managerial accounting 1 - cost behavior and allocation.pdf

1

Copyright © 2002 by Gleim Publications, Inc. and Gleim Internet, Inc. All rights reserved. Duplication prohibited.

COURSE 34: MANAGERIAL ACCOUNTING 1 - COST BEHAVIOR AND ALLOCATION

26 pages of outline A. Cost-Volume-Profit (CVP) AnalysisB. Variable and Absorption CostingC. Overhead AllocationD. Process Costing and Job-Order CostingE. Activity-Based Costing (ABC)F. Service Cost AllocationG. Joint Products and By-ProductsH. Standard Costing and Variance Analysis

Course 34 is the first of two courses on managerial accounting. It concerns cost behavior,that is, whether costs are fixed, variable, or some combination thereof. Cost behavior must beunderstood to plan for firm profitability. This course also concerns cost allocation methods. These methods are used to assign indirect costs to cost objects. The last subunit coversstandard costing and variance analysis.

A. Cost-Volume-Profit (CVP) Analysis

1. CVP (breakeven) analysis predicts the relationships among revenues, variable costs,and fixed costs at various production levels. It determines the probable effects ofchanges in sales volume, sales price, product mix, etc.

2. The variables include

a. Revenue as a function of price per unit and quantity producedb. Fixed costsc. Variable cost per unit or as a percentage of salesd. Profit per unit or as a percentage of sales

3. The inherent simplifying assumptions used in CVP analysis are the following:

a. Costs and revenues are predictable and are linear over the relevant range.

b. Total variable costs change proportionally with volume, but unit variable costsare constant over the relevant range.

c. Changes in inventory are insignificant in amount.

d. Fixed costs remain constant over the relevant range of volume, but unit fixedcosts vary indirectly with volume.

e. Selling prices remain fixed.

f. Production equals sales.

g. The product mix is constant, or the firm makes only one product.

h. A relevant range exists in which the various relationships are true for a given timespan.

i. All costs are either fixed or variable relative to a given cost object.

j. Productive efficiency is constant.

k. Costs vary only with changes in physical sales volume.

l. The breakeven point is directly related to costs and indirectly related to thebudgeted margin of safety and the contribution margin.

S = FC + VC$2.00X = $6,000 + $.80X$1.20X = $6,000

X = 5,000 units at breakeven point

S = FC + VC + P$6.00X = $37,500 + $2.00X + $.90X$3.10X = $37,500

X = 12,097 units at breakeven to earn a 15% profit

Course 34: Cost Behavior and Allocation -- Cost-Volume-Profit (CVP) Analysis2


4. Definitions

a. The relevant range is the set of limits within which the cost and revenuerelationships remain linear and fixed costs are fixed.

b. The breakeven point is the sales level at which total revenues equal total costs.

c. The margin of safety is the excess of budgeted sales dollars over breakevensales dollars (or budgeted units over breakeven units).

d. The sales mix is the composition of total sales in terms of various products, i.e.,the percentages of each product included in total sales. It is maintained for allvolume changes.

e. The unit contribution margin (UCM) is the unit selling price minus the unitvariable cost. It is the contribution from the sale of one unit to cover fixed costs(and possibly a targeted profit).

1) It is expressed as either a percentage of the selling price (contributionmargin ratio) or a dollar amount.

2) The UCM is the slope of the total cost line plotted so that volume is on thex axis and dollar value is on the y axis.

5. Breakeven Formula

a. P = S --- FC --- VC If: P = profit (zero at breakeven)S = XY S = sales

FC = fixed costsVC = variable costs

X = quantity of units soldY = unit sales price

6. Applications

a. The basic problem equates sales with the sum of fixed and variable costs.

1) EXAMPLE: Given a selling price of $2.00 per unit and variable costs of40%, what is the breakeven point if fixed costs are $6,000?

2) The same result can be obtained by dividing fixed costs by the UCM.

3) The breakeven point in dollars can be calculated by dividing fixed costs bythe contribution margin ratio.

b. An amount of profit, either in dollars or as a percentage of sales, may berequired.

1) EXAMPLE: If units are sold at $6.00 and variable costs are $2.00, howmany units must be sold to realize a profit of 15% ($6.00 x .15 = $.90 perunit) before taxes, given fixed costs of $37,500?

S = FC + VCS = $150,000 + .6(.6S) + .85(.4S)S = $150,000 + .36S + .34S

.30S = $150,000S = $500,000

Course 34: Cost Behavior and Allocation -- Cost-Volume-Profit (CVP) Analysis 3


2) The desired profit of $.90 per unit is treated as a variable cost. If thedesired profit were stated in total dollars rather than as a percentage, itwould be treated as a fixed cost.

3) Selling 12,097 units results in $72,582 of sales. Variable costs are $24,194and profit is $10,888 ($72,582 x 15%). The proof is that fixed costs of$37,500, plus variable costs of $24,194, plus profit of $10,888 equals$72,582 of sales.

c. Multiple products may be involved in calculating a breakeven point.

1) EXAMPLE: If A and B account for 60% and 40% of total sales, respectively,and the variable cost ratios are 60% and 85%, respectively, what is thebreakeven point, given fixed costs of $150,000?

a) In effect, the result is obtained by calculating a weighted-averagecontribution margin ratio (30%) and dividing it into the fixed costs toarrive at the breakeven point in sales dollars.

b) Another approach is to divide fixed costs by the UCM for acomposite unit (when unit prices are known) to determine thenumber of composite units. The number of individual units canthen be calculated based on the stated mix.

d. Sometimes breakeven analysis is applied to analysis of the profitability of specialorders. This application is essentially contribution margin analysis.

1) EXAMPLE: What is the effect of accepting a special order for 10,000 unitsat $8.00, given the following unit operating data?

Per UnitSales $12.50 Manufacturing costs -- variable (6.25) -- fixed (1.75)Gross profit $ 4.50 Selling expenses -- variable (1.80) -- fixed (1.45)Operating profit $ 1.25

a) The assumptions are that idle capacity is sufficient to manufacture10,000 extra units, that sale at $8.00 per unit will not affect the priceor quantity of other units sold, and that no additional sellingexpenses are incurred.

b) Because the variable cost of manufacturing is $6.25, the UCM is$1.75 ($8 special-order price --- $6.25), and the increase in operatingprofit is $17,500 ($1.75 x 10,000 units).

Course 34: Cost Behavior and Allocation -- Variable and Absorption Costing4


Variable Cost Absorption Cost

Sales $800 Beginning inventory $ 0 Variable cost of manufacturing 450

$450 Ending inventory (90)Variable cost of goods sold (360)Manufacturing contribution margin $440 Variable selling expenses (20)Contribution margin $420 Fixed factory overhead (300)Fixed selling expenses (60) Operating profit $ 60

Sales $800 Beginning inventory $ 0 Cost of goods manufactured 750 Cost of goods available for sale $750 Ending inventory (150)Cost of goods sold (600)Gross margin $200 Selling expenses (80) Operating profit $120

B. Variable and Absorption Costing

1. These methods result in different inventory values and net profits. They also result inincome statements in which the classification and order of costs are different. Underabsorption (full) costing, all factory overhead costs are assigned to products.

