Question 1. What Is A Flexible Budget?
A flexible budget is a budget that adjusts or flexes for changes in the volume of activity. The flexible budget is more sophisticated and useful than a static budget, which remains at one amount regardless of the volume of activity.
Assume that a manufacturer determines that its cost of electricity and supplies for the factory are approximately $10 per machine hour (MH). It also knows that the factory supervision, depreciation, and other fixed costs are approximately $40,000 per month. Typically, the production equipment operates between 4,000 and 7,000 hours per month. Based on this information, the flexible budget for each month would be $40,000 + $10 per MH.
Now let’s illustrate the flexible budget by using some data. If the production equipment is required to operate for 5,000 hours during January, the flexible budget for January will be $90,000 ($40,000 fixed + $10 x 5,000 MH). If the equipment is required to operate in February for 6,300 hours, then the flexible budget for February will be $103,000 ($40,000 fixed + $10 x 6,300 MH). If March requires only 4,100 machine hours, the flexible budget for March will be $81,000 ($40,000 fixed + $10 x 4,100 MH).
If the plant manager is required to use more machine hours, it is logical to increase the plant manager’s budget for the additional cost of electricity and supplies. The manager’s budget should also decrease when the need to operate the equipment is reduced. In short, the flexible budget provides a better opportunity for planning and controlling than does a static budget.
Question 2. What Is Cost Accounting?
Cost accounting involves the techniques for:
- determining the costs of products, processes, projects, etc. in order to report the correct amounts on the financial statements, and
- assisting management in making decisions and in the planning and control of an organization.
For example, cost accounting is used to compute the unit cost of a manufacturer’s products in order to report the cost of inventory on its balance sheet and the cost of goods sold on its income statement. This is achieved with techniques such as the allocation of manufacturing overhead costs and through the use of process costing, operations costing, and job-order costing systems.
Cost accounting assists management by providing analysis of cost behavior, cost-volume-profit relationships, operational and capital budgeting, standard costing, variance analyses for costs and revenues, transfer pricing, activity-based costing, and more.
Cost accounting had its roots in manufacturing businesses, but today it extends to service businesses. For example, a bank will use cost accounting to determine the cost of processing a customer’s check and/or a deposit. This in turn may provide management with guidance in the pricing of these services.
Question 3. What Is Absorption Costing?
Absorption costing means that all of the manufacturing costs are absorbed by the units produced. In other words, the cost of a finished unit in inventory will include direct materials, direct labor, and both variable and fixed manufacturing overhead. As a result, absorption costing is also referred to as full costing or the full absorption method.
Absorption costing is often contrasted with variable costing or direct costing. Under variable or direct costing, the fixed manufacturing overhead costs are not allocated or assigned to (not absorbed by) the products manufactured. Variable costing is often useful for management’s decision-making. However, absorption costing is required for external financial reporting and for income tax reporting.
Question 4. What Is Job Order Costing?
Job order costing or job costing is a system for assigning manufacturing costs to an individual product or batches of products. Generally, the job order costing system is used only when the products manufactured are sufficiently different from each other. (When products are identical or nearly identical, the process costing system will likely be used.)
Since there is a significant variation in the products manufactured, the job order costing system will create a job cost record for each item, job or special order. The job cost record will report the direct materials and direct labor actually used plus the manufacturing overhead assigned to each job.
An example of an industry where job order costing is used is the building construction industry since each building is unique. The manufacturers of custom equipment or custom cabinetry are also examples of companies that will keep track of production costs by item or job.
The job cost records also serve as the subsidiary ledger or documentation for the cost of the work-in-process inventory, the finished goods inventory, and the cost of goods sold.
Question 5. What Is The Difference Between Actual Overhead And Applied Overhead?
In accounting, overhead usually refers to the indirect manufacturing costs. These are the manufacturing costs other than direct materials and direct labor.
The actual overhead refers to the indirect manufacturing costs actually occurring and recorded. These include the manufacturing costs of electricity, gas, water, rent, property tax, production supervisors, depreciation, repairs, maintenance, and more.
The applied overhead refers to the indirect manufacturing costs that have been assigned to the goods manufactured. Manufacturing overhead is usually applied, assigned, or allocated by using a predetermined annual overhead rate. For example, a manufacturer might estimate that in its upcoming accounting year there will be $2,000,000 of manufacturing overhead and 40,000 machine hours. As a result, this manufacturer sets its predetermined annual overhead rate at $50 per machine hour.
Since the future overhead costs and future number of machine hours were not known with certainty, and since the actual machine hours will not occur uniformly throughout the year, there will always be a difference between the actual overhead costs incurred and the amount of overhead applied to the manufactured goods. Hopefully, the differences will be minimal at the end of the accounting year.
Question 6. What Are Direct Costs?
Direct costs can be traced directly to a cost object such as a product or a department. In other words, direct costs do not have to be allocated to a product, department, or other cost object.
For example, if a company produces artisan furniture, the cost of the wood and the cost of the craftsperson are direct costs—they are clearly traceable to the production department and to each item produced—no allocation was needed. On the other hand, the rent of the building that houses the production area, warehouse, and office is not a direct cost of either the production department or the items produced. The rent is an indirect cost—an indirect cost of operating the production department and an indirect cost of crafting the product.
To calculate the total cost of the production department or to calculate each product’s total cost, it is necessary to allocate some of the rent (and other indirect costs) to the department and to the product.
Question 7. What Are Manufacturing Costs?
