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# Managerial Accounting 1 - Cost Behavior and Allocation

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COURSE 34:           MANAGERIAL ACCOUNTING 1 - COST BEHAVIOR AND ALLOCATION
26 pages of outline                                    A.   Cost-Volume-Profit (CVP) Analysis
B.   Variable and Absorption Costing
D.   Process Costing and Job-Order Costing
E.   Activity-Based Costing (ABC)
F.   Service Cost Allocation
G.   Joint Products and By-Products
H.   Standard Costing and Variance Analysis

Course 34 is the first of two courses on managerial accounting. It concerns cost behavior,
that is, whether costs are fixed, variable, or some combination thereof. Cost behavior must be
understood to plan for firm profitability. This course also concerns cost allocation methods.
These methods are used to assign indirect costs to cost objects. The last subunit covers
standard costing and variance analysis.

A.   Cost-Volume-Profit (CVP) Analysis
1.    CVP (breakeven) analysis predicts the relationships among revenues, variable costs,
and fixed costs at various production levels. It determines the probable effects of
changes in sales volume, sales price, product mix, etc.
2.    The variables include
a.    Revenue as a function of price per unit and quantity produced
b.    Fixed costs
c.    Variable cost per unit or as a percentage of sales
d.    Profit per unit or as a percentage of sales
3.    The inherent simplifying assumptions used in CVP analysis are the following:
a.    Costs and revenues are predictable and are linear over the relevant range.
b.    Total variable costs change proportionally with volume, but unit variable costs
are constant over the relevant range.
c.    Changes in inventory are insignificant in amount.
d.    Fixed costs remain constant over the relevant range of volume, but unit fixed
costs vary indirectly with volume.
e.    Selling prices remain fixed.
f.    Production equals sales.
g.    The product mix is constant, or the firm makes only one product.
h.    A relevant range exists in which the various relationships are true for a given time
span.
i.    All costs are either fixed or variable relative to a given cost object.
j.    Productive efficiency is constant.
k.    Costs vary only with changes in physical sales volume.
l.    The breakeven point is directly related to costs and indirectly related to the
budgeted margin of safety and the contribution margin.

2       Course 34: Cost Behavior and Allocation -- Cost-Volume-Profit (CVP) Analysis

4.    Definitions
a.    The relevant range is the set of limits within which the cost and revenue
relationships remain linear and fixed costs are fixed.
b.    The breakeven point is the sales level at which total revenues equal total costs.
c.    The margin of safety is the excess of budgeted sales dollars over breakeven
sales dollars (or budgeted units over breakeven units).
d.    The sales mix is the composition of total sales in terms of various products, i.e.,
the percentages of each product included in total sales. It is maintained for all
volume changes.
e.    The unit contribution margin (UCM) is the unit selling price minus the unit
variable cost. It is the contribution from the sale of one unit to cover fixed costs
(and possibly a targeted profit).
1)    It is expressed as either a percentage of the selling price (contribution
margin ratio) or a dollar amount.
2)    The UCM is the slope of the total cost line plotted so that volume is on the
x axis and dollar value is on the y axis.
5.    Breakeven Formula
a.    P = S --- FC --- VC          If:    P   =   profit (zero at breakeven)
S = XY                              S   =   sales
FC   =   fixed costs
VC   =   variable costs
X   =   quantity of units sold
Y   =   unit sales price
6.    Applications
a.    The basic problem equates sales with the sum of fixed and variable costs.
1)    EXAMPLE: Given a selling price of \$2.00 per unit and variable costs of
40%, what is the breakeven point if fixed costs are \$6,000?
S   =    FC + VC
\$2.00X   =    \$6,000 + \$.80X
\$1.20X   =    \$6,000
X   =    5,000 units at breakeven point

2)    The same result can be obtained by dividing fixed costs by the UCM.
3)    The breakeven point in dollars can be calculated by dividing fixed costs by
the contribution margin ratio.
b.    An amount of profit, either in dollars or as a percentage of sales, may be
required.
1)    EXAMPLE: If units are sold at \$6.00 and variable costs are \$2.00, how
many units must be sold to realize a profit of 15% (\$6.00 x .15 = \$.90 per
unit) before taxes, given fixed costs of \$37,500?
S   =    FC + VC + P
\$6.00X   =    \$37,500 + \$2.00X + \$.90X
\$3.10X   =    \$37,500
X   =    12,097 units at breakeven to earn a 15% profit

Course 34: Cost Behavior and Allocation -- Cost-Volume-Profit (CVP) Analysis                           3

2)    The desired profit of \$.90 per unit is treated as a variable cost. If the
desired profit were stated in total dollars rather than as a percentage, it
would be treated as a fixed cost.
3)    Selling 12,097 units results in \$72,582 of sales. Variable costs are \$24,194
and profit is \$10,888 (\$72,582 x 15%). The proof is that fixed costs of
\$37,500, plus variable costs of \$24,194, plus profit of \$10,888 equals
\$72,582 of sales.
c.    Multiple products may be involved in calculating a breakeven point.
1)    EXAMPLE: If A and B account for 60% and 40% of total sales, respectively,
and the variable cost ratios are 60% and 85%, respectively, what is the
breakeven point, given fixed costs of \$150,000?
S   =   FC + VC
S   =   \$150,000 + .6(.6S) + .85(.4S)
S   =   \$150,000 + .36S + .34S
.30S   =   \$150,000
S   =   \$500,000

a)   In effect, the result is obtained by calculating a weighted-average
contribution margin ratio (30%) and dividing it into the fixed costs to
arrive at the breakeven point in sales dollars.
b) Another approach is to divide fixed costs by the UCM for a
composite unit (when unit prices are known) to determine the
number of composite units. The number of individual units can
then be calculated based on the stated mix.
d.    Sometimes breakeven analysis is applied to analysis of the profitability of special
orders. This application is essentially contribution margin analysis.
1)    EXAMPLE: What is the effect of accepting a special order for 10,000 units
at \$8.00, given the following unit operating data?
Per Unit
Sales                                                      \$12.50
Manufacturing costs -- variable                              (6.25)
-- fixed                               (1.75)
Gross profit                                               \$ 4.50
Selling expenses -- variable                                 (1.80)
-- fixed                                    (1.45)
Operating profit                                           \$ 1.25

a)   The assumptions are that idle capacity is sufficient to manufacture
10,000 extra units, that sale at \$8.00 per unit will not affect the price
or quantity of other units sold, and that no additional selling
expenses are incurred.
b) Because the variable cost of manufacturing is \$6.25, the UCM is
\$1.75 (\$8 special-order price --- \$6.25), and the increase in operating
profit is \$17,500 (\$1.75 x 10,000 units).