2. However, variable (direct) costing has won increasing support. This method assignsvariable but not fixed factory overhead to products.

a. The term direct costing may be misleading because it suggests traceability,which is not what cost accountants mean when they speak of direct costing. Many accountants believe that variable costing is a more suitable term, andsome even call the method contribution margin reporting.

3. Variable and absorption costing are just two of a continuum of possible inventorycosting methods. At one extreme is supervariable costing, which treats directmaterials as the only variable cost. At the other extreme is superabsorption costing,which treats costs from all links in the value chain as inventoriable.

4. Under variable costing, all direct labor, direct materials, variable factory overheadcosts, and selling and administrative costs are handled in precisely the same manneras under absorption costing. Only fixed factory overhead costs are treateddifferently. They are expensed when incurred.

a. EXAMPLE: A firm, during its first month in business, produced 100 units ofproduct X and sold 80 units while incurring the following costs:

Direct materials $100Direct labor 200Variable factory overhead 150Fixed factory overhead 300

1) Given total costs of $750, the absorption cost per unit is $7.50 ($750 ÷ 100units). Thus, total ending inventory is $150 (20 x $7.50). Using variablecosting, the cost per unit is $4.50 ($450 ÷ 100 units), and the total valueof the remaining 20 units is $90.

2) If the unit sales price is $10, and the company incurred $20 of variableselling expenses and $60 of fixed selling expenses, the following incomestatements result from using the two methods:

Course 34: Cost Behavior and Allocation -- Variable and Absorption Costing 5


3) The $60 difference in operating profit ($120 --- $60) is the differencebetween the two ending inventory values ($150 --- $90). In essence, theabsorption method treats 20% of the fixed factory overhead costs (20% x$300 = $60) as an asset (inventory) because 20% of the month’sproduction (100 --- 80 sold = 20) is still on hand. The variable-costingmethod assumes that the fixed factory overhead costs are not productcosts because they would have been incurred even if no production hadoccurred.

4) The contribution margin is an important element in the variable costingincome statement. It equals sales minus total variable costs. It indicateshow much sales contribute toward covering fixed costs and providing aprofit.

5. Variable costing permits the adoption of the contribution approach to performancemeasurement. This approach is emphasized because it focuses on controllability. Fixed costs are much less controllable than variable costs, so the contribution margin(revenues --- all variable costs) may therefore be a fairer basis for evaluation thangross margin (also called gross profit), which equals revenues minus cost of sales. The following contribution approach income statement for a manufacturer is a moredetailed presentation than that on the opposite page:

a. The profit margin is net profit divided by revenues. It shows the percentage ofrevenue dollars resulting in net profit (return on investment).

b. The manufacturing contribution margin equals revenues minus variablemanufacturing costs.

c. The contribution margin is the manufacturing contribution minusnonmanufacturing variable costs.

d. The short-run performance margin is the contribution margin minuscontrollable (discretionary) fixed costs.

1) Discretionary costs are characterized by uncertainty about the relationshipbetween input (the costs) and the value of the related output. Examplesare advertising and research costs.

e. The segment margin is the short-run performance margin minus traceable(committed) fixed costs.

1) Committed costs result when a going concern holds fixed assets(property, plant, and equipment). Examples are insurance, long-termlease payments, and depreciation.

f. Net profit is the segment margin minus allocated common costs.

g. EXAMPLE: Contribution (Variable Costing) Approach Income Statement

Revenues $150,000 Variable manufacturing costs (40,000)Manufacturing contribution margin $110,000 Variable selling and administrative costs (20,000)Contribution margin $ 90,000 Controllable fixed costs: Manufacturing $30,000 Selling and administrative 25,000 (55,000)Short-run performance margin $ 35,000 Traceable fixed costs Depreciation $10,000 Insurance 5,000 (15,000)Segment margin $ 20,000 Allocated common costs (see next page) (10,000) Net profit $ 10,000

Course 34: Cost Behavior and Allocation -- Variable and Absorption Costing6


h. Allocation of central administration costs (allocated common costs) is afundamental issue in responsibility accounting. It has often been made basedon budgeted revenue or contribution margin. If allocation is based on actualsales or contribution margin, a responsibility center that surpasses expectationswill be penalized (charged with increased overhead).

1) Research has shown that central administrative costs are allocated toorganizational subunits for the following reasons:

a) The allocation reminds managers that such costs exist and that themanagers would incur these costs if their operations wereindependent.

b) The allocation also reminds managers that profit center earningsmust cover some amount of support costs.

c) Organizational subunits should be motivated to use centraladministrative services appropriately.

d) Managers who must bear the costs of central administrative servicesthat they do not control may be encouraged to exert pressure onthose who do. Thus, they may be able to restrain such costsindirectly.

2) If central administrative or other fixed costs are not allocated, responsibilitycenters might reach their revenue or contribution margin goals withoutcovering all fixed costs, a necessity to operate in the long run.

3) Allocation of overhead, however, is motivationally negative; centraladministrative or other fixed costs may appear noncontrollable and beunproductive. Furthermore,

a) Managers’ morale may suffer when allocations depress operatingresults.

b) Dysfunctional conflict may arise among managers when costscontrolled by one are allocated to others.

c) Resentment may result if cost allocation is perceived to be arbitraryor unfair. For example, an allocation on an ability-to-bear basis,such as operating profit, penalizes successful managers andrewards underachievers and may therefore have a demotivatingeffect.

4) A much preferred alternative is to budget a certain amount of thecontribution margin earned by each responsibility center to the centraladministration based on negotiation. The hoped-for result is for eachsubunit to see itself as contributing to the success of the overall entityrather than carrying the weight (cost) of central administration.

a) The central administration can then make the decision whether toexpand, divest, or close responsibility centers.

6. Differences between Variable and Absorption Costing. Under absorption costing,recurring costs are classified into three broad categories: manufacturing, selling, andadministrative. In the income statement, the cost of goods sold is subtracted fromsales revenue to give the gross margin (profit) on sales. Selling and administrativeexpenses are deducted from the gross margin to arrive at operating profit.

a. Under variable costing, operating profit equals the contribution margin minusfixed costs.

CIA IV -- SU 7: Cost Behavior and Allocation -- Variable and Absorption Costing 7


1) Because fixed factory overhead is not applied to products under variablecosting, no volume variance occurs. However, other variances are thesame under absorption costing and variable costing.

2) The contribution margin under variable costing is considerably differentfrom the gross margin under absorption costing.

b. Inventory costs computed under variable costing are lower than underabsorption costing, and operating profit may be higher or lower, dependingupon whether inventories are increased or liquidated.

1) When production and sales are equal for a period, the two report thesame operating profit. Total fixed costs budgeted for the period arecharged to sales revenue in the period under both methods.

2) When production exceeds sales and ending inventories are increased,the operating profit reported under absorption costing is higher thanunder variable costing. Under absorption costing, a portion of the fixedcosts budgeted for the period is deferred to the following period via theending inventories. Under variable costing, the total fixed costs areexpensed.

