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The Flexible Budget:Factory Overhead
Chapter Fourteen
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Distinguish between the product-costing andcontrol purposes of standard costs for factoryoverhead
Calculate and properly interpret standard costvariances for factory overhead using traditionalapproaches
Record factory overhead costs and associatedstandard cost variances
Apply standard costs to service organizations
Learning Objectives
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Analyze overhead variances in an activity-basedcost (ABC) system
Understand decision rules that can be used toguide the variance-investigation decision
Learning Objectives(continued)
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Standard Variable Overhead Costs:Product Costing vs. Control
VariableOverhead
Cost
Activity Variable(e.g., DL Hrs.)
Product Costing &Control (SQ x SP)
SQ = Standard allowed DLHs for units producedSP = Standard variableoverhead rate/DLH
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Variable Overhead VarianceAnalysis
VariableOverhead
Cost
Activity Variable(e.g., DL Hrs.)
Product Costing &Control (SQ x SP)
SQ = Standard allowed DLHs for units produced; AQ = Actual DLHs worked;overhead rate/DLH; SP = Standard variable overhead rate/DLH; AP = Actual variableoverhead rate/DLH
SQ x SP
AQ x SP
AQ x AP
SQAQ
SpendingVariance
EfficiencyVariance Total
Variance
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Variable Overhead Variance Analysis:Equation Approach
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Variable Overhead Variance Analysis:Equation Approach (continued)
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Variable Overhead Variance Analysis:Example Calculations
Hanson, Inc. applies variable factory overhead onthe basis of DLHs. Hanson has the following
variable factory overhead standard to
manufacture one unit of product:1.5 standard DLHs per unit @ a variable overhead
rate of $3.00 per DLH
Last month, 1,550 hours were worked to make1,000 units, and $5,115 was spent for variable
factory overhead
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Variable Overhead Variance Analysis:Example Calculations (continued)
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Variable Overhead Variance Analysis:Alternative Solution Format
Total Variable Overhead Variance = Actual VariableOverhead Flexible Budget for Variable Overhead
= $5,115 - $4,500 = $615 U
Variable Overhead Spending Variance = AQ x (AP SP)
= 1,550 DLHs x ($3.30 - $3.00)/DLH
= $465 U
Variable Overhead Efficiency Variance = SP x (AQ SQ)
= $3.00/DLH x (1,550 1,500) DLHs
= $150 U
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Standard Fixed Overhead Cost:Planning vs. Control
FixedOverhead
Cost
Activity Variable(e.g., DL Hrs.)
Product Costing:Standard Fixed OHApplied = SQ x SP
SQ = Standard allowed DLHs for units producedSP = Standard fixedoverhead rate/DLH
Control Budget(Lump Sum)
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Determine the total budgeted fixed factoryoverhead for level of operation.
Select an activity driver (or drivers) for applying
fixed factory overhead.
Choose a denominator volume for the selectedactivity driver (e.g., practical capacity).
Divide the amount in Step 1 by the amount inStep 3 to determine the standard fixed factoryoverhead application rate for product costingpurposes.
Product Costing: Determining the StandardFixed Factory Overhead Rate
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Fixed Overhead Variance Analysis
FixedOverhead
Cost
Activity Variable(e.g., DL Hrs.)
Product Costing: StandardFixed OH Applied = SQ x SP
SQ = Standard allowed DLHs for units producedSP = Standard fixedoverhead rate/DLH
Actual FOH
Budgeted FOH
Applied FOH
Spending
Variance (U)VolumeVariance (U)
SQ Den. Vol.
TotalVariance
(U)
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Calculating Fixed Overhead Variances
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Example: Calculating Fixed OverheadVariances
Hanson Inc.s budgeted fixed overhead is $9,000 forthe month. The budgeted activity measure for the
month is 3,000 units.
Actual production is 3,200 units and actual fixedoverhead is $8,450 for the month.
Compute the fixed overhead spending andvolume variances.