4       Course 34: Cost Behavior and Allocation -- Variable and Absorption Costing

B.   Variable and Absorption Costing
1.    These methods result in different inventory values and net profits. They also result in
income statements in which the classification and order of costs are different. Under
absorption (full) costing, all factory overhead costs are assigned to products.
2.    However, variable (direct) costing has won increasing support. This method assigns
variable but not fixed factory overhead to products.
a.    The term direct costing may be misleading because it suggests traceability,
which is not what cost accountants mean when they speak of direct costing.
Many accountants believe that variable costing is a more suitable term, and
some even call the method contribution margin reporting.
3.    Variable and absorption costing are just two of a continuum of possible inventory
costing methods. At one extreme is supervariable costing, which treats direct
materials as the only variable cost. At the other extreme is superabsorption costing,
which treats costs from all links in the value chain as inventoriable.
4.    Under variable costing, all direct labor, direct materials, variable factory overhead
costs, and selling and administrative costs are handled in precisely the same manner
as under absorption costing. Only fixed factory overhead costs are treated
differently. They are expensed when incurred.
a.    EXAMPLE: A firm, during its first month in business, produced 100 units of
product X and sold 80 units while incurring the following costs:
Direct materials                                               \$100
Direct labor                                                    200
Variable factory overhead                                       150
Fixed factory overhead                                          300
1)    Given total costs of \$750, the absorption cost per unit is \$7.50 (\$750 ÷ 100
units). Thus, total ending inventory is \$150 (20 x \$7.50). Using variable
costing, the cost per unit is \$4.50 (\$450 ÷ 100 units), and the total value
of the remaining 20 units is \$90.
2)    If the unit sales price is \$10, and the company incurred \$20 of variable
selling expenses and \$60 of fixed selling expenses, the following income
statements result from using the two methods:

Variable Cost                                 Absorption Cost

Sales                                 \$800       Sales                                \$800
Beginning inventory          \$   0               Beginning inventory       \$    0
Variable cost of                                 Cost of goods
manufacturing                450                 manufactured                 750
\$450                Cost of goods available
Ending inventory              (90)                for sale                 \$750
Variable cost of goods sold           (360)       Ending inventory          (150)
Manufacturing contribution                       Cost of goods sold                   (600)
margin                               \$440       Gross margin                         \$200
Variable selling expenses              (20)      Selling expenses                      (80)
Contribution margin                   \$420         Operating profit                   \$120
Fixed factory overhead                (300)
Fixed selling expenses                 (60)
Operating profit                   \$ 60

Course 34: Cost Behavior and Allocation -- Variable and Absorption Costing                             5

3)    The \$60 difference in operating profit (\$120 --- \$60) is the difference
between the two ending inventory values (\$150 --- \$90). In essence, the
absorption method treats 20% of the fixed factory overhead costs (20% x
\$300 = \$60) as an asset (inventory) because 20% of the month’s
production (100 --- 80 sold = 20) is still on hand. The variable-costing
method assumes that the fixed factory overhead costs are not product
costs because they would have been incurred even if no production had
occurred.
4)    The contribution margin is an important element in the variable costing
income statement. It equals sales minus total variable costs. It indicates
how much sales contribute toward covering fixed costs and providing a
profit.
5.    Variable costing permits the adoption of the contribution approach to performance
measurement. This approach is emphasized because it focuses on controllability.
Fixed costs are much less controllable than variable costs, so the contribution margin
(revenues --- all variable costs) may therefore be a fairer basis for evaluation than
gross margin (also called gross profit), which equals revenues minus cost of sales.
The following contribution approach income statement for a manufacturer is a more
detailed presentation than that on the opposite page:
a.    The profit margin is net profit divided by revenues. It shows the percentage of
revenue dollars resulting in net profit (return on investment).
b.    The manufacturing contribution margin equals revenues minus variable
manufacturing costs.
c.    The contribution margin is the manufacturing contribution minus
nonmanufacturing variable costs.
d.    The short-run performance margin is the contribution margin minus
controllable (discretionary) fixed costs.
1)    Discretionary costs are characterized by uncertainty about the relationship
between input (the costs) and the value of the related output. Examples
are advertising and research costs.
e.    The segment margin is the short-run performance margin minus traceable
(committed) fixed costs.
1)    Committed costs result when a going concern holds fixed assets
(property, plant, and equipment). Examples are insurance, long-term
lease payments, and depreciation.
f.    Net profit is the segment margin minus allocated common costs.
g.    EXAMPLE:              Contribution (Variable Costing) Approach Income Statement
Revenues                                                      \$150,000
Variable manufacturing costs                                   (40,000)
Manufacturing contribution margin                             \$110,000
Variable selling and administrative costs                      (20,000)
Contribution margin                                           \$ 90,000
Controllable fixed costs:
Manufacturing                                  \$30,000
Selling and administrative                      25,000     (55,000)
Short-run performance margin                                  \$ 35,000
Traceable fixed costs
Depreciation                                   \$10,000
Insurance                                        5,000     (15,000)
Segment margin                                                \$ 20,000
Allocated common costs (see next page)                         (10,000)
Net profit                                             \$ 10,000

6       Course 34: Cost Behavior and Allocation -- Variable and Absorption Costing

h.    Allocation of central administration costs (allocated common costs) is a
fundamental issue in responsibility accounting. It has often been made based
on budgeted revenue or contribution margin. If allocation is based on actual
sales or contribution margin, a responsibility center that surpasses expectations
will be penalized (charged with increased overhead).
1)    Research has shown that central administrative costs are allocated to
organizational subunits for the following reasons:
a)   The allocation reminds managers that such costs exist and that the
managers would incur these costs if their operations were
independent.
b) The allocation also reminds managers that profit center earnings
must cover some amount of support costs.
c)   Organizational subunits should be motivated to use central
d) Managers who must bear the costs of central administrative services
that they do not control may be encouraged to exert pressure on
those who do. Thus, they may be able to restrain such costs
indirectly.
2)    If central administrative or other fixed costs are not allocated, responsibility
centers might reach their revenue or contribution margin goals without
covering all fixed costs, a necessity to operate in the long run.
3)    Allocation of overhead, however, is motivationally negative; central
administrative or other fixed costs may appear noncontrollable and be
unproductive. Furthermore,
a)   Managers’ morale may suffer when allocations depress operating
results.
b) Dysfunctional conflict may arise among managers when costs
controlled by one are allocated to others.
c)   Resentment may result if cost allocation is perceived to be arbitrary
or unfair. For example, an allocation on an ability-to-bear basis,
such as operating profit, penalizes successful managers and
rewards underachievers and may therefore have a demotivating
effect.
4)    A much preferred alternative is to budget a certain amount of the
contribution margin earned by each responsibility center to the central
administration based on negotiation. The hoped-for result is for each
subunit to see itself as contributing to the success of the overall entity
rather than carrying the weight (cost) of central administration.
a)   The central administration can then make the decision whether to
expand, divest, or close responsibility centers.
6.    Differences between Variable and Absorption Costing. Under absorption costing,
recurring costs are classified into three broad categories: manufacturing, selling, and
administrative. In the income statement, the cost of goods sold is subtracted from
sales revenue to give the gross margin (profit) on sales. Selling and administrative
expenses are deducted from the gross margin to arrive at operating profit.
a.    Under variable costing, operating profit equals the contribution margin minus
fixed costs.
CIA IV -- SU 7: Cost Behavior and Allocation -- Variable and Absorption Costing                        7

