Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-38 (Continued-1)
3. If the fixed factory overhead rate was based on practical capacity rather than
theoretical (maximum) capacity, Yuba Machine Company’s reported operating
income at May 31, 2017 would be $12,000 less, not $90,000 as reported. The
revised CGS calculation follows.
Cost of goods sold (CGS), revised amount:
Yuba Machine Company
Interim Income Statement, Revised
For Six Months Ended May 31, 2017
Sales $625,000
CGS ($380,000 + $12,000) 392,000
Gross profit $233,000
Less:
Selling expense $ 44,000
Principal point: Choice of the denominator volume affects product costs. If
resulting overhead variances for a period are closed to CGS (rather than
allocated), then these differences will affect “the bottom line.”
(4) As noted in part (1), the use of theoretical capacity is generally not recommended,
although perhaps some might argue that in an increasingly competitive environment
this alternative has some merit (since it will result in the smallest, that is, tightest,
From a managerial standpoint, the use of practical capacity has a number of key
advantages. For one thing, it “reveals” the cost of unused capacity (rather than
“hiding” this cost as part of the cost of good units produced). For another thing, it
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
helps managers avoid what has been referred to as the “death spiral,” which can
15-38 (Continued-2)
occur if management sets selling prices on the basis of full-cost information (in this
case, to include the cost of unused capacity). The use of practical capacity also is
consistent with the way the numerator in the application rate is defined. That is, the
numerator represents planned spending on capacity-related resources and the
denominator represents, in practical terms, the supply of resources made available.
activity, results in more stable unit-cost data, which some managers find appealing.
Finally, we note that for U.S. federal income tax purposes, companies can base their
fixed overhead rates on practical capacity. So, for all of the above reasons, for
managerial purposes we recommend the use of practical capacity as the
denominator activity level used to calculate predetermined fixed overhead allocation
rates.
At this point, the instructor has an opportunity to provide an expanded discussion of
this issue by referencing appropriate financial reporting and income-tax
considerations concerning the setting of predetermined overhead rates, particularly
fixed overhead rates.
As indicated in the chapter, generally accepted accounting principles (viz., FASB
ASC 330-30-10-3, previously SFAS 151, and available at www.fasb.org)deal
specifically with the issue of establishing overhead allocation rates and the
production levels within which ordinary variations in production levels are expected.
Further, generally accepted accounting principles require that any “unallocated
overheads be recognized as an expense in the period in which they are incurred”
(FASB ASC 330-10-30-7, previously SFAS 151).
For U.S. income tax purposes, the issue regarding choice of the denominator level
for establishing fixed overhead allocation rates and the end-of-period treatment of
overhead cost variances is provided in the Regulations. Two, in particular, bear on
the subject at hand: Reg. §1.263A and Reg. §1.471-11.
Reg. §1.263A specifies that “indirect (production) costs be allocated…using
either…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
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
production…activities.” (emphasis added)
15-38 (Continued-3)
Reg. §1.471-11(“Inventories of Manufacturers”) extends the guidance provided in
Regulation 1.263A by specifying the following:
Unless minor in amount, end-of-period overhead cost variances must
be prorated; if minor in amount, and treated this way for financial-
reporting purposes, such variances can be written off as period costs
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-39 Ethics and Overhead Variance (60-75 minutes)
1. Operating income as currently reported ($9,600,000)
Production volume variance: $9,000,000 × 0.2 = 1 ,800,000 U
Operating income before adjusting for volume variance ($7,800,000)
Current fixed overhead application rate per machine hour:
operating income if the volume variance is capitalized) $7,056,000
Revised operating income (under given assumptions) ($744,000)
Changes in operating income
Operating income as currently reported ($9,600,000)
Revised operating income ( 744,000)
2. As indicated by the discussion in the text, there is a great deal of judgment
involved in determining the “denominator activity level” used to set the
predetermined fixed overhead application rate. That is, there is not necessarily a
clear-cut answer to this issue. Possible denominator levels include: budgeted
(forecasted) output, normal capacity, practical capacity, or theoretical capacity.