3) When sales exceed production and ending inventories are decreased,variable costing yields the higher operating profit. Under absorptioncosting, a portion of the fixed costs from the preceding period is carriedforward in beginning inventory. This amount is charged to the currentperiod’s cost of sales. These fixed costs would already have beenabsorbed by operations of the previous period if variable costing hadbeen used.

4) Under variable costing, operating profit always moves in the samedirection as sales volume. Operating profit reported under absorptioncosting may sometimes move in the opposite direction from sales.

5) Operating profit differences tend to be larger when calculations are madefor short periods. In the long run, the two methods will report the sametotal operating profit if sales equal production. The inequalities betweenproduction and sales are usually minor over an extended period becauseproduction cannot continually exceed sales. An enterprise will notproduce more than it can sell in the long run.

7. Benefits of Variable Costing for Internal Purposes. For planning and control,management is more concerned with treating fixed and variable costs separately thanwith calculating full costs. Full costs are usually of dubious value because theycontain arbitrary allocations of fixed cost.

a. Under variable costing, cost data are readily available from accounting recordsand statements. For example, CVP relationships and the effects of changes insales volume on operating profit can easily be computed from a variable-costing income statement but not from the absorption-cost income statement.

b. The full impact of fixed costs on operating profit, partially hidden in inventoryunder absorption costing, is emphasized by the presentation of costs on avariable-costing income statement. Thus, production managers cannotmanipulate operating profit by producing more or fewer products than neededduring a period.

Course 34: Cost Behavior and Allocation -- Overhead Allocation8


c. Variable costing is preferable for studies of relative profitability of products,territories, and other segments. It concentrates on the contribution that eachsegment makes to the recovery of fixed costs.

1) Marginal analysis leads to better pricing.

2) Out-of-pocket expenditures required to manufacture products conformclosely with the valuation of inventory.

3) Questions regarding whether a particular component should be made orbought can be more effectively answered if only variable costs are used.

4) Disinvestment decisions are facilitated because whether a product ordepartment is recouping its variable costs can be determined.

5) Costs are guided by sales. Under variable costing, the cost of goods soldwill vary directly with sales volume, and the influence of production onoperating profit is avoided.

C. Overhead Allocation

1. Factory overhead consists of indirect manufacturing costs that cannot be assigned tospecific units of production but are incurred as a necessary part of the productionprocess. Allocation bases (activity levels) in traditional cost accounting include directlabor hours, direct labor cost, machine hours, materials cost, and units of production. An allocation base should have a high correlation with the incurrence of overhead.

2. The distinction between variable and fixed factory overhead rates should beunderstood. Variable factory overhead per unit of the allocation base is assumed tobe constant within the relevant range of activity. Thus, estimation of the variablefactory overhead rate emphasizes the per-unit amount. However, fixed factoryoverhead is assumed to be constant in total over the relevant range. Accordingly, thefixed factory overhead rate is calculated by dividing the total budgeted cost by theappropriate denominator (capacity) level.

a. The use of an annual predetermined fixed factory overhead application rate isoften preferred. It smooths cost fluctuations that would otherwise occur as aresult of fluctuations in production from month to month. Thus, higheroverhead costs are not assigned to units produced in low production periodsand vice versa. The denominator of the fixed factory overhead rate may bedefined in terms of various capacity concepts.

1) Theoretical or ideal capacity is the level at which output is maximizedassuming perfectly efficient operations at all times. This level isimpossible to maintain and results in underapplied overhead.

2) Practical capacity is theoretical capacity minus idle time resulting fromholidays, downtime, changeover time, etc., but not from inadequate salesdemand.

3) Normal capacity is the level of activity that will approximate demand over aperiod of years. It includes seasonal, cyclical, and trend variations. Deviations in one year will be offset in other years.

4) Expected actual activity is a short-run activity level. It minimizes under- oroverapplied overhead but does not provide a consistent basis forassigning overhead cost. Per-unit overhead will fluctuate because ofshort-term changes in the expected production level.

Course 34: Cost Behavior and Allocation -- Overhead Allocation 9


3. Overapplied overhead (a credit balance in factory overhead) results when productcosts are overstated because the activity level was higher than expected or actualoverhead costs were lower than expected.

a. Underapplied overhead (a debit balance in factory overhead) results whenproduct costs are understated because the activity level was lower thanexpected or actual overhead costs were higher than expected.

b. Unit variable factory overhead costs and total fixed factory overhead costs areexpected to be constant within the relevant range. Accordingly, when actualactivity is significantly greater or less than planned, the difference between theactual and predetermined fixed factory overhead rates is likely to be substantial. However, a change in activity, by itself, does not affect the variable rate.

c. The treatment of over- or underapplied overhead depends on the materiality ofthe amount. If the amount is immaterial, it may be debited or credited to cost ofgoods sold.

1) If the amount is material, it should theoretically be allocated to work-in-process, finished goods, and cost of goods sold on the basis of thecurrently applied overhead in each of the accounts. This procedure willrestate inventory costs and cost of goods sold to the amounts actuallyincurred. An alternative is to prorate the variance based on the totalbalances in the accounts.

4. Two factory overhead accounts may be used: factory overhead control and factoryoverhead applied.

a. As actual overhead costs are incurred, they are debited to the control account. As overhead is applied (transferred to work-in-process) based on apredetermined rate, the factory overhead applied account is credited.

b. Assuming proration of under- or overapplied overhead, the entry to close theoverhead accounts is

Cost of goods sold (Dr or Cr) $XXX Work-in-process (Dr or Cr) XXX Finished goods (Dr or Cr) XXX Factory overhead applied XXX

Factory overhead control $XXX

5. The improvements in information technology and decreases in its cost have made arestated allocation rate method more appealing. This approach is implemented atthe end of the period to calculate the actual overhead rates and then restate everyentry involving overhead. The effect is that job-cost records, the inventory accounts,and cost of goods sold are accurately stated with respect to actual overhead. Thismeans of disposing of variances is costly but has the advantage of improving theanalysis of product profitability.

6. The foregoing discussion assumes that normal costing methods are applied. Undernormal costing, amounts are recorded for direct costs at actual rates and prices timesactual inputs. For indirect costs, budgeted rates are used.

a. Under actual costing, however, actual rates are used to record indirect costs.

b. Under budgeted costing, budgeted rates and prices are used for direct costs,and budgeted rates are used for indirect costs.

c. In practice, organizations may combine these methods in various ways.

Course 34: Cost Behavior and Allocation -- Process Costing and Job-Order Costing 10


7. The foregoing discussion also emphasizes cost control systems for manufacturingentities. However, the basic concepts are also applicable to service and retailingorganizations, although without the complications resulting from the need to accountfor inventories. For example, job-order costing principles apply to an audit by anaccounting firm, whereas the costs of routine mail delivery may be controlled usingprocess costing techniques.

