Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Chapter 15
Operational Performance Measurement: Indirect-Cost Variances
and Resource-Capacity Management
Teaching Notes for Readings
Reading 15-1: Kennard T. Wing, “Using Enhanced Cost Models in Variance Analysis for Better
Control and Decision Making,” Management Accounting Quarterly (Winter 2000), pp. 1-9.
This article points out that oversimplifications of fixed and variable costs can result in the standard
costing system not being used or, if used, can lead to bad decisions. That is, misclassifications of cost
behavior patterns make variance analyses “paper tigers.” For variance reporting to be useful, financial
managers need to develop cost models that reflect how costs actually behave.
Discussion Questions:
1. Describe the implications for variance analysis of analyzing a semi-variable cost as either a
variable or fixed cost.
Semi-variable costs are fixed below a certain level of volume, and are variable above that level. For
this reason, these costs are also referred to as “mixed costs.”
Treated as fixed costs: Unfavorable (volume) variance.
2. Describe the implications for variance analysis of analyzing a step-fixed cost as either a variable
or fixed cost.
Step-fixed costs are fixed up to a certain level of volume, and jump to a higher level of cost that is
fixed over a range of volumes until another point is reached at which costs jump again to a higher
level, and so on. These costs are sometimes referred to as “semi-fixed costs.”
Actual operating level above the budgeted level
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
3. Describe the implications on operating decisions of analyzing an operation with mixed costs as
either a variable or fixed cost.
When volume drops, classifying a mixed cost as a variable cost may lead to decreases in operating
resources such as lay-off of employees when the amounts of work needed to sustain the operations do
not decrease proportionally. As a result, employee morale of the remaining employees may plummet
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Reading 15-2: Jean C. Cooper and James D. Suver, “Variance Analysis Refines Overhead Cost
Control,” Healthcare Financial Management (February 1992).
This article illustrates analyses of full costs of selected medical procedures of a healthcare organization. A
key feature of the analysis is how the overhead variances are handled, and in particular how to develop an
understanding of the volume variance and how it affects profitability. Standard costs are determined for a
hypothetical “Procedure 101” and there is an illustration of how variances can be obtained and
interpreted, given example of actual results for the procedure over a year’s time. The analysis shows the
effect of volume changes on overhead recovery and on contribution to profits.
The common theme in this article and the next (15.3) is that variance analysis can be modified and
adapted to the specific situation to provide useful information. In reading 15.2, the context is healthcare,
which implies a focus on volume; in the second article, the use of activity analysis is implied.
Discussion Questions:
1. Based on the analysis in this article, what is the key driver of profitability in the discussion
example?
2. Explain how the two variances included in Exhibit 3 are developed and interpreted.
The volume variance is a reflection of the gain (or loss) due to an excess (or shortfall) of the actual
number of patients relative to the budget, and the cost at the pre-determined fixed overhead rate. This
3. Consider the example in Exhibit 4. Why are expenses improperly matched and the reported
income overstated?
The effect is due to the volume variance. The volume variance (unbilled overhead, at 150 patients x
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Reading 15-3: Robert E. Malcolm, “Overhead Control Implications of Activity Costing,”
Accounting Horizons (December 1991) pp. 69-78.
This article points out some of the limitations of the traditional treatment of standard cost overhead
variances. An example problem from the CMA exam is used as an illustration. The problem is solved both
in a traditional format and also using ABC drivers. Regression is used to identify the cost drivers, and a
revised solution is derived.
Discussion Questions:
1. What are the limitations of standard cost overhead analysis?
The article points out that overhead variances may have little, if any, useful interpretation, except to
provide some information to management regarding the efficiency of labor usage (the typical base for
determining the variances). Moreover, a typical variance analysis is done at a far too aggregate level
2. How does the activity approach improve upon the standard cost analysis of overhead?
By using the activity approach, the different elements of overhead can be identified and tied to the
relevant cost drivers. In this way, the interpretation of the variances has real significance for control
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Reading 15-4: “Using Theoretical Capacity to Eliminate Manipulation of Absorption
Costing Income” by Parvez R. Sopariwala, Cost Management (September/October, 2007), pp.
40-47.
This article deals with the general issue of how reported earnings under absorption costing can be
managed by varying production and by the method chosen to dispose of any end-of-period fixed overhead
variance. Specifically, the author recommends that to remove all inventory-related incentives for earnings
Discussion Questions:
1. What is the primary managerial issue addressed by the author of this article?
As stated in the article, reported income under absorption costing can be managed or manipulated by
varying production. This is attributable to charging each unit produced, under absorption costing, with a
share of fixed manufacturing overhead costs. When production increases, the cost per unit decreases
(and profitability based on units sold increases). The opposite effect occurs when production decreases
relative to sales. This article addresses a new twist to the issue: how this ability to manage earnings
2. Contrast the “absorption costing” and “direct costing.” Why might accounting rule makers
mandate in published financial statements the disclosure of pro forma results based on the latter?
