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Chapter 07 review Atef Abuelaish

Chapter 07 Master Budgets and
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Master Budgets and Performance Planning
Chapter 07 Master Budgets and Performance Planning Atef Abuelaish

Budget Process and Administration
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1) Motivates employees through participation in the budgeting process and the establishment of attainable goals. Enhances coordination so that activities of all units contribute to meeting the company’s overall goals. 2) Promotes analysis and a focus on the future. 3) Converts long-term strategic plans into short-term financial plans. 5) Communicates management plans throughout the organization. 4) Provides a benchmark for evaluating performance. Benefits of Budgeting The budgeting process with a company, coordinates the activities of various departments in order to meet the company’s overall goals. Most companies prepare long-term strategic plans spanning 5 to 10 years. Then they prepare shorter-term financial plans, called budgets, to guide their actions toward achieving the goals set forth in the strategic plan. Budgets are most often prepared on an annual basis, but can be prepared for any period of time. Budgets help fulfill the key managerial functions of planning and controlling. There are several benefits to having a written budget: A budget focuses on the future opportunities and threats to the organization. This focus on the future is important, because the daily pressures of operating an organization can divert management’s attention to planning. Since budgeted performance takes into account important company, industry, and economic factors, a comparison of actual to budgeted performance provides an effective monitoring and control system. Ensures that the activities of all departments contribute to meeting the company’s overall goals. This requires coordination. Budgeting helps to achieve this coordination across departments. A written budget provides a benchmark for evaluating performance, and communicates management’s plans throughout the organization. Converts long-term strategic plans into short-term financial plans, and promotes analysis and a focus on the future. Motivates employees through participation in the budgeting process and the establishment of attainable goals. Managers must also be aware of potential negative outcomes of budgeting. Some employees might be tempted to understate sales budgets and overstate expense budgets to allow themselves to more easily meet budget targets. Also, pressure to meet budgeted results might lead employees to engage in unethical behavior or commit fraud. Finally, some employees might always spend their budgeted amounts, even on unnecessary items, to ensure their budgets aren’t reduced for the next period. WARNING: If not properly applied, budgets can have a negative effect on a company…so make sure that budgets are realistic! C 1 Atef Abuelaish

Budget Reporting and Timing
Annual Budget 2015 2016 2017 2018 The annual budget may be divided into quarterly or monthly budgets. We need to choose a budgeting period. The budget period usually coincides with the accounting period. Most companies prepare at least an annual budget, which reflects the objectives for the next year. To provide specific guidance, the annual budget usually is separated into quarterly or monthly budgets. These short-term budgets allow management to periodically evaluate performance and take corrective action. Some companies use a continuous or rolling budget either exclusively or in conjunction with an annual budget. Rolling budgets drop off the immediate past month or quarter and add one future month or quarter as the year progresses. A rolling budget allows a company to continuously work with a full one-year budget in place. A continuous or rolling budget is a twelve-month budget that rolls forward one month as the current month is completed. C 1 Atef Abuelaish

Budget Committee Flow of budget data is a bottom-up process. C 1
The task of preparing a budget should not be the sole responsibility of any one department. Similarly, the budget should not be simply handed down as top management’s final word. Instead, budget figures and budget estimates developed through a bottom-up process usually are more useful. In a bottom-up budgeting process, information flows upward from lower levels of the business to top management. Lower-level managers have more detailed knowledge because they are closer to the day-to-day activities and operations of the business. Flow of budget data is a bottom-up process. C 1 Atef Abuelaish

Budget Committee The budget committee is responsible for budgeting policies and for coordinating the efforts of all participants in the budgeting process. Consists of managers from all departments of the organization. Provides central guidance to insure that individual budgets submitted from all departments are realistic and coordinated. Most large companies have a standing budget committee that is responsible for budgeting policies and for coordinating the efforts of all participants in the budgeting process. Most budgets should be developed by a bottom-up process, but the budgeting system requires central guidance. The budget committee provides this guidance. It is made up of department heads and other executives responsible for seeing that budgeted amounts are realistic and coordinated. C 1 Atef Abuelaish

Master Budget Components
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I - Operating Budgets II – CAPITAL EXPENDITURES Budget III - Cash Budget
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Master Budget Process for a Manufacturer
This slide summarizes the master budgeting process for a company that manufacturers a product. The master budgeting process typically begins with the sales budget and ends with a cash budget and budgeted financial statements. The master budget includes individual budgets for sales, production (or purchases), various expenses, capital expenditures, and cash. C 2 Atef Abuelaish