The numbers assumed in this problem might be viewed as extreme or contrived,
but this was done to drive home the point to students that choices made regarding
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-39 (Continued-1)
Our position is that a certain amount of latitude should be afforded managers in
regard to setting fixed overhead rates (specifically, choice of denominator activity
level) and the manner in which standard cost variances are treated at the end of the
year. Thus, one approach to this question is to focus on intent. Here the IMA’s
Statement of Ethical Professional Practice (www.imanet.org) may be helpful. This
statement refers to four ethical standards of behavior for management accountants:
Competence; Confidentiality; Integrity; and, Credibility. The present case raises
issues regarding the fourth of these standards, Credibility. “Each member (of the
profession) has a responsibility to: communicate information fairly and objectively;
and, to disclose all relevant information that could reasonably be expected to
influence an intended user’s understanding of reports, analyses, or
recommendation.”
Under this standard, therefore, one might argue that it would be unethical for the VP
of Finance to change the denominator activity level solely to improve reported
operating results, particularly when these results would then be communicated to
Finally, students might note that the standard of “competence” applies to the given
scenario. Part of this Standard states that members are expected “to perform
professional duties in accordance with relevant…technical standards.” At issue is
whether a production volume variance should be capitalized (carried forward on the
3. Generally accepted accounting principles GAAP (FASB ASC 330-10-30-3 to -7,
previously SFAS151—“Inventory Costs: An Amendment of ARB No. 43, Chapter 4,”
and available at www.fasb.org) reaffirms (and brings U.S. reporting standards more in
line with International Accounting Standards in the area) that abnormal amounts of
idle facility expense (as well as abnormal amounts of freight, handling costs, and
spoilage) be written off as a period expense (i.e., as a current-period charge).
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-39 (Continued-2)
4. The point of this question is to impress upon students the fact that under absorption
costing, reported operating income can be affected by the method used to dispose
of any production volume variance associated with fixed overhead. In other words,
the variance-disposition method can be used to “manage earnings” under absorption
costing.
As noted in the chapter, the amount of fixed overhead costs absorbed into or
released from inventory (i.e., the Balance Sheet) is affected by the denominator level
chosen to establish the predetermined fixed overhead application rate. Choice of the
denominator volume level simultaneously affects the amount of the production
If inventory is increasing, choosing a lower denominator-volume level will
Thus, it is through the interaction of how the fixed overhead rate is set and how the
resulting production volume variance is accounted for that provides management an
then the denominator-level choice has no effect on absorption-costing income. This
is because prorating this variance effectively changes the budgeted overhead
application rate to the actual overhead application rate.
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-40 Income Statement Effects of Alternative Denominator Activity Levels;
Spreadsheet Application (60 minutes)
(1) Production Volume Variance:
Budgeted Standard Standard Fixed OVH Production
Fixed Fixed OVH Allowed Applied to Volume
Alternative Overhead Rate/Hour Hours Production Variance
(2) Ending Inventory of Finished Goods:
Theoretical Practical Normal Budgeted
Beg. Inventory 0 0 0 0
Plus: Units Produced 12,250 12,250 12,250 12,250
Less: Units Sold 11,500 11,500 11,500 11,500
Units in Ending Inventory 750 750 750 750
(3) Profit Reports:
Theoretical Practical Normal Budgeted
Revenues $1,150,000 $1,150,000 $1,150,000 $1,150,000
CGS (@ Standard Cost) $916,021 $945,836 $969,688 $983,104
Plus/Minus Vol. Variance $64,167 $32,407 $7,000 ($7,292)
CGS, Adjusted $980,188 $978,243 $976,688 $975,813
Gross Profit $169,813 $171,757 $173,313 $174,188
Less: Operating Expenses:
Operating Profit % 4.16% 4.22% 4.47% 4.54%
15-40 (Continued-1)
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Calculation of Cost of Goods Sold @ Standard Manufacturing Cost:
Theoretical Practical Normal Budgeted
Beginning Inventory $0 $0 $0 $0
Plus: Cost of Goods Manufactured:
Variable Mfg. Costs1$692,875 $692,875 $692,875 $692,875
Notes:
1$60.25/unit (given)
2See part (1)
(4) The primary point of the preceding analysis is that once it is maintained that
products should be costed at full (absorption) cost, there is a need to “unitize”
budgeted fixed overhead (manufacturing support) costs. To do this, the accountant
must assume a level of activity over which the budgeted fixed costs can be spread.
