Standard Costs and Responsibility Accounting

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					Lesson 14
The accurate determination of a company's product costs provides managers with valuable information that can be used in a variety of ways to improve a company's performance. It's especially useful in helping management control its product costs. For example, a simple comparison of a company's costs per unit of production from one period to the next might highlight increasing costs that could be easily avoided through more focused management effort.

Lesson 14
Standard Costs and Responsibility Accounting

Although this simple monitoring of changing costs over time can be an effective tool in helping managers control costs, an additional and probably even more useful approach would involve the comparison of current costs with some budgeted amount reflecting management's goals and expectations. When comparing actual costs over time, increases and decreases can be identified and acted upon, but there's no assurance that any prior month's costs represent a benchmark or standard of what management believes is the lowest cost possible under the circumstances. All a comparison with prior costs does is indicate whether those costs have gone up or down. That's important to know, but its even more important to know how those costs compare to what management thinks those costs really should be if the company was operating at the highest level of performance possible.

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Standard Costs
Standard costs represent management's goals relative to a product's cost per unit of production. In most cases, those costs are determined based on the combined input of all of a company's managers having some responsibility or control over product costs, including managers involved in product design, raw material purchases, the hiring of production personnel and the general operation of the production department. In addition, a company's general manager and controller will also usually be involved in the final determination of a product's standard cost. In effect, standard costs are a company's budgeted costs per unit of production.
Perry Shirt Manufacturing Standard Cost Card - Basic Extra-Large Men's T-Shirt
Standard Quantity Standard Price or Rate Cost/Unit

In the establishment of a product's standard costs, should those standards be set at levels that reflect ideal performance that will seldom if ever be achieved, or should they be set at more reasonable levels? Most companies choose "tight but attainable" standards on the belief that such standards can actually have a greater motivating influence on employees. When actual performance is compared against attainable standards, any resulting unfavorable variances highlight opportunities for improvement. If unrealistically high standards are set, then unfavorable variances become the norm rather than the exception, and, as a result, such variances lose their significance as a managerial tool.

Direct materials Direct labor Mfg. overhead *

1.5 yards (Grade A cotton fabric) .10 hour .10 hour

x x x

$1.40/yd.* $16/hr. $8/hr. Total

= = =

$2.10 $1.60 $ .80 $4.50

Includes the purchase price plus any freight and other costs associated with the purchase and receipt of the materials used.

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"Management by Exception"
An approach that emphasizes the comparison of actual results to standards, budgets and other expected or desired measures of performance to highlight deviations that call for management attention.

A comparison of standard versus actual costs incurred in Perry Shirt Manufacturing's production of its Basic Extra-Large Men's T-Shirt in the month of October, 20X5. Actual Costs/October
Production Costs # Units Produced Cost per Unit Quantity Usage Quantity per Unit Price or Rate

Direct materials Direct labor Manufacturing Overhead Total

$240,000 $165,000 $ 87,000 $492,000

100,000 100,000 100,000

$2.40 $1.65 $ .87 $4.92

160,000 yds. 11,000 hours 11,000 hours

1.6 yds. .11 hr. .11 hr.

$1.50/yd. $15.00/hr. $7.91/hr.

Standard Cost Card - Basic Extra-Large Men's T-Shirt
Standard Quantity Standard Price or Rate Cost/Unit

Direct materials Direct labor Mfg. overhead

1.5 yards .10 hour .10 hour

$1.40/yd. $16/hr. $8/hr. Total Variance Analysis = = = = =
Variance per Unit

x x x

= = =

$2.10 $1.60 $ .80 $4.50

Actual Cost/Unit

Total Breakdown: Direct materials Direct labor Mfg. overhead

$4.92 $2.40 $1.65 $ .87

-

Standard Cost/Unit

# Units

$4.50 $2.10 $1.60 $ .80

$.42 (U) $.30 (U) $.05 (U) $.07 (U)

x Produced x 100,000 x x x 100,000 100,000 100,000

Variance = = $42,000 (U)

= $30,000 (U) = $ 5,000 (U) = $ 7,000 (U) $42,000 (U)

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14-1

Who is it in the company's management that's really responsible for this direct material variance? That depends. It depends on whether this variance is the result of higher than expected material prices or the use of excess materials in the production process. If the variance is the result of higher than expected prices, then the company's purchasing manager will probably be the one responsible for addressing this variance and improving the company's future performance. On the other hand, if the problem was due to excess material usage, then the production manager is probably the one responsible for solving this problem. What we really need to do here is figure out what portion, if any, of this $30,000 variance is attributable to higher than expected prices and what portion is due to excess material usage.
Direct materials Direct labor Manufacturing Overhead Total

Actual Costs/October
Production Costs # Units Produced Cost per Unit Quantity Usage Quantity per Unit Price or Rate

$240,000 $165,000 $ 87,000 $492,000

100,000 100,000 100,000

$2.40 $1.65 $ .87 $4.92

160,000 yds. 11,000 hours 11,000 hours

1.6 yds. .11 hr. .11 hr.

$1.50/yd. $15.00/hr. $7.91/hr.