I - Operating Budgets Atef Abuelaish

1) Sales Budget Sales Budget
The first step in preparing the master budget is the sales budget, which shows the planned sales units and the expected dollars from these sales. Sales Budget Estimated Unit Sales Estimated Unit Price The first step in preparing the master budget is the sales budget, which shows the planned sales units and the expected dollars from these sales. The sales budget is the starting point in the budgeting process because plans for most departments are linked to sales. The marketing department is usually responsible for developing the sales budget. A company’s sales personnel are usually asked to develop predictions of sales for each territory and department. Companies may also take a broader view by using economic forecasting models. Analysis of economic and market conditions + Forecasts of customer needs from marketing personnel P 1 Atef Abuelaish

Sales Budget Example: In September 2015, Toronto Sticks Company sold 700 hockey sticks at $60 each. Toronto Sticks prepared the following sales budget for the next three months: To illustrate the budgeting process, we are going to prepare a detailed budget for Toronto Sticks Company, a manufacturer of youth hockey sticks. We will begin with the sales budget. TSC sold 700 hockey sticks at $60 per unit. After considering sales predictions and market conditions, TSC prepares its sales budget for the next three months. Let’s take a look… P 1 Atef Abuelaish

Sales Budget Example: TSC sold 700 hockey sticks at $60 per unit. After considering sales predictions and market conditions, TSC prepares its sales budget for the next three months. In September of 2015, TSC sold 700 hockey sticks at $60 per unit. After considering sales predictions and market conditions, TSC prepares its sales budget for the next three months. The Sales budget will include forecasts of both unit sales and unit prices. Using this pricing information and the forecasted unit sales for the colder months of the fall season, the sales budget for the remaining three months of the year can be prepared. P 1 Atef Abuelaish

2) Production Budget A manufacturer prepares a production budget, which shows the number of units to be produced in a period. The production budget is based on the unit sales projected in the sales budget, along with inventory considerations. A manufacturer prepares a production budget, which shows the number of units to be produced in a period. The production budget is based on the unit sales projected in the sales budget, along with inventory considerations. This slide depicts the general computation for the production required for a period. We start with budgeted ending inventory. Then, we add the budgeted sales units for the period which came from the Sales budget. This will give us the required units needed for the period. Then, we subtract the number of units in beginning inventory and we are left with the total units to be produced in the period. A production budget does not show costs; it is always expressed in units of product. Note: A production budget does not show costs; it is always expressed in units of product. P 1 Atef Abuelaish

Production Budget The production budget is based on the unit sales projected in the sales budget, along with inventory considerations. The production budget for Toronto Sticks Company (TSC) is prepared next. Manufacturing companies, like TSC, prepare a production budget, which shows the number of units to be produced in a period. The production budget is based on the unit sales projected in the sales budget, along with inventory considerations. The first three lines of TSC’s production budget determine the budgeted ending inventories (in units). Budgeted unit sales are then added to the budgeted ending inventory to give the required units of production. We then subtract beginning inventory to determine the budgeted number of units to be produced. The information about units to be produced provides the basis for manufacturing budgets for the production costs of those units—direct materials, direct labor, and overhead. P 1 Atef Abuelaish

NEED-TO-KNOW 7-1 A manufacturing company predicts sales of 220 units for May and 250 units for June. The company wants each month’s ending inventory to equal 30% of next month’s predicted unit sales. Beginning inventory for May is 66 units. Compute the company’s budgeted production in units for May. Budgeted ending inventory for May 75 30% of 250 (June’s expected sales) Plus: Budgeted sales for May 220 Required units of available production 295 Less: Beginning inventory (units) (66) Total units to be produced 229 A manufacturing company predicts sales of 220 units for May and 250 units for June. The company wants each month’s ending inventory to equal 30% of next month’s predicted unit sales. Beginning inventory for May is 66 units. Compute the company’s budgeted production in units for May. The budgeted ending inventory for May equals 30% of 250 units, June's expected sales. 75 units need to be on hand as of May 31. They also need to produce enough units to cover the budgeted sales for May, 220 units. The total required units of available production is 295. We subtract the number of units that are already on hand in beginning inventory, 66, to calculate the total number of units to be produced, 229. P 1 Atef Abuelaish

