Managerial Accounting by Whitecotton, Libby, and Phillips, second edition.

Standard Costing and Variances Chapter 9 Standard Costing and Variances Chapter 9: Standard Costing and Variances Chapter 8 described the role of budgets in the planning and control cycle. This chapter discusses the use of variances in the control phase of that process. A variance is simply the difference between actual and budgeted results. Variances act as signals to managers that their planned results are (or are not) being achieved.

Standard Cost Systems Based on carefully predetermined amounts. Standard Costs are Used for planning labor, material, and overhead requirements. The expected level of performance. Standard costs are preset costs for making a product or delivering a service. We expect to operate within the standard cost allowances under normal conditions. Standard costs are used for both planning and performance evaluation. In a standard cost system, all manufacturing costs are recorded at standard rather than actual amounts. Benchmarks for measuring performance. In a standard cost system, all manufacturing costs are recorded at standard rather than actual amounts.

Learning Objective 9-1 Describe the standard-setting process and explain how standard costs relate to budgets and variances. Learning objective 9-1 is to describe the standard-setting process and explain how standard costs relate to budgets and variances.

Ideal versus Attainable Standards I recommend using attainable standards that can be achieved with reasonable and efficient effort. Should we use ideal standards that require employees to work at 100 percent peak efficiency? Setting standards requires the combined expertise of everyone who has responsibility for purchasing and using resources. In a manufacturing setting, this might include managerial accountants, engineers, purchasing managers, production supervisors, line managers, and production workers. Standards should be designed to encourage efficient future operations, not just a repetition of past inefficient operations. Standards tend to fall into one of two categories: Ideal standards can only be attained under the best of circumstances. They allow for no work interruptions, and they require employees to continually work at 100 percent peak efficiency. Attainable standards are tight, but achievable. They allow for normal machine downtime and employee rest periods and can be attained through reasonable, highly efficient efforts of the average worker. Research suggests that tight but attainable standards—the happy medium in between the extremes of ideal and easily attainable standards—are best for motivating individuals to work hard.

Types of Standards Standard cost systems rely on two types of standards, quantity standards and price standards. Quantity standards specify how much of an input should be used to make one unit of product. Price standards specify how much should be paid for each unit of the input.

The Standard Cost Card Here you see a standard cost card for Cold Stone Creamery. First, we see a standard quantity. In this case, direct materials are expressed in terms of ounces, direct labor in hours, and variable manufacturing overhead in hours. Second, we have a standard price or standard rate expressed in dollars per ounce for materials and dollars per hour for labor and variable manufacturing overhead. Finally, we have a standard cost per unit for each input. The price and quantity standards for each input are multiplied to get the standard unit cost. Then all the standard costs are summarized on a standard cost card, which shows what the company should spend to make a single unit of product. Cold Stone should use 10 ounces of direct material. The standard price is 5 cents per ounce for materials, resulting in a standard unit cost of 50 cents. The direct labor standard shows that employees should be able to produce and serve an average of 10 units per hour at a rate of $10.00 per hour, resulting in a direct labor cost per unit of $1.00. Variable manufacturing costs are applied to the product based on a rate of $1.00 per direct labor hour. When this standard variable overhead is rate is multiplied by the standard quantity of 0.10 labor hours per unit, we get a standard unit cost of 10 cents for variable manufacturing overhead. Notice that fixed manufacturing overhead is not expressed in terms of ounces or hours as are the other inputs. To determine the fixed manufacturing overhead rate per unit, we divided budgeted fixed manufacturing overhead of $6,000 by the 15,000 units we expect to produce and sell to get a rate of 40 cents per unit.

Learning Objective 9-2 Prepare a flexible budget and show how total costs change with sales volume. Learning objective 9-2 is to prepare a flexible budget and show how total costs change with sales volume.

Master Budgets Versus Flexible Budgets A master budget is prepared for one level of activity based on a sales forecast. For that reason it is often referred to as a static budget. Because predicting activity with 100 percent certainty is impossible, managers often adjust the master budget for different levels of activity to show how budgeted costs and revenues will change as activity changes. The adjusted budget is referred to as a flexible budget. On your screen, you see Cold Stone Creamery’s manufacturing cost master budget for 15,000 units that is flexed down to 12,000 units and flexed up to 20,000 units. Note that all of the flex is in the variable manufacturing costs. Total variable costs change in direct proportion to changes in activity. For example, when Cold Stone’s activity increases from 15,000 units to 18,000 units, the total cost ingredients should increase from $7,500 to $9,000. The 20 percent increase in activity produces a 20 percent increase in total cost. Fixed costs remain the same (in total), regardless of changes in activity. Cold Stone’s budgeted fixed cost is $6,000 at all levels of activity shown. The fixed cost of 40 cents per unit is valid only for the master budget of 15,000 units ($6,000 / 15,000 units = 40 cents per unit).

