Blocher8e EOC SM Ch15 Final Student
Blocher8e EOC SM Ch15 Final Student
Blocher8e EOC SM Ch15 Final Student
QUESTIONS
15-2 This question pertains to text Exhibits 15.1 and 15.3. As indicated in Exhibit 15.1, the
amount of variable overhead applied to production for a period (product-costing
purpose) is exactly equal to the amount of variable overhead in the flexible budget
based on outputs (control purpose). In short, there is no difference between the total
variable overhead applied to the units manufactured and the total standard variable
overhead in the control budget for the period.
However, as indicated in Exhibit 15.3, the amount of fixed factory overhead in the
flexible budget is likely to be different from the amount of fixed factory overhead
assigned to production for the period. The flexible budget for fixed overhead includes
a “lump-sum” amount (control purpose) while the amount of fixed overhead applied
to production is equal to the product of a predetermined (i.e., standard) fixed
overhead allocation rate and the standard allowed activity units for the production in
the period. The difference is a result of the discrepancy between the activity units
assumed when the fixed overhead application rate was determined, what we call the
“denominator activity level,” and the number of units manufactured during the period.
In short, when dealing with fixed factory overhead, the (“lump-sum”) amount used for
control purposes and the amount applied to production will be identical only if the
actual output of the period exactly equals the denominator activity level.
15-4 Because an alternative activity measure usually is used as the basis for applying
manufacturing overhead to production, a variable overhead efficiency variance is a
result of efficiencies or inefficiencies regarding the use of this activity measure. For
example, a favorable overhead efficiency variance for a firm that uses machine
hours to apply overhead can be a result of the firm’s use of fewer machine hours
than the standard machine hours for the units manufactured. In short, the variable
overhead efficiency variance does not measure efficiency regarding consumption of
variable overhead costs (electricity, indirect labor, etc.); it represents an impact on
variable overhead cost of efficiency or inefficiency in the use of the activity measure
used to construct the flexible budget.
15-6 A production volume variance results when actual output differs from the output level
assumed when the fixed overhead application rate was developed. Among reasons
for this discrepancy are:
Unexpected stoppage or slowdown of operations because of unscheduled
equipment maintenance, strike, or workers’ slowdown.
Changes in market demand for the products of the firm.
15-8 The “denominator activity level” refers to the size of the denominator when
determining the standard fixed overhead application rate for product-costing
purposes. Various options for the volume of the denominator are possible, including
budgeted volume, practical capacity, and theoretical capacity. Most writers today
recommend the use of practical capacity for at least two reasons:
15-10 If a standard cost system is used, variances related to overhead costs can be
recorded formally in the accounting records. Such variances, however, are
considered “temporary accounts,” which at the end of the year must be closed out.
There are two primary methods for doing this at the end of the year:
(1) Method #1 is to close the net variance to Cost of Goods Sold (for example, if
the net overhead variance is favorable, then the CGS account would be
decreased, that is credited, at the end of the year). This practice can be
defended for several reasons. One, it is the most expedient (and therefore
least costly) method to use. Two, one can argue that the incremental
information that results from the more-complicated proration (allocation)
method is small relative to cost involved. Three, some accountants would
argue that variances inherently represent inefficiencies and, as such, should
not be carried forward on the balance sheet (through adjustment to inventory
accounts). Four, when companies maintain minimal inventories, the bulk of
the adjustment for the period under the proration method would go to the
CGS account anyway. Five, even with inventories, it is just a matter of a
timing difference with respect to getting the amount to CGS given that all
product costs eventually become CGS. Six, most of the units to which the
amount would be attached have likely already been sold anyway.