A - Direct Materials Budget
The direct materials budget shows the budgeted costs for the direct materials that will need to be purchased to satisfy the estimated production for the period The direct materials budget shows the budgeted costs for the direct materials that will need to be purchased to satisfy the estimated production for the period. Whereas the production budget shows units to be produced, the direct materials budget translates the units to be produced into budgeted costs. It is based on the budgeted production volume from the production budget. The direct materials budget for Toronto Sticks company is shown on your screen. The direct materials budget is driven by the budgeted materials needed to satisfy each month’s production requirement. This budget begins with the budgeted production, taken directly from the production budget. Next, TSC needs to know the amount of direct materials needed for each of the units to be produced—in this case, half a pound (.5) of wood. With these two inputs we can now compute the amount of direct materials needed for production. For example, to produce 710 hockey sticks in October, TSC will need 355 pounds of wood (710 units x 0.5 lbs. = 355 lbs.). The company then needs to consider its safety stock of direct materials. TSC has determined that it wants to have a safety stock of direct materials on hand at the end of each month to complete 50% of the budgeted units to be produced in the next month. Since TSC expects to produce 1,340 units in November, requiring 670 pounds of materials, it needs ending inventory of direct materials of 335 pounds (50% x 670) at the end of October. TSC’s total direct materials requirement for October is therefore 690 pounds ( ). Since TSC already has 178 pounds of direct materials in its beginning inventory it deducts the amount of direct materials that were in beginning inventory from the total materials requirements for the month. For October, the calculation is 690 pounds pounds, resulting in the need for 512 pounds of direct materials to be purchased in October. The direct materials budget next translates the pounds of direct materials to be purchased into budgeted costs. TSC estimates that the cost of direct materials will be $20 per pound over the quarter. At $20 per pound, purchasing 512 pounds of direct materials for October production will cost $10,240. P 1 Atef Abuelaish

B - Direct Labor Budget The direct labor budget shows the budgeted costs for the direct labor that will be needed to satisfy the estimated production for the period. The direct labor budget shows the budgeted costs for the direct labor that will be needed to satisfy the estimated production for the period. About 15 minutes (one-fourth of an hour) of labor time is required to produce one unit. Labor is paid at the rate of $12 per hour. Budgeted labor hours are computed by multiplying the budgeted production level for each month by one-quarter (0.25) of an hour. Direct labor cost is then computed by multiplying budgeted labor hours by the labor rate of $12 per hour. P 1 Atef Abuelaish

NEED-TO-KNOW 7-2 A manufacturing company budgets production of 800 units during June and 900 units during July. Each unit of finished goods requires 2 pounds of direct materials, at a cost of $8 per pound. The company maintains an inventory of direct materials equal to 10% of next month’s budgeted production. Beginning direct materials inventory for June is 160 pounds. Each finished unit requires 1 hour of direct labor at the rate of $14 per hour. Compute the budgeted (a) cost of direct materials purchases for June and (b) direct labor cost for June. Budgeted production (units) 800 Materials requirements per unit (lbs.) 2 Materials needed for production (lbs.) 1,600 Add: Budgeted ending inventory (lbs.) 180 (July production of 900 units x 2 lbs. per unit x 10%) Total materials requirements (lbs.) 1,780 Less: Beginning inventory (lbs.) (160) Materials to be purchased (lbs.) 1,620 Material price per pound $8 Total cost of direct materials purchases $12,960 Budgeted production (units) 800 A manufacturing company budgets production of 800 units during June and 900 units during July. Each unit of finished goods requires 2 pounds of direct materials, at a cost of $8 per pound. The company maintains an inventory of direct materials equal to 10% of next month’s budgeted production. Beginning direct materials inventory for June is 160 pounds. Each finished unit requires 1 hour of direct labor at the rate of $14 per hour. Compute the budgeted (a) cost of direct materials purchases for June and (b) direct labor cost for June. The company requires 800 units to be produced during June. Each unit will require 2 pounds of direct materials. The company requires a total of 1,600 pounds of direct materials for the current month's production. They also require an ending inventory equal to 10% of next month's budgeted production. July's production of 900 units multiplied by 2 pounds per unit, 1,800 pounds, multiplied by 10% is 180 pounds in ending inventory. Total materials requirements, 1,780 pounds. We subtract the number of pounds in beginning inventory, 160, to calculate the number of pounds to be purchased, 1,620. Each pound of direct materials costs $8. The total cost of direct materials purchases, 1,620 pounds at $8 per pound, is a total cost of $12,960. Budgeting the direct labor cost is simpler, as there is no beginning or ending inventory of labor hours to consider. The budgeted production in units is Each of the 800 units requires 1 hour of direct labor, a total of 800 direct labor hours are required. We multiply by the labor rate, $14 per hour, to calculate the total cost of direct labor, $11,200. Labor requirements per unit (hrs.) 1 Total direct labor hours needed 800 Labor rate (per hour) $14 Total cost of direct labor $11,200 P 1 Atef Abuelaish