Manufacturing Overhead Variance Analysis This variance is unfavorable because the actual cost exceeds the standard cost. These variances are favorable because the actual cost is less than the standard cost. Standard Amount Direct Material The difference between an actual cost and a standard cost is called a standard cost variance. A favorable variance (F) occurs when actual costs are less than budgeted or standard costs. An unfavorable variance occurs when actual costs are more than budgeted or standard costs. You can see from this diagram that the actual direct labor cost is less than the standard cost for direct labor, and that the actual direct material cost is also less than the standard cost for direct material. In contrast, the actual manufacturing overhead cost is greater than the standard cost for manufacturing overhead. Therefore, the direct labor and direct material cost variances are favorable while the manufacturing overhead cost variance is unfavorable. Direct Labor Manufacturing Overhead Type of Product Cost

Variance Analysis Here you see some common causes of favorable and unfavorable variances.

Comparing Actual Results to the Master Budget Cold Stone Creamery’s master budget of $7,500 for ice cream was based on a sales forecast of 15,000 units (50 cents per unit × 15,000 units). During the period, the amount actually spent for ice cream was $8,000, or $500 higher than the master budget. Did Cold Stone do a good job controlling ice cream costs? Cold Stone Creamery’s master budget of $7,500 for ice cream was based on a sales forecast of 15,000 units ($0.50 per unit × 15,000 units). During the period, the amount spent for ice cream was $8,000, or $500 higher than the master budget. Did Cold Stone do a good job controlling ice cream costs?

Comparing Actual Results to the Master Budget There are two possible reasons why spending exceeded the master budget: 1. Cold Stone may have spent more than $0.50 on ice cream for each unit produced. Cold Stone produced more than 15,000 units, requiring more ice cream than planned. To answer this question, we need to think about the two possible reasons that ice cream costs might have been more than the master budget: • Cold Stone may have spent more than 50 cents on ice cream for each unit produced. • Cold Stone may have produced more than 15,000 units, requiring more ice cream than planned. Cold Stone actually produced 18,000 units for the period, 3,000 units more than the sales forecast used to develop the master budget. Comparing actual results for 18,000 units with a master budget at 15,000 units makes performance evaluation impossible. It’s like comparing apples and oranges. Let’s prepare a flexible budget at 18,000 units so that we can compare actual results and budgeted results for the same level of activity. Let’s prepare a flexible budget at 18,000 units and evaluate performance.

Volume Variance versus Spending Variance When we compare the flexible budget cost of $9,000 for 18,000 units to the actual cost of $8,000 for 18,000 units, we can see that we spent $1,000 less than the flexible budget on ingredients. This variance is called a spending variance. The lesson here is that to evaluate cost control, we can’t just compare actual results to the master budget. The master budget is useful in planning, but a flexible budget should be used to evaluate performance. Using the flexible budget for performance evaluation allows us to separate the effect of a change in sales volume from the effect of a change in cost. The only difference between the master budget and the flexible budget is the sales volume that is used to create each budget. The comparison of the master budget to the flexible budget creates a volume variance that represents the difference between actual and budgeted sales volume. The volume variance for ingredients is $1,500 (3,000 units X $.50 per unit), because Cold Stone produced 3,000 more units than expected.

Variable Cost Variances Spending Variance Actual Costs Actual Quantity (AQ) × Actual Price (AP) Actual Quantity (AQ) × Standard Price (SP) Flexible Budget Standard Quantity (SQ) × Standard Price (SP) Price Variance Quantity Variance The spending variance for variable costs (such as direct materials and direct labor) can be divided into two components: a price variance and a quantity variance. The price variance relates the actual price paid (AP) for the input to the price the company should have paid (SP). The quantity variance relates the actual quantity of input used (AQ) to create the final product to the quantity the company should have used (SQ) given the actual volume of output. Separating the spending variance into price and quantity variances in this manner helps us to identify the cause of the variances. If the actual price is more than the standard price, it will result in an unfavorable price variance. If the actual price is less than the standard price, it will result in a favorable price variance. If the actual quantity is more than the standard quantity, it will result in an unfavorable quantity variance. If the actual quantity is less than the standard quantity, it will result in a favorable quantity variance. Total Spending Variance

Learning Objective 9-3 Calculate and interpret the direct materials price and quantity variances. Learning objective 9-3 is to calculate and interpret the direct materials price and quantity variances.

Direct Materials Variances Cold Stone’s Standard Cost Information for Ice Cream Cold Stone’s actual results for the period were: 18,000 units produced and sold. 200,000 ounces of ice cream purchased at a total cost of $8,000. Earlier we saw that Cold Stone Creamery had a $1,000 favorable spending variance for ice cream as the actual cost was $8,000 and the flexible budget was $9,000. Let’s separate the spending variance into price and quantity variances. Cold Stone’s standards for ice cream are: Standard Quantity = 10 ounces per unit Standard Price = 5 cents per ounce. Cold Stone’s actual results for the period were: 18,000 units were produced and sold. 200,000 ounces of ice cream were purchased at a total cost of $8,000. Let’s start the analysis by computing or identifying amounts that we will use. Actual Price (AP) = $8,000 ÷ 200,000 ounces = 4 cents per ounce Actual Quantity (AQ) = 200,000 ounces Standard Price (SP) = 5 cents per ounce Standard Quantity (SQ) = 10 ounces per unit × 18,000 actual units = 180,000 ounces Actual Price (AP) = $8,000 ÷ 200,000 ounces = $0.04 per ounce Actual Quantity (AQ) = 200,000 ounces Standard Price (SP) = $0.05 per ounce Standard Quantity (SQ) = 10 ounces per unit × 18,000 actual units = 180,000 ounces