D. Process Costing and Job-Order Costing

1. Process cost accounting is used to assign costs to products or services. It isapplicable to relatively homogeneous items that are mass produced on a continuousbasis (e.g., refined oil).

a. The objective is to determine the portion of cost that is to be expensed becausethe products or services were sold and the portion that is to be deferred.

b. Process costing is an averaging process that calculates the average cost of allunits. Thus, the costs are accumulated by cost centers, not jobs. Moreover, ina manufacturing setting, work-in-process (WIP) inventory is stated in terms ofequivalent units of production (EUP) so that average costs may be calculated.

c. A manufacturing entity’s direct materials, direct labor, and factory overhead aredebited to WIP when they are committed to the process.

1) The sum of these costs and the beginning WIP (BWIP) is the totalproduction cost to be accounted for in any one period. This total isallocated to finished goods and to ending WIP (EWIP), which may becredited for abnormal spoilage.

2) Direct materials are usually accounted for in a separate account.

Direct materials inventory $XXX Accounts payable or cash $XXX

3) When direct materials are transferred to WIP, the inventory account iscredited.

4) Direct labor is usually debited directly to WIP when the payroll is recorded. Any wages not attributable directly to production, e.g., those for janitorialservices, are considered indirect labor and debited to overhead. Shiftdifferentials and overtime premium are likewise deemed to be overhead. However, shift differentials and overtime premium are charged to aspecific job when a customer requirement, rather than a managementdecision, causes the differential in the overtime.

WIP $XXX Factory overhead XXX

Wages payable $XXX Payroll taxes payable XXX

5) Indirect costs are debited to a single factory overhead control account (butsee subunit E.).

a) They include supplies, plant depreciation, etc.

Factory overhead $XXX Insurance expense $XXX Supplies expense XXX Depreciation expense (or accum. dep.) XXX

FLOW OF COSTS THROUGH ACCOUNTS

Cost ofDirect Materials (DM) Work-in-Process (WIP) Finished Goods (FG)

BI

Pur

El

DM Used BWIP

DM Used

DL

CGM

(Spoilage?)

FOH

BI

CGM

El

CGS

Factory Overhead (FOH)

Supplies

Indirect labor

Depreciation

Other IndirectCosts

EWIP

Cost of Goods Sold (CGS)



b) To charge all factory overhead incurred over a period, such as ayear, to WIP, factory overhead is credited and WIP is debited onsome systematic basis.

WIP $XXX Factory overhead $XXX

6) Transferred-in costs are similar to direct materials added at a point in theprocess because both attach to (become part of) the product at thatpoint, usually the beginning of the process. However, transferred-incosts are dissimilar because they attach to the units of production thatmove from one process to another. Thus, they are the basic units beingproduced. By contrast, direct materials are added to the basic unitsduring processing.

7) As goods are completed, their cost is credited to WIP and debited tofinished goods. When the finished goods are sold, their cost is debitedto cost of sales. The deferred manufacturing costs are held in the endingWIP, finished goods inventory, and direct materials inventory accounts.

Finished goods inventory $XXX WIP $XXX

Cost of goods sold $XXX Finished goods inventory $XXX

8) In the following T-account illustration, each arrow represents a journalentry to record a transfer. It indicates a credit to the original account anda debit to the next account in the sequence.

a) Cost of goods manufactured (CGM) equals the costs of goodscompleted in the current period and transferred to finished goods(BWIP + DM + DL + FOH --- EWIP).

b) For simplicity, a single overhead account is shown. However, manyaccountants prefer to accumulate actual costs (debits) in theoverhead control account and the amounts charged to WIP in aseparate overhead applied account. This account will have a creditbalance. Overhead applied is based on a predetermined rate.



c) The debits to WIP are the total costs incurred. They equal the sum ofthe CGM, EWIP, and abnormal spoilage.

d) Abnormal spoilage is not inherent in the particular process. It ischarged to a loss in the period in which detection occurs. However, normal spoilage is a product cost included in CGM andEWIP.

2. Equivalent units of production (EUP) measure the amount of work performed ineach production phase in terms of fully processed units during a given period. Anequivalent unit is a set of inputs required to manufacture one physical unit. Calculating EUP for each factor of production facilitates measurement of output andcost allocation when WIP exists.

a. Incomplete units are restated as the equivalent amount of completed units. Thecalculation is made separately for direct materials (transferred-in costs aretreated as direct materials for this purpose) and conversion cost (direct laborand factory overhead).

b. One equivalent unit is the amount of conversion cost (direct labor and factoryoverhead) or direct materials cost required to produce one finished unit.

1) EXAMPLE: If 10,000 units in EWIP are 25% complete, they equal 2,500(10,000 x 25%) equivalent units.

2) Some units may be more advanced in the production process with respectto one factor than another; e.g., a unit may be 75% complete as to directmaterials but only 15% complete as to direct labor.

c. The objective is to allocate direct materials costs and conversion costs to finishedgoods, EWIP, and, possibly, spoilage based on relative EUP.

d. Under the FIFO assumption, only the costs incurred this period are allocatedbetween finished goods and EWIP. Beginning inventory costs are maintainedseparately from current-period costs. Thus, goods finished this period arecosted separately as either started last period or started this period.

1) The FIFO method determines equivalent units by subtracting the workdone on the BWIP in the prior period from the weighted-average total.

e. The weighted-average assumption averages all direct materials and allconversion costs (both those incurred this period and those in BWIP). Nodifferentiation is made between goods started in the preceding and the currentperiods.

1) The weighted-average EUP calculation differs from the FIFO calculation bythe amount of EUP in BWIP. EUP equal the EUP transferred to finishedgoods plus the EUP in EWIP. Total EUP completed in BWIP are notdeducted.

COST ELEMENT SOURCE OF DATA

DIRECT MATERIALSMATERIALSREQUISITIONS

DIRECT LABOR

FACTORY OVERHEAD

TIME TICKETS

Predeterminedrate based onestimated costs

JOB-COST SHEET(Stored in WIP file)

JOB-COST SHEET(Stored in FG File)

JOB-COST SHEET(Stored in CGS File)

Work is complete

Goods are sold



3. Job-order costing is concerned with accumulating costs by specific job. Thismethod is at the opposite end of the continuum from process costing. In practice,organizations tend to combine elements of both approaches. However, a job-ordercosting orientation is appropriate when an entity’s products or services haveindividual characteristics or when identifiable groupings are possible, e.g., when theentity produces batches of certain styles or types of furniture.

a. Units (jobs) should be dissimilar enough to warrant the special record keepingrequired by job-order costing. Costs are recorded by classification (directmaterials, direct labor, and factory overhead) on a job-cost sheet specificallyprepared for each job.

b. The difference between process and job-order costing is often overemphasized. Job-order costing simply requires subsidiary ledgers to record the additionaldetails needed to account for specific jobs. However, the totals of subsidiaryledger amounts should equal the balances of the related general ledger controlaccounts. The latter are the basic accounts used in process costing. Forexample, the total of all amounts recorded on job-cost sheets for manufacturingjobs in process equals the balance in the WIP control account.