Manufacturing costs are the costs necessary to convert raw materials into products. All manufacturing costs must be attached to the units produced for external financial reporting under US GAAP. The resulting unit costs are used for inventory valuation on the balance sheet and for the calculation of the cost of goods sold on the income statement.
Manufacturing costs are typically divided into three categories…
- Direct materials. This is the cost of the materials which become part of the finished product. For example, the cost of wood is a direct material in the manufacture of wooden furniture.
- Direct labor. This is the cost of the wages of the individuals who are physically involved in converting raw materials into a finished product. For example, the wages of the person cutting wood into the specified lengths and the wages of the assemblers are direct labor costs in a furniture factory.
- Factory overhead or manufacturing overhead. Factory overhead refers to all other costs incurred in the manufacturing activity which cannot be directly traced to physical units in an economically feasible way. The wages of the person who inspects the completed furniture and the depreciation on the factory equipment are part of the factory overhead costs. Factory overhead is also described as indirect manufacturing costs.
Question 8. What Is Variance Analysis?
In accounting, a variance is the difference between an expected or planned amount and an actual amount. For example, a variance can occur for items contained in a department’s expense report. Variance analysis attempts to identify and explain the reasons for the difference between a budgeted amount and an actual amount.
Variance analysis is usually associated with a manufacturer’s product costs. In this setting, variance analysis attempts to identify the causes of the differences between a manufacturer’s 1) standard costs of the inputs that should have occurred for the actual products it manufactured, and 2) the actual costs of the inputs used for the actual products manufactured.
To illustrate, let’s assume that a company manufactured 10,000 units of product (output). The company’s standards indicate that it should have used $40,000 of materials (an input), but it actually used $48,000 of materials. This unfavorable variance needs to be analyzed. A common variance analysis will divide the $8,000 into a price variance and a quantity variance. The price variance identifies whether the company paid too much for each unit of input. (Perhaps it paid more per pound of the input than it had planned.) The quantity variance identifies whether the company used too much of the input. (Perhaps it used too many pounds of the raw materials for the number of products it manufactured.)
Variance analysis for manufacturing overhead costs is more complicated than the variance analysis for materials. However, the variance analysis of manufacturing overhead costs is very important as manufacturing overhead costs have become a very large percentage of a product’s costs.
Question 9. What Is The Difference Between Normal Costing And Standard Costing?
Normal costing is used to value manufactured products with the actual materials costs, the actual direct labor costs, and manufacturing overhead based on a predetermined manufacturing overhead rate. These three costs are referred to as product costs and are used for the cost of goods sold and for inventory valuation. If there is a difference between 1) the overhead costs assigned or applied to products, and 2) the overhead costs actually incurred, the difference is referred to as a variance. If the amount of the variance is not significant, it will usually be assigned to the cost of goods sold. If the variance is significant, it should be prorated to the cost of goods sold and to the work in process and finished goods inventories.
Standard costing values its manufactured products with a predetermined materials cost, a predetermined direct labor cost, and a predetermined manufacturing overhead cost. These standard costs will be used for valuing the manufacturer’s cost of goods sold and inventories. If the actual costs vary only slightly from the standard costs, the resulting variances will be assigned to the cost of goods sold. If the variances are significant, they should be prorated to the cost of goods sold and to the inventories.
Question 10. What Do Negative Variances Indicate?
Accountants often use negative amounts to indicate an unfavorable variance. For instance, if actual revenues are less than the budgeted revenues, the variance (or difference) will be shown as a negative amount. The reason is that having less revenues than planned is not good. On the other hand, if actual expenses are less than the budgeted amount of expenses, the variance will be shown as a positive amount. The reason is that fewer actual expenses than budgeted is favorable (or good, positive).
Let’s illustrate this further with an example. Assume that a company had the following actual amounts in a recent week: revenues $750, expenses $525, net income $225. For the same week, the company had budgeted the following amounts: revenues $900, expenses $700, net income $200. The comparison of actual to budget resulted in the following variances:
- Revenues variance: unfavorable $150. Presented as (150).
- Expenses variance: favorable $175. Presented as 175.
- Net income variance: favorable $25. Presented as 25.
The net income variance is favorable because the favorable expense variance was $25 greater than the unfavorable revenues variance. The favorable $175 variance exceeded the unfavorable $150 variance resulting in the net variance of $25 favorable.
Our example shows that the positive and negative signs for the variances are logical if you focus is on the company’s net income. In other words, ask yourself one of the following questions:
- “Is the difference between the actual and the budgeted amounts good or bad as far as the company’s net income?”
- “Is the variance favorable or unfavorable as far as the company’s net income?”
- “Does the difference have a positive or negative effect on the company’s net income?”
To assist others, it may be helpful to indicate on your report “( ) = an unfavorable effect on net income.”
Question 11. What Is Inventory Shrinkage?
Inventory shrinkage is the term used to describe the loss of inventory. For example, if the inventory records of a retailer report that 3,261 units of Product X are on hand, but a physical count indicates that there are only 3,248 units on hand, there is an inventory shrinkage of 13 units. The retailer’s inventory shrinkage might be due to shoplifting, employee theft, damage, obsolescence, etc.
The term shrinkage is also used by manufacturers when referring to the loss of raw materials during a production process. For example, a manufacturer of baked food items will experience shrinkage throughout its processes due to ingredients adhering to the beaters and bowls, and also due to evaporation. This shrinkage is also known as spoilage or waste and it can be either normal or abnormal.
Question 12. What Are Indirect Manufacturing Costs?
