Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
efficiency of the customer order-handling process. (Note: this cost might increase a
bit to cover the cost of the TQM initiative.)
15-48 (Continued-2)
Note, however, that the cost of unused capacity increases, from $72,000 (90%
capacity utilization) to $180,000 (75% capacity utilization).
Practical Capacity:
Prior to TQM Implementation = 10,000
After TQM Implementation = 12,000
Resource Cost (Handling Customer Orders) = $720,000
Budgeted # of Customer Orders = 9,000
ABC Rates–Handling a Customer Order:
After TQM Implementation = 9,000 ÷ 12,000 = 75%
Conclusion: Efficiency initiatives (e.g., TQM) will lead to reduce resource spending
only if managers eliminate or redeploy the unused resource capacity that was created
by the efficiency improvement.
5. Faced with unused capacity, for example, the company can:
6. Logically, we would assign to a given customer or market segment the cost of unused
capacity IF the associated capacity were acquired specifically to serve that customer
or market segment. IF the unused capacity is associated with a given product line,
then the cost of unused capacity should logically be assigned to that product line (but
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-49 Two-Variance Analysis: Service Company Example (30 minutes)
1. Budgeted number of letters of credit approved: $1,000,000 $2,000 = 500
Overhead application rates:
2. Actual overhead costs incurred:
Variable: ($2,000 × 600 × 0.70) × 110% = $924,000
Insurance premium 270,000 $1,194,000
Flexible Budget:
Variable: $2,000 × 600 × 0.70 = $840,000
Insurance premium =
$270,000 0.9 = 300,000 $1,140,000
Fixed ($600,000 × 0.95) 670,000
Flexible-budget: $1,810,000
Overhead applied $3,340 × 600 × 0.70 = $1,402,800
$2,700 ÷ (1 − 0.10) = 300,000 1,702,800
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-50 ABC versus Traditional Approaches to Control of Batch-Related Overhead
Costs (50-60 minutes)
Additional information needed to solve this problem (highlighted in bold):
Budgeted Actual
Results Results
Units produced and sold 10,000 9,000
Batch size (units) 250 200
No. of batches 40 45
Set-up hours per batch 4 4.25
Total Set-up hours 160 191.25
Note that the control (flexible) budget for set-up-related variable overhead costs should
be based in this case on set-up hours (the controllable factor). Thus, given an output
equates to 144 set-up hours.
(1) (a) Fixed overhead spending variance = Actual fixed setup-related costs – budgeted
(b) Production volume variance = budgeted fixed setup-related costs – applied fixed
setup-related overhead costs= $20,000 − (36 batches × 4 setup-hours/batch ×
As the name implies, the fixed overhead spending variance means that last
spending on setup-related fixed overhead costs was $1,000 more than what was
envisioned when the master budget was prepared. The production volume
variance in this context means that capacity, measured in terms of budgeted
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-50 (Continued-1)
(2) (a) Variable setup-related overhead spending variance = actual variable setup-
related overhead costs − budgeted variable setup-related overhead costs based
on inputs (i.e., based on actual setup hours worked during the year)
= (actual batches × actual setup hours/batch × actual variable setup-related
overhead costs/setup hour) − (actual batches × actual setup hours/batch ×
(b) Variable setup-related overhead efficiency variance = FB for variable setup-
related overhead costs based on Inputs − FB for variable setup-related
overhead costs based on Outputs
batches than standard (actual # of batches = 45; standard allowed batches = 36,
as shown above); and (2) each setup took slightly more time than standard (4.25
hours/setup vs. 4.00 hours/setup). The net unfavorable variable setup-related
overhead variance indicates that the favorable spending variance was not
enough to offset the unfavorable efficiency variance.
(3) Fixed setup-related overhead costs are controlled primarily prior to the point of
operations. That is, they are controlled primarily through the planning process (for
example, the capital budgeting process or the use of zero-based budgeting). These
costs basically relate to the capacity/ability to produce.
On the other hand, variable setup-related costs, by definition, vary in response to
allocated all setup-related overhead costs by a single, volume-based activity
measure: number of machine hours. This approach (a) fails to recognize that some
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Chapter 15 – Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-50 (Continued-2)
of these overhead costs are capacity-related and therefore controlled differently,
and (b) fails to identify meaningful strategies for cost control. When machine hours
are used as the basis for cost allocation and some costs (as in this case) are not
(4) Most companies find that a comprehensive control system consists of both financial
and nonfinancial performance indicators. Thus, one would expect that operating
units in the Bangor Manufacturing Company would have timely access to
nonfinancial performance indicators such as process yields (e.g., ratio of good
outputs to inputs), manufacturing processing time, reject rates, percent first-pass
yield, defect rates (e.g., parts-per-million, ppm), etc. Such information has the
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