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1 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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 Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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). Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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 Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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 Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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 Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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) Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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 Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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 Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited. 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. Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. 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