Indirect manufacturing costs are a manufacturer’s product costs other than direct materials and direct labor. Indirect manufacturing costs are also referred to as manufacturing overhead, factory overhead, factory burden, or burden.
Under traditional cost accounting, the indirect manufacturing costs are allocated (or spread) to the products manufactured based on direct labor hours, direct labor costs, or production machine hours. However, in recent decades the indirect manufacturing costs have increased significantly and are less likely to be caused by the quantity of direct labor or production machine hours. (This may not be a problem for financial reporting if the amount of inventory is consistently small, but it can be a problem for pricing and other decisions.)
Examples of indirect manufacturing costs include:
- depreciation, repairs and maintenance, electricity, etc. for the production facilities and equipment
- salaries, wages and fringe benefits of the indirect manufacturing personnel such as production supervisors, material handlers, quality assurance, and other factory support personnel
- factory supplies, outside services pertaining to manufacturing, and other manufacturing related costs.
Question 13. What Is Relevant Range?
In accounting, relevant range refers to a limited span of volume or activity. To illustrate, let’s assume that a manufacturer’s monthly production volume is consistently between 10,000 and 13,000 units and between 20,000 and 25,000 machine hours. Within this range of activity it operates smoothly with the same amount of monthly fixed costs (say $200,000) for supervisors, rent, depreciation, etc. If the volume were to drop below this range, the company would reduce the number of supervisors, the space rented, etc. so that its total monthly fixed costs would be smaller. If the volume exceeds the range, the company would incur additional fixed costs for more supervisors, space, etc. Hence, this company’s relevant range of activity is 10,000 to 13,000 units of product or 20,000 to 25,000 machine hours. It is only in this relevant range that the monthly fixed costs are $200,000.
There are also relevant ranges for variable costs and selling prices. Volume that is lower and/or higher than the respective relevant range can mean different variable costs per unit and different selling prices per unit.
In short, cost behavior and pricing is complicated. In order to simplify the analysis accountants will often assume that costs and selling prices are linear within the narrow band of activity known as the relevant range.
Question 14. What Is A Cost Variance?
Generally a cost variance is the difference between a cost’s actual amount and its budgeted or planned amount. For example, if a company had actual repairs expense of $950 for May but the budgeted amount was $800, the company had a cost variance of $150. Since the actual cost was more than the budgeted amount, the cost variance is said to be unfavorable. When an actual cost is less than the budgeted amount, the cost variance is said to be favorable.
Cost variances are a key part of the standard costing system used by many manufacturers. In such a system the cost variances explain the difference between 1) the standard, predetermined and expected costs of the good output, and 2) the actual manufacturing costs incurred. These cost variances send an early signal to management that the company is experiencing actual costs that are different from the company’s plan. Standard costing systems will report a minimum of two cost variances for each of the following manufacturing costs: direct materials, direct labor and manufacturing overhead.
Question 15. What Is The Difference Between A Budget And A Standard?
A budget usually refers to a department’s or a company’s projected revenues, costs, or expenses. A standard usually refers to a projected amount per unit of product, per unit of input (such as direct materials, factory overhead), or per unit of output.
For example, a manufacturer will have budgets for its manufacturing or factory overhead departments. Let’s assume that the budgeted manufacturing overhead for the upcoming year is expected to be $1,000,000 in order to produce the expected 100,000 identical units of product. The standard cost of manufacturing overhead per unit of product is $10 ($1,000,000 divided by 100,000 units). When the products are not identical, the $1,000,000 of manufacturing overhead might be divided by the expected number of machine hours required to manufacture the units of product. Assuming it will take 50,000 machine hours, the standard cost of the manufacturing overhead will be $20 per machine hour ($1,000,000 divided by 50,000 machine hours).
Question 16. What Is Direct Labor?
Direct labor refers to the employees and temporary help who work directly on a manufacturer’s products. (People working in the production area, but not directly on the products, are referred to as indirect labor.)
The direct labor cost is 1) the cost of the wages and fringe benefits of the direct labor employees and 2) the cost of the temporary help who work directly on the manufacturer’s products.
The direct labor cost is also defined as:
- a product cost (along with the costs of the direct materials and manufacturing overhead)
- an inventoriable cost (along with the costs of the direct materials and manufacturing overhead)
- a prime cost (along with direct materials)
- a conversion cost (along with manufacturing overhead)
Question 17. What Are Direct Materials?
Direct materials are the traceable matter used in manufacturing a product. The direct materials for a manufacturer of dessert products will include flour, sugar, eggs, milk, vegetable oil, spices, and other ingredients in the recipes. In manufacturing, the direct materials are listed in each product’s bill of materials. (Indirect materials such as oil for greasing the baking pans, etc. will likely be viewed as part of the manufacturing supplies and will be allocated to products along with other manufacturing overhead.)
The direct materials contained in manufactured products are also defined as:
- a product cost (along with the costs of the direct labor and manufacturing overhead)
- an inventoriable cost (along with the costs of direct labor and manufacturing overhead)
- a prime cost (along with the cost of direct labor) The costs of direct materials should be reported in the financial statements according to their location or position:
- if not yet put into production, report as raw materials inventory on the balance sheet
- if put into production but the goods are not completed, report as part of the cost of work-in-process inventory on the balance sheet
- if put into production and the goods are completed but not yet sold, report as part of the cost of the finished goods inventory on the balance sheet
- if put into production and the goods have been completed and sold, report as part of the cost of goods sold on the income statement
Question 18. What Is The Difference Between Cost And Price?