Standard Cost Card - Basic Extra-Large Men's T-Shirt
Standard Quantity Standard Price or Rate Cost/Unit

Direct materials Direct labor Mfg. overhead

1.5 yards .10 hour .10 hour

x x x

$1.40/yd. $16/hr. $8/hr. Total

= = =

$2.10 $1.60 $ .80 $4.50

Variance Analysis
Actual Cost/Unit

Total Breakdown: Direct materials Direct labor Mfg. overhead

$4.92 $2.40 $1.65 $ .87

-

Standard Cost/Unit

$4.50 $2.10 $1.60 $ .80

= = = = =

Variance per Unit

# Units

$.42 (U) $.30 (U) $.05 (U) $.07 (U)

x Produced x 100,000 x x x 100,000 100,000 100,000

Variance = = $42,000 (U)

= $30,000 (U) = $ 5,000 (U) = $ 7,000 (U) $42,000 (U)

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Materials Price Variance ( Actual Price - Standard Price ) ( $1.50/yd. - $1.40/yd. ) $.10/yd. x Actual Quantity x 160,000 yds.

$16,000 Unfavorable Materials Quantity (Usage) Variance ( Actual Quantity - Standard Quantity ) ( 160,000 yd. - 150,000 yd.* ) 10,000 yd. $14,000 Unfavorable * Based on the standard of 1.5 yards per shirt x 100,000 shirts produced. x x Standard Price $1.40/yd.

These variances are then separately accounted for through a journal entry made to record the transfer of direct materials from raw materials inventory to WIP:
WIP Inventory ($1.40/yd. x 150,000 yds.) Materials Price Variance ($ .10 x 160,000 yds.) Materials Quantity Variance (10,000 yds. x $1.40) Raw Materials Inventory ($1.50/yd. x 160,000 yds.) 210,000 16,000 14,000 240,000

These variance accounts serve a useful managerial purpose, but for financial reporting purposes, any balances in these variance accounts at the end of the period must be closed out to either WIP, finished goods and/or cost of goods sold, based on the relative amount of direct materials included in the ending balances of those accounts. In actual practice, the total amounts of these variances are usually closed out to cost of goods sold based on the fact that most of a company's WIP inventory is completed and sold by the end of the period. However, when that's not the case, an allocation of some portion of these variance amounts should be made to WIP and finished goods as well as cost of goods sold.

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Our ultimate goal here is to use this variance information to better control the company's product costs. That requires a company's management to identify and act on the underlying causes behind those variances. For Perry Shirt Manufacturing, the company's unfavorable materials price variance could be the result of higher than expected supplier prices, failure to take advantage of available volume or purchase discounts, and/or as higher than expected freight costs. Generally speaking, the company's purchasing manager would be the one responsible for investigating and ferreting out the source of this unfavorable variance, and then taking action, if possible, to improve the company's future performance. However, in some cases, higher material prices and freight costs result from rush orders caused by poor production planning. In that case, the responsibility for this variance might properly fall to the company's production manager. Unfavorable material quantity variances typically reflect higher than expected material waste or spoilage in the production process incurred as a result of untrained workers, poor supervision, malfunctioning equipment and/or the use of inferior materials. In most cases, the production manager is the one to address these problems; however, responsibility for inferior materials might rest with a company's purchasing department. In some cases, a company's price and quantity standards may simply be unrealistic. In those cases, more reasonable standards should be considered to produce variances that highlight real opportunities for improved performance.

Labor Rate Variance ( Actual Rate ( $15/hr. - Standard Rate ) x - $16/hr. ) x $1/hr. $11,000 Favorable Actual Hours 11,000 hrs.

Labor Efficiency (Quantity) Variance ( Actual Hours - Standard Hours ) x ( 11,000 hrs. - 10,000 hrs. ) x 1,000 hrs. $16,000 Unfavorable Standard Rate $16/hr.

* .10 standard hours per shirt x 100,000 shirts produced.

Journal entry to record these labor costs:
WIP Inventory ($16/hr. x 10,000 hrs.) Labor Efficiency Variance 1,000 hrs. x $16 hrs. Labor Rate Variance $1 x 11,000 hrs. Cash or Wages Payable ($15/hr. x 11,000 hrs.) 160,000 16,000 11,000 165,000

These variance accounts are, in effect, temporary accounts used to highlight variances for management use, but at the end of the period they must be closed out to WIP, finished goods and/or cost of goods sold as appropriate to reflect those amounts at their actual cost. In most cases, these accounts are simply closed out to cost of goods sold.