C - Factory Overhead Budget
The factory overhead budget shows the budgeted costs for factory overhead that will be needed to complete the estimated production for the period. The factory overhead budget shows the budgeted costs for factory overhead that will be needed to complete the estimated production for the period. TSC’s factory overhead budget is shown on your screen. TSC separates variable and fixed overhead costs in its overhead budget, as do many companies. The variable portion of factory overhead is assigned at the rate of $2.50 per unit of production. The fixed overhead is $1,500 per month. The variable portion of factory overhead is assigned at the rate of $2.50 per unit of production. The fixed overhead is $1,500 per month. P 1 Atef Abuelaish

Product Cost Per Unit With the information from the three manufacturing budgets (direct materials, direct labor, and factory overhead), we can compute TSC’s product cost per unit. For budgeting purposes, TSC assumes it will normally produce 3,000 units of product each quarter, yielding fixed overhead of $1.50 per unit. TSC’s other product costs are all variable. With the information from the three manufacturing budgets (direct materials, direct labor, and factory overhead), we can compute TSC’s product cost per unit. This is useful in computing cost of goods sold and preparing a budgeted income statement, as we show later. For budgeting purposes, TSC assumes it will normally produce 3,000 units of product each quarter, yielding fixed overhead of $1.50 per unit. TSC’s other product costs are all variable. This slide summarizes the product cost per unit calculation. P 1 Atef Abuelaish

3) Selling Expense Budget
The selling expense budget is an estimate of the types and amounts of selling expenses expected during the budget period. TSC pays sales commissions equal to 10 percent of total sales. TSC pays a monthly salary of $2,000 to its sales manager. The selling expense budget is an estimate of the types and amounts of selling expenses expected during the budget period. It is usually prepared by the vice president of marketing or an equivalent sales manager. Budgeted selling expenses are based on the sales budget, plus a fixed amount of sales manager salaries. We use the sales budget to prepare a selling expense budget for TSC. Sales commissions are variable, based on a percentage of sales revenue. The sales manager’s salary is a fixed expense. Let’s prepare the selling expense budget for Toronto Sticks Company. P 1 Atef Abuelaish

Selling Expense Budget
We begin the selling expense budget with sales revenues amounts taken from the sales budget. Next, we compute sales commissions for each month by multiplying sales revenue for each month times 10 percent. The sales manager’s salary of $2,000 per month is then added to sales commissions to get the total selling expense for each month. From TSC’s sales budget TSC pays sales commissions equal to 10 percent of total sales. TSC pays a monthly salary of $2,000 to its sales manager. P 1 Atef Abuelaish

4) General and Administrative Expense Budget
The general and administrative expense budget plans the predicted operating expenses not included in the selling expenses or manufacturing budgets. Toronto Sticks Company has general and administrative salaries of $54,000 per year or $4,500 per month. The general and administrative expense budget plans the predicted operating expenses not included in the selling expenses or manufacturing budgets. These expenses may be either variable or fixed with respect to sales volume. The office manager responsible for general administration often is responsible for preparing the general and administrative expense budget. Toronto Sticks Company’s general and administrative expense budget includes salaries of $54,000 per year, or $4,500 per month. Let’s see what their general and administrative expense budget looks like. Let’s prepare the general and administrative expense budget for TSC. P 1 Atef Abuelaish

General and Administrative Expense Budget
Toronto Sticks Company has general and administrative salaries of $54,000 per year or $4,500 per month. The general and administrative expense budget for each month is the administrative salaries of $4,500. The total amount is the same each month since the amount is a fixed expense. P 1 Atef Abuelaish