Some people use cost and price interchangeably. Others use the term cost to mean one component of a product’s selling price. Even the same person might use the terms differently.
For example, in standard costing the price variance of the raw materials refers to the difference between the standard cost and the actual cost of the materials.
In other situations we define a product’s selling price as: product costs + expenses + profit.
As these two examples indicate, there can be different meanings for the terms cost and price.
Question 19. What Is A Standard Cost?
A standard cost has been described as a predetermined cost, an estimated future cost, an expected cost, a budgeted unit cost, a forecast cost, or a “should be” cost. Standard costs are often a part of a manufacturer’s annual profit plan and operating budgets. Standard costs will be established for the following year’s direct materials, direct labor, and manufacturing overhead. If standard costs are used, there will be:
- a standard cost for each unit of input (e.g., $20 per hour of direct labor)
- a standard quantity of each input for each unit of output (e.g., 2 hours of labor for each product)
- a standard cost for each unit of output (e.g., $20 X 2 hours = $40 of direct labor per product)
Under a standard cost system, the standard costs of the manufacturing activities will be recorded in the inventories and the cost of goods sold accounts. Since the company must pay its vendors and production workers the actual costs incurred, there are likely to be some differences. The difference between the standard costs and the actual manufacturing costs is referred to as a cost variance and will be recorded in separate variance accounts. Any balance in a variance account indicates that the company is deviating from the amounts in its profit plan.
While standard costs can be a useful management tool for a manufacturer, its external financial statements must comply with the cost principle and the matching principle. Therefore, significant variances must be reviewed and properly reported as part of the cost of goods sold and/or inventories.
Question 20. What Is Managerial Accounting?
Managerial accounting is also known as management accounting and it includes many of the topics found in cost accounting.
Some managerial accounting topics focus on computing a manufacturer’s product costs that are needed for the external financial statements. For example, the manufacturer’s income statement must report the actual cost of the products sold, and its balance sheet must report the actual costs in its ending inventories. The managerial accounting topics needed for these calculations include: product vs. period costs, job order costing, process costing, allocation of manufacturing overhead, costing of joint products, and more.
Other managerial accounting topics are more beneficial for planning and controlling a business and in helping management make financial decisions. These topics include:
- understanding cost behavior and cost-volume-profit analysis
- operational budgeting and capital budgeting
- standard costing and variance analysis
- activity based costing
- pricing of individual products and services
- analyzing the profitability of product lines, customers, territories, etc.
The appropriate and relevant amounts for these topics will likely be unaudited, estimated, and future amounts (instead of the past, sunk costs found in the general ledger). Management’s focus on these managerial accounting topics can make a difference in a company’s profitability.
Question 21. What Is The Meaning Of A Favorable Budget Variance?
A favorable budget variance indicates that an actual result is better for the company (or other organization) than the amount that was budgeted.
Here are three examples of favorable budget variances:
- Actual revenues are more than the budgeted or planned revenues.
- Actual expenses are less than the budget or plan.
- Actual manufacturing costs are less than the amount budgeted for the period.
Occasionally, a favorable budget variance for revenues will be analyzed to determine whether it was the result of higher than planned selling prices, greater quantities, or a more favorable mix of items sold.
Question 22. What Is The Meaning Of Fixed Overhead Absorbed?
This phrase is used in cost accounting and involves the assigning, applying, or allocating of fixed manufacturing overhead costs to the units produced by a manufacturer.
Three examples of fixed manufacturing overhead costs include 1) depreciation of the manufacturing equipment, 2) the property tax on the factory building, and 3) the salaries of the factory supervisors. Each of these costs comes in large dollar amounts (they do not occur at a rate of say $1.00 per unit) and none is directly traceable to the products manufactured. The dollar amount of each of these costs will probably not change if the company produces 10% more units or 10% fewer units.
Because the fixed manufacturing overhead costs are indirect product costs (not directly traceable to the products) the accountant allocates (or assigns or applies) these costs to the products on some basis—perhaps on the basis of machine hours or through activity-based costing. While the accountant assigns or allocates these costs, the products are said to be absorbing these fixed manufacturing costs. (Absorption costing, which is required for external financial statements, means that each product’s cost includes direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead.)
Fixed manufacturing overhead cost is usually applied to the products (and is absorbed by the products) through the use of a predetermined annual overhead rate that is based on some planned volume of production. If the actual product volume is less than the planned volume (and the costs are as planned) the fixed manufacturing overhead will be underabsorbed. When the actual volume exceeds the planned volume and the costs are as planned, the fixed manufacturing overhead will be overabsorbed.
Question 23. In Standard Costing, How Is The Purchase Price Variance Reclassified To Arrive At Actual Cost?
I assume that the purchase price variance was recorded at the time that the raw materials were purchased. If that price variance is significant, it should be reclassified to the following: raw materials inventory, work-in-process inventory, finished goods inventory, and cost of goods sold. The reclassification is also known as prorating the variance or allocating the variance.
The reclassification of the purchase price variance should be based on the location of the raw materials which had created the price variance. If those raw materials were recently purchased and are entirely in the raw materials inventory, then all of the price variance should be assigned to the raw materials inventory. If the price variance occurred throughout the year, the variance should be assigned to the raw materials inventory, work-in-process inventory, finished goods inventory, and cost of goods sold based on the quantity of the raw materials in each of these categories.
If the amount of the purchase price variance is very small and/or the inventory turnover rates are very high, the entire amount of the price variance might be reclassified entirely to the cost of goods sold.