Blocher,Stout,Juras,Smith Cost Management, 8e 15-2
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(2) Method #2 is to prorate (allocate) the variance among accounts that contain
standard manufacturing costs. For factory overhead costs, this means that
the net variance can be allocated among WIP Inventory, Finished Goods
Inventory, and Cost of Goods Sold (CGS) based on the amount of the current
period’s standard overhead costs contained in the end-of-period balance in
these accounts. Note that when we expand the analysis to include direct
materials, any price variance that occurs during the period should be
allocated to the Direct Materials Inventory account, the materials usage
(quantity) variance, the WIP Inventory account, the Finished Goods Inventory
account, and CGS. Similarly, any fixed overhead spending variance should, in
theory, be partially allocated to the Production Volume Variance for the
period. The proration method is required in some contexts (e.g., any
government contract work for which the contractor must comply with the
standards set by the Cost Accounting Standards Board [CASB]). Others
would defend this approach because the resulting data approximate actual-
cost results.
One variation of the allocation method is to use the total end-of-period dollar
balance (not simply the standard overhead costs from this period) in relevant
accounts to determine allocation percentages. This method is simpler to
implement, but would result in a different end-of-year allocation of the net
manufacturing cost variance for the year compared to the conceptually correct
method noted above.
We note here that both financial reporting and income tax considerations are
associated with the end-of-period variance disposition question:
(1) For external reporting purposes, accountants need to follow the provisions of
generally accepted accounting principles (FASB ASC 330-10-30-6 and -7,
www.fasb.org, which specify that abnormal amounts of idle facility expense
should be recognized as current-period charges and not capitalized as part
of inventory cost. One implication of this reporting requirement is that the
amount of fixed overhead allocated to each unit of production is not
increased because of abnormally low production or an idle plant.
BRIEF EXERCISES
Thus, the spending (budget) variance for the production supervisory salaries in
August is:
That is, fixed overhead was underapplied by $50,000 during the period.
EXERCISES
(2) Cost function, within the relevant range, for montly factory overhead cost:
For example:
X Y
3,000 $128,500
3,5008e 15-6 $139,000
Blocher,Stout,Juras,Smith Cost Management,
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rights reserved.$149,500
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4,500 $160,000
5,000 $170,500
5,500 $181,000
6,000 $191,500
15-24 (Continued-2)
(3) Graphical representation of monthly factory overhead cost (using the Chart
function in Excel) over the range of 3,000-6,000 machine hours per month:
(A)
(C)
Ex. 15-24.xlsx
Slope of Line = (D)
(H)
(K)
(I) (J)
15-26 Graphical Analysis—Fixed Overhead Cost Variances (continuation of Ex. 15-25)
(L)
(30–40 minutes) (E)
(B)
(F) (G)
Solution:
(A) = Fixed Overhead Cost (label)
(B) = Machine Hours = Activity Measure for Applying Fixed Overhead Cost (label)
(C) = Standard Fixed Overhead Applied
(D) = Standard Fixed Overhead Application Rate (per Machine Hour)
(E) = Budgeted Fixed Overhead (“Lump-Sum” Amount)
(F) = Denominator Activity Level (for setting the fixed overhead allocation rate)
(G) = Standard Allowed Machine Hours for Units Produced this Period
(H) = Standard Fixed Overhead Applied to Units Produced = (G) × (D)
(I) = Actual Fixed Overhead Costs Incurred During the Period
(J) = Fixed Overhead Production Volume Variance (= D × (G − F))
(K) = Total Fixed Overhead Variance = (J) + (L)
(L) = Fixed Overhead Spending (Budget) Variance = (I) − (E)
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15-30 (Continued)
Note: for fixed overhead cost, the spending variance and flexible-budget variance are, by definition, equal; see
(Note: if the Fixed Overhead Spending Variance were favorable (F), then the variance account would be credited, not
debited (as above), while the Factory Overhead account would be debited.)
(Note: if the Fixed Overhead Spending Variance were favorable (F), then the variance account would be credited, not
debited (as above), while the Factory Overhead account would be debited.)
4. The $2,000 unfavorable fixed factory overhead spending variance could be a result of unexpected fluctuations,
overspending, or budgeting errors in one or more fixed overhead items. However, since the amount is small (2.22% of
the budgeted amount), it is unlikely that management needs to spend any time or resources to investigate this
variance.
