ACTG 321 Agenda for Lecture 14 Denominator choices for the fixed manufacturing overhead rate Production incentives Break Variances for variable overhead Variances for fixed overhead

Two Ways To Treat Fixed Manufacturing Overhead Variable Costing a.k.a. direct costing Fixed Mfg O/H is a Period Cost Focus is on Contri- bution Margin This isn’t G.A.A.P. Absorption Costing a.k.a. full costing Fixed Mfg O/H is an Inventoriable Cost Focus is on Gross Margin This is G.A.A.P.

What Costs Are Included In Inventory? Non-manufacturing costs (e.g. selling, general & admin.) Variable manufac- turing costs (& any direct, fixed costs) Variable Costing Absorption Costing Fixed Manufacturing Overhead

Allocating Fixed Manufacturing Overhead There are important issues related to how the denominator in the overhead rate is calculated for the purpose of allocating fixed overhead. Two choices are: 1. Practical Capacity: The level of the allocation base that would be incurred if fixed assets run full-time, but allowing for routine maintenance and unavoidable interruptions. 2. Budgeted Utilization: The level of the allocation base that would be incurred for budgeted production.

ACTG 321 Agenda for Lecture 14 Denominator choices for the fixed manufacturing overhead rate Production incentives Break Variances for variable overhead Variances for fixed overhead

ACTG 321 Agenda for Lecture 14 Denominator choices for the fixed manufacturing overhead rate Production incentives Break Variances for variable overhead Variances for fixed overhead

The variable cost flexible budget variance decomposes into a “price” variance and an “efficiency” variance Abbreviations: Price or Wage Rate or Spending Variance = PV Quantity or Usage or Efficiency Variance = QV Actual quantity of inputs = AQ Standard quantity of inputs = SQ Actual price per input unit = AP Standard price per input unit = SP

The variable cost flexible budget variance decomposes into a “price” variance and an “efficiency” variance These variances apply to direct materials, direct labor, and variable overhead. Formulas: PV = AQ x (AP - SP) QV = SP x (AQ - SQ) For Variable Overhead, the Q’s are the quantity of the allocation base. AQ is the actual quantity of the allocation base used. SQ is the standard quantity of the allocation base. The P’s are the Overhead Rate. AP is the Actual Overhead Rate. SP is the Budgeted Overhead Rate.

The variable overhead variances Spending Variance = Actual quantity of allocation base incurred x (Actual O/H rate – Budgeted O/H rate) Efficiency Variance = Budgeted O/H rate x (Actual quantity of allocation base incurred – Standard quantity of allocation base based on actual output)

The variable overhead variances Spending Variance = Actual quantity of allocation base incurred x (Actual O/H rate – Budgeted O/H rate) Efficiency Variance = Budgeted O/H rate x (Actual quantity of allocation base incurred – Standard quantity of allocation base based on actual output) Question: Given the above definitions, what is the economic interpretation of each of these variances?

ACTG 321 Agenda for Lecture 14 Denominator choices for the fixed manufacturing overhead rate Production incentives Break Variances for variable overhead Variances for fixed overhead

Cost Variances for Fixed Overhead There are important issues related to how the denominator in the overhead rate is calculated for the purpose of allocating fixed overhead. Two choices are: 1. Practical Capacity: The level of the allocation base that would be incurred if fixed assets run full-time, but allowing for routine maintenance and unavoidable interruptions. 2. Budgeted Utilization: The level of the allocation base that would be incurred for budgeted production.

Cost Variances for Fixed Overhead Budget variance (a.k.a. spending variance) = actual total FMOH  budgeted total FMOH Volume variance = budgeted total FMOH  FMOH allocated to output using a standard costing system (budgeted FMOH per unit x actual units produced) Budgeted FMOH per unit = FMOH ÷ the denominator concept, as discussed on the previous slide. The volume variance is favorable if actual production exceeds the denominator in the FMOH rate.

Coachman Company The Coachman Company manufactures pencils. The pencils are sold by the box. Budget Actual Capacity # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Machine hr.s 500 600 10,000 Fixed O/H $40,000 $42,000

Coachman Company # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Budget Actual Capacity # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Machine hr.s 500 600 10,000 Fixed O/H $40,000 $42,000 The outputs here are boxes of pencils. The inputs are direct labor hours and machine hours.

