1. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 The Flexible Budget: Factory Overhead Chapter Fourteen

2. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 2 Distinguish between the product-costing and control purposes of standard costs for factory overhead Calculate and properly interpret standard cost variances for factory overhead using traditional approaches Record factory overhead costs and associated standard cost variances Apply standard costs to service organizations Learning Objectives

3. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 3 Analyze overhead variances in an activity-based cost (ABC) system Understand decision rules that can be used to guide the variance-investigation decision Learning Objectives (continued)

4. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 4 Energy costs Indirect materials Indirect labor Equipment repair and maintenance Energy costs Indirect materials Indirect labor Equipment repair and maintenance Variable Overhead Factory Overhead Costs: Examples Fixed Overhead Factory managers’ salaries Plant and equipment depreciation Plant security guards Insurance and property taxes for factory building and equipment Factory managers’ salaries Plant and equipment depreciation Plant security guards Insurance and property taxes for factory building and equipment

5. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 5 Standard Variable Overhead Costs: Product Costing vs. Control Variable Overhead Cost Activity Variable (e.g., DL Hrs.) Product Costing & Control (SQ x SP) SQ = Standard allowed DLHs for units produced SP = Standard variable overhead rate/DLH

6. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 6 Variable Overhead Variance Analysis Variable Overhead Cost Activity Variable (e.g., DL Hrs.) Product Costing & Control (SQ x SP) SQ = Standard allowed DLHs for units produced; AQ = Actual DLHs worked; overhead rate/DLH; SP = Standard variable overhead rate/DLH; AP = Actual variable overhead rate/DLH SQ x SP AQ x SP AQ x AP SQ AQ Spending Variance Efficiency Variance Total Variance

7. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 7 Variable Overhead Variance Analysis: Equation Approach

8. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 8 Variable Overhead Variance Analysis: Equation Approach (continued)

9. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 9 Variable Overhead Variance Analysis: Example Calculations Hanson, Inc. applies variable factory overhead on the basis of DLHs. Hanson has the following variable factory overhead standard to manufacture one unit of product: 1.5 standard DLHs per unit @ a variable overhead rate of $3.00 per DLH Last month, 1,550 hours were worked to make 1,000 units, and $5,115 was spent for variable factory overhead

10. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 10 Variable Overhead Variance Analysis: Example Calculations (continued)

11. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 11 Variable Overhead Variance Analysis: Alternative Solution Format Total Variable Overhead Variance = Actual Variable Overhead – Flexible Budget for Variable Overhead = $5,115 - $4,500 = $615 U Variable Overhead Spending Variance = AQ x (AP – SP) = 1,550 DLHs x ($3.30 - $3.00)/DLH = $465 U Variable Overhead Efficiency Variance = SP x (AQ – SQ) = $3.00/DLH x (1,550 – 1,500) DLHs = $150 U

12. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 12 Interpretation of Variable Overhead Variances Results from spending more or less than expected for overhead items such as supplies and utilities. Reflects efficiency or inefficiency in the use of the selected activity measure; does not reflect overhead control. Spending VarianceEfficiency Variance

13. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 13 Standard Fixed Overhead Cost: Planning vs. Control Fixed Overhead Cost Activity Variable (e.g., DL Hrs.) Product Costing: Standard Fixed OH Applied = SQ x SP SQ = Standard allowed DLHs for units produced SP = Standard fixed overhead rate/DLH Control Budget (Lump Sum)

14. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 14  Determine the total budgeted fixed factory overhead for level of operation.  Select an activity driver (or drivers) for applying fixed factory overhead.  Choose a denominator volume for the selected activity driver (e.g., “practical capacity”).  Divide the amount in Step 1 by the amount in Step 3 to determine the standard fixed factory overhead application rate for product costing purposes.  Determine the total budgeted fixed factory overhead for level of operation.  Select an activity driver (or drivers) for applying fixed factory overhead.  Choose a denominator volume for the selected activity driver (e.g., “practical capacity”).  Divide the amount in Step 1 by the amount in Step 3 to determine the standard fixed factory overhead application rate for product costing purposes. Product Costing: Determining the Standard Fixed Factory Overhead Rate

15. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 15 Fixed Overhead Variance Analysis Fixed Overhead Cost Activity Variable (e.g., DL Hrs.) Product Costing: Standard Fixed OH Applied = SQ x SP SQ = Standard allowed DLHs for units produced SP = Standard fixed overhead rate/DLH Actual FOH Budgeted FOH Applied FOH Spending Variance (U) Volume Variance (U) SQDen. Vol. Total Variance (U)

16. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 16 Calculating Fixed Overhead Variances

17. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 17 Example: Calculating Fixed Overhead Variances Hanson Inc.’s budgeted fixed overhead is $9,000 for the month. The budgeted activity measure for the month is 3,000 units. Actual production is 3,200 units and actual fixed overhead is $8,450 for the month. Compute the fixed overhead spending and volume variances. $9,000 budgeted fixed overhead 3,000 budgeted units FR = = $3.00 per unit

18. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 18 Example: Calculating Fixed Overhead Variances (continued)

19. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 19 Fixed Overhead Variance Analysis: Alternative Solution Format Total Fixed Overhead Variance = Actual Fixed Overhead – Fixed Overhead Applied to Production = $8,450 - $9,600 = $1,150 F (also called Overapplied fixed overhead) Fixed Overhead Spending (Budget) Variance = Actual Fixed Overhead – Budgeted Fixed Overhead = $8,450 - $9,000 = $550 F Fixed Overhead Production Volume Variance = Budgeted Fixed Overhead – Applied Fixed Overhead = $9,000 - $9,600 = $600 F

20. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 20 Fixed Overhead Production Volume Variance: Alternative Calculation Fixed Overhead Production Volume Variance = Standard Fixed Overhead Application Rate x (Actual Units Produced – Denominator Volume) = $3.00/unit x (3,200 – 3,000) units = $600 F (i.e., overapplied fixed overhead)

21. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 21 Interpretation of Fixed Overhead Variances Results from spending more or less than expected for individual fixed overhead items. That is, spending on individual fixed overhead items was different than planned. Spending (Budget) Variance Production Volume Variance Results from operating at a level other than the denominator volume level. Arises because of the product-costing purpose of fixed overhead. Not of direct interest for control purposes

22. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 22 Causes of Fixed Overhead Variances Spending (Budget) Variance: –Ineffective budget procedures –Inadequate control of costs –Misclassification of cost items Production Volume Variance: –Management decisions –Unexpected changes in market demand –Unforeseen problems in manufacturing operations

23. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 23 Three-Way Breakdown of Total Overhead Variance

24. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 24 Hanson, Inc.: Three-Way vs. Four-Way Analysis of Total Factory Overhead Variance

25. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 25 Two-Way Analysis of Total Factory Overhead Variance

26. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 26 Hanson, Inc.: Two-Way Analysis of Total Factory Overhead Variance

27. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 27 Disposition of Standard Manufacturing Cost Variances

28. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 28 Alternative 1: Close Net Manufacturing Cost Variance to CGS Dr. CGS (net variance) $1,005 Dr. DM Price Variance 170 Dr. FOH Spending Variance 550 Dr. FOH Volume Variance 600 Cr. DM Usage Variance $ 800 Cr. DL Rate Variance 310 Cr. DL Efficiency Variance 600 Cr. VOH Spending Variance 465 Cr. VOH Efficiency Variance 150

29. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 29 Income Statement after Disposition of Net Manufacturing Cost Variance

30. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 30 Alternative 2: Prorate (Allocate) Net Manufacturing Cost Variance End-of-period account balances are used to allocate the net manufacturing cost variance, as follows:

31. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 31 Alternative 2: Prorate Net Manufacturing Cost Variance Dr. CGS (net variance) $ 603 Dr. WIP Inventory 201 Dr. Finished Good Inventory 201 Dr. DM Price Variance 170 Dr. FOH Spending Variance 550 Dr. FOH Volume Variance 600 Cr. DM Usage Variance $ 800 Cr. DL Rate Variance 310 Cr. DL Efficiency Variance 600 Cr. VOH Spending Variance 465 Cr. VOH Efficiency Variance 150

32. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 32 Traditional vs. ABC Approach to Overhead Cost Analysis Traditional Approach to Product Costing:

33. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 33 Traditional Performance Report

34. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 34 Flexible Budget Using ABC

35. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 35 Performance Report Using ABC

36. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 36 Standard Costing Applied to Service Contexts Examples Jobs with repetitive tasks lend themselves to efficiency measures Computing non-manufacturing efficiency variances requires some assumed relationship between input and output activity

37. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 37 Service Applications (continued)

38. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 38 The Variance Investigation Decision How do I know which variances to investigate? Larger variances, in dollar amount or as a percentage of the standard, are investigated first.

39. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 39 The Variance Investigation Decision (continued) Uncontrollable: – Random Error Controllable (Systematic): – Prediction error – Modeling error – Measurement error – Implementation error

40. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 40 Control Charts Display variations in a process and help to analyze the variations over time Distinguish between random variations and variations that should be investigated Provide a warning signal when variations are beyond a specified level

41. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 41 Control Charts (continued)

42. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 42 Control Charts (continued)

43. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 43 Appendix: Variance Investigation Decisions—Using Payoff Tables States of Nature Action Random Nonrandom Investigate I I + C Do not investigate none L Where: I = cost of an investigation C = the cost to correct a variance L = present value of losses by not correcting the variance

44. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 44 Appendix: Variance Investigation Decisions—Indifference Probability E(Investigate) = [(I + (1 - p)] + [(I + C) x p] E(Do not investigate) = L x p Set the above two equations equal, solve for p, the indifference probability: p = I/(L –C)

45. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 45 We distinguished between the product-costing and control purposes of standard costs for factory overhead –For variable overhead costs, we saw that these two purposes are the same (see Exhibit 14.1) –For fixed overhead costs, these purposes are different (see Exhibit 14.3) Chapter Summary

46. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 46 For product-costing purposes, we defined the total overhead variance for the period as the difference between the actual overhead costs incurred and the overhead costs applied to production using the overhead application rate –We saw that this total variance is also referred to as the “total over- or under-applied” overhead for the period Chapter Summary (continued)

47. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 47 The total overhead variance for the period can be decomposed using a four-way, three-way, or two- way analysis: –Four-way analysis = variable overhead spending variance + variable overhead efficiency variance + fixed overhead spending (budget) variance + fixed overhead production volume variance –Three-way analysis = total overhead spending variance + variable overhead efficiency variance + fixed overhead production volume variance –Two-way analysis = flexible (controllable) budget variance + fixed overhead production volume variance Chapter Summary (continued)

48. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 48 Chapter Summary (continued) We discussed how to record standard overhead costs in the accounting records and how any standard cost variances for product-costing purposes are disposed of at the end of the accounting period We learned how traditional and ABC approaches to overhead cost analysis differ in terms of insights provided to management We learned how to apply standard costs to service organizations

49. Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies 2008 49 We discussed indicated managerial actions associated with particular types of errors We covered the use of control charts, including statistical control charts, for monitoring activities and ensuring financial control Finally, we presented in the Appendix a formal decision approach to the variance-investigation decision under uncertainty; this decision model involved the use of “pay-off” tables Chapter Summary (continued)