NEED-TO-KNOW 7-3 A manufacturing company budgets sales of $70,000 during July. It pays sales commissions of 5% of sales and also pays a sales manager a salary of $3,000 per month. Other monthly costs include depreciation on office equipment ($500), insurance expense ($200), advertising ($1,000), and office manager salary of $2,500 per month. For the month of July, compute the total (a) budgeted selling expense and (b) budgeted general and administrative expense. Budgeted selling expense Total Sales commissions ($70,000 x 5%) $3,500 Sales manager's salary 3,000 Advertising expense 1,000 Total budgeted selling expense $7,500 Budgeted general and administrative expense Total Depreciation on office equipment $500 Insurance expense 200 Office manager's salary 2,500 Total budgeted and administrative expense $3,200 A manufacturing company budgets sales of $70,000 during July. It pays sales commissions of 5% of sales and also pays a sales manager a salary of $3,000 per month. Other monthly costs include depreciation on office equipment ($500), insurance expense ($200), advertising ($1,000), and office manager salary of $2,500 per month. For the month of July, compute the total (a) budgeted selling expense and (b) budgeted general and administrative expense. Selling expenses are costs that are targeting the customer, vs. general and administrative expenses which are non-customer related. Sales commissions are selling expenses. 5% of $70,000 is $3,500. The sales manager's salary is also a selling expense. Depreciation on office equipment is non-customer related; it's considered a general and administrative expense. Insurance expense is also considered general and administrative expense. Advertising expense is customer related; it's included as part of the budgeted selling expense. And the office manager's salary is a general and administrative expense. Total budget selling expenses; $7,500. Total budgeted general and administrative expense; $3,200. P 1 Atef Abuelaish

II - CAPITAL EXPENDITURES Budgets
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Capital Expenditures Budget
The capital expenditures budget shows dollar amounts estimated to be spent to purchase additional plant assets the company will use to carry out its budgeted business activities. TSC does not anticipate disposal of any plant assets through December 2015, but management is planning to acquire additional equipment for $25,000 cash in December 2015. It also shows any amounts expected to be received from plant asset disposals, as companies replace old assets with new ones. The capital expenditures budget lists dollar amounts to be received from plant asset disposals and spent on additional plant assets. Since TSC only plans one capital expenditure of $25,000 and no disposals of plant assets, this information will be incorporated into the cash budget. *Since this is the only budgeted capital expenditure for the quarter, no separate budget is shown. P 1 Atef Abuelaish

III - Cash Budget Atef Abuelaish

Cash Budgets After developing budgets for sales, manufacturing costs, expenses, and capital expenditures, the next step is to prepare the cash budget, which shows expected cash inflows and outflows during the budget period. The general formula for a cash budget is: After developing budgets for sales, manufacturing costs, expenses, and capital expenditures, the next step is to prepare the cash budget, which shows expected cash inflows and outflows during the budget period. The cash budget is especially important because it helps the company maintain a cash balance necessary to meet ongoing obligations. Let’s prepare TSC’s budgets for cash receipts and cash disbursements. The cash budget is especially important because it helps the company maintain a cash balance necessary to meet ongoing obligations. P 2 Atef Abuelaish

Preparing the Cash Budget
Beginning Cash Balance Budgeted Cash Receipts Budgeted Cash Disbursements Preliminary Cash Balance + – = If adequate, repay loans or buy securities. If inadequate, increase short-term loans. Now that we have completed the following budgets: cash receipts from sales budget, cash payments for direct materials, cash payments for direct labor, cash payments for variable overhead, cash payments for selling expenses and cash payments for general and administrative expenses, we are ready to complete the cash budget. When preparing a cash budget, we add expected cash receipts to the beginning cash balance and deduct expected cash disbursements. If the expected ending cash balance is inadequate, additional cash requirements appear in the budget as planned increases from short-term loans. If the expected ending cash balance exceeds the desired balance, the excess is used to repay loans or to acquire short-term investments. Some additional events affecting TSC’s cash are displayed on your screen. You may need to make a few notes from this information to keep from referring back to this screen as we use this information. We will continue with the additional information on the next slide. Additional information for TSC’s cash budget: Has a September 30 cash balance of $20,000. Will pay a cash dividend of $3,000 in November. Continue P 2 Atef Abuelaish