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The $3,600 unfavorable production volume variance is a result of the lower output for the period (4,800 units) as
compared to the volume of output (5,000 units) assumed when the fixed overhead allocation rate was determined. The
production manager is responsible for the unfavorable variance if the reason for the lower output is a result of activities
or events in the factory such as equipment failure, inefficient workers, or high defective rates. However, the factory is
doing its job if the lower production is a result of the decreased demand for its product. As indicated in the text, this
variance generally has shared responsibility (with marketing, purchasing, etc.).
Note that when the denominator activity level is set at practical capacity, then any resulting production volume
variances can be interpreted as the cost of unused (i.e., idle) capacity. The disclosure of this information over time can
help managers make better decisions regarding capacity-related spending.
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15-32 Two-Variance vs. Four-Variance Breakdown of the Total Overhead Variance (60 minutes)
15- 32 (Continued-1)
2. Four-Variance
Breakdown of the
Total Overhead Cost
Variance for the
Period
15-32 (Continued-2)
The following
summary
diagram
(similar to
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Panel 1 in Exhibit 15.7) may be useful:
In comparing the
above two
summary
diagrams, we see
that three items from the four-variance analysis (viz., the variable overhead spending variance, the variable overhead
efficiency variance, and the fixed overhead spending variance) are combined into one variance, the total flexible-
budget variance, under the two-variance analysis. The production volume variance component of the total overhead
variance is the same in the two-variance, the three-variance, and the four-variance breakdown of the total overhead
variance, a point illustrated in Panels 1, 2, and 3 in Exhibit 15.7.
3. The two-variance breakdown of the total overhead variance reports two important factors concerning overhead costs.
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The flexible-budget variance measures the difference between the actual overhead incurred and the overhead that
should have been incurred based on the actual output of the period. (This latter term is referred to as the “Flexible-
budget Based on Output.”) To motivate cost control on the part of managers, the total flexible-budget variance is
sometimes referred to as the total “controllable” overhead variance—it signals to managers the need to control costs
vis-à-vis the amounts reflected in the flexible-budget based on outputs for the period.
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15-32 (Continued-3)
The production volume variance, when the fixed overhead application rate is based on practical capacity, reports the
effectiveness of the organization in using available capacity. Over time, this variance can signal to managers the
existence of excess capacity or the need for capacity expansion. In short, this variance helps managers control
capacity-related resource spending.
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15-34 Journal Entries for Factory Overhead Costs and Standard Cost Variances; Spreadsheet Application (60
minutes)
Supporting data:
Actual variable overhead cost incurred = # machine hours worked during the month × actual variable overhead cost per
machine hour = 5,600 hours × $21.60 per machine hour = $120,960
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15-34 (Continued-1)
1. Total flexible-budget variance and production volume variance for the month:
15- 34 (Continued-2)
15- 34 (Continued-3)
Note: An Excel
spreadsheet solution file
for this assignment is
embedded below. You can
open this “object” by doing
the following:
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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. 15-34.xlsx
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15-36 ABC and Practical Capacity; Spreadsheet Application (50 minutes) (note: answers rounded to 4 decimal places)
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15-36 (Continued)
Note: An Excel spreadsheet solution file for this assignment is embedded below. You
can open this “object” by doing the following:
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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. 15-36.xlsx
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PROBLEMS
As indicated in the text, at least three other options exist for determining the
denominator activity level when setting the fixed overhead allocation rate:
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).
Applied
Actual Overhead
Costs Costs Variance
Total variable factory overhead $120,220 $120,000 $220U
Fixed factory overhead:
Salaries $ 39,000 $ 40,000 $1,000F
Depreciation and amortization 25,000 25,000 –
Other expenses 15,300 15,000 $300U
Total fixed factory overhead $ 79,300 $ 80,000 $ 700F
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15-38 (Continued-1)
Calculations for Applied Fixed Overhead, First Six Months (see above):
Salaries: 40,000 DLHs × $1.00 per DLH = $40,000
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, 2020 would be $12,000 less, not $90,000 as reported. The
revised cost of goods sold (CGS) calculation follows.