$9,000 budgeted fixed overhead
3,000 budgeted unitsFR = = $3.00 per unit
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Example: Calculating Fixed OverheadVariances (continued)
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Fixed Overhead Variance Analysis:Alternative Solution Format
Total Fixed Overhead Variance = Actual Fixed OverheadFixed Overhead Applied to Production
= $8,450 - $9,600 = $1,150 F (also called
Overapplied fixed overhead)Fixed Overhead Spending (Budget) Variance
= Actual Fixed Overhead Budgeted Fixed Overhead= $8,450 - $9,000 = $550 F
Fixed Overhead Production Volume Variance
= Budgeted Fixed Overhead Applied Fixed Overhead= $9,000 - $9,600 = $600 F
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Fixed Overhead Production VolumeVariance: Alternative Calculation
Fixed Overhead Production Volume Variance
= Standard Fixed Overhead Application Rate x(Actual Units Produced DenominatorVolume)
= $3.00/unit x (3,200 3,000) units
= $600 F (i.e., overapplied fixed overhead)
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Interpretation of Fixed OverheadVariances
Results from spending
more or less thanexpected for individualfixed overhead items.That is, spending on
individual fixed
overhead items wasdifferent than planned.
Spending (Budget)Variance
Production VolumeVariance
Results from operating
at a level other than thedenominator volumelevel. Arises because of
the product-costingpurpose of fixed
overhead. Not of directinterest for control
purposes
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Causes of Fixed Overhead Variances
Spending (Budget) Variance:
Ineffective budget procedures
Inadequate control of costs
Misclassification of cost items
Production Volume Variance:
Management decisions Unexpected changes in market demand
Unforeseen problems in manufacturing operations
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Three-Way Breakdown of Total OverheadVariance
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Hanson, Inc.: Three-Way vs. Four-Way Analysisof Total Factory Overhead Variance
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Two-Way Analysis of Total FactoryOverhead Variance
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Hanson, Inc.: Two-Way Analysis of TotalFactory Overhead Variance
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Disposition of Standard Manufacturing CostVariances
From Chapter 13
Material price variance $ 170 F
Material usage variance 800 U
Labor rate variance 310 U
Labor efficiency variance 600 U
From Chapter 14
Variable factory overhead spending variance 465 UVariable factory overhead efficiency variance 150 U
Fixed factory overhead spending variance 550 F
Fixed factory overhead volume variance 600 F
Total manufacturing cost variance $ 1,005 U
Hanson IncManufacturing Cost Variances
For the Month Ending June 30, 2008
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Alternative 1: Close Net Manufacturing CostVariance to CGS
Dr. CGS (net variance) $1,005
Dr. DM Price Variance 170
Dr. FOH Spending Variance 550
Dr. FOH Volume Variance 600
Cr. DM Usage Variance $ 800
Cr. DL Rate Variance 310
Cr. DL Efficiency Variance 600
Cr. VOH Spending Variance 465
Cr. VOH Efficiency Variance 150
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Income Statement after Disposition of NetManufacturing Cost Variance
Sales 100,000$
Add: Favorable selling price variance 7,000
Net sales 107,000$
Cost of goods sold (at standard) 60,000$
Add: Unfavorable manufacturing cost variances 1,005
Total cost of goods sold 61,005
Gross margin 45,995$Selling and administrative expenses 41,000
Operating income 4,995$
Hanson Inc
Income statement
For the Month Ended June 30, 2008
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Alternative 2: Prorate (Allocate) NetManufacturing Cost Variance
Cost at Percent Adjusted
Accounts Standard of Total Total cost
Ending WIP 20,000$ 20% 20% of $1,005 201$ 20,201$
Ending Fin. Goods 20,000 20% 20% of $1,005 201 20,201
CGS 60,000 60% 60% of $1,005 603 60,603
Total 100,000$ 100% 1,005$ 101,005$
Proration of
Variance
Proration of Manufacturing Cost Variances
End-of-period account balances are used to allocatethe net manufacturing cost variance, as follows:
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Alternative 2: Prorate Net ManufacturingCost Variance
Dr. CGS (net variance) $ 603
Dr. WIP Inventory 201
Dr. Finished Good Inventory 201
Dr. DM Price Variance 170
Dr. FOH Spending Variance 550
Dr. FOH Volume Variance 600
Cr. DM Usage Variance $ 800
Cr. DL Rate Variance 310
Cr. DL Efficiency Variance 600
Cr. VOH Spending Variance 465
Cr. VOH Efficiency Variance 150
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Traditional vs. ABC Approach to OverheadCost Analysis
Cost Item Variable Per Fixed
Direct materials $20 UnitDirect labor 30 DLH
Indirect materials 2 DLH
Repair and Maintenance 5 DLH
Receiving $5,000Engineering Support 30,000
Setup 75,000
Traditional Approach to Product Costing:
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Traditional Performance Report
Actual Flexible
Cost Item Cost Budget Variance
Direct materials $50,000 $40,000 $10,000 U
Direct labor 36,000 30,000 6,000 U
Indirect materials 3,000 2,000 1,000 URepair and Maintenance 6,500 5,000 1,500 U
Receiving 3,000 5,000 2,000 F