Question 24. What Is A Learning Curve?
A common learning curve shows that the cumulative average time to complete a manual task which involves learning will decrease 20% whenever volume doubles. This is referred to as an 80% learning curve.
Let’s illustrate the 80% learning curve with a person learning to design and code websites of similar size and complexity. If the first website takes 100 hours, then after the second website the cumulative average time will be 80 hours (80% of 100 hours). The cumulative average of 80 hours consists of 100 hours for the first website plus only 60 hours for the second website resulting in a total of 160 hours divided by 2 websites. After the fourth website the cumulative average time will be 64 hours (80% of 80 hours). After the eighth website the cumulative average will be 51.2 hours (80% of 64 hours). In other words, the total time to have completed all eight websites will be 409.6 hours (8 websites times an average time of 51.2 hours).
Improvements in technology can mean time and cost reductions beyond those in the learning curve. For example, software may become available to assist in the design and coding, computer processing speeds might increase, there may be lower costs of processing and storage, etc.
The learning curve is important for setting standards, estimating costs, and establishing selling prices.
Question 25. What Is A Fixed Cost?
A fixed cost is one that does not change in total within a reasonable range of activity. For example, the rent for a production facility is a fixed cost if the rent will not change when there are reasonable changes in the amount of output or input. (Of course, if there is a need to double the output the rent will change when the company occupies additional work space.)
While a fixed cost remains constant in total, the fixed cost per unit of output or input will change inversely with the change in the quantity of output or input. For instance, if the rent of the production facility is fixed at $120,000 per year and there are 30,000 machine hours of good output during the year, the rent will be $4 ($120,000/30,000) per machine hour. If there are 40,000 machine hours during the year, the rent will be $3 ($120,000/40,000) per machine hour.
Many manufacturing overhead costs are fixed and the amounts occur in large increments. Some examples include depreciation on a company-owned factory, depreciation on machinery and equipment, salaries and benefits of manufacturing supervisors, factory administration costs, etc. One challenge for accountants is the allocation or assigning of the large fixed costs to the individual units of product (which likely vary in size and complexity). This allocation (or assigning or absorbing) is required by the accounting and income tax rules for valuing inventories and the cost of goods sold. If the fixed overhead is assigned using machine hours, one must keep in mind that the cost rate per machine hour is not how the fixed costs behave or occur. In our example, the cost of the rent might be assigned to the products at the rate of $3 or $4 per machine hour but the rent actually occurs at the rate of $10,000 per month.
Question 26. What Does The Direct Labor Efficiency Variance Tell Us?
This variance tells us how efficient the direct labor was in making the actual output that was produced by the direct labor.
The direct labor efficiency variance compares the standard hours that it should have taken to make the actual output Vs. the actual hours it took and multiplies the difference in hours by the standard cost per direct labor hour.
Here’s an example with amounts. Let’s assume the standard for direct labor is 3 hours per unit of output and the standard cost for an hour of direct labor is $10. Let’s say the output for the period is 6,000 units and the actual direct labor hours were 18,400 hours and the labor earned $10.30 per hour. The standard direct labor cost for the actual output should have been 18,000 hours (6,000 units of output times 3 standard hours) at $10 per hour for a total of $180,000. The actual direct labor cost was $189,520 (18,400 hours at $10.30 per hour). This means a TOTAL (efficiency and rate) variance of $9,520. Some of that variance is due to the rate being $0.30 too much and some of that variance is due to the direct labor using too many hours—not being efficient.
The direct labor efficiency variance focuses on the direct labor hours: 6,000 units of output should have taken 3 hours each for a total of 18,000 direct labor hours. The actual direct labor hours were 18,400 hours. This means there was an unfavorable direct labor efficiency variance of 400 hours times the standard rate of $10 for a total of $4,000.
The direct labor rate variance is the $0.30 unfavorable variance in the hourly rate ($10.30 actual rate Vs. $10.00 standard rate) times the 18,400 actual hours for an unfavorable direct labor rate variance of $5,520.
The combination of the unfavorable direct labor efficiency variance of $4,000 + the unfavorable direct labor rate variance of $5,520 is the total unfavorable direct labor variance of $9,520.
Question 27. What Is The Materials Usage Variance?
The materials usage variance, which is also referred to as the materials quantity variance, is associated with a standard costing system. The materials usage variance results when a company uses more or less than the standard quantity of materials (input) that should have been used for the products actually manufactured (the good output).
The materials usage variance is unfavorable when the actual quantity of materials used exceeded the standard quantity of materials. The materials usage variance is favorable when the actual quantity of materials used was less than the standard quantity. In the U.S. the materials usage variance is expressed in dollars, which is calculated by multiplying the favorable or unfavorable quantity (such as pounds) times the standard cost per pound.
To illustrate, let’s assume that a company has a standard of 5 pounds of materials to produce one unit of output. The company also established that the standard cost per pound of the materials is $3 per pound. If the company produced 100 units of output, the company should have used 500 pounds of input (100 units of good output X 5 pounds of input per unit of output). If the company actually used 530 pounds of input, the materials usage variance will be $90 unfavorable (30 pounds of additional input X the standard cost per pound of $3). The $90 unfavorable materials usage variance can be explained by the following: $1,590 (530 actual pounds used X $3 standard cost) vs. the standard of $1,500 (100 units of output X 5 standard pounds = 500 standard pounds x $3 standard cost).
Question 28. What Is The Production Volume Variance?