Budgeted Cash Receipts (from Sales)
40% of TSC’s sales are for cash. The remaining 60% are credit sales that are collected in full in the month following the sale. Managers use the sales budget, combined with knowledge about how frequently customers pay on credit sales, to budget monthly cash receipts. Forty percent of TSC’s sales are for cash. The remaining 60 percent of sales are credit sales. None of the sales on account are collected in the month of sale. However they are expected to be collected in the month following the sale. Let’s prepare the cash receipts budget for TSC. P 2 Atef Abuelaish

Budgeted Cash Receipts from Sales
We begin the cash receipts budget with sales revenues amounts taken from the sales budget. September sales revenue is included because 60 percent of September sales will be collected in October. The accounts receivable balance at the end of each month is 60 percent of that month’s budgeted sales. Cash sales are 40 percent of each month’s sales. The accounts receivable balance at the end of each month is collected in full during the next month. Cash sales are added to accounts receivable collections to get total cash receipts for the month. We now can compute the budgeted cash receipts from customers, as shown in the table on this slide. October’s budgeted cash receipts consist of $24,000 from expected cash sales ($60,000 x 40%) plus the anticipated collection of $25,200 of accounts receivable from the end of September. Cash sales are 40% of each month’s sales From TSC’ sales budget Accounts receivable balance at the end of each month is 60% of that month’s budgeted sales. P 2 Atef Abuelaish

Cash Payments for Materials
Managers use the beginning balance sheet and the direct materials budget prepared earlier, to help prepare a schedule of cash disbursements for materials. TSC’s purchases of materials are entirely on account. Full payment is made in the month following the purchase. We’re now ready to prepare the cash payments for materials budget. Managers use the beginning balance sheet and the direct materials budget prepared earlier, to help prepare a schedule of cash disbursements for materials. Managers must also know how TSC purchases direct materials (pay cash or on account), and for credit purchases, how quickly TSC pays. TSC’s materials purchases are entirely on account. It makes full payment during the month following its purchases. Using this information, the schedule of cash payments for materials can be prepared. Let’s take a look at it on the next slide. Let’s look at the schedule of cash payments for materials for TSC. P 2 Atef Abuelaish

Cash Payments for Direct Materials
Remember that TSC’s materials purchases are entirely on account. It makes full payment during the month following its purchases. We start with the direct materials budget and that budget told TSC to purchase $10,240 of materials in October. But none of these purchases will be paid for this month—instead those material costs end up in November’s column.. We then add the balance owed from the previous month’s purchases (September) of $7,060. The total cash disbursements for direct materials in October, is $7,060. TSC’s purchases of materials are entirely on account. Full payment is made in the month following the purchase. From direct materials budget P 2 Atef Abuelaish

Cash Budget Toronto Sticks Company:
Has an income tax liability of $20,000 from the previous quarter that will be paid in October. Will purchase $25,000 of equipment in December. Has an agreement with its bank for loans at the end of each month to enable a minimum cash balance of $20,000. Pays interest each month equal to one percent of the prior month’s ending loan balance. Repays loans when the ending cash balance exceeds $20,000. Owes $10,000 on this loan arrangement on September 30. Has 40 percent income tax rate. Will pay taxes for current quarter next year. Here is the remainder of the information needed to complete TSC’s cash budget. Again, you my find it helpful to take a few notes summarizing this information. P 2 Atef Abuelaish

From Cash Receipts Budget
TSC’s cash balance at the beginning of October is $20,000. Budgeted cash receipts for October are $49,200, resulting in a total of $69,200 available for the month. We begin the cash budget with October. TSC’s cash balance at the beginning of October is $20,000. Budgeted cash receipts for October are $49,200, resulting in a total of $69,200 available for the month. Now we are ready to look at TSC’s cash disbursements. Now we are ready to look at TSC’s cash disbursements P 2 Atef Abuelaish

We next subtract expected cash payments for direct materials, direct labor, overhead, selling expenses, and general and administrative expenses. Income taxes of $20,000 were due as of the end of September 30, 2015, and payable in October. We next subtract expected cash payments for direct materials, direct labor, overhead, selling expenses, and general and administrative expenses. Income taxes of $20,000 were due as of the end of September 30, 2015, and payable in October. Now we are ready to use some of the additional information affecting cash. Let’s take a look at the next slide. P 2 Atef Abuelaish