Coachman Company # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Budget Actual Capacity # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Machine hr.s 500 600 10,000 Fixed O/H $40,000 $42,000 Let’s calculate a fixed overhead rate using actual information: $42,000  12,000 boxes = $3.50 per box

Coachman Company # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Budget Actual Capacity # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Machine hr.s 500 600 10,000 Fixed O/H $40,000 $42,000 Let’s calculate a fixed overhead rate using budgeted costs, budgeted production, and outputs as the allocation base: $40,000  10,000 boxes = $4.00 per box

Coachman Company # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Budget Actual Capacity # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Machine hr.s 500 600 10,000 Fixed O/H $40,000 $42,000 Let’s calculate a fixed overhead rate using budgeted costs in the numerator, production capacity in the denominator, and outputs as the allocation base: $40,000  20,000 boxes = $2.00 per box

Coachman Company # of boxes 10,000 12,000 20,000 Budget Actual Capacity # of boxes 10,000 12,000 20,000 Fixed O/H $40,000 $42,000 $40,000  20,000 boxes = $2.00 per box The advantage of using capacity in the denominator is that this shows how low the fixed cost per unit can go. Fixed cost per unit goes down as production goes up. But production levels cannot generally exceed capacity.

Coachman Company # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Budget Actual Capacity # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Machine hr.s 500 600 10,000 Fixed O/H $40,000 $42,000

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead This is what we actually spent From either the static or flexible budget O/H rate x the application base Budget Variance Volume Variance Under- or Over- applied Fixed Overhead These variances are computed for the company as a whole, not for individual jobs.

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 From either the static or flexible budget O/H rate x the application base Budget Variance Volume Variance Under- or Over- applied Fixed Overhead These variances are computed for the company as a whole, not for individual jobs.

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 O/H rate x the application base Budget Variance Volume Variance Under- or Over- applied Fixed Overhead These variances are computed for the company as a whole, not for individual jobs.

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 O/H rate x the application base $2,000 Unfavorable Volume Variance Under- or Over- applied Fixed Overhead These variances are computed for the company as a whole, not for individual jobs.

First let’s allocate based on factory capacity in the denominator

Coachman Company # of boxes 10,000 12,000 20,000 Budget Actual Capacity # of boxes 10,000 12,000 20,000 Fixed O/H $40,000 $42,000 $40,000  20,000 boxes = $2.00 per box The advantage of using capacity in the denominator is that this shows how low the fixed cost per unit can go. Fixed cost per unit goes down as production goes up. But production levels cannot generally exceed capacity.

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $2.00 per unit x 12,000 units $2,000 Unfavorable Volume Variance Under- or Over- applied Fixed Overhead These variances are computed for the company as a whole, not for individual jobs.

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $24,000 $2,000 Unfavorable Volume Variance Under- or Over- applied Fixed Overhead These variances are computed for the company as a whole, not for individual jobs.

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $24,000 $2,000 Unfavorable $16,000 Unfavorable Under- or Over- applied Fixed Overhead These variances are computed for the company as a whole, not for individual jobs.

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $24,000 $2,000 Unfavorable $16,000 Unfavorable $18,000 Fixed Overhead Underapplied. These variances are computed for the company as a whole, not for individual jobs.

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $24,000 $2,000 Unfavorable $16,000 Unfavorable $18,000 Fixed Overhead Underapplied. The $16,000 Unfavorable Volume Variance can also be calculated as follows: $2 per unit x 8,000 units (capacity less actual production). Hence, this is the cost of producing below capacity.

Now let’s allocate based on budgeted production in the denominator

Coachman Company # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Budget Actual Capacity # of boxes 10,000 12,000 20,000 D.L.H. 200 250 5,000 Machine hr.s 500 600 10,000 Fixed O/H $40,000 $42,000 Let’s calculate a fixed overhead rate using budgeted costs and production, and outputs as the allocation base: $40,000  10,000 boxes = $4.00 per box

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $4.00 per unit x 12,000 units $2,000 Unfavorable Volume Variance Under- or Over- applied Fixed Overhead These variances are computed for the company as a whole, not for individual jobs.

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $48,000 $2,000 Unfavorable $8,000 Favorable Under- or Over- applied Fixed Overhead These variances are computed for the company as a whole, not for individual jobs.

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $48,000 $2,000 Unfavorable $8,000 Favorable $6,000 Fixed Overhead Overapplied. These variances are computed for the company as a whole, not for individual jobs.

Overhead Variances For Fixed Overhead Actual Fixed Overhead Budgeted Fixed Overhead Applied Fixed Overhead $42,000 $40,000 $48,000 $2,000 Unfavorable $8,000 Favorable $6,000 Fixed Overhead Over-applied. The $8,000 Favorable Volume Variance can also be calculated as follows: $4 per unit x 2,000 units (actual production less budgeted production). Hence, this is the cost/benefit of producing below/above budget.