Accounting: The Language of Business - Vol. 1 (Part 139)

You can’t be the accountant in your accounting firm.
Michael Gerber

 Performance Evaluation Using Variances from Standard Costs (Part F)

by

Charles Lamson

Fixed Factory Overhead Volume Variance

Using currently attainable standards, Western Rider Inc. set its budgeted normal capacity at 5,000 direct labor hours. This is the amount of expected capacity that management believes will be used under normal business conditions. You should note that this amount may be much less than the total available capacity if management believes demand will be low.

The fixed factory overhead volume variance is the difference between the budgeted fixed overhead at 100% of normal capacity and the standard fixed overhead for the actual production achieved during the period. The volume variance measures the use of fixed overhead resources. If the standard fixed overhead exceeds the budgeted overhead at 100% of normal capacity, the variance is favorable. Thus, the firm used its plant and equipment more than would be expected under normal operating conditions. If the standard fixed overhead is less than the budgeted overhead at 100% of normal capacity, the variance is unfavorable. Thus, the company used its plant and equipment less than would be expected under normal operating conditions.

The volume variance for Western Rider Inc. is shown in the following calculation:

Exhibit 6 illustrates the volume variance graphically. For Western Rider Inc., the budgeted fixed overhead is $12,000 at all levels. The standard fixed overhead at 5,000 hours is also $12,000. This is the point at which the standard fixed overhead line intersects the budgeted fixed cost line. For actual volume greater than 100% of normal capacity, the volume variance is favorable. For volume at less than 100% of normal volume, the volume variance is unfavorable. For Western Rider Inc., the volume variance is unfavorable because the actual production is 4,000 standard hours, or 80% of normal volume. The amount of the volume variance, $2,400, can be viewed as the cost of the unused capacity ($1,000).

EXHIBIT 6 Graph of Fixed Overhead Volume Variance

An unfavorable volume variance may be due to such factors as failure to maintain an even flow of work, machine breakdowns, repairs causing work stoppages, and failure to obtain enough sales orders to keep the factory operating at normal capacity. Management should determine the causes of the unfavorable variance and consider taking corrective action. A volume variance caused by an uneven flow of work, for example, can be remedied by changing operating procedures. Volume variances caused by lack of sales orders may be corrected through increased advertising or other sales effort.

Volume variances tend to encourage manufacturing managers to run the factory above the normal capacity. This is favorable when the additional production can be sold. However, if the additional production cannot be sold and must be stored as inventory, favorable volume variances may actually be harmful. For example, one paper company ran paper machines above normal volume in order to create favorable volume variances. Unfortunately, this created a six months' supply of finished goods inventory that had to be stored in public warehouses. The "savings" from the very favorable volume variances were exceeded by the additional inventory carrying costs. By creating incentives for manufacturing managers to overproduce, the volume variances produced goal conflicts as we described in a preceding post.

Reporting Factory Overhead Variances

The total factory overhead cost variance is the difference between the actual factory overhead and the total overhead applied to production. This calculation is as follows:

The factory overhead cost variance may be broken down by each variable factory overhead cost and fixed factory overhead cost element in a factory overhead cost variance report. Such a report, which is useful to management in controlling costs, is shown in Exhibit 7. The report indicates both the controllable variables (variables whose values are determined by the decision process and/or decision maker) and the volume variance (the difference between the actual quantity sold or consumed and the budgeted amount expected to be sold or consumed, multiplied by the standard price per unit).

EXHIBIT 7  Factory Overhead Cost Variance Report

Factory Overhead Variances and the Factory Overhead Account

At the end of the period, the factory overhead account normally has a balance. As we discussed in an earlier post, a debit balance in Factory Overhead is underapplied overhead, while a credit balance is overapplied overhead. This end of period balance, which represents the difference between actual overhead incurred and applied overhead, is also the total factory overhead variance for the period. A debit balance, underapplied overhead, represents an unfavorable total factory overhead variance, while a credit balance, overapplied overhead, is a favorable variance.

To illustrate, the factory overhead account for Western Rider Inc. For the month ending June 30, 2023, is shown below.

The $1,600 overapplied factory overhead is the favorable total factory cost variance shown in Exhibit 7. The variable factory overhead controllable variance and the volume variance can be computed using the factory overhead account and comparing it with the budget total overhead for the actual amount produced. As shown below the difference between the actual overhead incurred and the budgeted overhead is the controllable variables. The difference between the applied overhead and the budgeted overhead is the volume variance.

If the actual factory overhead exceeds (is less than) the budgeted factory overhead, the controllable variance is unfavorable (favorable). In contrast, if the applied factory overhead is less than (exceeds) the budgeted factory overhead, the volume variance is unfavorable (favorable). This is because, when the applied overhead is less than the budgeted overhead, the company has operated at less than normal capacity, and thus the volume variance is unfavorable.