Sales $625,000
CGS (see (a) above) 392,000
Gross profit $233,000
Less:
Selling expense $ 44,000
Depreciation expense 58,000
Administrative expense 53,000 155,000
Revised Operating Income (Loss) $ 78,000
(4) As noted in requirement (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
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smallest, that is, tightest, standard costs). As discussed in the text, the ultimate
choice
15-38 (Continued-2)
From a managerial standpoint, the use of practical capacity has several key
advantages. For one thing, it “reveals” the cost of unused (i.e., idle) 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 based on 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.
Thus, the resulting cost figure represents the cost of capacity as the cost of capacity
supplied, not cost based on the amount of capacity demanded. The time-series
reporting of the cost of unused capacity (i.e., production volume variances) under
practical capacity enables managers to better manage spending on capacity-related
resources. The use of practical capacity, at least compared to the use of budgeted
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 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.
15-38 (Continued-3)
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 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
production…activities.” (emphasis added)
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15-40 Income Statement Effects of Alternative Denominator Activity Levels;
Spreadsheet Application (60 minutes)
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15-40 (Continued-1)
Notes:
(1) Standard manufacturing cost of goods manufactured = no. of units produced ×
standard manufacturing cost per unit. Calculations:
Theoretical Capacity: 12,250 units × $83.58 per unit = $1,023,896
Practical Capacity: 12,250 units × $86.18 per unit = $1,055,655
Normal Capacity: 12,250 units × $88.25 per unit = $1,081,063
Budgeted Output: 12,250 units × $89.42 per unit = $1,095,354
(2) Ending Inventory, at standard manufacturing cost = answers from Requirement
2.
(3) Adjusted Cost of Goods Sold (CGS) = CGS at standard cost + unfavorable
volume variance or – favorable volume variance
(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 will be spread.
Differences in the assumed activity level, as the example above shows, lead to
differences in per-unit manufacturing costs and, in turn, in the amount of the
production volume variance (over- or underapplied budgeted fixed overhead). The
situation is further clouded by two factors: (a) costs are allocated to products for
different purposes (e.g., planning and control, motivation, to meet financial
reporting requirements, and for income-tax purposes) and depending on the
purpose, different denominator activity levels might be appropriate; and (b) there
are different end-of-year treatments for the disposal of the production volume
variance that occurred during the year. The 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 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
readjusted based on the actual manufacturing support cost per unit of activity) the
ability to manage earnings is somewhat decreased since the inventory and CGS
accounts after rate readjustment approximate, if not equal, actual costs.
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15-40 (Continued-2)
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:
Pr. 15-40.xlsx
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15-42 Strategy, Resource Capacity Planning, and Time-Driven ABC (50-60 Minutes)
1) Stage 1: Develop the Strategy (e.g., what business are we in, and why? what are
the key issues we face in our business? how can we best compete?)
3) Stage 3: Plan Operations (i.e., how the organization intends to accomplish its
strategic objectives specified in Stage 2; available tools include: process-
improvement plans; resource capacity planning; and budgeting—both operating
budgets and capital budgets)
4) Stage 4: Monitor and Learn (i.e., both operational-review meetings and strategy-
review meetings are conducted to review results and performance metrics)
5) Stage 5: Test and Adapt the Strategy (i.e., assessment of the strategy itself and,
if necessary, revision of the strategy)
2. As noted above, resource capacity planning is one of the key elements of Stage 3 of
the strategic management system proposed by the authors. As noted on page 72 of
the article, the process of planning resource capacity presumes the existence of a
sales forecast and operating plan for the coming period (generally, a quarter). Either
traditional ABC or time-driven ABC (TDABC) can be used to then translate these
plans into resource requirements. For example, once we have an idea of the sales
forecast for the quarter, we can break that forecast down into products, customers,
services, and sales mix. The ABC information provides an idea of the level of
resource spending (resource support) that is implied by products, services, and
customers envisioned in the operating and sales plan for the period. In Stage 4 of the
management process, the organization compares actual operating results and
measures to forecasted/budgeted amounts.