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14-2

Problem 14-1

In most cases, an unfavorable labor efficiency variance results when employees lack proper supervision, are poorly trained or lack adequate motivation. In addition, equipment breakdowns, poor quality of materials and unreasonable standards can contribute to unmet goals in terms of labor hours. Generally speaking, a company's production manager assumes responsibility for addressing these variances as long they fall within his/her control. However, if inferior materials are the cause of production slowdowns, then the purchasing manager is probably the one to follow up on that problem. Labor rate variances often result when a company uses higher or lower skilled employees for certain production jobs. In this case, Perry's favorable labor rate variance may be the result of lower skilled and lower paid employees put to work in tasks that typically require higher skilled employees. If that's true, then that may also explain the cause behind the higher than expected labor hours worked during the period. Lower skilled workers will usually take more time to complete a task. If that's the case, then the labor rate and efficiency variances should probably be evaluated on a combined basis to determine their net affect on the company's profits. In some cases, unfavorable labor rate variances are caused by higher than expected overtime pay or the unplanned use of higher paid temporary employees. If that's the result of poor production planning then a company's production manager will assume responsibility for future improvement. However, if production scheduling is complicated by inaccurate sales forecasts then improved projections from the company's sales manager may be the solution to this problem.

Material and Labor Variances
Given the following information for Carmack, Inc. for the month of June, 20X8:
Actual costs incurred in the production of 400 units: $ 7,000 Direct materials purchased (1,000 lbs. at $7/lb.) 900 lbs. Direct materials used $11,000 Direct labor incurred (550 hours at $20/hr.) Standard costs per unit: Direct materials (2lbs. at $7.50/lb.) Direct labor (1.4 hours. at $18/hr.) $15.00 $25.20

Determine the company's: a. Materials price variance recorded at the time of purchase. b. Material quantity variance. c. Labor rate variance. d. Labor efficiency variance. Prepare journal entries to record the company's purchase and use of materials as well as its labor costs so that all inventories are carried at standard and all variances are separately recorded. Prepare closing entries for all of the recorded variances assuming they are all closed to cost of goods sold at the end of the period.

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Problem 14-1 - Answer

Problem 14-1 - Answer

Material and Labor Variances
a. Materials price variance recorded at the time of purchase:
( Actual Price - Standard Price ) ( $7.00/lb. - $7.50/lb. ) $ .50/lb. $500 Favorable x Actual Quantity x 1,000 lbs. x 1,000 lbs.

Material and Labor Variances
c. Labor rate variance:
( Actual Rate ( $20/hr. - Standard Rate ) x - $18/hr. ) x x $2/hr. $1,100 Unfavorable Actual Hours 550 hrs. 550 hrs.

b. Material quantity variance:
( Actual Quantity ( 900 lbs. - Standard Quantity ) - 800 lbs.* ) 100 lbs. $750 Unfavorable * 2 lbs. per unit x 400 units produced. x x x Standard Price $7.50/lb. $7.50/lb.

d. Labor efficiency variance:
( Actual Hours ( 550 hrs. - Standard Hours ) - 560 hrs.* ) 10 hrs. $180 Favorable x x x Standard Rate $18/hr. $18/hr.

* 1.4 standard hours per unit x 400 units produced.

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Problem 14-1 - Answer

Problem 14-1 - Answer

Journal entry to record the purchase of materials:
Raw Materials Inventory $7.50/lb. x 1,000 lbs. Materials Price Variance $.50 x 1,000 lbs. Cash or A/P $7.00/lb. x 1,000 lbs. 7,500 500 7,000

Closing entries:

Materials Price Variance Cost of Goods Sold Cost of Goods Sold Materials Quantity Variance Cost of Goods Sold Labor Rate Variance

500 750 1,100 180

500 750 1,100 180

Journal entry to record the use of materials:
WIP Inventory 800 lbs. x $7.50/lb. Materials Quantity Variance 100 lbs. x $7.50/lb. Raw Materials Inventory 900 lbs. x $7.50/lb. 6,000 750 6,750

Labor Efficiency Variance Cost of Goods Sold
Or combined closing entry:

Journal entry to record labor costs:
WIP Inventory $18/hr. x 560 hrs.* Labor Rate Variance $2/hour x 550 hrs. Labor Efficiency Variance 10 hrs. x $18/hr. Cash or Wages Payable $20/hr. x 550 hrs. * 1.4 standard hours per unit x 400 units. 10,080 1,100 180 11,000

Materials Price Variance Labor Efficiency Variance Cost of Goods Sold Materials Quantity Variance Labor Rate Variance

500 180 1,170 750 1,100

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14-3

Problem 14-2

Problem 14-2

Material and Labor Variances
Given the following information for Harkin Company.
Actual results: Number of direct material yards purchased Total cost of direct labor incurred Total cost of direct material yards purchased Number of units produced Number of direct material yards used Direct labor rate per hour Standard costs: Price per yard of direct materials Number of direct material yards per unit Direct labor rate per hour Number of direct labor hours per unit 20,000 yards. $46,000 $84,000 12,000 units 22,000 yards $23.00 $4.00 1.5 yards $21.00 0.15 hours

Material and Labor Variances
Given the following information for Harkin Company.
Actual results: Number of direct material yards purchased Total cost of direct labor incurred Total cost of direct material yards purchased Number of units produced Number of direct material yards used Direct labor rate per hour Standard costs: Price per yard of direct materials Number of direct material yards per unit Direct labor rate per hour Number of direct labor hours per unit 20,000 yards. $46,000 $84,000 12,000 units 22,000 yards $23.00 $4.00 1.5 yards $21.00 0.15 hours

Determine the company's: a. Materials price variance recorded at the time of purchase. b. Material quantity variance. c. Labor rate variance. d. Labor efficiency variance.