As implied by its name, under absorption costing each unit produced is assigned a share of fixed
manufacturing overhead costs—that is, each unit produced “absorbs” a portion of fixed manufacturing
costs. By contrast, under direct costing fixed overhead costs are treated as period, not product, costs. As
such, under direct costing such costs are expensed in their entirety in the period incurred. Direct costing
3. What is the specific recommendation of the author for decreasing management’s ability to
manipulate reported accounting income?
The remove the incentive for inventory build-ups, and profit manipulation in general, the author
recommends that the ability to influence reported earnings based on choice of the denominator activity
level be removed. Specifically, he recommends that “theoretical capacity” be used to determine fixed
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
4. Explain what is meant by the “cost of idle or unused capacity”? How is this amount related to the
recommendation reflected in item 3 above?
Fixed overhead costs are basically capacity-related costs. They provide the capacity or ability to
produce. One important question is the extent to which management has best managed the supply of
and demand for resource capacity. The author of this article maintains that a by-product of the use of
5. What practical difficulties might companies face were they attempting to implement the
recommendation set forth in this article?
The author provides the following two practical (i.e., implementation-related) issues associated with his
proposal to require companies to base their fixed overhead allocation rates on theoretical capacity:
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-5: “The Case for Resource Consumption Accounting” by Anton Van Der Merwe and
David E. Keys, Strategic Finance (April 2002), pp. 1-6.
This article provides an argument for the superiority of so-called Resource-Consumption Accounting
(RCA) relative to both conventional costing systems and to activity-based cost (ABC) systems. The
authors maintain that, conceptually, RCA is a combination of GPK and RCA systems, a point made in
Chapter 15 of the text.
Discussion Questions:
1. Describe in general terms what is meant by the term RCA.
As indicated in the article, RCA (resource consumption accounting) is the name given to a
comprehensive cost-management system. As such, it can be compared to alternative systems such as
typically promote this cost-management alternative as a blending between GPK and ABC.
2. The authors suggest that RCA systems are based on “three pillars.” Provide an overview of each
of these three elements of an RCA system.
According to the authors, RCA systems are built upon three foundational principles:
3. According to the authors of this article, how does RCA potentially improve upon ABC systems
and activity-based budgeting (ABB) procedures? (Alternatively, describe what the authors mean
when they use the term “activity-based resource planning” (ABRP).)
According to the authors, ABB (activity-based budgeting) falls short in three areas:
First, the approach doesn’t adequately consider the fixed costs on unit-related activities. ABB
assumes all costs of these activities to be variable. Yet every activity/process inherits the nature
of the cost of the resource that executes it, and very few, if any, activities contain zero fixed costs.
(Practitioners have adopted various approaches to address the fixed cost problem. An interview
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
4. Provide a brief overview of the steps needed to implement an ABRP system.
The ABRP approach recommended by the authors basically appears to be a more detailed, that is, finer,
cost-allocation approach as compared to traditional ABC. This can be seen by examining Figure 1 as
well as Tables 2, 3, and 4 in the article.
The authors suggest the following four-step process for implementing an ABRP system:
Establish resource-pool-level unit standards for resource elements (see Tables 2 and 3)
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-6: “RCA at Clopay: Here’s Innovation in Management Accounting with Resource
Consumption Accounting” by B. Douglas Clinton and Sally A. Webber, Strategic Finance
(October 2004), pp. 21-26.
This article begins with the premise that RCA systems provide more accurate cost information compared
to both traditional cost systems and ABC systems. It then describes a pilot implementation of RCA at
Clopay Plastics Company, located in Cincinnati, OH.
Discussion Questions:
1. What distinguishes RCA from conventional or ABC systems?
RCA, relative to both conventional (i.e., non-ABC) and ABC systems seems to provide more detailed
and therefore potentially accurate information regarding the cost or resource demands of an
organization’s outputs (products, services, customers). This is implied by the comment of the authors
that RCA captures “information at the lowest level (such as the manufacturing point) to accurately
2. What factor, or factors, motivated Clopay Plastics Company to reexamine its cost-information
system?
Clopay Plastics manufactures plastic products, such as film, that are sold to consumer-product
companies for use in hygiene and healthcare products. The Augusta, GA plant, which piloted the use of
RCA, manufactures 200 products in 60 product families. In addition to manufacturing, there are five
major departments: shipping, materials management, quality assurance, plant maintenance, and
administration. Prior to the RCA pilot, the company had used a traditional standard costing system.
In general, dissatisfaction with the company’s traditional costing system led to the pilot implementation
of RCA. Specific issues included the following:
3. What specific system-design choices were associated with the pilot implementation of RCA at
Clopay Plastics?
Clopay created 23 resource pools for costs, in two general categories: general support costs and
production department costs. The previous system used by the company accumulated costs by eight
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