It is also possible to break down many of the individual factory overhead cost variances into quantity and price variances, similar to direct materials and direct labor. For example, the indirect factory wages variance may include both time and rate variances. Likewise, the indirect materials variance may include both a quantity variance and a price variance.

*WARREN,REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 926-930*

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Katy Trail: Bikepacking America's Longest Rail Trail

Accounting: The Language of Business - Vol. 1 (Part 138)

To get qualified accountants, it’s extremely difficult.

Craig Scott

 Performance Evaluation Using Variances from Standard Costs (Part E)

by

Charles Lamson

Factory Overhead Variances

Factory overhead costs are more difficult to manage than are direct labor and material costs. This is because the relationship between production volume and indirect costs is not easy to determine. For example, when production is increased, the direct materials will increase. But what about the engineering department overhead? The relationship between production volume and cost is less clear for the engineering department. Companies normally respond to this difficulty by separating factory overhead into variable and fixed costs. For example, manufacturing supplies are considered variable to production volume, whereas straight-line plant depreciation is considered fixed. In the following sections, we discuss the approaches used to budget and control factory overhead by separating overhead into fixed and variable components.

The Factory Overhead Flexible Budget

A flexible budget may be used to determine the impact of changing production on fixed and variable factory overhead cost. The standard overhead rate is determined by dividing the budgeted factory overhead costs by the standard amount of productive activity, such as direct labor hours. Exhibit 5 is a flexible factory overhead budget for Western Rider Inc.

EXHIBIT 5 Factory Overhead Cost Budget Indicating Standard Factory Overhead Rate

In Exhibit 5, the standard factory overhead cost rate is $6. It is determined by dividing the total budgeted cost of 100% of normal capacity by the standard hours required at 100% of normal capacity, or $30,000 / $5,000 = $6 per hour. This rate can be subdivided into $3.60 per hour for variable factory overhead ($18,000 / 5000 hours) and $2.40 per hour for fixed factory overhead ($12,000 / $5,000).

Variances from standard for factory overhead cost result from:

1. Actual variable factory overhead cost greater or less than budgeted variable factory overhead for actual production.

2. Actual production at a level above or below 100% of normal capacity.

The first factor results in the controllable variables for variable overhead costs. The second factor results in a volume variance for fixed overhead costs. We will discuss each of these variances next.

Variable Factory Overhead Controllable Variance

The variable factory overhead controllable variance is the difference between the actual variable overhead incurred and the budgeted variable overhead for actual production. The controllable variance measures the efficiency of using variable overhead resources. Thus, if the actual variable overhead is less than the budgeted variable overhead, the variance is unfavorable.

To illustrate, recall that Western Rider Inc. produced 5,000 pairs of XL jeans in June. Each pair requires 0.80 standard labor hour for production. As a result, Western Rider Inc. had 4,000 standard hours at actual production (5,000 jeans x 0.80 hour). This represents 80% of normal productive capacity (4,000 hours / 5,000 hours). The standard variable overhead at 4,000 hours worked, according to the budget in Exhibit 5, was $14,000 (4,000 direct labor hours * $3,600). The following actual factory overhead costs were incurred in June:

The controllable variance can be calculated as follows:

The variable factory overhead controllable variance indicates management's ability to keep the factory overhead costs within the budget limits. Since variable factory overhead costs are normally controllable at the department level, responsibility for controlling this variance usually rests with department supervisors. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 925-926*

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Katy Trail: Day 327 of 365 of Training for Trek across Missouri via the ...

Accounting: The Language of Business - Vol. 1 (Part 137)

The prudent heir takes careful inventory of his legacies and gives a faithful accounting to those whom he owes an obligation of trust.
John F. Kennedy

Performance Evaluation Using Variances from Standard Costs (Part D) 

by

Charles Lamson

Direct Labor Variances

Western Rider Inc.'s direct labor cost variance can be separated into two parts. Recall that the direct labor standards from Exhibit 1 (from part 136 and reintroduced below) are as follows:

Rate standard: $8 per hour

 Time standard: 0.80 hour per pair of XL jeans]

The actual production (5,000 pairs) is multiplied by the time standard (0.80) hour per pair to determine the number of standard direct labor hours budgeted. The standard direct labor hours are then multiplied by the standard rate per hour ($9) to determine the standard direct labor cost at actual volumes. These calculations are shown below.

EXHIBIT 2 Budget Performance Report

Assume that the actual total cost for direct labor during June 2023 was as follows: 

Recall from part 135 that unfavorable variance is an accounting term that describes instances where actual costs are greater than the standard (estimates of the actual costs in a company's production process), or projected costs (estimated costs based on the previous period's sales and expenses). An unfavorable variance can alert management that the company's profit will be less than expected.

Bearing this in mind, the total unfavorable cost variance $2,500 ($38,500 - $36,000) results from an excess rate of $1 per direct labor hour and using 150 fewer direct labor hours. These two reasons can be reported as two separate variances, as we discuss next.