Questions: Who would typically be responsible for a company's unfavorable materials price variance and what might be some of the causes for that variance? Who would typically be responsible for a company's unfavorable materials quantity variance and what might be some of the causes for that variance?

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Problem 14-2 - Answer

Problem 14-2 - Answer

Material and Labor Variances
a. Materials price variance recorded at the time of purchase:
( Actual Price - Standard Price ) ( $4.20/yd - $4/yd. ) $ .20/yd x Actual Quantity x 20,000 yds. x 20,000 yds.

Material and Labor Variances
c. Labor rate variance:
( Actual Rate ( $23/hr. - Standard Rate ) x - $21/hr. ) x x $2/hr. $4,000 Unfavorable Actual Hours 2,000 hrs. 2,000 hrs.

$4,000 Unfavorable

b. Material quantity variance:
( Actual Quantity - Standard Quantity ) ( 22,000 yds. - 18,000 yds.* ) 4,000 yds. $16,000 Unfavorable * 1.5 standard yards per unit x 12,000 units produced. x x x Standard Price $4/yd. $4/yd.

d. Labor efficiency variance:
( Actual Hours ( 2,000 hrs. - Standard Hours ) x - 1,800 hrs.* ) x x 10 hrs. $4,200 Unfavorable Standard Price $21/hr. $21/hr.

* .15 standard hours x 12,000 units produced.

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Problem 14-2 - Answer

Problem 14-2 - Answer

Questions: Who would typically be responsible for a company's unfavorable materials price variance and what might be some of the causes for that variance? Answer: Generally speaking a company's purchasing manager is responsible for any unfavorable materials price variance.
Because material prices may depend on the supplier used, the number of units purchased, payment terms, and the mode and timing of delivery, some common causes of this variance might be: 1. Higher than expected supplier prices. 2. Failure to take advantage of volume or purchase discounts. 3. Higher than expected freight costs. In some cases higher prices and delivery costs may be associated with rush orders that are actually the result of poor production scheduling. In that case the production manager would be the responsible party rather than the purchasing manager. Sometimes this variance is simply the result of unreasonable standards.

Questions: Who would typically be responsible for a company's unfavorable materials quantity variance and what might be some of the causes for that variance? Answer: Generally speaking a company's production manager is responsible for any unfavorable materials quantity variance.
In most cases this variance indicates higher than expected material waste or spoilage resulting from inexperienced and untrained workers, poor planning and supervision, and/or mechanical breakdowns in the production process. In the event waste or spoilage is the result of poor quality materials, then the purchasing manager may be the one responsible for the failure to meet expectations. In some cases, the company's standards may simply be unreasonable.

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14-4

Perry Shirt Manufacturing
Actual Costs/October Basic Extra-Large Men's T-Shirt
Production Costs # Units Produced Cost per Unit Quantity Usage Quantity per Unit Price or Rate

Manufacturing Overhead
Actual costs 87,000 80,000 Application to WIP ($8/hr. 10,000 hrs. *) * .10 hrs/unit 100,000 units

Direct materials Direct labor Manufacturing Overhead Total

$240,000 $165,000 $ 87,000 $492,000

100,000 100,000 100,000

$2.40 $1.65 $ .87 $4.92

160,000 yds. 11,000 hours 11,000 hours

1.6 yds. .11 hr. .11 hr.

$1.50/yd. $15.00/hr. $7.91/hr.

Standard Cost Card - Basic Extra-Large Men's T-Shirt
Standard Quantity Standard Price or Rate Cost/Unit

Under-applied overhead (Unfavorable variance)

7,000 7,000 0 Closing entry

Direct materials Direct labor Mfg. overhead

1.5 yards .10 hour .10 hour

$1.40/yd. $16/hr. $8/hr. Total Variance Analysis = = = = =
Variance per Unit

x x x

= = =

$2.10 $1.60 $ .80 $4.50

Closing entry:

Actual Cost/Unit

Total Breakdown: Direct materials Direct labor Mfg. overhead

$4.92 $2.40 $1.65 $ .87

-

Standard Cost/Unit

# Units

$4.50 $2.10 $1.60 $ .80

$.42 (U) $.30 (U) $.05 (U) $.07 (U)

x Produced x 100,000 x x x 100,000 100,000 100,000

Variance = = $42,000 (U)

Cost of Goods Sold Manufacturing Overhead

7,000

7,000

= $30,000 (U) = $ 5,000 (U) = $ 7,000 (U) $42,000 (U)

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Standard = $8/hr. predetermined x .10 hrs/unit = $ .80/unit Overhead Cost overhead rate

Which of the company's various overhead costs exceeded management's budgeted goals?
To answer that question, we're going to need a further breakdown of the $7,000 variance, which requires a more detailed breakdown of both the company's standard and actual manufacturing overhead costs.