1)    Because fixed factory overhead is not applied to products under variable
costing, no volume variance occurs. However, other variances are the
same under absorption costing and variable costing.
2)    The contribution margin under variable costing is considerably different
from the gross margin under absorption costing.
b.    Inventory costs computed under variable costing are lower than under
absorption costing, and operating profit may be higher or lower, depending
upon whether inventories are increased or liquidated.
1)    When production and sales are equal for a period, the two report the
same operating profit. Total fixed costs budgeted for the period are
charged to sales revenue in the period under both methods.
2)    When production exceeds sales and ending inventories are increased,
the operating profit reported under absorption costing is higher than
under variable costing. Under absorption costing, a portion of the fixed
costs budgeted for the period is deferred to the following period via the
ending inventories. Under variable costing, the total fixed costs are
expensed.
3)    When sales exceed production and ending inventories are decreased,
variable costing yields the higher operating profit. Under absorption
costing, a portion of the fixed costs from the preceding period is carried
forward in beginning inventory. This amount is charged to the current
period’s cost of sales. These fixed costs would already have been
absorbed by operations of the previous period if variable costing had
been used.
4)    Under variable costing, operating profit always moves in the same
direction as sales volume. Operating profit reported under absorption
costing may sometimes move in the opposite direction from sales.
5)    Operating profit differences tend to be larger when calculations are made
for short periods. In the long run, the two methods will report the same
total operating profit if sales equal production. The inequalities between
production and sales are usually minor over an extended period because
production cannot continually exceed sales. An enterprise will not
produce more than it can sell in the long run.
7.    Benefits of Variable Costing for Internal Purposes. For planning and control,
management is more concerned with treating fixed and variable costs separately than
with calculating full costs. Full costs are usually of dubious value because they
contain arbitrary allocations of fixed cost.
a.    Under variable costing, cost data are readily available from accounting records
and statements. For example, CVP relationships and the effects of changes in
sales volume on operating profit can easily be computed from a variable-
costing income statement but not from the absorption-cost income statement.
b.    The full impact of fixed costs on operating profit, partially hidden in inventory
under absorption costing, is emphasized by the presentation of costs on a
variable-costing income statement. Thus, production managers cannot
manipulate operating profit by producing more or fewer products than needed
during a period.

8       Course 34: Cost Behavior and Allocation -- Overhead Allocation

c.    Variable costing is preferable for studies of relative profitability of products,
territories, and other segments. It concentrates on the contribution that each
segment makes to the recovery of fixed costs.
1)    Marginal analysis leads to better pricing.
2)    Out-of-pocket expenditures required to manufacture products conform
closely with the valuation of inventory.
3)    Questions regarding whether a particular component should be made or
bought can be more effectively answered if only variable costs are used.
4)    Disinvestment decisions are facilitated because whether a product or
department is recouping its variable costs can be determined.
5)    Costs are guided by sales. Under variable costing, the cost of goods sold
will vary directly with sales volume, and the influence of production on
operating profit is avoided.

1.    Factory overhead consists of indirect manufacturing costs that cannot be assigned to
specific units of production but are incurred as a necessary part of the production
process. Allocation bases (activity levels) in traditional cost accounting include direct
labor hours, direct labor cost, machine hours, materials cost, and units of production.
An allocation base should have a high correlation with the incurrence of overhead.
2.    The distinction between variable and fixed factory overhead rates should be
understood. Variable factory overhead per unit of the allocation base is assumed to
be constant within the relevant range of activity. Thus, estimation of the variable
factory overhead rate emphasizes the per-unit amount. However, fixed factory
overhead is assumed to be constant in total over the relevant range. Accordingly, the
fixed factory overhead rate is calculated by dividing the total budgeted cost by the
appropriate denominator (capacity) level.
a.    The use of an annual predetermined fixed factory overhead application rate is
often preferred. It smooths cost fluctuations that would otherwise occur as a
result of fluctuations in production from month to month. Thus, higher
overhead costs are not assigned to units produced in low production periods
and vice versa. The denominator of the fixed factory overhead rate may be
defined in terms of various capacity concepts.
1)    Theoretical or ideal capacity is the level at which output is maximized
assuming perfectly efficient operations at all times. This level is
impossible to maintain and results in underapplied overhead.
2)    Practical capacity is theoretical capacity minus idle time resulting from
holidays, downtime, changeover time, etc., but not from inadequate sales
demand.
3)    Normal capacity is the level of activity that will approximate demand over a
period of years. It includes seasonal, cyclical, and trend variations.
Deviations in one year will be offset in other years.
4)    Expected actual activity is a short-run activity level. It minimizes under- or
overapplied overhead but does not provide a consistent basis for
assigning overhead cost. Per-unit overhead will fluctuate because of
short-term changes in the expected production level.

Course 34: Cost Behavior and Allocation -- Overhead Allocation                                         9

3.    Overapplied overhead (a credit balance in factory overhead) results when product
costs are overstated because the activity level was higher than expected or actual
overhead costs were lower than expected.
a.    Underapplied overhead (a debit balance in factory overhead) results when
product costs are understated because the activity level was lower than
expected or actual overhead costs were higher than expected.
b.    Unit variable factory overhead costs and total fixed factory overhead costs are
expected to be constant within the relevant range. Accordingly, when actual
activity is significantly greater or less than planned, the difference between the
actual and predetermined fixed factory overhead rates is likely to be substantial.
However, a change in activity, by itself, does not affect the variable rate.
c.    The treatment of over- or underapplied overhead depends on the materiality of
the amount. If the amount is immaterial, it may be debited or credited to cost of
goods sold.
1)    If the amount is material, it should theoretically be allocated to work-in-
process, finished goods, and cost of goods sold on the basis of the
currently applied overhead in each of the accounts. This procedure will
restate inventory costs and cost of goods sold to the amounts actually
incurred. An alternative is to prorate the variance based on the total
balances in the accounts.
4.    Two factory overhead accounts may be used: factory overhead control and factory
a.    As actual overhead costs are incurred, they are debited to the control account.
As overhead is applied (transferred to work-in-process) based on a
predetermined rate, the factory overhead applied account is credited.
b.    Assuming proration of under- or overapplied overhead, the entry to close the

Cost of goods sold (Dr or Cr)                           \$XXX
Work-in-process (Dr or Cr)                               XXX
Finished goods (Dr or Cr)                                XXX
Factory overhead applied                                 XXX
Factory overhead control                                     \$XXX
5.    The improvements in information technology and decreases in its cost have made a
restated allocation rate method more appealing. This approach is implemented at
the end of the period to calculate the actual overhead rates and then restate every
entry involving overhead. The effect is that job-cost records, the inventory accounts,
and cost of goods sold are accurately stated with respect to actual overhead. This
means of disposing of variances is costly but has the advantage of improving the
analysis of product profitability.
6.    The foregoing discussion assumes that normal costing methods are applied. Under
normal costing, amounts are recorded for direct costs at actual rates and prices times
actual inputs. For indirect costs, budgeted rates are used.
a.    Under actual costing, however, actual rates are used to record indirect costs.
b.    Under budgeted costing, budgeted rates and prices are used for direct costs,
and budgeted rates are used for indirect costs.
c.    In practice, organizations may combine these methods in various ways.
10      Course 34: Cost Behavior and Allocation -- Process Costing and Job-Order Costing

7.    The foregoing discussion also emphasizes cost control systems for manufacturing
entities. However, the basic concepts are also applicable to service and retailing
organizations, although without the complications resulting from the need to account
for inventories. For example, job-order costing principles apply to an audit by an
accounting firm, whereas the costs of routine mail delivery may be controlled using
process costing techniques.