Direct Materials Variances Spending Variance (AQ) × (AP) 200,000 × $0.04 $8,000 (AQ) × (SP) 200,000 × $0.05 $10,000 (SQ) × (SP) 180,000 × $0.05 $9,000 Price Variance $2,000F Quantity Variance $1,000U The direct materials price variance is the difference between the actual price (AP = 4 cents) and the standard price (SP = 5 cents), multiplied by the actual quantity (AQ = 200,000 ounces) of direct materials purchased. The direct materials quantity variance is the difference between the actual quantity (AQ = 200,000 ounces) and the standard quantity (SQ = 180,000 ounces) for direct materials, multiplied by the standard price (SP = 5 cents). The direct materials price variance is $2,000 favorable because the company paid 1 cent less than the standard cost for the 200,000 ounces of materials purchased. The direct materials quantity variance is $1,000 unfavorable because the company used 200,000 ounces of ingredients to make 18,000 units, when only 180,000 ounces were required. The direct materials spending variance combines the direct materials price and quantity variances. Since the price variance is $2,000 favorable and the quantity variance is $1,000 unfavorable, the result is a $1,000 favorable spending variance. Spending Variance $1,000F

Direct Materials Variances Materials Price Variance Materials Quantity Variance Purchasing Manager Production Manager The purchasing manager and production manager are usually held responsible for the materials price variance, and materials quantity variance, respectively. The standard price is used to compute the quantity variance so that the production manager is not held responsible for the performance of the purchasing manager. The standard price is used to compute the quantity variance so that the production manager is not held responsible for the purchasing manager’s performance.

Learning Objective 9-4 Calculate and interpret the direct labor rate and efficiency variances. Learning objective 9-4 is to calculate and interpret the direct labor rate and efficiency variances.

Direct Labor Variances Spending Variance Actual Costs Actual Hours (AH) × Actual Rate (AR) Actual Hours (AH) × Standard Rate (SR) Flexible Budget Standard Hours(SH) × Standard Rate (SR) Rate Variance Efficiency Variance We use the same approach to calculate direct labor variances with only two minor modifications: The price of direct labor is called the direct labor rate, so the price variance for labor is called the direct labor rate (not price) variance. The direct labor quantity is measured in hours, so the quantity variance for labor is called the direct labor efficiency (not quantity) variance. The rate variance relates the actual labor rate (AR) for the hours worked to the rate the company should have paid (SR). The efficiency variance relates the actual hours worked (AH) to create the final product to the standard hours (SH) that should have been worked given the actual volume of output. Separating the spending variance into rate and efficiency variances in this manner helps us to identify the cause of the variances. If the actual rate is more than the standard rate, it will result in an unfavorable rate variance. If the actual rate is less than the standard rate, it will result in a favorable rate variance. If actual hours are more than standard hours, it will result in an unfavorable efficiency variance. If actual hours are less than standard hours, it will result in a favorable efficiency variance. Total Spending Variance

Direct Labor Variances Cold Stone’s Standard Cost Information for Direct Labor Cold Stone’s actual results for the period were: 18,000 units produced and sold. Direct labor costs were $20,500 for 2,000 hours worked. Actual Rate (AR) = $20,500 ÷ 2,000 hours = $10.25 per hour Actual Hours (AH) = 2,000 hours Standard Rate (SR) = $10.00 per hour Standard Hours (SH) = 0.10 hours per unit × 18,000 actual units = 1,800 hours Cold Stone’s standards for direct labor are: Standard Hours = 0.10 hours per unit. Standard Rate = $10.00 per hour. Cold Stone’s actual results for the period were: 18,000 units were produced and sold. Actual direct labor costs were $20,500 for 2,000 hours worked. Let’s start the analysis by computing or identifying amounts that we will use. Actual Rate (AR) = $20,500 ÷ 2,000 hours = $10.25 per hour Actual Hours (AH) = 2,000 hours Standard Rate (SR) = $10.00 per hour Standard Hours (SH) = 0.10 hours per unit × 18,000 actual units = 1,800 hours