Predetermined = Overhead Rate

Total budgeted overhead costs for the upcoming period Total budget for a measurable activity or cost that correlates with or drives overhead costs over the same period of time

In this case, we'll assume the company's $8 rate was determined at the beginning of the year (20X5) based on management's budgeted costs and direct labor hours for the upcoming year. We'll also assume the company plans to produce 960,000 shirts during the course of the year, and based on that amount, has budgeted manufacturing overhead costs at a total of $768,000. In addition, the company's budgeted direct labor hours, based on its .10 standard direct labor hours per unit, comes to 96,000 hours. Given that information:

$8/hr. =

$768,000 96,000 hours

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Detailed Manufacturing Overhead Budget For the year, 20X5
Budget per Hour Total Budgeted Hours Total Budgeted Costs

Variable Manufacturing Overhead Variances October
Actual
Costs* Hours Rate/hr. Rate/hr.

Standard/Budget
Hours Costs

Variable costs per hour: Indirect materials Factory utilities Repairs and maintenance Total variable

$1.00/hr. 2.00/hr. .50/hr. $3.50/hr.
Budget per Month

x x x

96,000 hrs. 96,000 hrs. 96,000 hrs.

= = =

$ 96,000 192,000 48,000 $336,000

Variable costs: x 10,000** $14,000 - 11,000 = $1.27 $1.00 Indirect materials x 10,000 21,000 - 11,000 = 1.91 2.00 Factory utilities x 10,000 15,000 - 11,000 = 1.36 .50 Repair/maintenance $50,000 $4.54 $3.50 Total variable * Actual costs incurred in the company's production of 100,000 shirts. ** 100,000 shirts at a standard of .10 hours per shirt

= = =

$10,000 20,000 5,000 $35,000

Total Variable Manufacturing Overhead Variance = $15,000 Unfavorable

Variable Manufacturing Overhead Spending Variance
x x x 12 months 12 months 12 months = = = $240,000 48,000 144,000 $432,000 $768,000 ( Actual Rate ( $4.54/hr. - Standard Rate ) x - $3.50/hr. ) x $1.04/hr. $11,440 Unfavorable
($11,500 if no rounding error)

Fixed costs per month: Indirect labor Equipment depreciation Building rent Total fixed costs Total costs

Actual Hours 11,000 hrs.

$20,000/mo. 4,000/mo. 12,000/mo. $36,000/mo.

Variable Manufacturing Overhead Efficiency (Quantity) Variance
( Actual Hours - Standard Hours ) x ( 11,000 hrs. - 10,000 hrs. ) x 1,000 hrs. $3,500 Unfavorable Standard Rate $3.50/hr.

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14-5

Variable Manufacturing Overhead Variances October
Actual
Costs* Hours Rate/hr. Rate/hr.

Variable Manufacturing Overhead Variances October
Actual
Costs Costs* Hours Rate/hr. Rate/hr.

Standard/Budget
Hours

Standard/Budget
Hours Costs

Variable costs: x 10,000** $14,000 - 11,000 = $1.27 $1.00 Indirect materials x 10,000 21,000 - 11,000 = 1.91 2.00 Factory utilities x 10,000 15,000 - 11,000 = 1.36 .50 Repair/maintenance $50,000 $4.54 $3.50 Total variable * Actual costs incurred in the company's production of 100,000 shirts. ** 100,000 shirts at a standard of .10 hours per shirt

= = =

$10,000 20,000 5,000 $35,000

Variable costs: x 10,000** $14,000 - 11,000 = $1.27 $1.00 Indirect materials x 10,000 21,000 - 11,000 = 1.91 2.00 Factory utilities x 10,000 15,000 - 11,000 = 1.36 .50 Repair/maintenance $50,000 $4.54 $3.50 Total variable * Actual costs incurred in the company's production of 100,000 shirts. ** 100,000 shirts at a standard of .10 hours per shirt

= = =

$10,000 20,000 5,000 $35,000

Total Variable Manufacturing Overhead Variance = $15,000 Unfavorable

Total Variable Manufacturing Overhead Variance = $15,000 Unfavorable

Indirect Materials Spending Variance
( Actual Rate ( $1.27/hr. - Standard Rate ) x - $1.00/hr. ) x $ .27/hr. $2,970 Unfavorable
($3,000 if no rounding error)

Repairs and Maintenance Spending Variance
( Actual Rate ( $1.36/hr. - Standard Rate ) x - $ .50/hr. ) x $ .86/hr. $9,460 Unfavorable
($9,500 if no rounding error)

Actual Hours 11,000 hrs.

Actual Hours 11,000 hrs.

Indirect Materials Efficiency Variance
( Actual Hours - Standard Hours ) x ( 11,000 hrs. - 10,000 hrs. ) x 1,000 hrs. $1,000 Unfavorable Standard Rate $1.00/hr.

Repairs and Maintenance Efficiency Variance
( Actual Hours - Standard Hours ) x ( 11,000 hrs. - 10,000 hrs. ) x 1,000 hrs. $500 Unfavorable Standard Rate $ .50/hr.