c. Source documents for costs incurred include stores’ requisitions for directmaterials and work (or time) tickets for direct labor.

d. Overhead is usually assigned to each job through a predetermined overheadrate, e.g., $3 of overhead for every direct labor hour.

e. Journal entries record direct materials, direct labor, and factory overhead usedfor a specific job. They are similar to the entries used in process costing.

f. Evaluating the efficiency of the production process under a job-order systemcan be accomplished through the use of a standard cost system or bybudgeting costs for each job individually, based on expected materials andlabor usage.

g. A summary of the accounting process for a manufacturer’s job-order systemfollows:

Course 34: Cost Behavior and Allocation -- Activity-Based Costing (ABC)14


4. Operation costing is a hybrid of job-order and process costing systems used bycompanies that manufacture batches of similar units that are subject to selectedprocessing steps (operations). Different batches may pass through different sets ofoperations, but all units are processed identically within a given operation.

a. Operation costing may also be appropriate when different materials areprocessed through the same basic operations, such as the woodworking,finishing, and polishing of different product lines of furniture.

b. Operation costing accumulates total conversion costs and determines a unitconversion cost for each operation. This procedure is similar to overheadallocation. However, direct materials costs are charged specifically to productsas in job-order systems.

c. More work-in-process accounts are needed because one is required for eachoperation.

E. Activity-Based Costing (ABC)

1. Key Terms

a. Cost objects are the intermediate and final dispositions of cost pools. Intermediate cost objects receive temporary accumulations of costs as the costpools move from their originating points to the final cost objects. A final costobject, such as a job, product, or process, should be logically linked with thecost pool based on a cause-and-effect relationship.

b. A cost pool is an account in which a variety of similar costs are accumulatedprior to allocation to cost objects. It is a grouping of costs associated with anactivity. The overhead account is a cost pool into which various types ofoverhead are accumulated prior to their allocation.

2. Activity-based costing (ABC) may be used by manufacturing, service, or retailingentities and in job-order or process costing systems. It has been popularizedbecause of the rapid advance of technology, which has led to a significant increasein the incurrence of indirect costs and a consequent need for more accurate costassignment. However, developments in computer and related technology (such asbar coding) also allow management to obtain better and more timely information atrelatively low cost.

a. ABC is one means of improving a cost system to avoid what has been calledpeanut-butter costing. Inaccurately averaging or spreading costs like peanutbutter over products or service units that use different amounts of resourcesresults in product-cost cross-subsidization.

1) This term describes the condition in which the miscosting of one productcauses the miscosting of other products. In the traditional systemsdescribed in subunits C. and D., direct labor and direct materials aretraced to products or service units, a single pool of costs (overhead) isaccumulated for a given organizational unit, and these costs are thenassigned using an allocative rather than a tracing procedure. The effectis an averaging of costs that may result in significant inaccuracy whenproducts or service units do not use similar amounts of resources.

Course 34: Cost Behavior and Allocation -- Activity-Based Costing (ABC) 15


3. To improve its costing system, an organization can attempt to identify as many directcosts as economically feasible. It can also increase the number of separate pools forcosts not directly attributable to cost objects.

a. Each of these pools should be homogeneous; that is, each should consist ofcosts that have substantially similar relationships with the driver or other baseused for assignment to cost objects. Thus, choosing the appropriate base,preferably one with a driver or cause-and-effect relationship (a high correlation)between the demands of the cost object and the costs in the pool, is anotherway to improve a costing system.

4. ABC attempts to improve costing by assigning costs to activities rather than to anorganizational unit. Accordingly, ABC requires identification of the activities thatconsume resources and that are subject to demands by ultimate cost objects.

a. Design of an ABC system starts with process value analysis, a comprehensiveunderstanding of how an organization generates its output. It involves adetermination of which activities that use resources are value-adding ornonvalue-adding and how the latter may be reduced or eliminated.

1) This linkage of product costing and continuous improvement of processesis activity-based management (ABM). It encompasses driver analysis,activity analysis, and performance measurement.

5. Once an ABC system has been designed, costs may be assigned to the identifiedactivities, costs of related activities that can be reassigned using the same driver orother base are combined in homogeneous cost pools, and an overhead rate iscalculated for each pool.

a. The next step, as in traditional methods, is to assign costs to ultimate costobjects. In other words, cost assignment is a two-stage process: First, costsare accumulated for an activity based on the resources it can be directlyobserved to use and on the resources it can be assumed to use based on itsconsumption of resource drivers (factors that cause changes in the costs ofan activity); second, costs are reassigned to ultimate cost objects on the basisof activity drivers (factors measuring the demands made on activities).

1) In ABC, these objects may include not only products and services but alsocustomers, distribution channels, or other objects for which activity andresource costs may be accumulated.

6. An essential element of ABC is driver analysis that emphasizes the search for thecause-and-effect relationship between an activity and its consumption of resourcesand for an activity and the demands made on it by a cost object. For this purpose,activities and their drivers have been classified in accounting literature as follows:

a. Unit-level (volume-related) activities occur when a unit is produced, e.g., directlabor and direct materials activities.

b. Batch-level activities occur when a batch of units is produced, e.g., ordering,setup, or materials handling.

c. Product- or service-level (product- or service-sustaining) activities providesupport of different kinds to different types of output, e.g., engineeringchanges, inventory management, or testing.

d. Facility-level (facility-sustaining) activities concern overall operations, e.g.,management of the physical plant, personnel administration, or securityarrangements.

Course 34: Cost Behavior and Allocation -- Activity-Based Costing (ABC)16


7. Using this model, activities are grouped by level, and drivers are determined for theactivities. Within each grouping of activities, the cost pools for activities that can usethe same driver are combined into homogeneous cost pools. In contrast, traditionalsystems assign costs largely on the basis of unit-level drivers.

a. At the unit level, examples of drivers are direct labor hours or dollars, machinehours, and units of output.

b. At the batch level, drivers may include number or duration of setups, ordersprocessed, number of receipts, weight of materials handled, or number ofinspections.

c. At the product level, drivers may include design time, testing time, number ofengineering change orders, or number of categories of parts.

d. At the facility level, drivers may include any of those used at the first three levels.

8. A difficulty in applying ABC is that, whereas the first three levels of activities pertain tospecific products or services, facility-level activities do not. Thus, facility-level costsare not accurately assignable to products. The theoretically sound solution may beto treat these costs as period costs. Nevertheless, organizations that apply ABCordinarily assign them to products to obtain a full absorption cost suitable for externalfinancial reporting in accordance with GAAP.

9. As the foregoing discussion indicates, an advantage of ABC is that overhead costs areaccumulated in multiple cost pools related to activities instead of in a single pool for adepartment, process, plant, or company. ABC also is more likely than a traditionalsystem to assign costs to activities and reassign them to ultimate cost objects using abase that is highly correlated with the resources consumed by activities or with thedemands placed on activities by cost objects.

a. Furthermore, process value analysis provides information for eliminating orreducing nonvalue-adding activities (e.g., scheduling production, movingcomponents, waiting for the next operating step, inspecting output, or storinginventories). The result is therefore not only more accurate cost assignments,especially of overhead, but also better cost control and more efficientoperations.

b. A disadvantage of ABC is that it is costly to implement because of the moredetailed information required. Another disadvantage is that ABC-based costs ofproducts or services may not conform with GAAP; for example, ABC mayassign research costs to products but not such traditional product costs asplant depreciation, insurance, or taxes.

