Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Chapter 15
Operational Performance Measurement: Indirect-Cost Variances and
Resource-Capacity Management
Learning Objectives
1. Distinguish between the product-costing and control purposes of standard costs for manufacturing
overhead
2. Use flexible budgets to calculate and properly interpret standard cost variances for manufacturing
overhead.
3. Record overhead costs and associated standard cost variances
4. Dispose of standard cost variances at the end of a period
5. Apply standard costs to service organizations
6. Analyze overhead variances in a traditional activity-based cost (ABC) system
7. Understand decision rules that can be used to guide the variance-investigation decision
8. Formulate the variance-investigation decision under uncertainty (appendix)
New in the this Edition
Revision of four end-of-chapter problems
Continued emphasis on exercises and problems dealing with capacity-resource planning and the
financial reporting requirements of FASB ASC 330-10-30.
Two entirely new Real-World Focus (RWF) items: one dealing with management of capacity-
related costs in the auto industry, the other dealing with evaluating sustainability performance
using flexible budgets
Explicit consideration of the “value of perfect information” in the Appendix (“Variance
Investigation Decisions Under Uncertainty”)
Teaching Suggestions
I most often cover this chapter in two days, and my focus is on the proper interpretation of the overhead
variances. On day one I generally try to cover three topics: (1) the difference between the product-costing
and control uses of standard costing for overhead; (2) the setting of standards for overhead application,
including the choice of the denominator activity level; and (3) traditional overhead variance calculations.
On day two I generally try to cover three topics: (1) extension of overhead variance analysis to ABC
systems, (2) journal entries for recording standard overhead costs and associated variances, (3) end-of-
period disposition of overhead variances.
For those wishing to devote time to the topic of the variance-investigation decision (including material
covered in the Appendix to this chapter), a third day is recommended.
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Assignment Matrix
End-of-Chapter Assignments Chapter Learning Objectives Text Features
7th
ed.
EOC
6th
ed.
Transitio
n
6e to 7e
X = included in Connect
Est.
Time
1. Product-Costing vs. Control
2. Calculate and interpret variances
3. Record overhead costs and variances
4. End-of-period variance disposition
5. Apply standards to service firms
6. Overhead variances and ABC
7. Decision rules: variance investigation
8. Variance investigation: Uncertainty
Strategy
Service
International
Ethics
Sustainability
Brief Exercises
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Chapter 15 Assignment Matrix—Continued
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End-of-Chapter Assignments
Chapter Learning Objectives
Text Features
7th
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EOC
6th
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Transitio
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6e to 7e
X = included in Connect
Est.
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1. Product-Costing vs. Control
2. Calculate and interpret variances
3. Record overhead costs and variances
4. End-of-period variance disposition
5. Apply standards to service firms
6. Overhead variances and ABC
7. Decision rules: variance investigation
8. Variance investigation: Uncertainty
Strategy
Service
International
Ethics
Sustainability
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Lecture Notes
This chapter uses the concepts introduced in Chapter 14 to explain how flexible budgets and standard
costs (along with associated standard cost variances) can be used in traditional accounting systems for the
short-term financial control of factory overhead (i.e., indirect manufacturing) costs. The chapter focuses
on (1) the product-costing vs. control use of standard overhead costs, (2) how to determine standard
factory overhead costs, including choice of the denominator activity level for setting the fixed overhead
application rate, (3) how to compute traditional standard cost variances for variable and fixed
manufacturing overhead costs, (4) the interpretation of these variances, (5) journal entries for recording
standard overhead costs and standard cost variances, as well as the end-of-period disposal of standard cost
variances, (6) how standard costing might be applied to service contexts, (7) overhead variance analysis
under activity-based cost (ABC) systems (including the situation where there is a standard production lot
size), and (7) the variance-investigation decision (based, fundamentally, on the “management-by-
exception” philosophy). A separate Appendix to this chapter provides a discussion of the variance-
investigation decision under uncertainty, including the Expected Value of Perfect Information (EVPI).
Product-Costing vs. Control Purposes of Standard Overhead Costs
This discussion is built around the following two exhibits: Exhibit 15.1 (variable factory
overhead) and Exhibit 15.3 (fixed factory overhead).
Steps in Establishing the Standard Variable Factory Overhead Application Rate
• Determining the behavior patterns of variable factory overhead costs:
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
oThe standard variable factory overhead for a manufacturing firm is a function of both the
number of units to be manufactured and activities of the manufacturing process.
oUse of proper cost drivers is very important.