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15-42 (Continued-1)
dividing budgeted resource expenditures (in the cost pool) by the outputs of each
activity (e.g., number of orders processed). Such systems were therefore subject to
inherent inaccuracies. Further, traditional ABC systems are difficult (cumbersome) to
update (e.g., to account for increases in operational efficiencies). These problems,
and others, combined to prevent the successful implementation of traditional ABC
systems by many organizations. In response, time-driven ABC (TDABC) has been
proposed as an alternative to traditional ABC systems. TDABC assigns support costs
to products, services, and customers based on the following two parameters:
b) The capacity (time) required from each department or process to perform the
activity in question (e.g., handling a customer’s order)
As noted on page 72 of the article, time equations from TDABC are used to model
resource consumption of products, services, and customers. Once a sales and
operating plan has been determined, TDABC can be used to forecast resource
requirements needed to support those plans. This forecast can then be used by
management to authorize spending on needed resources: people, equipment, and
other resources.
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15-44 Proration of Variances (60 minutes)
1. The amount of direct materials price variance, PV, prorated to finished goods ending inventory is $1,794 (see
calculation above); answer rounded to nearest whole number.
2. The total amount of direct materials in finished goods ending inventory after proration of all materials variances is
$85,732 (see calculation above)
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15-44 (Continued-1)
3. The total amount of direct labor in finished goods inventory at December 31, after all variances have been prorated:
$130,500 + $2,250 = $132,750 (see calculation above)
4. The total cost of goods sold for the year ended December 31 after all variances have been prorated: $1,681,678 (see
calculation above)
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.
6. 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
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period. Consequently, the effect of a change in physical inventory can be intensified or reduced based on how the
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15-44 (Continued-2)
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:
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
denominator levels if they expect inventory to increase. Note, however, that if the
production volume variance is prorated based on the units creating the variance,
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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15-46 Control of Overhead Costs; Strategy (45-60 Minutes)
1. In general, how does this article relate to the material covered in Chapter 15?
Chapter 15 deals with the accounting for and the management of indirect costs—
principally, indirect manufacturing costs (i.e., manufacturing overhead). The
discussion in Chapter 15 extends the discussion from Chapter 14 and as such uses
standard costs and flexible budgets at the end of an accounting period to generate
various standard cost variances. The framework presented in Chapters 14 and 15 is
a traditional model for achieving short-term financial control.
The beginning of the article notes an important context: you, as the decision maker/
manager, are not able to advocate a change in strategy or large-scale investments
in technology (either of which might produce long-term cost savings). Thus, you
have been asked to focus on ways to secure specified short-term administrative cost
savings.
One, organizations typically are not able to meet their cost-cutting goals with a single
idea or plan. In fact, as a rule-of-thumb, the authors suggest that typically a
combination of 10 or more actions will be needed.
Two, the type of cost-cutting plans or ideas implemented should be directly related
to the degree of cost-cutting required (e.g., 10%, 20%, or 30%). The reason for this
is the belief that the degree of organizational disruption is positively related to the
level of cost cutting that is required. Put another way, because action plans needed
to secure higher levels of administrative cost savings will be more “disruptive,” such
plans should be considered only if major (e.g., 30%) cost reductions are mandated.
On the other hand, a combination of less-disruptive (i.e., more locally confined)
action plans would be entirely appropriate for a lower cost-reduction goal (e.g.,
10%).