The production volume variance is associated with a standard costing system used by some manufacturers. This variance indicates the difference between 1) the company’s budgeted amount of fixed manufacturing overhead costs, and 2) the amount of the fixed manufacturing overhead costs that were assigned to (or absorbed by) the company’s production output.
To illustrate the production volume variance, let’s assume that a manufacturer had budgeted $300,000 of fixed manufacturing overhead (supervisors’ compensation, depreciation, etc.) for the upcoming year. During that period it expected to have 30,000 machines hours of good output. Based on this plan the manufacturer established a fixed manufacturing overhead rate of $10 per standard machine hour. If the company actually produces 29,000 standard machine hours of good output, the products will be assigned (or will have absorbed) $290,000 of the fixed manufacturing overhead. This will cause an unfavorable production volume variance of $10,000 ($300,000 budgeted vs. $290,000 assigned; or 1,000 too few standard machine hours of good output X $10 per standard machine hour).
If our example had stated that the manufacturer actually produced 32,000 standard machine hours of good output, the products would have been assigned $320,000 of fixed manufacturing overhead costs compared to the budgeted amount of $300,000. This scenario would result in a favorable production volume variance of $20,000 ($300,000 budgeted vs. $320,000 assigned; or 2,000 additional standard machine hours of good output X $10 per standard machine hour).
Question 29. Why Do Manufacturers Use Standard Costs?
One reason for a manufacturer to use standard costs is to plan carefully what its costs will be for the upcoming budgeting year and to then compare the actual costs with those planned costs. If the actual costs are similar to the standard costs (the planned costs; what the costs should be) the company is on track to reach the cost part of its profit plan. If the actual costs deviate from the standard costs, management is alerted by the variances that are reported for materials, labor and manufacturing overhead. Hence standard costs allow a manufacturer to practice management by exception. That is, if the actual costs are what they should be, management action is not required. If the actual costs are more than the standard costs, management must take action or it will not achieve the planned profit.
The standard cost variances direct management’s attention to the area where the problems are occurring. If the problems cannot be solved easily, management may need to explore alternate materials or processes, attempt to increase selling prices, etc. Again, without reacting to the variances the company’s planned profit for the year will not be met.
Question 30. Is Standard Costing Gaap?
Standard costing was developed to assist a manufacturer plan and control its operations. Generally accepted accounting principles or GAAP require that a manufacturer’s financial statements comply with the cost principle. This means that the inventories, the cost of goods sold, and the resulting net income must reflect the manufacturer’s actual costs.
Standard costing will meet the GAAP requirements if the variances between the standard costs and the actual costs are properly prorated to the inventories and to the cost of goods sold prior to issuing the financial statements.
Question 31. What Is Standard Costing?
Standard costing is an accounting technique that some manufacturers use to identify the differences or variances between 1) the actual costs of the goods that were produced, and 2) the costs that should have occurred for those goods. The costs that should have occurred for the actual good output are known as standard costs.
Standard costing is likely integrated with a manufacturer’s budgets (profit plan, master budget) for an accounting year and involve the product costs: direct materials, direct labor, and manufacturing overhead. With standard costing, the accounts for inventories and the cost of goods sold contain the standard costs of the inputs that should have been used to make the actual good output.
If the company had incurred more than the standard costs for the direct materials, direct labor, and manufacturing overhead, the company will not meet its projected net income. In other words, the variances will direct management’s attention to the production inefficiencies or higher input costs. In turn, management can take action to correct the problems or seek higher selling prices.
Since the external financial statements must reflect the historical cost principle, the standard costs in the inventories and the cost of goods sold will need to be adjusted for the variances. Since most of the goods manufactured will have been sold, most of the variances will be reported on the income statement as part of the cost of goods sold.
Question 32. How Is The Material Usage Variance Account Reported On The Financial Statements?
The material usage variance in a standard costing system results from using more or less than the standard quantity of direct materials specified for the actual goods produced. If the actual quantity of the input direct materials is more than the standard quantity allowed for the good output, the variance is unfavorable and the Material Usage Variance account will have a debit balance . If the actual quantity of the input direct materials is less than the standard quantity allowed for the good output, the variance is favorable and a credit will be entered in the Materials Usage Variance account.
When preparing the financial statements, a debit balance in the Materials Usage Variance account (which means an unfavorable variance) will have to be added to the standard cost of the products. If the standard costs associated with the variance are in the goods that have been sold, the debit balance in the variance account will be added to the Cost of Goods Sold, an income statement expense. (This is reasonable, because the standard cost is too low compared to the actual cost of the materials.) If the output associated with the variances is entirely in finished goods inventory, then the debit balance in the variance account will be added to the finished goods inventory amount reported on the balance sheet. Again, this is necessary because the standard cost of the finished goods inventory is too low. If the products are in work in process, finished goods inventory, and cost of goods sold, you would assign the variance to all three categories based on the proportions associated with the variance amounts. Accountants refer to this as prorating the variances. If the variance amount is insignificant, accountants will simply assign these small variances to the cost of goods sold. This is reasonable if most of the goods that were produced have been sold. Generally, inventories are small in relation to the quantities produced.
Credit balances in the variance accounts represent favorable variances and will reduce the standard costs that are reported as debit balances in inventory on the balance sheet or as cost of goods sold expense on the income statement. The favorable variances will be prorated as discussed above or simply credited to cost of goods sold when the variances are not significant or material in amount.
Question 33. What Do Overabsorbed And Underabsorbed Mean?