D.   Process Costing and Job-Order Costing
1.    Process cost accounting is used to assign costs to products or services. It is
applicable to relatively homogeneous items that are mass produced on a continuous
basis (e.g., refined oil).
a.   The objective is to determine the portion of cost that is to be expensed because
the products or services were sold and the portion that is to be deferred.
b.   Process costing is an averaging process that calculates the average cost of all
units. Thus, the costs are accumulated by cost centers, not jobs. Moreover, in
a manufacturing setting, work-in-process (WIP) inventory is stated in terms of
equivalent units of production (EUP) so that average costs may be calculated.
c.   A manufacturing entity’s direct materials, direct labor, and factory overhead are
debited to WIP when they are committed to the process.
1)   The sum of these costs and the beginning WIP (BWIP) is the total
production cost to be accounted for in any one period. This total is
allocated to finished goods and to ending WIP (EWIP), which may be
credited for abnormal spoilage.
2)   Direct materials are usually accounted for in a separate account.
Direct materials inventory                                  \$XXX
Accounts payable or cash                                         \$XXX
3)   When direct materials are transferred to WIP, the inventory account is
credited.
4)   Direct labor is usually debited directly to WIP when the payroll is recorded.
Any wages not attributable directly to production, e.g., those for janitorial
services, are considered indirect labor and debited to overhead. Shift
differentials and overtime premium are likewise deemed to be overhead.
However, shift differentials and overtime premium are charged to a
specific job when a customer requirement, rather than a management
decision, causes the differential in the overtime.
WIP                                                         \$XXX
Wages payable                                                     \$XXX
Payroll taxes payable                                              XXX
5)   Indirect costs are debited to a single factory overhead control account (but
see subunit E.).
a)   They include supplies, plant depreciation, etc.
Insurance expense                                           \$XXX
Supplies expense                                             XXX
Depreciation expense (or accum. dep.)                        XXX

Course 34: Cost Behavior and Allocation -- Process Costing and Job-Order Costing                         11

b) To charge all factory overhead incurred over a period, such as a
year, to WIP, factory overhead is credited and WIP is debited on
some systematic basis.
WIP                                                  \$XXX
6)   Transferred-in costs are similar to direct materials added at a point in the
process because both attach to (become part of) the product at that
point, usually the beginning of the process. However, transferred-in
costs are dissimilar because they attach to the units of production that
move from one process to another. Thus, they are the basic units being
produced. By contrast, direct materials are added to the basic units
during processing.
7)   As goods are completed, their cost is credited to WIP and debited to
finished goods. When the finished goods are sold, their cost is debited
to cost of sales. The deferred manufacturing costs are held in the ending
WIP, finished goods inventory, and direct materials inventory accounts.
Finished goods inventory                                              \$XXX
WIP                                                                      \$XXX
Cost of goods sold                                                    \$XXX
Finished goods inventory                                                 \$XXX

8)   In the following T-account illustration, each arrow represents a journal
entry to record a transfer. It indicates a credit to the original account and
a debit to the next account in the sequence.
FLOW OF COSTS THROUGH ACCOUNTS

Cost of
Direct Materials (DM)           Work-in-Process (WIP)       Finished Goods (FG)

BI        DM Used             BWIP        CGM                 BI      CGS
DM Used                         CGM
Pur                                       (Spoilage?)
DL
El                            FOH                             El

EWIP

Cost of Goods Sold (CGS)

Supplies
Indirect labor

Depreciation
Other Indirect
Costs

a)      Cost of goods manufactured (CGM) equals the costs of goods
completed in the current period and transferred to finished goods
(BWIP + DM + DL + FOH --- EWIP).
b) For simplicity, a single overhead account is shown. However, many
accountants prefer to accumulate actual costs (debits) in the
overhead control account and the amounts charged to WIP in a
separate overhead applied account. This account will have a credit
balance. Overhead applied is based on a predetermined rate.
12      Course 34: Cost Behavior and Allocation -- Process Costing and Job-Order Costing

c)   The debits to WIP are the total costs incurred. They equal the sum of
the CGM, EWIP, and abnormal spoilage.
d) Abnormal spoilage is not inherent in the particular process. It is
charged to a loss in the period in which detection occurs.
However, normal spoilage is a product cost included in CGM and
EWIP.
2.    Equivalent units of production (EUP) measure the amount of work performed in
each production phase in terms of fully processed units during a given period. An
equivalent unit is a set of inputs required to manufacture one physical unit.
Calculating EUP for each factor of production facilitates measurement of output and
cost allocation when WIP exists.
a.   Incomplete units are restated as the equivalent amount of completed units. The
calculation is made separately for direct materials (transferred-in costs are
treated as direct materials for this purpose) and conversion cost (direct labor
b.   One equivalent unit is the amount of conversion cost (direct labor and factory
overhead) or direct materials cost required to produce one finished unit.
1)   EXAMPLE: If 10,000 units in EWIP are 25% complete, they equal 2,500
(10,000 x 25%) equivalent units.
2)   Some units may be more advanced in the production process with respect
to one factor than another; e.g., a unit may be 75% complete as to direct
materials but only 15% complete as to direct labor.
c.   The objective is to allocate direct materials costs and conversion costs to finished
goods, EWIP, and, possibly, spoilage based on relative EUP.
d.   Under the FIFO assumption, only the costs incurred this period are allocated
between finished goods and EWIP. Beginning inventory costs are maintained
separately from current-period costs. Thus, goods finished this period are
costed separately as either started last period or started this period.
1)   The FIFO method determines equivalent units by subtracting the work
done on the BWIP in the prior period from the weighted-average total.
e.   The weighted-average assumption averages all direct materials and all
conversion costs (both those incurred this period and those in BWIP). No
differentiation is made between goods started in the preceding and the current
periods.
1)   The weighted-average EUP calculation differs from the FIFO calculation by
the amount of EUP in BWIP. EUP equal the EUP transferred to finished
goods plus the EUP in EWIP. Total EUP completed in BWIP are not
deducted.

Course 34: Cost Behavior and Allocation -- Process Costing and Job-Order Costing                      13

3.    Job-order costing is concerned with accumulating costs by specific job. This
method is at the opposite end of the continuum from process costing. In practice,
organizations tend to combine elements of both approaches. However, a job-order
costing orientation is appropriate when an entity’s products or services have
individual characteristics or when identifiable groupings are possible, e.g., when the
entity produces batches of certain styles or types of furniture.
a.   Units (jobs) should be dissimilar enough to warrant the special record keeping
required by job-order costing. Costs are recorded by classification (direct
materials, direct labor, and factory overhead) on a job-cost sheet specifically
prepared for each job.
b.   The difference between process and job-order costing is often overemphasized.
Job-order costing simply requires subsidiary ledgers to record the additional
details needed to account for specific jobs. However, the totals of subsidiary
ledger amounts should equal the balances of the related general ledger control
accounts. The latter are the basic accounts used in process costing. For
example, the total of all amounts recorded on job-cost sheets for manufacturing
jobs in process equals the balance in the WIP control account.
c.   Source documents for costs incurred include stores’ requisitions for direct
materials and work (or time) tickets for direct labor.
d.   Overhead is usually assigned to each job through a predetermined overhead
rate, e.g., \$3 of overhead for every direct labor hour.
e.   Journal entries record direct materials, direct labor, and factory overhead used
for a specific job. They are similar to the entries used in process costing.
f.   Evaluating the efficiency of the production process under a job-order system
can be accomplished through the use of a standard cost system or by
budgeting costs for each job individually, based on expected materials and
labor usage.
g.   A summary of the accounting process for a manufacturer’s job-order system
follows:
COST ELEMENT                  SOURCE OF DATA
MATERIALS
DIRECT MATERIALS
REQUISITIONS