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15-46 (Continued-1)
3. The authors of this article also state (p. 75) that cost-reduction goals typically
require “ten or more actions.” For each of the three classifications of cost-
reduction goals discussed in the article provide examples of specific actions
that managers can pursue to meet the stated cost-reduction goal.
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15-46 (Continued-2)
The authors’ thoughts in this regard are presented at the top of pages 78 and 79.
From management’s perspective, the underlying issue is “are we cutting enough—or
too much?”
In attempting to answer this question, the authors suggest that overhead spending
occurs for the following three reasons: (1) to enable direct activities, (2) to increase
the effectiveness of direct activities, and (3) to lay the groundwork for future growth.
For spending in the first category above, competitive benchmarking may provide
guidance as to a reasonable commitment of resources. For category-two spending,
the authors suggest the application of a cost-benefit trade-off analysis. An
effectiveness ranking may be helpful in this regard. For category-three spending,
traditional capital-budgeting techniques (e.g., discounted cash flow [DCF]) may
provide useful guidance.
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15-48 Managing Resource Capacity through Traditional Activity-Based Costing
(ABC) (60 Minutes)
1. “Variable” and “fixed” costs represent descriptions of how a given cost changes in
response to one or more specified activities or “cost drivers.” (Mathematically, we
would say that “cost” is the dependent variable and the cost drivers represent
independent variables. A mathematical equation, in linear or non-linear form, can be
used to depict the underlying “behavior” of a given cost.)
We say a given cost is “variable” if, in the short run, that cost changes in response to
one or more cost drivers. In other words, such costs change, in total, as related
activity changes (up or down). Examples of short-run “variable costs” include some
type of labor (e.g., temporary or part-time employees, or employees paid on a
piecework basis), energy, materials, and telephone expense. From an ABC
perspective, these costs are supplied on an “as needed” (or, on-demand) basis. As
such, there is no unused capacity regarding such resource expenditures.
Fixed costs are those that, in the short run, are related to the amount of capacity
supplied. That is, these costs are independent of actual activity levels—they relate
more to the ability to produce, rather than the actual level of production. (Of course,
in the long-run, these costs can be managed—increased or decreased—by
managerial action.) Resource expenditures for these items are therefore independent
of how much of the resource is used in a given period. Examples include things such
as engineering salaries, production scheduling, sales and marketing managers, and
depreciation expense (or most rental expenses).
For many organizations today, their support costs are significant in amount and
largely short-term fixed. That is, many (if not most) support costs, including
manufacturing overhead, are incurred regardless of short-term demands. This, in
turn, presents an important managerial challenge: how to manage the demand for
and supply of resource spending on support costs. Properly implemented ABC
systems can help in this regard because they reveal to management the amount and
approximate cost of acquired, but unused, capacity.
As noted above in (1), many (if not most) support costs are fixed in the short run.
Thus, using budgeted activity volume as the denominator in the determination of
ABC rates means that as volume of activity decreases, the cost-allocation rate
increases. If these increased rates are used to determine contract bids, product
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15-48 (Continued-1)
prices, and order acceptance, the company may set an increased price to offset the
seemingly increased activity cost rates. Predictably, the effect is even lower demand,
lower activity volume, and higher activity cost rates. This situation is referred to in the
literature as the death-spiral effect. Eventually, there are no customers left to bear
the (basically fixed) support costs.
Managers can monitor, for each resource supplied, the cost of unused capacity. In
doing so, they can make decisions to bring the demands for and supply of resources
for support costs into balance.
The management of support costs for companies like Zen is of strategic concern
because, more than likely, the company is competing based on a differentiation
strategy. Thus, managing resource spending in support areas (e.g., manufacturing
support, customer support) is strategically important. Further, the dollar amount of
such costs is likely to be large and therefore worthy of special attention (monitoring
and control).
4. The point of this question is to demonstrate that the ABC data, based on practical
capacity, can be used to reveal the increased efficiencies associated with the TQM
initiative (in terms of the impact of that initiative on the customer-handling process).
