Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Chapter 15
Operational Performance Measurement: Indirect-Cost Variances and
Resource-Capacity Management
Learning Objectives
8. Formulate the variance-investigation decision under uncertainty (appendix)
New in the this Edition
• Revision of four end-of-chapter problems
• Continued emphasis on exercises and problems dealing with capacity-resource planning and the
financial reporting requirements of FASB ASC 330-10-30.
• Two entirely new Real-World Focus (RWF) items: one dealing with management of capacity-
related costs in the auto industry, the other dealing with evaluating sustainability performance
using flexible budgets
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Assignment Matrix
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
-
15-57
Deleted
-
Lecture Notes
This chapter uses the concepts introduced in Chapter 14 to explain how flexible budgets and standard costs
(along with associated standard cost variances) can be used in traditional accounting systems for the short-
term financial control of factory overhead (i.e., indirect manufacturing) costs. The chapter focuses on (1)
the product-costing vs. control use of standard overhead costs, (2) how to determine standard factory
overhead costs, including choice of the denominator activity level for setting the fixed overhead application
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
• Determining the behavior patterns of variable factory overhead costs:
o The standard variable factory overhead for a manufacturing firm is a function of both the number
of units to be manufactured and activities of the manufacturing process.
o Use of proper cost drivers is very important.
• Selecting one or more appropriate cost drivers for applying variable factory overhead to cost objects
(such as, products, services, or divisions):
o Using a single cost driver, such as direct labor hours (DLHs), for applying variable factory
overhead is satisfactory only if the total variable factory overhead relates to the selected cost
driver.
o An activity-based cost (ABC) driver applies factory overhead to products or services according
to the activity level of manufacturing operations and is likely to result in more accurate allocation
of variable overhead costs. Activities that change the amount of factory overhead may be unit-
based, batch-based, product-based, and facility-based. Unit-based cost drivers include machine
hours, direct labor hours, and units of materials. Batch-based cost drivers include the number of
times materials and parts are moved during manufacturing, number of set-ups, number of times
materials are parts are received and inspected. Product-based cost drivers include number of
products, number of processes, and number of schedule changes. Facility-based cost drivers relate
mostly with the size of operations, not with production activities.
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Total Standard Activity Measure
Actual Input × Standard Rate Per for the Output × Standard Rate
Unit of the Activity Measure for Per Unit of the Activity Measure
Actual Applying Variable Overhead for Applying Variable Overhead
Cost Incurred (AH × SR) (SH × SR)
Spending Variance Efficiency Variance
Variable Overhead Flexible Budget Variance
or, Under- or Over-applied Variable Overhead
The above alternative presentation format has the advantage of being consistent with the
framework developed in Chapter 14 of the text.
Interpreting Variable Overhead Cost Variances
Unlike direct materials and direct labor variances, the total variable factory overhead cost, in addition to
varying with volume, also varies with activities that change categorically or at intervals such as the number
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
Fixed factory overhead cost variances include the fixed overhead spending variance and the fixed overhead
production volume variance. Exhibit 15.5 provides a diagrammatic representation of the determination of
these two variances.
o Fixed overhead spending variance is the difference between the actual and the budgeted fixed
factory overhead for the period. This variance is also referred to as fixed overhead flexible budget
variance, or simply fixed overhead budget variance. Neither the actual units produced nor the actual
level of the cost driver incurred during the period has any effect on the amount of the fixed factory
overhead spending variance.
o Fixed overhead production volume variance is the difference between the budgeted fixed
overhead and the total fixed overhead applied to the units manufactured during the period. Other
terms for this variance are denominator variance, idle-capacity variance, and output-level
variance.
o Alternative Representation of Fixed Overhead Variances: The difference between the actual
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
The preceding discussion, including text Exhibit 15.4 and Exhibit 15.5, refers to what is called a “four-
way analysis of the total overhead variance” for the period. Text Exhibit 15.6 can be used to illustrate the
four-way approach to variance decomposition.
However, the total factory overhead variance can also be viewed in a 2-variance or 3-variance format. The
3-variance breakdown creates a factory overhead spending variance by combining variable overhead
spending variances and fixed overhead spending variances into one variance. The variable overhead
efficiency variance and fixed overhead production volume variance remain intact. The 2-variance format
further combines overhead spending variance with variable overhead efficiency variance. This combined
variance is called the factory overhead flexible-budget variance. Exhibit 15.7 can be used to illustrate all
three approaches to the decomposition of the total overhead variance (i.e., four-way, three-way, and two-
way breakdowns of the total variance). Exhibit 15.17 provides an alternative diagrammatic representation
of the overhead variance-decomposition process. As such, it is an alternative to the general framework
presented in Exhibit 15.7.
Journal Entries and Disposition of Overhead Variances
After discussing overhead variances, I then cover journal entries associated with the recording of standard
overhead costs and associated standard cost variances (for product-costing purposes). This discussion is a
straightforward extension of the standard cost journal entries covered in Chapter 14.
2. Another implication (not stated explicitly, but implied in FASB ASC 330) is that when normal
capacity is used, any unallocated fixed overhead is viewed as “abnormal,” and therefore should be
treated as a period cost. That is, unallocated overhead is recognized as an expense in the period in
which this cost is incurred.
General income tax provisions regarding inventory costing are contained in IRC 263: Uniform
Capitalization Rules. This Code Section specifies only that an “allocable” share of costs, including
indirect manufacturing costs, be included in inventory. Treasury Regulation §1.263A specifies that
“indirect costs should be allocated … using either a specific identification (“tracing”) method, the
standard cost method, or a method using burden rates, such as ratios based on direct costs, hours, or other
items, or similar formulas, so long as the method employed reasonably allocates indirect costs among
production … activities.”
Treasury Regulation §1.471-11: Inventories of Manufactures specifies that companies must prorate
variances, unless minor, in which case these variances can be charged as a period cost (but only if done
for financial reporting purposes). Also, this Regulation goes on to state that when practical capacity is
used to set fixed overhead allocation rates, “allocated cost” = ratio of actual output to practical capacity.
Any resulting fixed overhead cost variance can then be written off as a period cost.
Chapter 15 - Operational Performance Measurement: Indirect-Cost Variances and Resource-Capacity Management
The instructor can conclude the discussion with brief reference to either (or both) of the following
issues/points:
• GPK (German cost accounting) and RCA (resource consumption accounting) as options for
producing even more refined data as compared to both traditional and traditional ABC systems,
and
• The need to supplement financial results (i.e., standard cost variances) with nonfinancial
performance indicators, a point made as well in Chapter 14.
The Variance-Investigation Decision
I tell students that the standard cost variances that are reported by the accountant can be thought of in terms
of “information signals” to management. Using the principle of “management by exception,” the task is to
determine when to assume that an exception has occurred, that is, a variance due to a systematic
(nonrandom) cause.