Differences in assumed activity level, as the example above shows, lead to
differences in per-unit manufacturing costs and, in turn, in the amount of the
end-of-year treatments for the disposal of the production volume variance that
occurred during the year. Choice of the denominator activity level and some latitude
in terms of how resulting volume variances are disposed of imply that short-term
profit reporting can, at least to some extent, be “managed,” just as shown in the
example above.
As a general rule, as stated in the text, we favor the use of “practical capacity” as
the denominator volume used to set the standard fixed overhead allocation rate.
Finally, we note that if either the allocation method or what is called rate-adjustment
method (where the cost of all jobs and units produced during the period is
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-40 (Continued-2)
5. Generally accepted accounting principles (GAAP) (FASB ASC 330-10-30-3 to -7,
previously SFAS151—“Inventory Costs: An Amendment of ARB No. 43, Chapter 4,”
and available at www.fasb.org) reaffirms (and brings U.S. reporting standards more in
line with International Accounting Standards in the area) that abnormal amounts of
idle facility expense (as well as abnormal amounts of freight, handling costs, and
spoilage) be written off as a period expense (i.e., as a current-period charge).
Further, GAAP specifies that “normal capacity” be used for establishing fixed
overhead allocation rates and that any unallocated overhead be recognized as an
expense of the period (rather than be prorated to inventories and CGS). While not
stating this explicitly, it appears that GAAP implies that when normal capacity is used
for allocating fixed overhead costs to product, then any amount of unallocated
overhead should be viewed as “abnormal” and therefore treated as a period cost.
This question allows the instructor to reinforce the “different costs for different
purposes” argument regarding the design of cost-information systems. Students can
also be directed to current federal income tax rules regarding the setting of overhead
cost-allocation rates and the end-of-period disposition of any resulting overhead
variances, including the production volume (“idle capacity”) variance. Guidance in this
regarding is provided in Treasury Reg. §1.471-11 (“Inventories of Manufacturers”).
Note: An Excel spreadsheet solution for this problem is embedded below. You can
open this “object” by doing the following:
1. Right click anywhere in the worksheet area below.
2. Select “worksheet object” and then select “Open.”
3. To return to the Word document, select “File” and then “Close and return
to…” while you are in the spreadsheet mode. The screen should then return
you to this Word document
Pr. 15-40 7e.xlsx
Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-41 Managing Earnings, Denominator Capacity-Level, and Ethics (45-60 Minutes)
1. Predetermined overhead application rates (for both normal cost systems and
standard cost systems) are developed prior to the operating period. These rates are
predetermined in the sense that they rely on two pieces of estimated information.
The estimated variable overhead cost rate per unit of activity can be determined on
the basis of the cost-estimation techniques discussed in Chapter 8. The fixed
component requires an estimate of all capacity-related (i.e., short-term fixed)
assign indirect manufacturing costs to outputs during the period.
Under an ABC system the process is conceptually the same. The primary difference
is the use under ABC of multiple manufacturing support cost pools, each of which has
For the determination of the fixed overhead component of predetermined overhead
costs in conventional cost systems, and for the determination of cost-allocation rates
under ABC systems (both traditional and Time-Driven), a critical assumption is choice
of the denominator volume level. Since cost-allocation rates are determined using
both a numerator and a denominator value, choice of the denominator volume level
(over which fixed overhead costs are spread) directly affects the predetermined rates.
For financial reporting purposes, GAAP (FASB ASC 330-10-30-3, previously SFAS
151: Inventory Costs—An Amendment of ARB No. 43, Chapter 4, and available at:
www.fasb.org) specifies that normal capacity be used as the denominator volume for
purposes of allocated fixed overhead costs to outputs. GAAP further specifies that
“normal capacity refers to a range of production levels.” Alternatively, “normal
capacity” can be viewed as the level of production expected over a number of
periods.
The Internal Revenue Code (IRC) does not deal directly with the issue of the choice
of the denominator volume level for purposes of allocating indirect manufacturing
Education.