• Selecting one or more appropriate cost drivers for applying variable factory overhead to cost objects
(such as, products, services, or divisions):
oUsing a single cost driver, such as direct labor hours (DLHs), for applying variable factory
overhead is satisfactory only if the total variable factory overhead relates to the selected cost
driver.
oAn activity-based cost (ABC) driver applies factory overhead to products or services according
to the activity level of manufacturing operations and is likely to result in more accurate
allocation of variable overhead costs. Activities that change the amount of factory overhead may
be unit-based, batch-based, product-based, and facility-based. Unit-based cost drivers include
machine hours, direct labor hours, and units of materials. Batch-based cost drivers include the
number of times materials and parts are moved during manufacturing, number of set-ups,
number of times materials are parts are received and inspected. Product-based cost drivers
include number of products, number of processes, and number of schedule changes. Facility-
based cost drivers relate mostly with the size of operations, not with production activities.
• Computing the standard variable factory overhead rate:
Analyzing Variable Overhead Cost Variances
Total variable overhead variance, or variable overhead flexible-budget variance, is the difference
between the total variable factory overhead cost incurred and the total standard variable factory overhead
for the number of units manufactured. This difference is also the under– or over-applied variable
overhead. Exhibit 15.4 can be used to illustrate the total variable overhead variance and its
decomposition into spending and efficiency components.
oVariable overhead spending variance (OSV) is the difference between actual variable overhead
costs incurred and budgeted variable overhead for the actual quantity of the cost driver for
applying variable factory overhead.
oVariable overhead efficiency variance (OEV) is the difference between the budgeted variable
factory overhead for the actual quantity of the cost driver for applying variable factory overhead
and the budgeted variable factory overhead for the standard allowed activity units for the period.
Alternatively, this variance can be defined as the difference between the budgeted variable
overhead based on inputs and the budgeted variable overhead based on outputs. It is important to
point out to students that this variance does not reflect efficiency or inefficiency in using variable
overhead cost items. Rather, it relates to efficiency or inefficiency in use of the activity variable
(or cost driver) used to apply standard variable overhead to production.
oAlternative Format for Variable Overhead Cost Variances: the following diagram can be used
as an alternative to, or in conjunction with, text Exhibit 15.4 to illustrate the breakdown of the
total variable overhead variance into a spending and an efficiency variance.
Total Standard Activity Measure
Actual Input × Standard Rate Per for the Output × Standard Rate
Unit of the Activity Measure for Per Unit of the Activity Measure
Actual Applying Variable Overhead for Applying Variable Overhead
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Cost Incurred (AH × SR) (SH × SR)
Spending Variance Efficiency Variance
Variable Overhead Flexible Budget Variance
or, Under- or Over-applied Variable Overhead
The above alternative presentation format has the advantage of being consistent with the
framework developed in Chapter 14 of the text.
Interpreting Variable Overhead Cost Variances
Unlike direct materials and direct labor variances, the total variable factory overhead cost, in addition to
varying with volume, also varies with activities that change categorically or at intervals such as the
number of production runs, number of batches, and type of product. Because of imperfect association
between the cost driver (or drivers) for applying overhead and the variable factory overhead costs, a
variable factory overhead spending variance may include both price and usage variances.
The variable overhead efficiency variance reflects the effect of deviation in quantities only if the cost
driver for applying the overhead is a perfect surrogate for the unknown actual cost drivers for the
overhead.
Steps in Determining Standard Fixed Factory Overhead Application Rate
Because the total fixed factory overhead does not vary with changes in the activity level, there is in effect
no activity measure for fixed factory overhead during the period. However, many firms use fixed
overhead application rates to charge fixed overhead to cost objects in order to determine “full
manufacturing costs.” The steps to determine fixed factory overhead rates include:
• Determine the total budgeted fixed factory overhead for the period.
• Select a cost driver for applying fixed factory overhead.
• Calculate the denominator activity level (quantity) for the selected cost driver.
• Compute the fixed factory overhead application rate.
The denominator activity level can be set at: theoretical capacity, practical capacity, normal capacity, or
budgeted capacity usage. For reasons discussed in the chapter, we prefer the use of “practical capacity” as
the denominator activity level for setting the fixed overhead application rate.