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Fixed Manufacturing Overhead Variances October
Fixed costs: Indirect labor Equip. depreciation Building rent Total fixed costs
Actual Costs Standard/ Budgeted Costs

Costs Applied to WIP

Summary of Total Manufacturing Overhead Variances October

$20,000 5,000 12,000 $37,000

$20,000 4,000 12,000 $36,000

$45,000*

Fixed Manufacturing Overhead Budget Variance = $1,000 Unfavorable Fixed Manufacturing Overhead Volume Variance = $9,000 Favorable**
* Fixed manufacturing overhead costs that were included in the company's total application of overhead to WIP during the period. That amount's based on: Total application of overhead ($8.hr. x 10,000 hours) Deduct: Applied overhead attributable to variable costs ($3.50/hr. x 10,000 hours) Fixed costs included in the application of overhead to WIP $80,000 (35,000) $45,000

Variable: Spending variance Efficiency variance Fixed: Budget variance Volume variance Total

$11,500 (U) 3,500 (U) 1,000 (U) 9,000 (F) 7,000 (U) *

* The difference between the total actual overhead costs incurred and the total standard overhead cost applied to WIP.

** Reflects the benefit of having fixed costs in a period of higher than expected production volume. A company's fixed cost per unit goes down with increasing volume. That's because a company's fixed costs are effectively spread out over more units, resulting in a lower cost per unit. In this case, the company's average monthly production was budgeted at 80,000 shirts per month (960,000 total shirts 12 months). However, in the month of October, the company's actual production was 100,000 shirts, which effectively reduced the company's fixed costs per unit for the period.

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Perry Shirt Manufacturing
Actual Costs/October Basic Extra-Large Men's T-Shirt
Production Costs # Units Produced Cost per Unit Quantity Usage Quantity per Unit Price or Rate

Problem 14-3

Variable Manufacturing Overhead Variances
Given the following information for Harper, Inc. in the year 20X6:
Budgeted amounts for the year:
Total direct labor hours Total variable manufacturing overhead costs Total fixed manufacturing overhead costs Total units of production 200,000 hours $400,000 $300,000 10,000 units 1,000 units 800 units $34,200 $26,500 15,000 hours
1.6 yds. .11 hr. .11 hr. $1.50/yd. $15.00/hr. $7.91/hr.

Direct materials Direct labor Manufacturing Overhead Total

$240,000 $165,000 $ 87,000 $492,000

100,000 100,000 100,000

$2.40 $1.65 $ .87 $4.92

160,000 yds. 11,000 hours 11,000 hours

Standard Cost Card - Basic Extra-Large Men's T-Shirt
Standard Quantity Standard Price or Rate Cost/Unit

Data provided for the month of March:
Budgeted units of production Actual number of units produced Actual variable manufacturing overhead costs Actual fixed manufacturing overhead costs Actual direct labor hours worked

Direct materials Direct labor Mfg. overhead

1.5 yards .10 hour .10 hour

$1.40/yd. $16/hr. $8/hr. Total Variance Analysis = = = = =
Variance per Unit

x x x

= = =

$2.10 $1.60 $ .80 $4.50

Determine the following for the month of March assuming the company applies manufacturing overhead to WIP on the basis of direct labor hours:
A. Variable manufacturing overhead rate used in the application of variable manufacturing overhead costs to WIP inventory. B. Variable manufacturing overhead spending variance. C. Variable manufacturing overhead efficiency variance.

Actual Cost/Unit

Total Breakdown: Direct materials Direct labor Mfg. overhead

$4.92 $2.40 $1.65 $ .87

-

Standard Cost/Unit

$4.50 $2.10 $1.60 $ .80

$.42 (U) $.30 (U) $.05 (U) $.07 (U)

x x x x x

# Units Produced

100,000 100,000 100,000 100,000

Variance = = $42,000 (U)

= $30,000 (U) = $ 5,000 (U) = $ 7,000 (U) $42,000 (U)

Question: Generally speaking, what causes an unfavorable variable manufacturing overhead efficiency variance?

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14-6

Problem 14-3 - Answer

Problem 14-3 - Answer

Variable Manufacturing Overhead Variances
A. Variable manufacturing overhead rate used in the application of variable manufacturing overhead costs to WIP inventory.
Variable manufacturing overhead rate: $400,000 200,000 hrs. = $2.00/hr.

Question: Generally speaking, what causes an unfavorable variable manufacturing overhead efficiency variance?
Answer: The basic cause of an unfavorable efficiency variance is a higher than budgeted level of direct labor hours, or other activity or cost serving as the basis for the company's standard predetermined overhead rate. Whether that basis is direct labor hours, machine hours, direct material costs or any other activity or cost that drives the company's manufacturing overhead, an unfavorable variance results if more of those hours or costs are incurred in the production process than would be expected given the company's current level of production.

B. Variable manufacturing overhead spending variance.
( Actual Rate - Standard Rate ) x Actual Hours ( $2.28/hr. - $2.00/hr. ) 15,000 hrs. x $ .28/hr. 15,000 hrs. x $4,200 Unfavorable

C. Variable manufacturing overhead efficiency variance.
( Actual Hours - Standard Hours ) x ( 15,000 hrs. - 16,000 hrs.* ) x 1,000 hrs. x $2,000 Favorable Standard Price $2.00/hr. $2.00/hr.