10. Organizations most likely to benefit from using ABC are those with products orservices that vary significantly in volume, diversity of activities, and complexity ofoperations; relatively high overhead costs; or operations that have undergone majortechnological or design changes.

a. However, service organizations may have some difficulty in implementing ABCbecause they tend to have relatively high levels of facility-level costs that aredifficult to assign to specific service units. They also engage in manynonuniform human activities for which information is not readily accumulated. Furthermore, output measurement is more problematic in service than inmanufacturing entities. Nevertheless, ABC has been adopted by variousinsurers, banks, railroads, and health care providers.

Course 34: Cost Behavior and Allocation -- Service Cost Allocation 17


F. Service Cost Allocation

1. Service (support) department costs are considered part of overhead (indirect costs). Thus, they cannot feasibly be traced to cost objects and therefore must be allocatedto the operating departments that use the services.

a. When service departments also render services to each other, their costs may beallocated to each other before allocation to operating departments.

2. Four criteria are used to allocate costs.

a. Cause and effect should be used if possible because of its objectivity andacceptance by operating management.

b. Benefits received is the most frequently used criterion when cause and effectcannot be determined. However, it requires an assumption about the benefitsof costs, for example, that advertising promoting the company but not specificproducts increased sales by the various divisions.

c. Fairness is sometimes mentioned in government contracts but appears to bemore of a goal than an objective allocation base.

d. Ability to bear (based on profits) is usually unacceptable because of itsdysfunctional effect on managerial motivation.

3. The direct method is the simplest and most common method of service costallocation. It allocates costs directly to the producing departments withoutrecognition of services provided among the service departments.

a. No attempt is made to allocate the costs of service departments to other servicedepartments under the direct method.

b. Allocations of service department costs are made only to productiondepartments based on their relative use of services.

4. The step or step-down method includes an allocation of service department costs toother service departments in addition to the producing departments.

a. The allocation may begin with the costs of the service department that

1) Provides the highest percentage of its total services to other servicedepartments,

2) Provides services to the greatest number of other service departments, or

3) Has the greatest dollar cost of services provided to other servicedepartments.

b. The costs of the remaining service departments are then allocated in the samemanner, but no cost is assigned to service departments whose costs havealready been allocated.

c. The process continues until all service department costs are allocated.

Course 34: Cost Behavior and Allocation -- Joint Products and By-Products18


5. The reciprocal method is the most theoretically sound. It allows reflection of allreciprocal services among service departments. It is also known as thesimultaneous-solution method, cross-allocation method, matrix-allocation method, ordouble-distribution method.

a. The step method considers only services rendered among service departmentsin one direction, but the reciprocal method considers services in bothdirections.

1) If all reciprocal services are recognized, linear algebra may be used toreach a solution. The typical problem on a professional examination canbe solved using two or three simultaneous equations.

G. Joint Products and By-Products

1. Definitions

a. When two or more separate products are produced by a commonmanufacturing process from a common input, the outputs from the process arejoint products. The joint costs of two or more joint products with significantvalues are usually allocated to the joint products at the point at which theybecame separate products.

b. By-products are one or more products of relatively small total value that areproduced simultaneously from a common manufacturing process withproducts of greater value and quantity (joint products).

c. Joint costs (sometimes called common costs) are incurred prior to the split-offpoint to produce two or more goods manufactured simultaneously by a singleprocess or series of processes. Joint costs, which include direct materials,direct labor, and overhead, are not separately identifiable and must be allocatedto the individual joint products.

d. At the split-off point, the joint products acquire separate identities. Costsincurred after split-off are separable costs.

e. Separable costs can be identified with a particular joint product and allocated toa specific unit of output. They are the costs incurred for a specific product afterthe split-off point.

2. Several methods are used to allocate joint costs. Each assigns a proportionateamount of the total cost to each product on a quantitative basis.

a. The physical-unit method is based on some physical measure such as volume,weight, or a linear measure.

b. The sales-value method is based on the relative sales values of the separateproducts at split-off.

c. The estimated net realizable value (NRV) method is based on final sales valueminus separable costs.

d. The constant gross margin percentage NRV method is based on allocatingjoint costs so that the percentage is the same for every product.

1) This method determines the overall percentage, deducts the appropriategross margin from the final sales value of each product to calculate totalcosts for that product, and then subtracts the separable costs to arrive atthe joint cost amount.

Sales value or NRV of XTotal sales value or NRV of joint products

× Joint costs

Course 34: Cost Behavior and Allocation -- Joint Products and By-Products 19


3. Joint costs are normally allocated to joint products but not by-products. The mostcost-effective method for the initial recognition of by-products is to account for theirvalue at the time of sale as a reduction in the cost of goods sold or as a revenue. Thus, cost of sales does not exist for by-products.

a. The alternative is to recognize their value at the time of production, a methodthat results in the recording of by-product inventory. Under this method, thevalue of the by-product may also be treated as a reduction in cost of goodssold or as a separate revenue item. The value to be reported for by-productsmay be sales revenue, sales revenue minus a normal profit, or estimated netrealizable value.

b. Regardless of the timing of their recognition in the accounts, by-productsusually do not receive an allocation of joint costs because the cost of thisaccounting treatment ordinarily exceeds the benefit. However, allocating jointcosts to by-products is acceptable. In that case, they are treated as jointproducts despite their small relative values.

c. Although scrap is similar to a by-product, joint costs are almost never allocatedto scrap.

4. The relative sales value method is the most frequently used way to allocate joint coststo joint products. It allocates joint costs based upon each product’s proportion oftotal sales revenue.

a. For joint products salable at the split-off point, the relative sales value is theselling price at split-off.

b. If further processing is needed, the relative sales value may be approximated bysubtracting the additional anticipated processing and marketing costs from thefinal sales value to arrive at the estimated net realizable value.

c. Thus, the allocation of joint costs to Product X is determined as follows:

5. In determining whether to sell a product at the split-off point or process the item furtherat additional cost, the joint cost of the product is irrelevant because it is a sunk(already expended) cost.

a. The cost of additional processing (incremental costs) should be weighed againstthe benefits received (incremental revenues). The sell-or-process decisionshould be based on that relationship.

Course 34: Cost Behavior and Allocation -- Standard Costing and Variance Analysis20


H. Standard Costing and Variance Analysis

1. Standard costs are budgeted unit costs established to motivate optimal productivityand efficiency. A standard cost system is designed to alert management when theactual costs of production differ significantly from target or standard costs.

a. A standard cost is a monetary measure with which actual costs are compared.

b. A standard cost is not an average of past costs but a scientifically determinedestimate of what costs should be.

c. A standard cost system can be used in both job-order and process costingsystems to isolate variances.

d. Because of the effect of fixed costs, standard costing is most effective in a flexiblebudgeting system.

e. When actual costs and standard costs differ, the difference is a variance.