Direct Labor Variances Spending Variance (AH) × (AR) 2,000 × $10.25 $20,500 (AH) × (SR) 2,000 × $10.00 $20,000 (SH) × (SR) 1,800 × $10.00 $18,000 Rate Variance $500U Efficiency Variance $2,000U The direct labor rate variance is the difference between the actual rate (AR = $10.25) and the standard rate (SR = $10.00), multiplied by the actual hours (AH = 2,000 hours) of direct labor. The direct labor efficiency variance is the difference between the actual hours (AH = 2,000 hours) and the standard hours (SH = 1,800 hours) for direct labor, multiplied by the standard rate (SR = $10.00). The direct labor rate variance is $500 unfavorable because the company paid 25 cents per hour more than the standard rate for the 2,000 hours worked. The direct labor efficiency variance is $2,000 unfavorable because the employees worked 2,000 hours to make 18,000 units, when only 1,800 hours were required. The direct labor spending variance combines the direct labor rate and efficiency variances. Since the rate variance is $500 unfavorable and the efficiency variance is $2,000 unfavorable, the result is a $2,500 unfavorable spending variance. Spending Variance $2,500U

Responsibility for Labor Variances Production managers are usually held accountable for labor variances because they can influence the: Mix of skill levels assigned to work tasks. Level of employee motivation. Quality of production supervision. Quality of training provided to employees. Production Manager Labor variances are partially controllable by employees within the production department. For example, production managers/supervisors can influence the: Deployment of highly skilled workers and less skilled workers on tasks consistent with their skill levels; Level of employee motivation within the department;  Quality of production supervision; and Quality of the training provided to the employees.

Learning Objective 9-5 Calculate and interpret the variable overhead rate and efficiency variances. Learning objective 9-5 is to calculate and interpret the variable overhead rate and efficiency variances.

Variable Manufacturing Overhead Variances Spending Variance Actual Costs Actual Hours (AH) × Actual Rate (AR) Actual Hours (AH) × Standard Rate (SR) Flexible Budget Standard Hours(SH) × Standard Rate (SR) Rate Variance Efficiency Variance We use the same approach to analyze variable manufacturing overhead that we used for direct labor. When we compare actual hours times actual variable overhead rate to actual hours times the standard variable overhead rate, we get the rate variance for variable overhead. When we compare actual hours times the standard variable overhead rate to standard hours at the standard variable overhead rate, we get the efficiency variance for variable overhead. Manufacturing overhead costs cannot be traced directly to specific units so they must be applied to products using a predetermined overhead rate and an allocation measure, such as direct labor hours. The predetermined overhead rate is estimated before the accounting period begins, based on budgeted costs and budgeted levels of the overhead allocation measures. The variable overhead rate will be the same for all levels of activity. Variable manufacturing overhead costs include the costs of indirect materials, such as cleaning supplies and paper products, as well as the power to run machines and other incidentals that vary with some activity measure. We will assume that these costs vary in direct proportion to direct labor hours—a realistic assumption for a labor-oriented business like Cold Stone Creamery. Total Spending Variance

Variable Manufacturing Overhead Variances Cold Stone’s Standard Cost Information for Variable Manufacturing Overhead Cold Stone’s actual results for the period were: 18,000 units produced and sold. Actual VOH costs were $1,800 for 2,000 direct labor hours. Actual Direct Labor Hours (AH) = 2,000 hours Standard Direct Labor Hours (SH) = 0.10 hours per unit × 18,000 units = 1,800 hours Actual Variable Overhead Rate (AR) = $1,800 ÷ 2,000 hours = $0.90 per hour Standard Variable Overhead Rate (SR) = 0.10 hours per unit × $1.00 per hour = $0.10 per unit Cold Stone’s standards for variable manufacturing overhead are: Standard Direct Labor Hours = 0.10 hours per unit. Standard Variable Overhead Rate = $1.00 per hour. Cold Stone’s actual results for the period were: 18,000 units were produced and sold. Actual direct labor hours were 2,000. • Actual variable overhead costs were $1,800. Let’s start the analysis by computing or identifying amounts that we will use. Actual Direct Labor Hours (AH) = 2,000 hours Standard Direct Labor Hours (SH) = 0.10 hours per unit × 18,000 actual units = 1,800 hours Actual Variable Overhead Rate (AR) = $1,800 ÷ 2,000 hours = 90 cents per hour Standard Variable Overhead Rate (SR) = 0.10 hours per unit × $1.00 per hour = 10 cents per unit

Variable Manufacturing Overhead Variances Spending Variance (AH) × (AR) 2,000 × $0.90 $1,800 (AH) × (SR) 2,000 × $1.00 $2,000 (SH) × (SR) 1,800 × $1.00 $1,800 Rate Variance $200F Efficiency Variance $200U The variable overhead rate variance is the difference between the actual variable overhead rate (AR = 90 cents) and the standard variable overhead rate (SR = $1.00), multiplied by the actual hours (AH = 2,000 hours) of direct labor. The variable overhead efficiency variance is the difference between the actual hours (AH = 2,000 hours) and the standard hours (SH = 1,800 hours) for direct labor, multiplied by the standard variable overhead rate (SR = $1.00). The variable overhead rate variance is $200 favorable because the company paid 10 cents per hour less than the standard rate for the 2,000 hours worked. The variable overhead efficiency variance is $200 unfavorable because the employees worked 2,000 hours to make 18,000 units, when only 1,800 hours were required. Since the rate variance is $200 favorable and the efficiency variance is $200 unfavorable, the total spending variance for variable overhead is zero. Spending Variance $0

Variable Manufacturing Overhead Variances Rate Variance Efficiency Variance Results from paying more or less than expected for overhead items and from excessive usage of overhead items. A function of the selected allocation measure (direct labor hours). It does not reflect overhead control. The variable overhead rate variance results from paying more or less than expected for variable overhead items, or from the excessive use of those variable overhead items. The efficiency variance is controlled through proper management of the overhead allocation measure, direct labor hours for Cold Stone.