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Problem 14-4

Problem 14-4 - Answer

Closing Variance Accounts
Given the following information for Corbin, Inc. at the end of the year:
Cost of goods sold (before closing entries) . . . . . . $730,000 Labor rate variance . . . . . . . . . . . . . . . . . . . . . . . . . $12,000 favorable Labor efficiency variance . . . . . . . . . . . . . . . . . . . . $9,000 unfavorable Materials price variance . . . . . . . . . . . . . . . . . . . . . $14,000 unfavorable Materials quantity variance . . . . . . . . . . . . . . . . . . $8,000 favorable Over-applied manufacturing overhead . . . . . . . . . . $30,000

Closing entries:
Labor Rate Variance Cost of Goods Sold Cost of Goods Sold Labor Efficiency Variance Cost of Goods Sold Materials Price Variance Materials Quantity Variance Cost of Goods Sold Manufacturing Overhead Cost of Goods Sold 12,000 12,000 9,000 9,000 14,000 14,000 8,000 8,000 30,000 30,000

Compute Corbin's final cost of goods sold for financial reporting purposes assuming the company originally records its inventory and cost of goods sold at standard costs. (Also assume the company's entire WIP inventory is completed and sold as of the end of the year.)

Or combined closing entry:
Labor Rate Variance Materials Quantity Variance Manufacturing Overhead Cost of Goods Sold Labor Efficiency Variance Materials Price Variance 12,000 8,000 30,000 27,000 9,000 14,000

Cost of Goods Sold = $730,000 - $27,000 = $703,000

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Advantages of a Standard Cost System
1. Simply involving various management personnel in the establishment of a company's standard costs can encourage improved communication and coordination among a company's various departments. In fact, the actual process of setting standards can often help identify opportunities for improved performance even before those costs are implemented in a standard cost system. 2. Standards that are viewed as reasonable and achievable can motivate employees to reach higher levels of performance. The key is having standards employees accept and then evaluating performance based on factors within the employee's control. 3. The timely determination of variances between actual and standard costs can help management prioritize and focus their efforts on problem areas that present the greatest opportunities for improvement. 4. The use of standards costs can facilitate the preparation of a company's operating budgets with respect to future purchases of direct materials and projected expenditures for direct labor and manufacturing overhead. Those budgets are crucial in the determination of a company's future cash needs and the use of standard costs can simplify those projections and often improve their accuracy.

Disadvantages and Potential Pitfalls of a Standard Cost System
1. The cost associated with implementation. The process of establishing and regularly updating a company's standard costs can take considerable time and effort, and as a result, the costs of setting up and effectively running a standard cost system can be substantial. 2. Variances between actual and standard costs can often be misinterpreted and misused in a way that can have actually have a negative affect on employee morale. If unfavorable variances are used to browbeat workers rather than identify opportunities for improvement, then the use of standards could ultimately prove to be detrimental to a company's overall performance. 3. In some cases, employee efforts to avoid unfavorable variances can also have unintended consequences. For example, employees seeking to avoid unfavorable labor efficiency variances might seek shortcuts in the manufacturing process that could negatively affect the product's quality. That could lead to customer dissatisfaction and ultimately to declining sales. 4. Meeting a company's established standards may actually discourage continuous improvement if those standards are not set and updated in a way that stretches management's creativity and effort.

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14-7

Responsibility Accounting
Refers to an information system designed to provide reports that assess the performance of management personnel assigned to specific areas of responsibility within the company. Such reports are necessary when companies increase in size and complexity over time leading to the decentralization of management responsibilities. Decentralization refers to the delegation or spreading out of management decision making to lower levels of a company's management personnel.
Benefits of decentralization: 1. Free up top management to concentrate on more important matters involving business strategy. 2. Moves the day-to-day operating decisions to those who are closer to the action and may be in a position to make better decisions. 3. Can improve the job satisfaction of lower level employees and provide enhanced opportunities for their personal growth in the company. Disadvantages of decentralization: 1. Some decisions will be made at lower levels without consideration for the overall affect on the company's goals and objectives. 2. Can make the coordination of operations between a company's various departments more difficult.

In a decentralized company, responsibility accounting is absolutely crucial. Management reports identifying an employee's area of responsibility and his or her performance relative to established standards or goals are invaluable when decision making is dispersed among a large number of employees.

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Clark Clothing International

Cost center - A department or organizational unit in which the assigned manager has control over and is accountable for the costs incurred in the operation of that department or unit.
Far East Operations

Western European Operations

North American Operations

Profit center - A department or organizational unit which has both revenues and costs over which the assigned manager has ultimate control and accountability. Investment center - An organizational unit over which the assigned manager has accountability for the allocation and use of assets as well as revenues and costs.