DIRECT LABOR                    TIME TICKETS            JOB-COST SHEET
(Stored in WIP file)
Predetermined
FACTORY OVERHEAD               rate based on
estimated costs
Work is complete                                        JOB-COST SHEET
(Stored in FG File)

JOB-COST SHEET
Goods are sold                                          (Stored in CGS File)

14      Course 34: Cost Behavior and Allocation -- Activity-Based Costing (ABC)

4.    Operation costing is a hybrid of job-order and process costing systems used by
companies that manufacture batches of similar units that are subject to selected
processing steps (operations). Different batches may pass through different sets of
operations, but all units are processed identically within a given operation.
a.    Operation costing may also be appropriate when different materials are
processed through the same basic operations, such as the woodworking,
finishing, and polishing of different product lines of furniture.
b.    Operation costing accumulates total conversion costs and determines a unit
conversion cost for each operation. This procedure is similar to overhead
allocation. However, direct materials costs are charged specifically to products
as in job-order systems.
c.    More work-in-process accounts are needed because one is required for each
operation.

E.   Activity-Based Costing (ABC)
1.    Key Terms
a.    Cost objects are the intermediate and final dispositions of cost pools.
Intermediate cost objects receive temporary accumulations of costs as the cost
pools move from their originating points to the final cost objects. A final cost
object, such as a job, product, or process, should be logically linked with the
cost pool based on a cause-and-effect relationship.
b.    A cost pool is an account in which a variety of similar costs are accumulated
prior to allocation to cost objects. It is a grouping of costs associated with an
activity. The overhead account is a cost pool into which various types of
overhead are accumulated prior to their allocation.
2.    Activity-based costing (ABC) may be used by manufacturing, service, or retailing
entities and in job-order or process costing systems. It has been popularized
because of the rapid advance of technology, which has led to a significant increase
in the incurrence of indirect costs and a consequent need for more accurate cost
assignment. However, developments in computer and related technology (such as
bar coding) also allow management to obtain better and more timely information at
relatively low cost.
a.    ABC is one means of improving a cost system to avoid what has been called
peanut-butter costing. Inaccurately averaging or spreading costs like peanut
butter over products or service units that use different amounts of resources
results in product-cost cross-subsidization.
1)    This term describes the condition in which the miscosting of one product
causes the miscosting of other products. In the traditional systems
described in subunits C. and D., direct labor and direct materials are
traced to products or service units, a single pool of costs (overhead) is
accumulated for a given organizational unit, and these costs are then
assigned using an allocative rather than a tracing procedure. The effect
is an averaging of costs that may result in significant inaccuracy when
products or service units do not use similar amounts of resources.

Course 34: Cost Behavior and Allocation -- Activity-Based Costing (ABC)                               15

3.    To improve its costing system, an organization can attempt to identify as many direct
costs as economically feasible. It can also increase the number of separate pools for
costs not directly attributable to cost objects.
a.    Each of these pools should be homogeneous; that is, each should consist of
costs that have substantially similar relationships with the driver or other base
used for assignment to cost objects. Thus, choosing the appropriate base,
preferably one with a driver or cause-and-effect relationship (a high correlation)
between the demands of the cost object and the costs in the pool, is another
way to improve a costing system.
4.    ABC attempts to improve costing by assigning costs to activities rather than to an
organizational unit. Accordingly, ABC requires identification of the activities that
consume resources and that are subject to demands by ultimate cost objects.
a.    Design of an ABC system starts with process value analysis, a comprehensive
understanding of how an organization generates its output. It involves a
determination of which activities that use resources are value-adding or
nonvalue-adding and how the latter may be reduced or eliminated.
1)    This linkage of product costing and continuous improvement of processes
is activity-based management (ABM). It encompasses driver analysis,
activity analysis, and performance measurement.
5.    Once an ABC system has been designed, costs may be assigned to the identified
activities, costs of related activities that can be reassigned using the same driver or
other base are combined in homogeneous cost pools, and an overhead rate is
calculated for each pool.
a.    The next step, as in traditional methods, is to assign costs to ultimate cost
objects. In other words, cost assignment is a two-stage process: First, costs
are accumulated for an activity based on the resources it can be directly
observed to use and on the resources it can be assumed to use based on its
consumption of resource drivers (factors that cause changes in the costs of
an activity); second, costs are reassigned to ultimate cost objects on the basis
of activity drivers (factors measuring the demands made on activities).
1)    In ABC, these objects may include not only products and services but also
customers, distribution channels, or other objects for which activity and
resource costs may be accumulated.
6.    An essential element of ABC is driver analysis that emphasizes the search for the
cause-and-effect relationship between an activity and its consumption of resources
and for an activity and the demands made on it by a cost object. For this purpose,
activities and their drivers have been classified in accounting literature as follows:
a.    Unit-level (volume-related) activities occur when a unit is produced, e.g., direct
labor and direct materials activities.
b.    Batch-level activities occur when a batch of units is produced, e.g., ordering,
setup, or materials handling.
c.    Product- or service-level (product- or service-sustaining) activities provide
support of different kinds to different types of output, e.g., engineering
changes, inventory management, or testing.
d.    Facility-level (facility-sustaining) activities concern overall operations, e.g.,
management of the physical plant, personnel administration, or security
arrangements.
16      Course 34: Cost Behavior and Allocation -- Activity-Based Costing (ABC)

7.    Using this model, activities are grouped by level, and drivers are determined for the
activities. Within each grouping of activities, the cost pools for activities that can use
the same driver are combined into homogeneous cost pools. In contrast, traditional
systems assign costs largely on the basis of unit-level drivers.
a.    At the unit level, examples of drivers are direct labor hours or dollars, machine
hours, and units of output.
b.    At the batch level, drivers may include number or duration of setups, orders
processed, number of receipts, weight of materials handled, or number of
inspections.
c.    At the product level, drivers may include design time, testing time, number of
engineering change orders, or number of categories of parts.
d.    At the facility level, drivers may include any of those used at the first three levels.
8.    A difficulty in applying ABC is that, whereas the first three levels of activities pertain to
specific products or services, facility-level activities do not. Thus, facility-level costs
are not accurately assignable to products. The theoretically sound solution may be
to treat these costs as period costs. Nevertheless, organizations that apply ABC
ordinarily assign them to products to obtain a full absorption cost suitable for external
financial reporting in accordance with GAAP.
9.    As the foregoing discussion indicates, an advantage of ABC is that overhead costs are
accumulated in multiple cost pools related to activities instead of in a single pool for a
department, process, plant, or company. ABC also is more likely than a traditional
system to assign costs to activities and reassign them to ultimate cost objects using a
base that is highly correlated with the resources consumed by activities or with the
demands placed on activities by cost objects.
a.    Furthermore, process value analysis provides information for eliminating or
reducing nonvalue-adding activities (e.g., scheduling production, moving
components, waiting for the next operating step, inspecting output, or storing
inventories). The result is therefore not only more accurate cost assignments,
especially of overhead, but also better cost control and more efficient
operations.
b.    A disadvantage of ABC is that it is costly to implement because of the more
detailed information required. Another disadvantage is that ABC-based costs of
products or services may not conform with GAAP; for example, ABC may
assign research costs to products but not such traditional product costs as
plant depreciation, insurance, or taxes.
10. Organizations most likely to benefit from using ABC are those with products or
services that vary significantly in volume, diversity of activities, and complexity of
operations; relatively high overhead costs; or operations that have undergone major
technological or design changes.
a.    However, service organizations may have some difficulty in implementing ABC
because they tend to have relatively high levels of facility-level costs that are
difficult to assign to specific service units. They also engage in many
nonuniform human activities for which information is not readily accumulated.
Furthermore, output measurement is more problematic in service than in
manufacturing entities. Nevertheless, ABC has been adopted by various
insurers, banks, railroads, and health care providers.