Summary of Spending Variances Variances are always calculated by comparing actual results to budgeted, or standard, results. Companies try to hold specific managers responsible for specific variances, while removing the effects of factors that are beyond managers’ control. The formulas for variances allow only one factor, such as price, quantity or volume to change, while holding everything else constant at either actual or standard values (depending on the type of variance). The driving factor for a variance always appears in parentheses in the formula, as well as in the name of the variance. For example, the formula for the direct materials price variance is AQ X (SP - AP). Try not to memorize rules or rely on the formulas to determine whether a variance is favorable or unfavorable; just think about it. For example, paying more for material, or using more materials to produce the same number of units is unfavorable. Let’s step back for a minute and think about the purpose of variances. Here are some general guidelines for calculating and interpreting variances: Variances are always calculated by comparing actual results to budgeted, or standard, results. Companies try to hold specific managers responsible for specific variances, while removing the effects of factors that are beyond managers’ control. The formulas for variances allow only one factor, such as price, quantity, or volume to change, while holding everything else constant at either actual or standard values (depending on the type of variance). The driving factor for a variance always appears in parentheses in the formula, as well as in the name of the variance. For example, the formula for the direct materials price variance is AQ X (SP - AP). Try not to memorize rules or rely on the formulas to determine whether a variance is favorable or unfavorable; just think about it. For example, paying more for material, or using more materials to produce the same number of units is unfavorable.

Learning Objective 9S-1 Calculate and interpret the fixed overhead spending and volume variances. Learning objective 9S-1 is to calculate and interpret the fixed overhead spending and volume variances.

Framework for Fixed Overhead Spending and Volume Variances The framework used to analyze fixed overhead variances differs from the model used to analyze variable cost variances. Fixed manufacturing overhead costs such as rent, machine depreciation, and factory supervision are incurred to provide the capacity to perform work. However, total fixed costs do not vary with volume in the same way that variable costs do. Even so, managers need to budget for total fixed costs. It’s possible that the actual amount spent on total fixed costs will be higher or lower than budgeted due to factors other than volume, for example, an unexpected change in the cost of insurance. Although the framework for analyzing fixed overhead looks a lot like the framework for analyzing variable costs, we interpret the variances differently. The first fixed overhead variance shown is the fixed overhead spending variance, also called the fixed overhead budget variance. It is calculated by comparing actual fixed overhead costs to budgeted fixed overhead costs. The other fixed overhead variance shown is the fixed overhead volume variance or capacity variance. Fixed overhead volume variances relate to the method used to apply fixed manufacturing costs to individual products or customers. Even though the costs are considered fixed, we still use a fixed overhead rate to apply the fixed manufacturing cost to individual units. Depending on how accurately we estimate the fixed overhead rate, the amount of fixed overhead applied is likely to differ from the amount budgeted. The fixed overhead rate is computed by dividing budgeted total fixed overhead cost by some measure of activity, such as the number of units or the number of direct labor hours. The question is whether the denominator, or measure of activity, used to calculate the fixed overhead rate should be based on budgeted volume or some other measure. Regardless of whether budgeted volume or some other measure is used, if actual volume differs from the value used in the denominator of the fixed overhead rate, it will create a fixed overhead volume variance. A volume variance has nothing to do with how much managers spent on fixed costs. It simply reflects the accuracy of the denominator used to compute the fixed overhead rate. The interpretation of the variance depends on the type of measure that was used in the denominator of the fixed overhead rate.

Fixed Overhead Rate Based on Budgeted Volume Budgeted Fixed Overhead Rate Budgeted Fixed Overhead Budgeted Volume = ÷ Cold Stone budgeted $6,000 for fixed manufacturing overhead for a budgeted volume of 15,000 units. Cold Stone’s budgeted fixed manufacturing overhead rate is: Fixed manufacturing costs are independent of volume. However, fixed manufacturing overhead is assigned to individual units using a fixed overhead rate that is set in advance. The fixed manufacturing overhead rate is computed by dividing budgeted total fixed overhead cost by some measure of activity, such as the number of units produced or the number of direct labor hours. Cold Stone Creamery budgeted fixed overhead costs of $6,000 and the master budget was based on planned production of 15,000 units. Cold Stone Creamery would apply fixed overhead at a rate of 40 cents per unit produced. But the amount of fixed overhead applied to production will only equal $6,000 if the company actually produces 15,000 units. If Cold Stone produces anything other than 15,000 units, the amount of fixed overhead applied to production will be different than the $6,000 budgeted.