Burnett Shoes

Perry Shirt Manufacturing

Jordan Jeans

Sales Department

Production Department

Purchasing Department

Personnel Department

Accounting Department

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Clark Clothing International

Clark Clothing International North American Division Segment-Margin Income Statement October, 20X5
North American Division Burnett Shoes

Segment Breakdown
Perry Shirt Mfg. Jordan Jeans

Western European Operations

North American Operations

Far East Operations

Sales revenues Less: Direct costs of each segment Cost of goods sold Selling and admin. expenses Segment margin/profit Less: Indirect/uncontrollable costs Net income (loss)

$6,972,000 (4,365,000) (1,725,000) 882,000 150,000 $ 732,000

$2,556,000

$828,000

$3,588,000

(1,740,000) (492,000) (2,133,000) (582,000) (90,000) (1,053,000) $ 234,000 $ 246,000 $ 402,000

Burnett Shoes

Perry Shirt Manufacturing

Jordan Jeans

Total assets Returns on investment (ROI)

$1,170,000 $1,025,000 24% 20%

$1,909,000 22%

Budgeted vs. Actual Income Statement Sales Department Production Department Purchasing Department Personnel Department Variance Reports Accounting Department

Let's also assume that each of these three segments is considered an investment center given that their general managers have responsibility for and control over each subsidiary's assets. In that case, each segment's return on investment or ROI would be a useful measure of performance. Return on Investment (ROI) = Segment Margin Segment Total Assets

If the North American division was given an additional $500,000 for expansion of one or all of its three segments, that money would best be put to use expanding Perry Shirt Manufacturing's operation assuming its manager could continue to generate a comparable rate of return on those additionally invested assets.

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14-8

Let's assume for a moment that Clark Clothing International's overall return on investment, or in other words, return on its total assets invested in all of its division's worldwide, amounted to 14%. Obviously, in that case, the North American division is doing very well compared to the results achieved in the company's other divisions. Let's also assume that the North American general manager has become aware of an investment opportunity that would yield the company a rate of return amounting to 18%. In that case, the general manager may decide that it's not in his or her best interests to pursue this investment on behalf of the company because it would lower the division's overall rate of return, even though it would have a positive affect on Clark Clothing International's total rate of return. In this case, the use of ROI to measure the performance of division managers may actually work against the company's overall best interests. As a result, most companies today choose to measure performance based on what's referred to as residual income, which is the amount of profit a division or investment center generates above the company's established minimum rate of return. For example, if a division manager controls $10,000,000 of assets and the company's minimum ROI is set at 15% then the manager will be evaluated on the amount of profit generated in excess of 15% of $10,000,000 or $1,500,000. In this case, the overall rate of return is not the goal; it's the dollar amount of profits over $1,500,000. Under this approach, managers are motivated to achieve results that are consistent with the company's overall goals and objectives.

Standard costs and responsibility accounting are all about setting goals and expectations for a company's managers and employees, and, if properly used, they can be effective tools in improving a company's operating performance.

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Problem 14-5

Problem 14-5 - Answer

Questions
Briefly respond to the following questions: 1. What are the major advantages and disadvantages of a standard cost system? 2. Why is responsibility accounting important for most businesses? 3. When might responsibility accounting have a negative affect on employee morale? 4. What distinguishes cost, profit and investment centers and which of the following reports or measures is most commonly associated each? a. Variance reports on actual versus standard costs. b. ROI or residual income. c. Segment-margin income statements. 5. Why is residual income often considered a more useful measure of an investment center's performance than ROI?

Questions
1. What are the major advantages and disadvantages of a standard cost system? Advantages: 1. Improved communication and coordination among department managers. 2. Potential source of motivation. 3. More efficient management by exception (variance analysis). 4. Facilitates operational budgeting. Disadvantages: 1. High cost of implementation. 2. Possible misuse resulting in decreasing employee morale. 3. Possible misinterpretation of results. 4. Could actually discourage continuous improvement.

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Problem 14-5 - Answer

Problem 14-5 - Answer

2. Why is responsibility accounting important for most businesses? Answer: Most businesses rely on a certain degree of decentralization to operate effectively. When management responsibilities are spread out among various personnel, some means of evaluating performance is essential. Responsibility accounting is the means whereby delegated responsibilities are measured and performance is assessed. 3. When might responsibility accounting have a negative affect on employee morale? Answer: If employees perceive that goals and standards exist to punish rather than encourage improved performance, those goals can have a detrimental affect on employee morale. Standards and goals must also be viewed as reasonable and employees should not be held accountable for results they can't control.

4. What distinguishes cost, profit and investment centers and which of the following reports or measures is most commonly associated each? a. Variance reports on actual versus standard costs. b. ROI or residual income. c. Segment-margin income statements. Answer: The distinguishing characteristic between cost, profit and investment centers is the extent of the related manager's responsibility and control over the costs, revenues and assets of the department or organizational unit. In a cost center, the manager's control is limited to costs, and variance reports are commonly used to help improve performance in that area. Managers of profit centers are responsible for both revenues and costs and segment-margin income statements are often used to measure the performance of those units. Finally, managers of investment centers have responsibility over assets, revenues, and costs and the key performance measure is the center's ROI or residual income.

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Problem 14-5 - Answer

5. Why is residual income often considered a more useful measure of an investment center's performance than ROI? Answer: Most businesses rely on a certain degree of decentralization to operate effectively. When management responsibilities are spread out among various personnel, some means of evaluating performance is essential. Responsibility accounting is the means whereby delegated responsibilities are measured and performance is assessed.

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