In cost accounting, manufacturing overhead costs are often assigned to products by using a predetermined overhead rate. The predetermined rate is likely based on an annual manufacturing overhead budget divided by some activity such as the expected number of machine hours. Instead of saying that the manufacturing overhead is assigned, we might say it is allocated, applied or apportioned to the products manufactured during the period. We could also say that the products have absorbed the overhead.
If the amount of overhead assigned to the products manufactured is greater than the amount of overhead actually incurred, the products have overabsorbed the overhead costs. If the amount of overhead assigned to the products is less than the amount of overhead actually incurred, the products have underabsorbed the overhead costs.
The cause of the overabsorption or underabsorption will be some combination of 1) the quantity of products manufactured, and 2) the actual overhead costs incurred.
Question 34. What Causes An Unfavorable Fixed Overhead Budget Variance?
An unfavorable fixed overhead budget variance results when the actual amount spent on fixed manufacturing overhead costs exceeds the budgeted amount. The fixed overhead budget variance is also known as the fixed overhead spending variance.
Fixed overhead costs are the indirect manufacturing costs that are not expected to change when the volume of activity changes. Some examples of fixed manufacturing overhead include the depreciation, property tax and insurance of the factory buildings and equipment, and the salaries of the manufacturing supervisors and managers.
Since the fixed manufacturing overhead costs should remain the same within reasonable ranges of activity, the amount of the fixed overhead budget variance should be relatively small.
Question 35. What Does An Unfavorable Volume Variance Indicate?
An unfavorable volume variance indicates that the amount of fixed manufacturing overhead costs applied (or assigned) to the manufacturer’s output was less than the budgeted or planned amount of fixed manufacturing overhead costs for the same time period. The unfavorable volume variance indicates that the period’s output was less than the planned output.
The volume variance is also referred to as the production volume variance, the capacity variance, or the idle capacity variance.
Question 36. What Is A Bom?
BOM is the acronym for bill of materials. A BOM is a listing of the quantities of each of the materials used in manufacturing a product.
Industrial manufacturers are likely to have an enormous number of BOMs. Each of the BOMs will be a very detailed list of all of the quantities of every material used in the various steps of manufacturing each part or product.
To visualize a BOM, think of a bakery that produces only pies. Each pie’s BOM will list the ingredients in the pie’s recipe. Each BOM will list the number of pounds (or other unit of measure) of the specific fruit, the quantity of a specific sugar (or other sweetener), the quantity and type of cinnamon, the quantity of nutmeg, the type of crust. There will also be a BOM for the pie crust. The pie crust BOM will specify the quantity and type of flour, the quantity and type of butter (or oil), the quantity of salt, etc.
Question 37. What Is A Burden Rate In Inventory?
I assume that the burden rate in inventory refers to a manufacturer’s indirect manufacturing costs, which are also referred to as factory overhead, indirect production costs, and burden. In the U.S., a manufactured product’s cost consists of direct materials, direct labor, and manufacturing overhead. Since manufacturing overhead is an indirect cost, it is usually assigned or allocated through an overhead rate or burden rate. Two examples of an overhead or burden rate are 1) a percentage of direct labor, and 2) an hourly cost rate assigned on the basis of machine hours.
A product’s manufacturing cost, consisting of direct materials, direct labor and manufacturing overhead, is used to report the cost of goods sold and also the cost of units in inventory. Therefore, if you look at the detail of a product’s inventory cost, you may see the manufacturing overhead being assigned or applied to the unit through a burden rate.
Question 38. What Are The Advantages Of Departmentalizing Manufacturing Overhead Costs?
The departmentalizing of manufacturing overhead costs allows for better planning and control if the head of each department is held responsible for the costs and productivity of his or her department.
The departmentalizing of manufacturing overhead costs also allows for the computation and application of several departmental overhead cost rates instead of having a single, plant-wide overhead rate. This is important when there are a variety of products and some require many operations in a department with high overhead rates, while other products require very few operations in the high cost department. There may also be products which require many hours of processing, but they occur in low cost departments. For instance, the assembly and packing departments of a manufacturer are likely to have very low overhead cost rates. On the other hand, the fabricating and milling departments will likely have much higher overhead cost rates.
Question 39. Is A Favorable Variance Always An Indicator Of Efficiency In Operation?
In a standard costing system, some favorable variances are not indicators of efficiency in operations. For example, the materials price variance, the labor rate variance, the manufacturing overhead spending and budget variances, and the production volume variance are generally not related to the efficiency of the operations.
On the other hand, the materials usage variance, the labor efficiency variance, and the variable manufacturing efficiency variance are indicators of operating efficiency. However, it is possible that some of these variances could result from standards that were not realistic. For example, if it realistically takes 2.4 hours to produce a unit of output, but the standard is set for 2.5 hours, there should be a favorable variance of 0.1 hour. This 0.1 hour variance results from the unrealistic standard, rather than operational efficiency.
Question 40. Is There A Relationship Between Direct Materials Variances And Direct Labor Variances?
There can be a connection between the direct materials variances and the direct labor variances. In fact, there can be a relationship between many of the variances.
Let’s assume that a lower costing material is purchased in order to achieve a favorable materials price variance. If the materials have some negative attributes, it is possible that an unfavorable materials usage variance could result. If the materials’ attributes cause additional labor hours, then an unfavorable direct labor efficiency variance will result. If the materials required more experienced labor, it is possible that a labor rate variance will also occur.