Fixed Manufacturing Overhead Variances Cold Stone’s Standard Cost Information for Fixed Manufacturing Overhead Cold Stone’s budget for fixed overhead was: 15,000 units to be produced and sold. Budgeted FOH costs were $6,000. Cold Stone’s standard for fixed manufacturing overhead is a fixed overhead rate of 40 cents per unit at a budgeted volume of 15,000 units. Cold Stone’s budget for fixed overhead for the period was: 15,000 units to be produced and sold. Budgeted FOH costs were $6,000. Cold Stone’s actual results for the period were: 18,000 units were produced and sold. Actual fixed overhead costs were $6,300. Cold Stone’s actual results for the period were: 18,000 units produced and sold. Actual FOH costs were $6,300.

Computing Fixed Overhead Spending and Volume Variances The fixed overhead spending variance is the difference between the actual fixed overhead and budgeted fixed overhead. The fixed overhead volume variance is the difference between budgeted fixed overhead at 15,000 units and applied fixed overhead at 18,000 units times the fixed overhead rate of 40 cents per unit. Since the spending variance is $300 unfavorable and the volume variance is $1,200 favorable, the result is over-applied fixed overhead of $900. The fixed manufacturing overhead spending variance is unfavorable because the actual costs are more than the budgeted costs. The fixed manufacturing overhead volume variance is $1,200 favorable because the 18,000 actual units produced are more than the 15,000 budgeted units. When Cold Stone produces 18,000 actual units, the fixed manufacturing overhead volume variance is $1,200 favorable.

Fixed Manufacturing Overhead Spending Variance We can also analyze the two fixed overhead variances with the alternative approach shown on your screen. The results are the same. The fixed overhead spending variance, also called the fixed overhead budget variance, is calculated by comparing actual fixed overhead costs to budgeted fixed overhead costs. For example, if Cold Stone Creamery budgeted for $6,000 in fixed manufacturing overhead but actually spent $6,300, it would report a $300 unfavorable fixed overhead spending variance. This $300 unfavorable spending variance could be due to an unexpected rise in fixed manufacturing overhead costs such as rent, insurance, or supervision. If actual volume differs from the value used in the denominator of the fixed overhead rate, it will create a fixed overhead volume variance. A volume variance has nothing to do with how much was spent on fixed costs. It simply reflects the accuracy of the denominator used to compute the fixed overhead rate. The favorable volume variance is computed by multiplying the fixed manufacturing overhead rate of 40 cents per unit times the difference in actual volume (18,000) and budgeted volume (15,000). The fixed manufacturing overhead volume variance is favorable because actual units produced are more than the budgeted units.

Fixed Overhead Rate Based on Practical Capacity Practical capacity is the number of units that could be produced under normal operating conditions. Fixed Overhead Rate Budgeted Fixed Overhead Practical Capacity = ÷ Cold Stone budgeted $6,000 for fixed manufacturing overhead and has a practical capacity of 20,000 units. Cold Stone’s fixed manufacturing overhead rate is: Practical capacity is the number of units that could be produced under normal operating conditions. The fixed manufacturing overhead rate is computed by dividing budgeted total fixed overhead cost by a measure of practical capacity. Cold Stone Creamery budgeted fixed overhead costs of $6,000 and the practical capacity is 20,000 units. Cold Stone Creamery would apply fixed overhead at a rate of 30 cents per unit produced. But the amount of fixed overhead applied to production will only equal $6,000 if the company actually produces 20,000 units. If Cold Stone produces anything other than 20,000 units, the amount of fixed overhead applied to production will be different than the $6,000 budgeted.

Fixed Manufacturing Overhead Spending and Capacity Variances Cold Stone’s Cost Information for Fixed Manufacturing Overhead Practical capacity is 20,000 units. Cold Stone’s budget for fixed overhead was: 15,000 units to be produced and sold. Budgeted FOH costs were $6,000. Cold Stone’s fixed manufacturing overhead rate is 30 cents per unit at a practical capacity of 20,000 units. Practical capacity is 20,000 units. Cold Stone’s budget for fixed overhead for the period was: 15,000 units to be produced and sold. Budgeted FOH costs were $6,000. Cold Stone’s actual results for the period were: 18,000 units were produced and sold. Actual fixed overhead costs were $6,300. Cold Stone’s actual results for the period were: 18,000 units produced and sold. Actual FOH costs were $6,300.

