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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
                                                             C.   Overhead Allocation
                                                             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.


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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

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        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).




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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




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        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

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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
                                  administrative services appropriately.
                            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.
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        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.


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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.

C.   Overhead Allocation
      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.

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        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
             overhead applied.
             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
                    overhead accounts is

                          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.
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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
                                Factory overhead                                             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.
                                       Factory overhead                          $XXX
                                           Insurance expense                                           $XXX
                                           Supplies expense                                             XXX
                                           Depreciation expense (or accum. dep.)                        XXX


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        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
                                                  Factory overhead                                        $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)
                          Factory Overhead (FOH)

                           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.
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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
                   and factory overhead).
             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.




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        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)




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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.




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        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.
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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.


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        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
                    already been allocated.
             c.    The process continues until all service department costs are allocated.




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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.


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        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
             (already expended) cost.
             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.




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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.




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        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.


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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

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        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.



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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


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        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.

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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.




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