Direct Labor Rate Variance

The direct labor rate variance is the difference between the actual rate ( the full amount paid for direct labor divided by the full amount for direct labor hours) per hour ($10) and the standard rate (rate of hourly pay) per hour ($9), multiplied by the actual hours worked (3,850 hours). The variance is favorable. If the actual rate per hour exceeds the standard rate per hour, the variance is unfavorable, as shown below for Western Rider Inc. 

Direct Labor Time Variance

The direct labor time variance is the difference between the actual hours worked (3,850 hours) and the standard hours (the amount of work achievable, at the expected level of efficiency, in an hour) at actual production (4,000 hours), multiplied by the standard rate per hour ($9). If the actual hours worked exceed the standard hours, the variance is unfavorable. If the actual hours worked are less than the standard hours, the variance is favorable, as shown below for Western Rider Inc.

Direct Labor Variance Relationships

The direct labor variances can be illustrated by making the 3 calculations shown in Exhibit 4.

EXHIBIT 4 Direct Labor Variance Relationships

Reporting Direct Labor Variances

Controlling direct labor cost is normally the responsibility of the production supervisors. To aid them, reports analyzing the cause of any direct labor variance may be prepared. Differences between standard direct labor hours and actual direct labor hours can be investigated. For example, the time variance may be incurred because of the shortage of skilled workers. Such variances may be uncontrollable unless they are related to high turnover rates among employees, in which case the cause of the high turnover should be investigated.

Likewise, differences between the rates paid for direct labor and the standard rates can be investigated. For example, unfavorable rate variances may be caused by the improper scheduling and use of workers. In such cases, skilled, highly paid workers may be used in jobs that are normally performed by unskilled, lower-paid workers. In this case, the unfavorable rate variance should be reported for corrective action to the managers who schedule work assignments. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 923-925*

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Katy Trail: Day 326 of 365 of Training for Trek across Missouri via the ...

Katy Trail: Day 325 of 365 of Training for Trek across Missouri via the ...

Accounting: The Language of Business - Vol. 1 (Part 136)

Use your accounting power for good!
Unknown

 Performance Evaluation Using Variances from Standard Costs (Part C)

by

Charles Lamson

Direct Materials Variances

What caused Western Rider Inc.'s unfavorable materials variance of $2,650? The direct materials standards from Exhibit 1 (from part 135 and reintroduced below) are as follows:

Price standard: $5.00 per square yard

Quantity standard: 1.5 square yards per pair of XL jeans

To determine the number of standard square yards of denim budgeted, multiply the actual production for June 2023 (5,000 pairs) for the quantity standard (1.5 square yards per pair). Then multiply the standard square yards by the standard price per square yard ($5) to determine the standard budgeted cost at the actual volume. The calculation is as follows:

EXHIBIT 2 Budget Performance Report

The calculation assumes that there is no change in the beginning and ending materials inventory. Thus, the amount of materials budgeted for production equals the amount purchased.

Assume that the actual total cost for denim used during June 2023 was as follows:

The total unfavorable cost variance of $2,650 ($40,150 - $37,500) results from an excess price per square yard of $0.50 and using 200 fewer square yards of denim. These two reasons can be reported as two separate variances, as shown in the next sections.

Direct Materials Price Variance

The direct materials price variance is the difference between the actual price per unit ($5.50) and the standard price per unit ($5), multiplied by the actual quantity used (7,300 square yards). If the actual price per unit exceeds the standard price per unit, the variance is unfavorable, as shown for Western Rider Inc. If the actual price per unit is less than the standard price per unit, the variance is favorable. The calculation for Western Rider Inc. is as follows:

Direct Materials Quantity Variance

The direct materials quantity variance is the difference between the actual quantity used (7,300 square yards) and the standard quantity at actual production (7,500 square yards), multiplied by the actual standard price per unit ($5). If the actual quantity of materials used exceeds the standard quantity budgeted, the variance is unfavorable. If the actual quantity of materials used is less than the standard quantity, the variance is favorable, as shown for Western Rider Inc.:

Direct Materials Variance Relationships

The direct materials variances can be illustrated by making the three calculations shown in Exhibit 3.

EXHIBIT 3 Direct Materials Variance Relationships

Reporting Direct Materials Variances

The direct materials quantity variance should be reported to the proper operating management level for corrective action. For example, an unfavorable quantity variance might have been caused by manufacturing equipment that has not been properly maintenanced or operated. However, unfavorable materials quantity variances are not always caused by operating departments. For example, the excess materials usage may be caused by purchasing inferior raw materials. In this case, the Purchasing Department should be held responsible for the variance.

The materials price variance should normally be reported to the purchasing department, which may or may not be able to control this variance. If materials of the same quality could have been purchased from another supplier at the standard price, the variance was controllable. On the other hand, if the variance resulted from a market-wide price increase, the variance may not be controllable. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 921-923*

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Katy Trail: Day 324 of 365 of Training for Trek across Missouri via the ...