Fixed Overhead Capacity Variances The expected capacity variance is computed before the period begins. The unexpected capacity variance is computed after the period is over. The expected capacity variance is computed before the period begins based on a comparison of budgeted volume and practical capacity. The planned (expected) cost of unused capacity is $1,500 unfavorable. It is unfavorable because the company planned to produce fewer units than the amount of practical capacity available. This capacity variance tells managers that $1,500 (5,000 units x $0.30) of the total fixed manufacturing overhead cost is expected to be unused or under-utilized. The unexpected capacity variance is computed after the budget period is over, based on a comparison of actual volume and budgeted volume. This unexpected capacity variance of $900 is favorable because the company produced more units than expected, and thus utilized more of the practical capacity than initially planned. The total capacity variance is $600 unfavorable, computed by combining the $1,500 unfavorable expected capacity variance with the $900 favorable unexpected capacity variance. The total capacity variance is $600 unfavorable because actual production of 18,000 units was still 2,000 units below practical capacity of 20,000 units (2,000 units x $0.30 = $600).

Prepare journal entries to record standard costs and variances. Learning Objective 9S-2 Prepare journal entries to record standard costs and variances. Learning objective 9S-2 is to prepare journal entries to record standard costs and variances.

Supplement 9B – Recording Standard Costs and Variances in a Standard Cost System Common Rules • The initial debit to an inventory account (Raw Materials, Work in Process, or Finished Goods) and the eventual debit to Cost of Goods Sold should be based on the standard cost, not the actual cost. • Cash, payables, or other accounts, such as accumulated depreciation or prepaid assets, should be credited for the actual cost incurred. • The difference between the standard cost (a debit) and the actual cost (a credit) should be recorded as the cost variance. • Unfavorable variances should appear as debit entries; favorable variances should appear as credit entries. • At the end of the accounting period, all the variances should be closed to the Cost of Goods Sold account to adjust the standard cost up or down to the actual cost. The common rules for preparing journal entries in a standard cost system are: • The initial debit to an inventory account (Raw Materials, Work in Process, or Finished Goods) and the eventual debit to Cost of Goods Sold should be based on the standard cost, not the actual cost. • Cash, payables, or other accounts, such as accumulated depreciation or prepaid assets, should be credited for the actual cost incurred. • The difference between the standard cost (a debit) and the actual cost (a credit) should be recorded as the cost variance. • Unfavorable variances should appear as debit entries; favorable variances should appear as credit entries. • At the end of the accounting period, all the variances should be closed to the Cost of Goods Sold account to adjust the standard cost up or down to the actual cost.

Recording Standard Costs for Cold Stone Creamery Standard Direct Material Cost Standard Direct Labor and Manufacturing Overhead Costs No Work in Process or Finished Goods Inventory Raw Materials Inventory Cost of Goods Sold Since Cold Stone does not make the product until a customer orders it, there is no need to keep track of work in process or finished goods inventory costs. Raw Material costs are transferred directly from the raw materials inventory account to the Cost of Goods Sold account. Direct labor and manufacturing overhead costs are recorded directly in the Cost of Goods Sold account.

Direct Materials Costs Cold Stone’s Standard Cost Information for Direct Materials Cold Stone’s actual results for the period were: 200,000 ounces of ingredients were purchased on account for a total of $8,000, at an average actual price of $0.04 per ounce. All 200,000 ounces of ingredients were used to make and sell 18,000 units. Cold Stone’s standards for direct materials: Standard quantity = 10 ounces per unit Standard price = 5 cents per ounce. Cold Stone’s actual results for the period were: 200,000 ounces of ingredients were purchased on account for a total of $8,000, at an average actual price of 4 cents per ounce. All 200,000 ounces of ingredients were used to make and sell 18,000 units. Let’s prepare the journal entry to record the purchase of direct materials. The debit to raw materials inventory is based on the standard price per unit of 5 cents, but the credit to accounts payable is based on the actual price paid of 4 cents per unit. The difference between the actual price and the standard price is the direct materials price variance, calculated by multiplying the 1 cent difference in price by 200,000 ounces of ingredients. The variance is favorable because the actual price was less than the standard price. Next let’s prepare the entry to record the use of direct materials. The journal entry to record the direct materials purchase is:

Direct Materials Costs Cold Stone’s Standard Cost Information for Direct Materials Cold Stone’s actual results for the period were: 200,000 ounces of ingredients were purchased on account for a total of $8,000, at an average actual price of $0.04 per ounce. All 200,000 ounces of ingredients were used to make and sell 18,000 units. The standard cost information and the actual result have not changed. The debit to cost of goods sold is based on the standard price per unit of 5 cents for the amount of ingredients that should have been used to make and sell 18,000 units. The credit to raw materials inventory is based on the standard price of 5 cents for the amount of ingredients actually used to make and sell 18,000 units. The difference between the actual quantity of 200,000 ounces and the standard quantity of 180,000 ounces multiplied the 5 cents per ounce standard price results in the $1,000 unfavorable direct materials quantity variance. The variance is unfavorable because the actual quantity used is greater than the standard quantity that should have been used. The journal entry to record the direct materials use is:

Direct Labor and Manufacturing Overhead Costs Cold Stone’s Standard Cost Information for Direct Labor Cold Stone’s actual results for the period were: 18,000 units produced and sold. Direct labor costs were $20,500 for 2,000 hours worked. Cold Stone’s standards for direct labor are: Standard hours = 0.10 hours per unit Standard rate = $10.00 per hour. Cold Stone’s actual results for the period were: 18,000 units were produced and sold. Actual direct labor costs were $20,500 for 2,000 hours worked, an average rate of $10.25 per hour. Let’s prepare the journal entry to record direct labor. The debit to cost of goods sold is based on the standard hourly rate of $10.00 for the 1,800 standard hours that should have been used to make 18,000 units. The credit to wages payable is based on the actual wage rate of $10.25 per hour and the 2,000 actual hours worked. The difference between the $10.25 per hour actual wage rate and the $10.00 standard wage rate, multiplied by 2,000 actual hours worked, results in a $500 unfavorable direct labor rate variance. The variance is unfavorable because the actual wage rate is greater than the standard wage rate. The difference between the 2,000 actual hours and the 1,800 standard hours multiplied by the $10.00 per hour standard rate results in the $2,000 unfavorable direct labor efficiency variance. The variance is unfavorable because the actual hours worked are greater than the standard hours allowed for the 18,000 units produced. Now let’s move on to variable manufacturing overhead. The journal entry to record direct labor is:

Direct Labor and Manufacturing Overhead Costs Standard Cost Information for Variable Manufacturing Overhead Cold Stone’s actual results for the period were: 18,000 units produced and sold. Actual VOH costs were $1,800 for 2,000 direct labor hours. The journal entry to record variable manufacturing overhead is: Cold Stone’s standards for variable manufacturing overhead are: Standard hours = 0.10 hours per unit Standard rate = $8.00 per hour. Cold Stone’s actual results for the period were: 18,000 units produced and sold. Actual VOH costs were $1,800 for 2,000 direct labor hours, resulting in an average variable manufacturing overhead rate of 90 cents per hour. Let’s prepare the journal entry to record variable manufacturing overhead costs. The debit to cost of goods sold is based on the standard variable manufacturing overhead rate of $1.00 per hour for the 1,800 standard hours that should have been used to make 18,000 units. The credit to wages payable or cash is based on the actual variable manufacturing overhead rate of 90 cents per hour and the 2,000 actual hours worked. The difference between the 2,000 actual hours and the 1,800 standard hours multiplied by the $1.00 per hour standard variable manufacturing overhead rate results in the $200 unfavorable variable manufacturing overhead efficiency variance. The variance is unfavorable because the actual hours worked are greater than the standard hours allowed for the 18,000 units produced. The difference between the $0.90 per hour actual variable manufacturing overhead rate and the $1.00 standard variable manufacturing overhead rate, multiplied by 2,000 actual hours worked, results in a $200 favorable variable manufacturing overhead rate variance. The variance is favorable because the actual variable manufacturing overhead rate is less than the standard variable manufacturing overhead rate. Last, we will record fixed manufacturing overhead variances.

Direct Labor and Manufacturing Overhead Costs Cold Stone’s Standard Cost Information for Fixed Manufacturing Overhead Cold Stone’s budget for fixed overhead: 15,000 units to be produced and sold. Budgeted FOH costs were $6,000. Cold Stone’ actual results for the period: 18,000 units produced and sold. Actual FOH costs were $6,300. The journal entry to record fixed manufacturing overhead costs is: Cold Stone’s standard for fixed manufacturing overhead is a fixed overhead rate of 40 cents per unit at a budgeted volume of 15,000 units. Cold Stone’s budget for fixed overhead for the period was: 15,000 units to be produced and sold. Budgeted FOH costs were $6,000. Cold Stone’s actual results for the period were: 18,000 units were produced and sold. Actual fixed overhead costs were $6,300. The debit to cost of goods sold is based on the fixed overhead rate of 40 cents per unit for 18,000 actual number of units produced and sold. The credit to various accounts (salaries payable, cash, etc.) is for the actual fixed overhead of $6,300. The fixed overhead spending variance is equal to the difference in the fixed overhead budget and the actual fixed overhead costs. It is unfavorable because the actual costs are more than the budgeted costs. The fixed overhead volume variance is the fixed overhead rate times the difference between budgeted units and actual units. It is favorable because the actual number of units produced is greater than the budgeted units.

Cost of Goods Sold and Cost Variance Summary The cost of goods sold balance is $36,000 before closing the variances accounts. By closing the variance accounts, we will increase cost of goods sold to $36,600 and reduce the balance in all variance accounts to zero. Now let’s look at the journal entry to close all of the individual variance accounts. The cost of goods sold balance is $36,000 before closing the variances accounts. By closing the variance accounts, we will increase cost of goods sold to $36,600.

Cost of Goods Sold and Cost Variance Summary The entry to close the variance accounts to the Cost of Goods Sold is: The entry to close the individual variance accounts debits the favorable variances to eliminate their credit balances and credits the unfavorable variances to eliminate their debit balances. Cost of Goods Sold is increased by $600 to the actual total of $36,600.

End of Chapter 9 End of chapter 9.