, charges all factory overheads to the profit and loss account
when the goods are made. The reverse happens when sales are greater than
production. Please note that absorption and marginal costing will (generally)
report the same profit/loss if there is no stock movement.
So which approach is right? While there are arguments for and against each
costing system, an argument in favour of absorption costing is that it applies
the matching concept. This is particularly relevant for manufacturing
companies with seasonal businesses - toys, fireworks etc - that produce
monthly accounts. Marginal costing will understate profits in months where
goods are made for future sales and inflate profits in months where sales
exceed production. Why? Because factory overheads are charged to the
month in which the products were made. Absorption costing, however, gives a
better measure of monthly profitability since factory overheads are charged to
the profit and loss account when the products are sold.
While this article considers absorption costing variances, the key message
remains the same. Students will be better placed to calculate variances,
understand why variances are calculated and cope with “unusual” data if they
ask a simple question!
Table 1: Budget data
Selling price
Sales
Production
£12.00per packet
1,000packets
1,000packets
Raw materials
Direct labour (hours)
Variable overheads (Electricity)
Fixed overheads (Production) *
* Overhead absorption rate =
5.00sq metres
0.10hours
15joules
£2,500
1,000
£1.20per sq metre
£4.00per hour
£0.02per joule
ie £2.50
Table 2: Actual data
Selling price
Sales
Production
Raw material cost
Raw material usage
Labour rate
Labour
Joule rate
Joules
Fixed overheads
£12.05per packet
960packets
1,050packets
£1.18per sq metre
5,300square metres
£3.90per hour
110Hours
£0.022per joule
15,000Joules
£2,600
Table 3: Absorption cost reconciliation
£2,800
Budget profit
Sales volume variance
Sales price variance
Material price variance
Material usage variance
Labour rate variance
Labour efficiency variance
Variable overhead expenditure variance
Variable overhead efficiency variance
Fixed overhead expenditure variance
Fixed overhead volume variance
Actual Profit
-40packets
-£112
£48
£106
-£60
£11
-£20
-£30
£15
-£100
£125
£2,783
Cost
£6.00
£0.40
£0.30
£2.50
£9.20
Table 4: Marginal cost reconciliation
Budget profit
Sales volume variance
-40packets
Sales price variance
Material price variance
Material usage variance
Labour rate variance
Labour efficiency variance
Variable overhead expenditure variance
Variable overhead efficiency variance
Fixed overhead variance
Actual Profit
£2,800
-£212
£48
£106
-£60
£11
-£20
-£30
£15
-£100
£2,558