Prior to the TQM initiative, the ABC cost was $72.00 per order; after the TQM
initiative, this cost drops to $60.00. In other words, after the TQM initiative, a
customer order can be handled with $60.00 of resources—this is the new inherent
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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
Capacity Utilization:
Prior to TQM Implementation = 9,000 ÷ 10,000 = 90.00%
(c) After TQM Implementation = 9,000 ÷ 12,000 = 75.00%
(d) Conclusion: Efficiency initiatives (e.g., TQM) will lead to reduced resource
spending only if managers eliminate or redeploy the unused resource capacity that
was created by the efficiency improvement.
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the unused capacity costs should be traced back to the place in the organization
where the decision to acquire the associated capacity was made.
15-50 ABC vs. Traditional Approaches to Control of Batch-Related Overhead Costs
(60 minutes)
Note that the flexible budget for setup-related variable overhead costs should be based
in this case on setup hours (the controllable factor). Thus, given an output last year of
9,000 units, the company should have used 36 batches (9,000 units ÷ 250 units per
batch). At a standard of 4.0 setup hours per batch, the 9,000 units produced equates to
144 setup hours.
(1) (a) Fixed setup-related overhead spending variance = Actual fixed setup-related
costs – budgeted fixed setup-related costs = $21,000 − $20,000 = $1,000U
(b) Production volume variance = budgeted fixed setup-related costs – applied fixed
setup-related overhead costs= $20,000 − (36 batches × 4 setup-hours per batch
× $125.00 per setup hour) = $20,000 − $18,000 = $2,000U
As the name implies, the fixed set-up-related overhead spending variance means
that last year’s 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 setup hours, was not fully utilized during the period.
Specifically, the standard allowed setup hours (for this year’s production), 144,
was 16 less than capacity available (160 hours). Thus, $2,000 = 16 hours × $125
per hour.
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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 per batch × actual variable setup-related
overhead costs per setup hour) − (actual batches × actual setup hours per
batch × budgeted variable setup-related overhead costs per setup hour)
= (45 batches × 4.25 setup-hours per batch × $19.00 per setup hour) − (45
batches × 4.25 setup-hours per batch × $20.00 per setup hour)
= $3,633.75 − $3,825.00 = $191.25F (rounded to two decimal places)
= $3,825 − (36 batches × 4 setup-hours per batch × $20.00 per setup hour)
= $3,825 − $2,880 = $945.00U (rounded to two decimal places)
The favorable setup-related spending variance is attributable to spending on
variable setup-related overhead costs being $1.00 per hour less than budgeted.
This amount could be broken down further if we had additional data regarding the
components of this cost (i.e., materials and electricity costs). The unfavorable
efficiency variance for variable setup-related overhead costs is due to a
combination of the following two factors: (1) the actual output of the period (9,000
units) took 9 more 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-base budgeting). These
costs basically relate to the capacity or ability to produce.
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of these overhead
15-50 (Continued-2)
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 related to machine
hours, then the variable overhead spending variance based on machine hours will
include the effect of spending on these other activities—in other words, the reported
variance does not yield actionable information. Further, the use of ABC allows the
accountant to isolate spending and efficiency variances at different levels in the
cost hierarchy. As in the present case, the analysis of batch-level support costs
would reveal financial tradeoffs of using larger lot sizes compared to the lot size
assumed for flexible-budgeting purposes.
(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
advantage of being expressed in a manner that is readily interpretable by operating
personnel. As well, these data direct worker attention to actionable steps when a
process is perceived to be out of control. The financial performance indicators are
also helpful. For one thing, they provide a common measure (dollars) that
managers can use to evaluate tradeoffs (e.g., larger lot sizes). For another thing,
dollar-based variance information provides decision makers with information that
can be used to determine which variances should be investigated. Finally, the
periodic financial performance indicators remind operating personnel of the financial
impact of their actions and decisions.