The above example can also extend to the overhead variances. If more electricity and supplies had to be used because of the materials’ attributes, there will be an unfavorable variable overhead efficiency variance. If the volume of output is curtailed by the materials’ attributes, there could possibly be a fixed overhead volume variance.
Question 41. Do Variance Accounts Have An Impact On Financial Statements? Or Are They For Performance Evaluation Only?
Since the financial statements must reflect the cost principle, both the standard costs and the variances must be included in the financial statements.
For example, if a direct material has a standard cost of $400 but the company paid $422, the financial statement must report $422 (the standard cost of $400 plus the price variance of $22).
How the variances are reported on the financial statements is discussed in the last part of our Explanation of Standard Costing.
Question 42. In Least Squares Regression, What Do Y And A Represent?
Here are the meanings of the components or symbols used in the least squares equation of y = a + bx:
y is the dependent variable, such as the estimated or expected total cost of electricity during a month. The amount of y is dependent upon the amounts of a and bx.
a is the estimated total amount of fixed electricity costs during the month. It is the value of y, when x is zero. If the total cost line intersects the y-axis at $1,000 then it is assumed that the total fixed costs for a month are $1,000.
b is the estimated variable cost per unit of x. It determines the slope of the total cost line. If b is $5, this means that the variable cost portion of electricity is estimated to be $5 for every unit of x.
x is the independent variable. For example, x could represent the known number of machine hours used in the month.
bx is the total variable cost of electricity. If the company’s electricity cost is estimated to be $5 per unit of x, and x is 4,000 machine hours, then the total variable cost of electricity for the month is estimated to be $20,000.
In our example the total estimated cost of electricity (y) in a month when x is 4,000 machine hours will be $21,000.
Question 43. Why Does A Cost System Developed For Inventory Valuation Distort Product Cost Information?
The cost system for inventory valuation may have been developed to provide a reasonable total cost of inventory and a reasonable total cost of goods sold in order to have reasonably accurate financial statements. If a company has small inventory amounts and significant sales, a simple cost system that spreads manufacturing overhead costs solely on the basis of machine hours can result in a reasonably accurate balance sheet and income statement.
While a simple cost system using just one cost driver (machine hours) may result in accurate financial statements, it often fails to provide the true cost of individual products that vary in complexity. For example, one product might require very few machine hours but will require many hours of special handling. The costs assigned on the basis of machine hours alone will be too low in relationship to the true cost of manufacturing this product. Another product might require many machine hours but no other activities. This product’s cost will be overstated because the rate assigned via the machine hours will include an amount for other activities that generally occur for the other products manufactured.
A cost system developed for inventory valuation is limited to the cost of direct materials, direct labor, and manufacturing overhead. The total cost of providing products to a customer will also include nonmanufacturing expenses. One customer might require a company to incur additional selling, delivering, storing, and administrative expenses. Another customer might not require any of those activities and their related expenses.
Activity based costing attempts to calculate the true cost of a product and customer by assigning costs and expenses based on their root causes. Because there are many root causes, the company will assign costs based on many cost drivers. This results in more accuracy for the cost and expense of a specific product for a specific customer than simply spreading the manufacturing costs on the basis of one cost driver such as machine hours.
Question 44. What Is The Normal Balance Of The Direct Materials Variance Accounts?
I don’t believe there is a normal balance. If a company pays exactly the standard cost of its direct materials, there will be no balance in the account Direct Materials Price Variance. If a company uses exactly the standard quantity of direct material for its output, there will be no balance in the account Direct Materials Usage Variance.
If the actual price per unit of direct materials is more than the standard cost per unit, the difference will be entered as a debit into the account Direct Materials Price Variance. If the actual price per unit of direct materials is less than the standard cost per unit, the difference will be entered as a credit into the price variance account.
The account Direct Materials Usage Variance will have a debit entered when the actual quantity of direct material used is greater than the standard quantity for the good output. If the actual quantity of direct material is less than the standard quantity of direct material for the good output, a credit is entered into the usage variance account.
If the standards are realistic, a manufacturer would be pleased with a zero balance in its variance accounts. A credit balance in a variance account signifies that things were better than standard. A debit in a variance account indicates that things were worse than the standard.
Question 45. What Is Meant By Overabsorbed?
Overabsorbed is usually used in the context of a manufacturer’s production overhead costs. Since manufacturing overhead costs are not directly traceable to products, they need to be allocated, assigned, or applied to the products through an overhead rate. We also state that the products absorb the overhead costs through the overhead rate.
The overhead rate is normally a predetermined rate—meaning that it was calculated prior to the start of the accounting year by using 1) the expected amount of overhead costs, and 2) the expected volume of production. Because of these two estimates, it is unlikely that the amount of overhead allocated, applied, assigned, or absorbed will be equal to the actual overhead costs incurred.
If the actual products manufactured are assigned or absorb more overhead through the overhead rate than the actual amount of overhead costs incurred, the products have overabsorbed the overhead costs.
At the end of the accounting year, the amount of the overapplied, overassigned, or overabsorbed overhead is often credited to the cost of goods sold. The reasons are 1) the overabsorbed amount is not significant, and 2) most of the products absorbing too much overhead costs have been sold. If the overabsorbed amount is significant, then the amount overabsorbed must be prorated or allocated as a reduction to the cost of the inventories and to the cost of goods sold based on where the overabsorbed overhead costs are residing at the end of the accounting year.
Question 46. What Is A Budget Variance?
A budget variance results when an actual amount is different from a planned or budgeted amount.
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