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Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-31
15-37 Factory Overhead Analysis–Two, Three, and Four Variances; Spreadsheet
Application (50-60 Minutes)
1. Total Factory Overhead Application Rate:
Fixed factory overhead application rate:
Total machine hours at practical capacity:
Number of units of output at practical capacity = 40,000
Machine hours per unit × 2
2. Total Flexible Budget (FB) for Overhead Based on Units Produced:
Total standard machine hours allowed for the units produced =
42,000 units produced × 2 machine hours per unit = 84,000 hours
Manufacturing overhead in the flexible budget for 42,000 units:
3. Production Volume Variance for 2013:
Fixed Overhead:
Actual Cost Budget Applied
$360,000 $378,000 = 84,000 hrs. × $4.50/hr.
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-32
15-37 (Continued-1)
4. and 5.
FB Based on FB Based on
Actual Inputs Output Applied
Spending Variance Efficiency Variance Prod. Volume Variance
= $625,000 − $615,000 = $615,000 − $612,000
= $10,000U = $3,000U
Total factory overhead incurred $625,000
FB for Overhead Based on Inputs (i.e., actual machine hours):
5. FB for Overhead Based on Inputs (i.e., actual machine hours) $615,000
FB for Overhead Based on Output (from 2. above) 612,000
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-33
15-37 (Continued-2)
FB Based FB Based
on Inputs on Output
6. Actual (AQ × SP) (SQ × SP) Applied
VOH $250,000 $255,000 $252,000
Spending Variance Efficiency Variance
= $250,000 − $255,000 = $255,000 − $252,000
An Excel spreadsheet solution file for this assignment 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.
Ex. 15-37.xlsx
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-34
15-38 Traditional ABC Costing (45-50 minutes)
Standard MH per unit = 32,000 MH 6,400 units = 5 MH per unit
No. of units manufactured during the period = standard allowed MH standard MH/unit
= 30,000MH 5MH/unit = 6,000 units
Budgeted no. of units/setup = 6,400 units 32 set-ups = 200 units/set-up
Standard no. of setups for the units manufactured = 6,000 200 = 30
FB based on Inputs FB based on Output
(i.e., based on actual (i.e., based on standard
1. Actual activity units) allowed activity units)
VOH:
Setup 28 × $600 = $ 16,800 30 × $600 = $ 18,000
MH 35,000 × $5 = 175,000 30,000 × $5 = 150,000
= $48,000U
FB based on Inputs FB Based on Output
(i.e., on actual (i.e., based on standard
2. Actual activity units) allowed activity units)
VOH:
Setup 28 × $2,600 = $ 72,800 30 × $2,600 = $ 78,000
= $52,000U
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-35
15-38 (Continued)
3. Standard variable overhead application rate = budgeted variable manufacturing
overhead in the master budget practical capacity (MH)
Setup cost = $64,000 + ($600 × 32) = $ 83,200
Applied based on machine hours = 32,000 × $5.00 = 160,000
Total variable factory overhead @ practical capacity = $243,200
VOH: 35,000 × $7.60 = 266,000 30,000 × $7.60 = 228,000
FOH: 200,000 200,000
Total OH $480,000 $466,000 $428,000
Spending Variance Efficiency Variance
= $14,000U = $38,000U
Flexible-Budget Variance
= $52,000U
Notice that assumptions made regarding the number and type of activity measures used
to apply standard overhead costs to production can affect both the total flexible-budget
(controllable) variance and the components of this variance. For this reason, the
activities used to construct flexible-budgets for control purposes should be carefully
selected.
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-36
15-39 ABC and Practical Capacity; Spreadsheet Application (40–50 minutes)
Note: An Excel spreadsheet solution file for this assignment 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 document.
Ex. 15-39.xlsx
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-37
15-40 Use of Payoff Tables (Appendix); Spreadsheet Application (30-45 minutes)
(1) Expected value of the decision to investigate the variance:
E(Investigate) = [(I × (1 −p)] + [(I + C) × p]
= [($1,200 × (1 − 0.25)] + [($1,200 + $3,800) × 0.25]
(3) Let p = the indifference probability, that is, the probability of for a nonrandom
variance such that management is indifferent between the two courses of action,
investigate or do not investigate:
p = I ÷ (L − C)
nonrandom cause.