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15-52 Summary Problem: Four-Variance Breakdown of the Total Overhead
Variance; Journal Entries (90 minutes)
2. Total overhead application rate, per machine hour (rounded to 2 decimal places):
3. Total overhead variance for the year (to nearest whole number):
15-52 (Continued-1)
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4. Interpretation of results reported in (3) above
The actual overhead cost incurred during the year is the same for all three
alternatives. The standard overhead cost per unit differs across the three options
because of the “denominator effect” (i.e., spreading a constant numerator amount
[budgeted fixed overhead cost] over a changing denominator). Notice that budgeted
output for the period is the lowest of the three denominator volumes. As such, use of
budgeted output volume will result in the highest amount of applied overhead during
the period. In turn, this means that the use of budgeted output as the denominator
produces the lowest total overhead variance. As shown below, this effect is
attributable to how we handle fixed overhead costs in the product-costing process. In
the case of “practical capacity,” unabsorbed budgeted fixed overhead costs are not
assigned to outputs; rather, they are calculated and reported separately as the
production volume variance. Finally, as noted in the text, the choice of the
denominator volume (for determining the fixed overhead application rate) is important
because the method we use to dispose of variances at the end of the year (writing off
to CGS vs. prorating the variances to ending inventories and CGS) will affect
reported operating income. (This is true under absorption, but not variable, costing.)
As can be seen from the results in (5), the variable overhead efficiency variance is
not affected at all by the choice of the denominator activity level for applying fixed
overhead. Rather, it is a function of the efficiency or inefficiency of whatever base is
used to apply variable overhead costs to production—in the present case, machine
hours. The variance here is caused by the fact that fewer machine hours per unit
were used during the period. If (that is, assuming) variable overhead cost is indeed
related to number of machine hours worked (and, this could be a big “if”), then the
efficiency
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15-52 (Continued-2)
in the use of machine hours would result in a savings of variable overhead costs
(e.g., electricity used to run machines used to manufacture the product).
As can be seen, the total overhead spending variance is not affected by choice of
the denominator activity level (used to set the fixed overhead application rate and
the total overhead application rate).
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15-52 (Continued-3)
The production volume variance arises from our need to assign fixed overhead costs
to production and the use of a predetermined application rate (here, the standard
fixed overhead application rate). If the actual output level (however measured) is
different from the volume level used to establish the fixed overhead application rate,
there will be a production volume variance. If actual activity (volume) is greater than
the denominator volume (i.e., the volume used to establish the fixed overhead rate),
the production volume variance will be favorable; the variance would be unfavorable
if the opposite is true--that is, if the actual activity for the period is less than the
denominator volume level.
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15-52 (Continued-4)
Note that when practical capacity is used to estimate the fixed overhead rate the
resulting production volume variance can be interpreted (roughly) as the cost of
unused capacity. In other words, in this situation the production volume variance
provides management with information that can be used for resource-capacity
planning (i.e., ensuring an adequate, but not excessive, supply of capacity-related
resources).
Finally, note that when denominator volumes less than practical capacity are used to
establish the fixed overhead application rate (e.g., budgeted output or normal
capacity), then the cost of unused capacity is basically assigned to current output, a
situation that raises the risk of what we refer to death-spiral effect (i.e., raising of
selling prices to recover fixed costs, despite successive decreases in demand).
Comment: Note that the production volume variance is the only cost variance that is
affected by the choice of the denominator volume (used to establish the fixed
overhead application rate and, by extension, the total overhead application rate).
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15-52 (Continued-5)
13. Summary journal entries (assuming that practical capacity was used to
establish the overhead application rates):
Note: at the end of the year, if the net variance for the period is unfavorable (U), it is
debited to the cost of goods sold (CGS) account; if the net variance is favorable (F),
it is credited to the CGS account; the other components of the above journal entry
close out the variance account balances to zero (thus, unfavorable variances are
closed to zero by crediting the variance account, while favorable variances are
closed to zero by debiting the variance account).
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