Course 34: Cost Behavior and Allocation -- Service Cost Allocation                                    17

F.   Service Cost Allocation
1.    Service (support) department costs are considered part of overhead (indirect costs).
Thus, they cannot feasibly be traced to cost objects and therefore must be allocated
to the operating departments that use the services.
a.    When service departments also render services to each other, their costs may be
allocated to each other before allocation to operating departments.
2.    Four criteria are used to allocate costs.
a.    Cause and effect should be used if possible because of its objectivity and
acceptance by operating management.
b.    Benefits received is the most frequently used criterion when cause and effect
cannot be determined. However, it requires an assumption about the benefits
of costs, for example, that advertising promoting the company but not specific
products increased sales by the various divisions.
c.    Fairness is sometimes mentioned in government contracts but appears to be
more of a goal than an objective allocation base.
d.    Ability to bear (based on profits) is usually unacceptable because of its
dysfunctional effect on managerial motivation.
3.    The direct method is the simplest and most common method of service cost
allocation. It allocates costs directly to the producing departments without
recognition of services provided among the service departments.
a.    No attempt is made to allocate the costs of service departments to other service
departments under the direct method.
b.    Allocations of service department costs are made only to production
departments based on their relative use of services.
4.    The step or step-down method includes an allocation of service department costs to
other service departments in addition to the producing departments.
a.    The allocation may begin with the costs of the service department that
1)    Provides the highest percentage of its total services to other service
departments,
2)    Provides services to the greatest number of other service departments, or
3)    Has the greatest dollar cost of services provided to other service
departments.
b.    The costs of the remaining service departments are then allocated in the same
manner, but no cost is assigned to service departments whose costs have
c.    The process continues until all service department costs are allocated.

18      Course 34: Cost Behavior and Allocation -- Joint Products and By-Products

5.    The reciprocal method is the most theoretically sound. It allows reflection of all
reciprocal services among service departments. It is also known as the
simultaneous-solution method, cross-allocation method, matrix-allocation method, or
double-distribution method.
a.    The step method considers only services rendered among service departments
in one direction, but the reciprocal method considers services in both
directions.
1)    If all reciprocal services are recognized, linear algebra may be used to
reach a solution. The typical problem on a professional examination can
be solved using two or three simultaneous equations.

G. Joint Products and By-Products
1.    Definitions
a.    When two or more separate products are produced by a common
manufacturing process from a common input, the outputs from the process are
joint products. The joint costs of two or more joint products with significant
values are usually allocated to the joint products at the point at which they
became separate products.
b.    By-products are one or more products of relatively small total value that are
produced simultaneously from a common manufacturing process with
products of greater value and quantity (joint products).
c.    Joint costs (sometimes called common costs) are incurred prior to the split-off
point to produce two or more goods manufactured simultaneously by a single
process or series of processes. Joint costs, which include direct materials,
direct labor, and overhead, are not separately identifiable and must be allocated
to the individual joint products.
d.    At the split-off point, the joint products acquire separate identities. Costs
incurred after split-off are separable costs.
e.    Separable costs can be identified with a particular joint product and allocated to
a specific unit of output. They are the costs incurred for a specific product after
the split-off point.
2.    Several methods are used to allocate joint costs. Each assigns a proportionate
amount of the total cost to each product on a quantitative basis.
a.    The physical-unit method is based on some physical measure such as volume,
weight, or a linear measure.
b.    The sales-value method is based on the relative sales values of the separate
products at split-off.
c.    The estimated net realizable value (NRV) method is based on final sales value
minus separable costs.
d.    The constant gross margin percentage NRV method is based on allocating
joint costs so that the percentage is the same for every product.
1)    This method determines the overall percentage, deducts the appropriate
gross margin from the final sales value of each product to calculate total
costs for that product, and then subtracts the separable costs to arrive at
the joint cost amount.

Course 34: Cost Behavior and Allocation -- Joint Products and By-Products                             19

3.    Joint costs are normally allocated to joint products but not by-products. The most
cost-effective method for the initial recognition of by-products is to account for their
value at the time of sale as a reduction in the cost of goods sold or as a revenue.
Thus, cost of sales does not exist for by-products.
a.    The alternative is to recognize their value at the time of production, a method
that results in the recording of by-product inventory. Under this method, the
value of the by-product may also be treated as a reduction in cost of goods
sold or as a separate revenue item. The value to be reported for by-products
may be sales revenue, sales revenue minus a normal profit, or estimated net
realizable value.
b.    Regardless of the timing of their recognition in the accounts, by-products
usually do not receive an allocation of joint costs because the cost of this
accounting treatment ordinarily exceeds the benefit. However, allocating joint
costs to by-products is acceptable. In that case, they are treated as joint
products despite their small relative values.
c.    Although scrap is similar to a by-product, joint costs are almost never allocated
to scrap.
4.    The relative sales value method is the most frequently used way to allocate joint costs
to joint products. It allocates joint costs based upon each product’s proportion of
total sales revenue.
a.    For joint products salable at the split-off point, the relative sales value is the
selling price at split-off.
b.    If further processing is needed, the relative sales value may be approximated by
subtracting the additional anticipated processing and marketing costs from the
final sales value to arrive at the estimated net realizable value.
c.    Thus, the allocation of joint costs to Product X is determined as follows:
Sales value or NRV of X
× Joint costs
Total sales value or NRV of joint products
5.    In determining whether to sell a product at the split-off point or process the item further
at additional cost, the joint cost of the product is irrelevant because it is a sunk
a.    The cost of additional processing (incremental costs) should be weighed against
the benefits received (incremental revenues). The sell-or-process decision
should be based on that relationship.

20      Course 34: Cost Behavior and Allocation -- Standard Costing and Variance Analysis

H.   Standard Costing and Variance Analysis
1.    Standard costs are budgeted unit costs established to motivate optimal productivity
and efficiency. A standard cost system is designed to alert management when the
actual costs of production differ significantly from target or standard costs.
a.    A standard cost is a monetary measure with which actual costs are compared.
b.    A standard cost is not an average of past costs but a scientifically determined
estimate of what costs should be.
c.    A standard cost system can be used in both job-order and process costing
systems to isolate variances.
d.    Because of the effect of fixed costs, standard costing is most effective in a flexible
budgeting system.
e.    When actual costs and standard costs differ, the difference is a variance.
1)    A favorable (unfavorable) variance arises when actual costs are less
(greater) than standard costs.
2)    Management will usually set standards so that they are currently attainable.
a)    If standards are set too high (or tight), they may be ignored by
workers, or morale may suffer.
3)    Standard costs must be kept current. If prices have changed considerably
for a particular raw material, there will always be a variance if the standard
cost is not changed. Much of the usefulness of standard costs is lost if a
large variance is always expected.
f.    Standard costs are usually established for materials, labor, and factory overhead.
2.    Direct materials variances are usually divided into price and efficiency components.
Part of a total materials variance may be attributed to using more raw materials than
the standard and part to a cost that was higher than standard.
a.    The direct materials quantity (usage) variance (an efficiency variance) is the
actual quantity minus standard quantity, times standard price: (AQ --- SQ)SP.
b.    The direct materials price variance is the actual price minus the standard price,
times the actual quantity: (AP --- SP)AQ.
1)    The price variance may be isolated either at the time of purchase or at the
time of transfer to WIP. The advantage of the former method is that the
variance is identified earlier.
a)    Normal spoilage is considered in the calculation of standard direct
materials cost per unit.