Analyzing Fixed Overhead Cost Variances
Fixed factory overhead cost variances include the fixed overhead spending variance and the fixed
overhead production volume variance. Exhibit 15.5 provides a diagrammatic representation of the
determination of these two variances.
oFixed overhead spending variance is the difference between the actual and the budgeted fixed
factory overhead for the period. This variance is also referred to as fixed overhead flexible budget
variance, or simply fixed overhead budget variance. Neither the actual units produced nor the
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factory overhead spending variance.
oFixed overhead production volume variance is the difference between the budgeted fixed
overhead and the total fixed overhead applied to the units manufactured during the period. Other
terms for this variance are denominator variance, idle-capacity variance, and output-level
variance.
oAlternative Representation of Fixed Overhead Variances: The difference between the actual
and the applied fixed factory overhead is referred to as underapplied or overapplied fixed factory
overhead. This is the total variance to be analyzed for product-costing purposes. The following
diagram can be used as an alternative to, or in conjunction with, text Exhibit 15.5:
Total Standard Activity Units for the Output
Achieved × Standard Fixed OVH rate per
Actual Budgeted Total Unit of Activity
Cost Incurred Fixed Overhead (SH × SR)
Spending Variance Production Volume Variance,
(or, Flexible Budget Variance) Denominator Variance, or
Output-level Variance
Under– or Over–applied Fixed Overhead
As noted above, an advantage of the preceding approach is the tie back to the general model used
in Chapter 14.
Interpreting Fixed Overhead Cost Variances
Factors contributing to fixed overhead spending variances include ineffective budget procedures,
inadequate control of costs, and misclassification of cost items.
Factors contributing to fixed overhead production volume variances include management decisions to
change the budgeted operating level, unexpected changes in market demand, or unforeseen problems in
manufacturing operations. This variance can also be a measure of facility or capacity utilization (and for
this reason is sometime referred to as the “idle-capacity variance”).
Alternative Analysis of Factory Overhead Variances
The preceding discussion, including text Exhibit 15.4 and Exhibit 15.5, refers to what is called a “four-
way analysis of the total overhead variance” for the period. Text Exhibit 15.6 can be used to illustrate the
four-way approach to variance decomposition.
However, the total factory overhead variance can also be viewed in a 2-variance or 3-variance format. The
3-variance breakdown creates a factory overhead spending variance by combining variable overhead
spending variances and fixed overhead spending variances into one variance. The variable overhead
efficiency variance and fixed overhead production volume variance remain intact. The 2-variance format
further combines overhead spending variance with variable overhead efficiency variance. This combined
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
variance is called the factory overhead flexible-budget variance. Exhibit 15.7 can be used to illustrate all
three approaches to the decomposition of the total overhead variance (i.e., four-way, three-way, and two-
way breakdowns of the total variance). Exhibit 15.17 provides an alternative diagrammatic representation
of the overhead variance-decomposition process. As such, it is an alternative to the general framework
presented in Exhibit 15.7.
Journal Entries and Disposition of Overhead Variances
After discussing overhead variances, I then cover journal entries associated with the recording of standard
overhead costs and associated standard cost variances (for product-costing purposes). This discussion is a
straightforward extension of the standard cost journal entries covered in Chapter 14.
At the discretion of the instructor, time could then be devoted to a discussion of the end-of-period
variance-disposition question, that is, what the accountant must do at the end of the period to dispose of
any standard cost variance. (Students should recall that the variances are recorded in what we call
“temporary” or “nominal” accounts and, as such, must be closed out to zero at the end of the year.) Thus,
the discussion of the variance-disposition issue can begin with a distinction between interim (e.g., end of
quarter) and annual (i.e., end of year) statements. The appropriate disposition of standard cost variances is
partly a function of the timing of the variance calculation. It is also a function of whether the net variance
is considered material or immaterial.
A company can dispose of variances in the income statement of the period in which the variance is
incurred by charging them to the cost of goods sold (CGS). Alternatively, the firm can prorate (i.e.,
allocate) the variance among the CGS and ending inventory accounts, including raw materials, finished
goods, and work-in-process. (Note, however, that overhead and labor variances would be allocated only
to WIP inventory, finished goods inventory, and CGS; only the materials purchase price variance would
be allocated in part to the ending inventory of raw materials.)
Firms are likely to prorate variances when the variances are caused due to inappropriate standards or
bookkeeping errors. Proration of variances would be inappropriate if the variances are caused due to
operational inefficiencies.
Discussion can then turn to the impact of general accepted accounting principles (FASB ASC 330-10-30
-6 and -7, previously, Statement of Financial Standards No. 151: Inventory Costs—An Amendment of
ARB No. 43, Chapter 4, available at www.fasb.org) and current IRS rules regarding the setting of
overhead allocation rates and the end-of-period disposition of any volume (idle capacity) variances. This
discussion is provides an excellent example of where tax, financial reporting, and managerial accounting
perspectives of a single topic exist and must be considered by the accountant.