Engineering Support 30,000 30,000 30,000
Setup 50,000 75,000 25,000 FTotal $178,500 $187,000 $8,500 F
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Flexible Budget Using ABC
Flexible
Cost Item Budget
Direct materials $40,000 (2,000 x $20)
Direct labor 30,000 (2,000 x 0.5 x $30)Indirect materials 2,000 (1,000 x $2)
Repair and Maintenance 6,000 (300,000 X $0.01 +$3,000)
Receiving 3,500 (2 x $1,500 + $500)
Engineering Support 30,000 ($30,000 per period)Setup 50,000 (2 x $25,000)Total $161,500
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Performance Report Using ABC
Actual Flexible
Cost Item Cost Budget Variance
Direct materials $50,000 $40,000 $10,000 U
Direct labor 36,000 30,000 6,000 UIndirect materials 3,000 2,000 1,000 U
Repair and Maintenance 6,500 6,000 500 U
Receiving 3,000 3,500 500 F
Engineering Support 30,000 30,000Setup 50,000 50,000
Total $178,500 $161,500 $17,000 U
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Standard Costing Applied toService Contexts
Examples
Jobs with repetitive tasks lend themselvesto efficiency measures
Computing non-manufacturing efficiencyvariances requires some assumedrelationship between input and outputactivity
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Service Applications (continued)
Department Input Output
Mailing Labor hours Number of pieces mailed
Personnel Labor hours Number of personnel changes processed
Food service Labor hours Number of meals served
Consulting Billable hours Customer revenues
Nursing Labor hours Number of patients and/or procedures
Check Processing Computer hours Number of checks processed
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The Variance Investigation Decision
How do I know whichvariances toinvestigate?
Larger variances, in
dollar amount or asa percentage of the
standard, areinvestigated first.
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The Variance Investigation Decision(continued)
Uncontrollable:
Random Error
Controllable (Systematic):
Prediction error
Modeling error
Measurement error
Implementation error
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Control Charts
ControlCharts
Display variations in aprocess and help to
analyze the variations
over time
Distinguish betweenrandom variationsand variations that
should be investigated
Provide a warning signal when variationsare beyond a specified level
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Control Charts (continued)
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Appendix: Variance InvestigationDecisionsUsing Payoff Tables
States of Nature
Action Random Nonrandom
Investigate I I+ C
Do not investigate none L
Where: I= cost of an investigation
C= the cost to correct a variance
L = present value of losses by notcorrecting the variance
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Appendix: Variance InvestigationDecisionsIndifference Probability
E(Investigate) = [(I + (1 - p)] + [(I + C) x p]
E(Do not investigate) = L x p
Set the above two equations equal, solve for
p, the indifference probability:p= I/(LC)
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We distinguished between the product-costingandcontrolpurposes of standard costs for factoryoverhead
For variable overhead costs, we saw that these twopurposes are the same (see Exhibit 14.1)
For fixed overhead costs, these purposes are different
(see Exhibit 14.3)
Chapter Summary
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For product-costing purposes, we defined the totaloverhead variance for the period as the differencebetween the actual overhead costs incurred and the
overhead costs applied to production using theoverhead application rate
We saw that this total variance is also referred to asthe total over- or under-applied overhead for theperiod
Chapter Summary(continued)
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The total overhead variance for the period can bedecomposed using a four-way, three-way, or two-way analysis:
Four-way analysis= variable overhead spending variance
+ variable overhead efficiency variance + fixed overheadspending (budget) variance + fixed overhead productionvolume variance
Three-way analysis= total overhead spending variance +
variable overhead efficiency variance + fixed overheadproduction volume variance
Two-way analysis= flexible (controllable) budget variance+ fixed overhead production volume variance
Chapter Summary (continued)
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Chapter Summary (continued)
We discussed how to record standard overhead costsin the accounting records and how any standard costvariances for product-costing purposes are disposed ofat the end of the accounting period
We learned how traditional and ABC approaches tooverhead cost analysis differ in terms of insightsprovided to management
We learned how to apply standard costs to serviceorganizations
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We discussed indicated managerial actionsassociated with particular types of errors
We covered the use of control charts, includingstatistical control charts, for monitoring activities andensuring financial control
Finally, we presented in the Appendix a formal
decision approach to the variance-investigationdecision under uncertainty; this decision modelinvolved the use of pay-off tables
Chapter Summary(continued)