Thus, if the probability (p) for a nonrandom cause (or causes) is 4.96%,
management would be indifferent, in expected value terms, between investigating
and not investigating the variance. The expected cost of each course of action to
the organization would be the same. If, as in the present case, the probability of
the process being out of control (i.e., the probability of a non-random variance)
exceeds 4.96%, the indicated course of action would be to investigate the
variance.
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-38
15-40 (Continued)
Note: An Excel spreadsheet solution for this exercise 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 document
Ex. 15-40.xlsx
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
PROBLEMS
15-41 Capacity Levels and Fixed Overhead Rates (60 minutes)
1. As the name suggests, maximum (theoretical) capacity is the maximum output
level for the plant, one that assumes operating at maximum efficiency. This
level of productivity suggests no “down time” for machine maintenance, no
internal disruptions to the manufacturing process, and no slack in external
budgeted (forecasted) activity; practical capacity (i.e., theoretical capacity
reduced by external demand considerations and normal internal losses due to
machine downtime, employee personal time, etc.); and, normal capacity
(expected sales demand over an upcoming three- to five-year period).
2. A revised variance report for Yuba Machine Company using expected
(budgeted) activity as the basis for applying fixed factory overhead is
presented below.
Yuba Machine Company
Revised Variance Report
for Six Months ended May 31, 2014
Applied
Actual Overhead
Costs Costs Variance
Total variable factory overhead $120,220 $120,000 $ (220)
Fixed factory overhead:
Applied Fixed Overhead, First Six Months
Salaries: 40,000 DLHs × $1.00/DLH = $40,000
Depreciation and amortization:
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-40
15-41 (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, 2014 would be $12,000 less, not $90,000 as reported. The
revised CGS calculation follows.
Cost of goods sold (CGS), revised amount:
CGS, as originally reported $380,000
Less: fixed OVH included by Sid Thorpe 48,000
Yuba Machine Company
Interim Income Statement, Revised
For Six Months Ended May 31, 2014
Sales $625,000
CGS ($380,000 + $12,000) 392,000
Gross profit $233,000
Less:
Selling expense $ 44,000
Depreciation expense 58,000
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,
standard costs). As discussed in the text, the ultimate choice of the denominator
denominator level in setting fixed overhead allocation rates in conventional
accounting systems and in ABC systems as well.
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-41
15-41 (Continued-2)
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
helps managers avoid what has been referred to as the “death spiral,” which can
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
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
disposition of any resulting overhead variances at the end of the period. GAAP
requires the use of “normal capacity” for allocating fixed overhead costs to
production. Further, “normal capacity refers to a range of production levels … (i.e.,
the amount of) production expected over a number of periods under normal
circumstances.” By this specification, “normal capacity” refers to a range of
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.
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-42
15-41 (Continued-3)
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 production…activities.” (emphasis added)
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 written off as a period cost.
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-43
15-42 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:
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)
Change (improvement) in operating income $8,856,000
or,
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,
decrease reported accounting income).
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-44
15-42 (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
the test of being an “asset”—that is, something that would benefit one or more future
periods. The underlying costs associated with a production volume variance are
capacity-related costs which, by definition, expire with the passing of time. Thus, by
capitalizing the volume variance the VP of Finance may, in fact, be violating a basic
accounting standard.
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
allocating fixed overhead costs to product, then any amount of unallocated overhead
should be viewed as “abnormal” and therefore treated as a period cost.
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
15-45
15-42 (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
volume variance for the period. Consequently, the effect of a change in physical
inventory can be intensified or reduced based on how the production volume
variance is disposed of at the end of the period. Specifically, this ability to affect
reported income is confined to the situation where the production volume variance is
written off entirely to cost of goods sold (CGS), as follows:
• If inventory is increasing, choosing a lower denominator-volume level will
fixed overhead into CGS.
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
opportunity to manage earnings under absorption costing. The above points suggest
that managers can increase short-run operating income by: (1) choosing larger
denominator levels if they expect inventory to decrease, or (2) choosing smaller