Course 34: Cost Behavior and Allocation -- Standard Costing and Variance Analysis                     21

c.    The direct materials quantity (usage) variance is sometimes supplemented by
the direct materials mix variance and the direct materials yield variance.
1)    These variances are calculated only when the production process involves
combining several materials in varying proportions (when substitutions
are allowable in combining materials).
2)    The direct materials mix variance equals total actual quantity times the
difference between the weighted-average unit standard cost of the
budgeted mix of ingredients and the weighted-average unit standard cost
of the actual mix.
3)    The direct materials yield variance is the weighted-average unit standard
cost of the budgeted mix multiplied by the difference between the actual
quantity of materials used and the standard quantity.
4)    Certain relationships may exist among the various materials variances. For
instance, an unfavorable price variance may be offset by a favorable mix
or yield variance because materials of better quality and higher price are
used. Also, a favorable mix variance may result in an unfavorable yield
variance, or vice versa.
d.    Productivity measures are related to the efficiency, mix, and yield variances.
Productivity is the relationship between outputs and inputs (including the mix of
inputs). The higher this ratio, the greater the productivity.
1)    A partial productivity measure may be stated as the ratio of output to the
quantity of a single factor of production (e.g., materials, labor, or capital).
2)    Partial productivity measures, for example, the number of finished units per
direct labor hour or per pound of direct materials, are useful when
compared over time, among different factories, or with benchmarks. A
partial productivity measure comparing results over time determines
whether the actual relationship between inputs and outputs has
improved or deteriorated.
3)    A disadvantage of a partial productivity measure is that it relates output to a
single factor of production and therefore does not consider substitutions
among input factors. Thus, total factor productivity ratios may be
calculated to compensate for that drawback. Total productivity is the
ratio of output to the cost of all inputs used.
a)    This ratio will increase from one period to the next as technological
improvements permit greater output to be extracted from a given
amount and mix of inputs. Use of a less costly input mix also
increases the ratio.
b) Accordingly, the change in total costs from one period to the next is
attributable to three factors: output levels, input prices, and
quantities and mix of inputs.
c)    In the same way that a variance can be decomposed into
components, the effect of each of the foregoing factors can be
isolated by holding the others constant. Refer to the diagram on
the following page. For example, the cost of Year Two output can
be calculated based on Year One input prices and input
relationships (actual inputs that would have been used in Year One
to produce the Year Two output). The difference between this
amount and actual Year One costs is the change in costs
attributable solely to output change.

22      Course 34: Cost Behavior and Allocation -- Standard Costing and Variance Analysis

d) Similarly, the cost of Year Two output at Year Two prices based on
Year One input relationships can also be calculated. The difference
between this amount and the cost of Year Two output based on
Year One input prices and input relationships is the change in costs
attributable to price changes.
e)   The difference between the actual cost of Year Two output and the
cost of Year Two output based on Year Two prices and Year One
input relationships is the change attributable solely to the change in
the quantities and mix of inputs.
f)   Diagram of factors causing the cost change

Year Two Costs                     Year Two Costs
Actual                 at Year Two Prices                 at Year One Prices             Actual
Year Two                 and Year One Input                 and Year One Input            Year One
Costs                  for Year Two Output                for Year Two Output             Costs

Input Quantities                         Price                           Output

3.    Direct labor variances are similar to direct materials variances. For example, the
direct labor rate and efficiency variances are calculated in much the same way as the
direct materials price and quantity variances, respectively.
4.    Factory overhead variances include variable and fixed components.
a.    The total variable factory overhead variance is the difference between actual
variable factory overhead and the amount applied based on the budgeted
application rate and the standard input allowed for the actual output.
1)    In four-way analysis of variance, it includes the
a)   Spending variance -- the difference between actual variable factory
overhead and the product of the budgeted application rate and the
actual amount of the allocation base (activity level or amount of
input)
b) Efficiency variance -- the budgeted application rate times the
difference between the actual input and the standard input allowed
for the actual output
i)      Variable factory overhead applied equals the flexible-budget
amount for the actual output level. The reason is that unit
variable costs are assumed to be constant within the relevant
range. The third column in the diagram below gives the
flexible budget amount (also the amount applied).
ii)     If variable factory overhead is applied on the basis of output,
not inputs, no efficiency variance arises.
iii)    Diagram of variable factory overhead variances

Standard Input Allowed
Actual Input                 for Actual Output
Actual Variable                              ×                                ×
Factory Overhead                    Budgeted Application Rate      Budgeted Application Rate

Spending                                          Efficiency
Variance                                          Variance

Course 34: Cost Behavior and Allocation -- Standard Costing and Variance Analysis                          23

b.    The total fixed factory overhead variance is the difference between actual fixed
factory overhead and the amount applied based on the budgeted application
rate and the standard input allowed for the actual output.
1)    In four-way analysis of variance, it includes the
a)    Budget variance (spending variance) -- the difference between
actual fixed factory overhead and the amount budgeted
b) Volume variance (idle capacity variance, production volume
variance, or output-level variance) -- the difference between
budgeted fixed factory overhead and the product of the budgeted
application rate and the standard input allowed for the actual output
i)    Fixed factory overhead applied does not necessarily equal the
flexible-budget amount for the actual output. The reason is
that the latter amount is assumed to be constant over the
relevant range of output. Thus, the second column in the
diagram below represents the flexible-budget amount, and the
third column represents the amount applied.
ii)   No efficiency variance is calculated because budgeted fixed
factory overhead is a constant at all relevant output levels.
2)    Diagram of fixed factory overhead variances
Standard Input Allowed
for Actual Output
Actual Fixed                        Budgeted Fixed                                 ×
Factory Overhead                     Factory Overhead                    Budgeted Application Rate

Budget                                            Volume
Variance                                           Variance

c.    The total overhead variance also may be divided into two or three variances (but
one variance is always the fixed overhead volume variance).
1)    Three-way analysis divides the total overhead variance into volume,
efficiency, and spending variances.
a)    The spending variance combines the fixed overhead budget and
variable overhead spending variances.
b) The variable overhead efficiency and fixed overhead volume
variances are the same as in four-way analysis.
2)    Two-way analysis divides the total overhead variance into two variances:
volume and controllable (the latter is sometimes called the budget, total
overhead spending, or flexible-budget variance).
a)    The variable overhead spending and efficiency variances and the
fixed overhead budget variance are combined.
5.    Sales variances are used to evaluate the selling departments. If a firm’s sales differ
from the amount budgeted, the difference could be attributable to either the sales
price variance or the sales volume variance (sum of the sales mix and quantity
variances). The analysis of these variances concentrates on contribution margins
because fixed costs are assumed to be constant.