1) A favorable (unfavorable) variance arises when actual costs are less(greater) than standard costs.

2) Management will usually set standards so that they are currently attainable.

a) If standards are set too high (or tight), they may be ignored byworkers, or morale may suffer.

3) Standard costs must be kept current. If prices have changed considerablyfor a particular raw material, there will always be a variance if the standardcost is not changed. Much of the usefulness of standard costs is lost if alarge variance is always expected.

f. Standard costs are usually established for materials, labor, and factory overhead.

2. Direct materials variances are usually divided into price and efficiency components. Part of a total materials variance may be attributed to using more raw materials thanthe standard and part to a cost that was higher than standard.

a. The direct materials quantity (usage) variance (an efficiency variance) is theactual quantity minus standard quantity, times standard price: (AQ --- SQ)SP.

b. The direct materials price variance is the actual price minus the standard price,times the actual quantity: (AP --- SP)AQ.

1) The price variance may be isolated either at the time of purchase or at thetime of transfer to WIP. The advantage of the former method is that thevariance is identified earlier.

a) Normal spoilage is considered in the calculation of standard directmaterials cost per unit.

Course 34: Cost Behavior and Allocation -- Standard Costing and Variance Analysis 21


c. The direct materials quantity (usage) variance is sometimes supplemented bythe direct materials mix variance and the direct materials yield variance.

1) These variances are calculated only when the production process involvescombining several materials in varying proportions (when substitutionsare allowable in combining materials).

2) The direct materials mix variance equals total actual quantity times thedifference between the weighted-average unit standard cost of thebudgeted mix of ingredients and the weighted-average unit standard costof the actual mix.

3) The direct materials yield variance is the weighted-average unit standardcost of the budgeted mix multiplied by the difference between the actualquantity of materials used and the standard quantity.

4) Certain relationships may exist among the various materials variances. Forinstance, an unfavorable price variance may be offset by a favorable mixor yield variance because materials of better quality and higher price areused. Also, a favorable mix variance may result in an unfavorable yieldvariance, or vice versa.

d. Productivity measures are related to the efficiency, mix, and yield variances. Productivity is the relationship between outputs and inputs (including the mix ofinputs). The higher this ratio, the greater the productivity.

1) A partial productivity measure may be stated as the ratio of output to thequantity of a single factor of production (e.g., materials, labor, or capital).

2) Partial productivity measures, for example, the number of finished units perdirect labor hour or per pound of direct materials, are useful whencompared over time, among different factories, or with benchmarks. Apartial productivity measure comparing results over time determineswhether the actual relationship between inputs and outputs hasimproved or deteriorated.

3) A disadvantage of a partial productivity measure is that it relates output to asingle factor of production and therefore does not consider substitutionsamong input factors. Thus, total factor productivity ratios may becalculated to compensate for that drawback. Total productivity is theratio of output to the cost of all inputs used.

a) This ratio will increase from one period to the next as technologicalimprovements permit greater output to be extracted from a givenamount and mix of inputs. Use of a less costly input mix alsoincreases the ratio.

b) Accordingly, the change in total costs from one period to the next isattributable to three factors: output levels, input prices, andquantities and mix of inputs.

c) In the same way that a variance can be decomposed intocomponents, the effect of each of the foregoing factors can beisolated by holding the others constant. Refer to the diagram onthe following page. For example, the cost of Year Two output canbe calculated based on Year One input prices and inputrelationships (actual inputs that would have been used in Year Oneto produce the Year Two output). The difference between thisamount and actual Year One costs is the change in costsattributable solely to output change.



Standard Input Allowed Actual Input for Actual Output

Actual Variable × ×Factory Overhead Budgeted Application Rate Budgeted Application Rate

Spending EfficiencyVariance Variance

d) Similarly, the cost of Year Two output at Year Two prices based onYear One input relationships can also be calculated. The differencebetween this amount and the cost of Year Two output based onYear One input prices and input relationships is the change in costsattributable to price changes.

e) The difference between the actual cost of Year Two output and thecost of Year Two output based on Year Two prices and Year Oneinput relationships is the change attributable solely to the change inthe quantities and mix of inputs.

f) Diagram of factors causing the cost change

Year Two Costs Year Two Costs Actual at Year Two Prices at Year One Prices Actual

Year Two and Year One Input and Year One Input Year OneCosts for Year Two Output for Year Two Output Costs

Input Quantities Price Output

3. Direct labor variances are similar to direct materials variances. For example, thedirect labor rate and efficiency variances are calculated in much the same way as thedirect materials price and quantity variances, respectively.

4. Factory overhead variances include variable and fixed components.

a. The total variable factory overhead variance is the difference between actualvariable factory overhead and the amount applied based on the budgetedapplication rate and the standard input allowed for the actual output.

1) In four-way analysis of variance, it includes the

a) Spending variance -- the difference between actual variable factoryoverhead and the product of the budgeted application rate and theactual amount of the allocation base (activity level or amount ofinput)

b) Efficiency variance -- the budgeted application rate times thedifference between the actual input and the standard input allowedfor the actual output

i) Variable factory overhead applied equals the flexible-budgetamount for the actual output level. The reason is that unitvariable costs are assumed to be constant within the relevantrange. The third column in the diagram below gives theflexible budget amount (also the amount applied).

ii) If variable factory overhead is applied on the basis of output,not inputs, no efficiency variance arises.

iii) Diagram of variable factory overhead variances



b. The total fixed factory overhead variance is the difference between actual fixedfactory overhead and the amount applied based on the budgeted applicationrate and the standard input allowed for the actual output.

1) In four-way analysis of variance, it includes the

a) Budget variance (spending variance) -- the difference betweenactual fixed factory overhead and the amount budgeted

b) Volume variance (idle capacity variance, production volumevariance, or output-level variance) -- the difference betweenbudgeted fixed factory overhead and the product of the budgetedapplication rate and the standard input allowed for the actual output

i) Fixed factory overhead applied does not necessarily equal theflexible-budget amount for the actual output. The reason isthat the latter amount is assumed to be constant over therelevant range of output. Thus, the second column in thediagram below represents the flexible-budget amount, and thethird column represents the amount applied.

ii) No efficiency variance is calculated because budgeted fixedfactory overhead is a constant at all relevant output levels.

2) Diagram of fixed factory overhead variances

Standard Input Allowed for Actual Output

Actual Fixed Budgeted Fixed ×Factory Overhead Factory Overhead Budgeted Application Rate

Budget VolumeVariance Variance

c. The total overhead variance also may be divided into two or three variances (butone variance is always the fixed overhead volume variance).

1) Three-way analysis divides the total overhead variance into volume,efficiency, and spending variances.

a) The spending variance combines the fixed overhead budget andvariable overhead spending variances.

b) The variable overhead efficiency and fixed overhead volumevariances are the same as in four-way analysis.