The above-referenced generally accepted accounting principles specify that normal capacity be used for
allocating fixed manufacturing costs to production and that abnormal amounts of idle facility expense
should be recognized as current-period charges and not capitalized as part of inventory cost. (Note:
“normal capacity” is defined as range of production levels—that is, production expected over a number of
periods (or seasons) under normal circumstances.)
There seem to be two major implications of the above reporting requirement:
1. The amount of fixed overhead allocated to each unit of production is not increased as a consequence of
abnormally low production or an idle plant.
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2. Another implication (not stated explicitly, but implied in FASB ASC 330) is that when normal capacity
is used, any unallocated fixed overhead is viewed as “abnormal,” and therefore should be treated as a
period cost. That is, unallocated overhead is recognized as an expense in the period in which this cost is
incurred.
General income tax provisions regarding inventory costing are contained in IRC 263: Uniform
Capitalization Rules. This Code Section specifies only that an “allocable” share of costs, including
indirect manufacturing costs, be included in inventory. Treasury Regulation §1.263A specifies that
“indirect costs should be allocated … using either a specific identification (“tracing”) method, the
standard cost method, or a method using burden rates, such as ratios based on direct costs, hours, or other
items, or similar formulas, so long as the method employed reasonably allocates indirect costs among
production … activities.”
Treasury Regulation §1.471-11: Inventories of Manufactures specifies that companies must prorate
variances, unless minor, in which case these variances can be charged as a period cost (but only if done
for financial reporting purposes). Also, this Regulation goes on to state that when practical capacity is
used to set fixed overhead allocation rates, “allocated cost” = ratio of actual output to practical capacity.
Any resulting fixed overhead cost variance can then be written off as a period cost.
Finally, a discussion regarding the effects on absorption costing income attributable to the choice of
denominator volume when setting the fixed overhead application rate can occur. This discussion can be
used by the instructor to illustrate a topic that has both managerial accounting and financial-reporting
implications.
Application of Standard Costing to Service Organizations
For those instructors wishing to cover this topic, the hospital example built around the information
provide in text Exhibit 15.10 can be used.
Overhead Variance Analysis under ABC Systems and GPK/RCA; the Role of Nonfinancial
Performance Indicators
Students may have been exposed earlier in the course to activity-based costing (ABC) systems. Time
permitting, the instructor could at this point discuss with students the analysis of overhead variances
within an ABC context. In this regard, we provide a discussion of flexible-budget amounts, and related
variances, when there is a standard production batch/lot size. Text Exhibits 15.11 & 15.13 provide the
necessary data to generate both a traditional financial performance report (Exhibit 15.12) as well as a
revised performance report using traditional ABC (Exhibit 15.14). Exhibit 15.15 provides a summary
comparison of the traditional vs. ABC-based financial report. We conclude the discussion of ABC-based
financial-performance reports by discussing how those reports are affected when there is a standard batch
size for production activity.
The instructor can conclude the discussion with brief reference to either (or both) of the following
issues/points:
GPK (German cost accounting) and RCA (resource consumption accounting) as options for
producing even more refined data as compared to both traditional and traditional ABC systems,
and
The need to supplement financial results (i.e., standard cost variances) with nonfinancial
performance indicators, a point made as well in Chapter 14.
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
The Variance-Investigation Decision
I tell students that the standard cost variances that are reported by the accountant can be thought of in
terms of “information signals” to management. Using the principle of “management by exception,” the
task is to determine when to assume that an exception has occurred, that is, a variance due to a systematic
(nonrandom) cause.
Text Exhibit 15.16 can be used by the instructor to frame the discussion. As indicated by this exhibit,
variances can be classified as uncontrollable (random) or controllable (nonrandom, or systematic).
Controllable variances can be caused by one or a combination of the following factors:
oprediction error
omodeling error
omeasurement error
oimplementation error
The point here is that the cause of the controllable variance will dictate the appropriate course of
corrective action to take. On the other hand, variances judged to be uncontrollable (random) require no
corrective action on the part of management.
Control charts and statistical control charts (discussed further in text Chapter 17) can be used to help
identify random from nonrandom (controllable) variances. As discussed in the Appendix to this chapter,
the variance investigation decision under uncertainty can be modeled through the use of payoff tables (see
Tables 15A.1 and 15A.2). Of particular importance in this model is the determination of the indifference
probability, as illustrated in Table 15A.3. The instructor can then conclude the discussion by discussing
the notion of “Expected Value of Perfect Information (EVPI),” that is, the maximum amount a rational
decision-maker would be willing to pay for “perfect information.”
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