24      Course 34: Cost Behavior and Allocation -- Standard Costing and Variance Analysis

a.    EXAMPLE (single product): A firm has budgeted sales of 10,000 units at \$17 per
unit. Variable costs are expected to be \$10 per unit, and fixed costs are
budgeted at \$50,000. Thus, the company anticipates a contribution margin of
\$70,000 and a net income of \$20,000. However, the actual results are
Sales (11,000 units)                       \$ 176,000
Variable costs                              (110,000)
Contribution margin                        \$ 66,000
Fixed costs                                  (50,000)
Net income                                 \$ 16,000

1)    Sales were greater than predicted, but the contribution margin is less than
expected. The \$4,000 discrepancy can be analyzed in terms of the sales
price variance and the sales volume variance.
2)    For a single-product firm, the sales price variance is the reduction in the
contribution margin because of the change in selling price. In the
example, the actual selling price of \$16 per unit is \$1 less than expected.
Thus, the sales price variance is \$1 times 11,000 units actually sold, or
\$11,000 unfavorable.
3)    For the single-product firm, the sales volume variance is the change in
contribution margin caused by the difference between the actual and
budgeted volume. In this case, it is \$7,000 favorable (\$7 budgeted UCM x
1,000-unit increase in volume).
4)    The sales mix variance is zero because the firm sells one product only.
Hence, the sales volume variance equals the sales quantity variance.
5)    The sales price variance (\$11,000 unfavorable) combined with the sales
volume variance (\$7,000 favorable) equals the total change in the
contribution margin (\$4,000 unfavorable).
6)    The same analysis may be done for cost of goods sold. The average
production cost per unit is used instead of the average unit selling price,
but the quantities for production volume are the same as those used for
sales quantity. Accordingly, the overall variation in gross profit is the sum
of the variation in revenue plus the variation in CGS.
b.    If a company produces two or more products, the sales variances reflect not
only the effects of the change in total unit sales but also any difference in the
mix sold.
1)    In the multiproduct case, the sales price variance may be calculated as in
5.a.2) for each product. The results are then added. An alternative is to
multiply the actual total units sold times the difference between the
weighted-average price based on actual units sold at actual unit prices
and the weighted-average price based on actual units sold at budgeted
prices.
2)    One way to calculate the multiproduct sales volume variance is to
determine the variance for each product as in 5.a.3) above and to add
the results. An alternative is to determine the difference between the
following:
a)    Actual total unit sales times the budgeted weighted-average UCM for
the actual mix
b) Budgeted total unit sales times the budgeted weighted-average UCM
for the planned mix

Course 34: Cost Behavior and Allocation -- Standard Costing and Variance Analysis                     25

3)    The sales quantity variance (the sales volume variance for a single-
product company) is the difference between the budgeted contribution
margin based on actual unit sales and the budgeted contribution margin
based on expected sales, assuming that the budgeted sales mix is
constant. One way to calculate this variance is to multiply the budgeted
UCM for each product times the difference between the budgeted unit
sales of the product and its budgeted percentage of actual total unit sales
and then to add the results.
a)    An alternative is to multiply the difference between total actual unit
sales and the total expected unit sales by the budgeted weighted-
average UCM based on the expected mix.
4)    The sales mix variance is the difference between the budgeted
contribution margin for the actual mix and actual total quantity of
products sold and the budgeted contribution margin for the expected
mix and actual total quantity of products sold. One way to calculate this
variance is to multiply the budgeted UCM for each product times the
difference between actual unit sales of the product and its budgeted
percentage of actual total unit sales and then to add the results.
a)    An alternative is to multiply total actual unit sales times the difference
between the budgeted weighted-average UCM for the expected mix
and the budgeted weighted-average UCM for the actual mix.
c.    The components of the sales quantity variance are the market size and the
market share variances.
1)    The market size variance equals the budgeted market share percentage,
times the difference between the actual market size in units and the
budgeted market size in units, times the budgeted weighted-average
UCM.
2)    The market share variance equals the difference between the actual
market share percentage and the budgeted market share percentage,
times the actual market size in units, times the budgeted weighted-
average UCM.
6.    Journal Entries. Variances usually do not appear on the financial statements of a
firm. They are used for managerial control and are recorded in the ledger accounts.
a.    When standard costs are recorded in inventory accounts, variances are also
recorded. Thus, direct labor is recorded as a liability at actual cost, but it is
charged to WIP control at its standard cost for the standard quantity used. The
direct labor rate and efficiency variances are recognized at that time.
1)    Direct materials, however, should be debited to materials control at
standard prices at the time of purchase. The purpose is to isolate the
direct materials price variance as soon as possible. When direct materials
are used, they are debited to WIP at the standard cost for the standard
quantity, and the materials quantity variance is then recognized.
b.    Actual overhead costs are debited to overhead control and credited to accounts
payable, wages payable, etc. Applied overhead is credited to an overhead
applied account and debited to WIP control.
1)    The simplest method of recording the overhead variances is to wait until
year-end. The variances can then be recognized separately when the
overhead control and overhead applied accounts are closed (by a credit
and a debit, respectively). The balancing debits or credits are to the
variance accounts.

26      Course 34: Cost Behavior and Allocation -- Standard Costing and Variance Analysis

c.    The following are the entries to record variances. Favorable variances are credits
and unfavorable variances are debits:
1)    Materials control (AQ × SP)                                       \$XXX
Direct materials price variance (Dr or Cr)                         XXX
Accounts payable (AQ × AP)                                                \$XXX
2)    WIP control (SQ × SP)                                              XXX
Direct materials quantity variance (Dr or Cr)                      XXX
Direct labor rate variance (Dr or Cr)                              XXX
Direct labor efficiency variance (Dr or Cr)                        XXX
Materials control (AQ × SP)                                                XXX
Wages payable (AQ × AP)                                                    XXX
3)    Overhead control (actual)                                          XXX
Wages payable (actual)                                                      XXX
Accounts payable (actual)                                                   XXX
4)    WIP control (standard)                                             XXX
Overhead applied (standard)                                                 XXX
5)    Overhead applied (standard)                                        XXX
Variable overhead spending variance (Dr or Cr)                     XXX
Variable overhead efficiency variance (Dr or Cr)                   XXX
Fixed overhead budget variance (Dr or Cr)                          XXX
Fixed overhead volume variance (Dr or Cr)                          XXX
Overhead control (actual)                                                  XXX
6)    The result of the foregoing entries is that WIP contains standard costs only.
d.    Disposition of variances. Immaterial variances are customarily closed to cost of
goods sold or income summary.
1)    Variances that are material may be prorated. A simple approach to
proration is to allocate the total net variance to work-in-process, finished
goods, and cost of goods sold based on the balances in those accounts.
However, more complex methods of allocation are possible.
e.    Several alternative approaches to the timing of recognition of variances are
possible. For example, direct materials and labor might be transferred to WIP at
their actual quantities. In that case, the direct materials quantity and direct labor
efficiency variances might be recognized when goods are transferred from WIP
to finished goods.
1)    Furthermore, the direct materials price variance might be isolated at the
time of transfer to WIP. These methods, however, delay the recognition
of variances. Early recognition is desirable for control purposes.