2) Two-way analysis divides the total overhead variance into two variances: volume and controllable (the latter is sometimes called the budget, totaloverhead spending, or flexible-budget variance).

a) The variable overhead spending and efficiency variances and thefixed overhead budget variance are combined.

5. Sales variances are used to evaluate the selling departments. If a firm’s sales differfrom the amount budgeted, the difference could be attributable to either the salesprice variance or the sales volume variance (sum of the sales mix and quantityvariances). The analysis of these variances concentrates on contribution marginsbecause fixed costs are assumed to be constant.



a. EXAMPLE (single product): A firm has budgeted sales of 10,000 units at $17 perunit. Variable costs are expected to be $10 per unit, and fixed costs arebudgeted at $50,000. Thus, the company anticipates a contribution margin of$70,000 and a net income of $20,000. However, the actual results are

Sales (11,000 units) $ 176,000 Variable costs (110,000)Contribution margin $ 66,000 Fixed costs (50,000)Net income $ 16,000

1) Sales were greater than predicted, but the contribution margin is less thanexpected. The $4,000 discrepancy can be analyzed in terms of the salesprice variance and the sales volume variance.

2) For a single-product firm, the sales price variance is the reduction in thecontribution margin because of the change in selling price. In theexample, the actual selling price of $16 per unit is $1 less than expected. Thus, the sales price variance is $1 times 11,000 units actually sold, or$11,000 unfavorable.

3) For the single-product firm, the sales volume variance is the change incontribution margin caused by the difference between the actual andbudgeted volume. In this case, it is $7,000 favorable ($7 budgeted UCM x1,000-unit increase in volume).

4) The sales mix variance is zero because the firm sells one product only. Hence, the sales volume variance equals the sales quantity variance.

5) The sales price variance ($11,000 unfavorable) combined with the salesvolume variance ($7,000 favorable) equals the total change in thecontribution margin ($4,000 unfavorable).

6) The same analysis may be done for cost of goods sold. The averageproduction cost per unit is used instead of the average unit selling price,but the quantities for production volume are the same as those used forsales quantity. Accordingly, the overall variation in gross profit is the sumof the variation in revenue plus the variation in CGS.

b. If a company produces two or more products, the sales variances reflect notonly the effects of the change in total unit sales but also any difference in themix sold.

1) In the multiproduct case, the sales price variance may be calculated as in5.a.2) for each product. The results are then added. An alternative is tomultiply the actual total units sold times the difference between theweighted-average price based on actual units sold at actual unit pricesand the weighted-average price based on actual units sold at budgetedprices.

2) One way to calculate the multiproduct sales volume variance is todetermine the variance for each product as in 5.a.3) above and to addthe results. An alternative is to determine the difference between thefollowing:

a) Actual total unit sales times the budgeted weighted-average UCM forthe actual mix

b) Budgeted total unit sales times the budgeted weighted-average UCMfor the planned mix



3) The sales quantity variance (the sales volume variance for a single-product company) is the difference between the budgeted contributionmargin based on actual unit sales and the budgeted contribution marginbased on expected sales, assuming that the budgeted sales mix isconstant. One way to calculate this variance is to multiply the budgetedUCM for each product times the difference between the budgeted unitsales of the product and its budgeted percentage of actual total unit salesand then to add the results.

a) An alternative is to multiply the difference between total actual unitsales and the total expected unit sales by the budgeted weighted-average UCM based on the expected mix.

4) The sales mix variance is the difference between the budgetedcontribution margin for the actual mix and actual total quantity ofproducts sold and the budgeted contribution margin for the expectedmix and actual total quantity of products sold. One way to calculate thisvariance is to multiply the budgeted UCM for each product times thedifference between actual unit sales of the product and its budgetedpercentage of actual total unit sales and then to add the results.

a) An alternative is to multiply total actual unit sales times the differencebetween the budgeted weighted-average UCM for the expected mixand the budgeted weighted-average UCM for the actual mix.

c. The components of the sales quantity variance are the market size and themarket share variances.

1) The market size variance equals the budgeted market share percentage,times the difference between the actual market size in units and thebudgeted market size in units, times the budgeted weighted-averageUCM.

2) The market share variance equals the difference between the actualmarket share percentage and the budgeted market share percentage,times the actual market size in units, times the budgeted weighted-average UCM.

6. Journal Entries. Variances usually do not appear on the financial statements of afirm. They are used for managerial control and are recorded in the ledger accounts.

a. When standard costs are recorded in inventory accounts, variances are alsorecorded. Thus, direct labor is recorded as a liability at actual cost, but it ischarged to WIP control at its standard cost for the standard quantity used. Thedirect labor rate and efficiency variances are recognized at that time.

1) Direct materials, however, should be debited to materials control atstandard prices at the time of purchase. The purpose is to isolate thedirect materials price variance as soon as possible. When direct materialsare used, they are debited to WIP at the standard cost for the standardquantity, and the materials quantity variance is then recognized.

b. Actual overhead costs are debited to overhead control and credited to accountspayable, wages payable, etc. Applied overhead is credited to an overheadapplied account and debited to WIP control.

1) The simplest method of recording the overhead variances is to wait untilyear-end. The variances can then be recognized separately when theoverhead control and overhead applied accounts are closed (by a creditand a debit, respectively). The balancing debits or credits are to thevariance accounts.



c. The following are the entries to record variances. Favorable variances are creditsand unfavorable variances are debits:

1) Materials control (AQ × SP) $XXX Direct materials price variance (Dr or Cr) XXX Accounts payable (AQ × AP) $XXX

2) WIP control (SQ × SP) XXX Direct materials quantity variance (Dr or Cr) XXX Direct labor rate variance (Dr or Cr) XXX Direct labor efficiency variance (Dr or Cr) XXX Materials control (AQ × SP) XXX Wages payable (AQ × AP) XXX

3) Overhead control (actual) XXX Wages payable (actual) XXX Accounts payable (actual) XXX

4) WIP control (standard) XXX Overhead applied (standard) XXX

5) Overhead applied (standard) XXX Variable overhead spending variance (Dr or Cr) XXX Variable overhead efficiency variance (Dr or Cr) XXX Fixed overhead budget variance (Dr or Cr) XXX Fixed overhead volume variance (Dr or Cr) XXX Overhead control (actual) XXX

6) The result of the foregoing entries is that WIP contains standard costs only.

d. Disposition of variances. Immaterial variances are customarily closed to cost ofgoods sold or income summary.

1) Variances that are material may be prorated. A simple approach toproration is to allocate the total net variance to work-in-process, finishedgoods, and cost of goods sold based on the balances in those accounts. However, more complex methods of allocation are possible.

e. Several alternative approaches to the timing of recognition of variances arepossible. For example, direct materials and labor might be transferred to WIP attheir actual quantities. In that case, the direct materials quantity and direct laborefficiency variances might be recognized when goods are transferred from WIPto finished goods.

1) Furthermore, the direct materials price variance might be isolated at thetime of transfer to WIP. These methods, however, delay the recognitionof variances. Early recognition is desirable for control purposes.