TSC has a dividend payment of $3,000 that it plans to pay in November.
TSC has a $10,000 loan and pays interest at the rate of one percent per month. The preliminary cash balance for October is $25,635. TSC has a dividend payment of $3,000 that it plans to pay in November. TSC has a dividend payment of $3,000 that it plans to pay in November. TSC has a $10,000 loan and pays interest at the rate of one percent per month. October’s interest is $100. P 2 Atef Abuelaish

TSC has an agreement with its bank for loans at the end of each month to provide a minimum cash balance of $20,000. If the cash balance exceeds $20,000 at a month-end, as it does here, TSC uses the excess to repay loans. TSC has an agreement with its bank for loans at the end of each month to provide a minimum cash balance of $20,000. If the cash balance exceeds $20,000 at a month-end, TSC uses the excess to repay loans. If the cash balance is less than $20,000 at month-end, the bank loans TSC the difference. At the end of each month, TSC pays the bank interest on any outstanding loan amount, at the monthly rate of 1% of the beginning balance of these loans. For October, this payment is 1% of the $10,000 note payable amount reported on its balance sheet. Based on our cash budget for the month of October, the preliminary cash balance increases to $25,635 (before any loan-related activity). This amount is more than the $20,000 minimum. Thus, TSC will pay off $5,635 of its outstanding loan. P 2 Atef Abuelaish

TSC interest on it’s outstanding loan amount in November is $44.
Ending cash balance for October is the beginning November balance. The expected loan repayment of $5,635 is deducted from the preliminary cash balance in October. October’s ending cash balance of $20,000 becomes the beginning cash balance in November. For November, TSC expects to pay interest of $44, computed as 1% of the $4,365 expected loan balance at October 31. No interest is budgeted for December because the company expects to repay the loans in full at the end of November. TSC interest on it’s outstanding loan amount in November is $44. P 2 Atef Abuelaish

One last item, before our cash budget is complete…TSC plans to pay $25,000 in December to purchase new equipment. The cash budget is completed with the December cash information. TSC plans to pay $25,000 in December to purchase new equipment. This large cash disbursement will reduce the December preliminary cash balance to $56,575 and leave an ending cash balance in December of $44,706. P 2 Atef Abuelaish

Budgeted Financial Statements
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Budgeted Income Statement
The budgeted income statement is a managerial accounting report showing predicted amounts of sales and expenses for the budget period. Cash Budget Budgeted Income Statement Completed Now that we have completed the cash budget, we are ready to prepare a budgeted income statement for the quarter. The budgeted income statement is a managerial accounting report showing predicted amounts of sales and expenses for the budget period. It summarizes the income effects of the budgeted activities. Information needed to prepare a budgeted income statement is primarily taken from already-prepared budgets. Let’s look at the budgeted income statement for Toronto Sticks Company. Let’s prepare the budgeted income statement for Toronto Sticks Company. P 3 Atef Abuelaish

Budgeted Income Statement
TSC’s condensed budgeted income statement is shown on this slide. All information in this statement is taken from the component budgets we’ve examined on previous slides. Also, we now can predict the amount of income tax expense for the quarter, computed as 40% of the budgeted pretax income. For TSC, these taxes are not payable until January 31, Thus, these taxes are not shown on the October–December 2015 cash budget. We can now move on to the budgeted balance sheet. The predicted amount of income tax expense for the quarter, computed as 40% of the budgeted pretax income, is included. All information in this budgeted income statement is taken from the component budgets we’ve examined on previous slides. Atef Abuelaish P 3

Budgeted Balance Sheet
The budgeted balance sheet shows predicted amounts for the company’s assets, liabilities, and equity as of the end of the budget period. Budgeted Balance Sheet Completed Income Statement Now that we have completed the income statement for the quarter, we can prepare the balance sheet. The final step in preparing the master budget is summarizing the company’s financial position. The budgeted balance sheet shows predicted amounts for the company’s assets, liabilities, and equity as of the end of the budget period. Let’s prepare the budgeted balance sheet for Toronto Sticks Company. P 3 Atef Abuelaish

Budgeted Balance Sheet
TSC’s budgeted balance sheet is shown on this slide. It is prepared using information from the other budgets. The budgeted balance sheet for TSC is prepared using information from the other budgets. P 3 Atef Abuelaish

Chapter 08 Flexible budgets &
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Flexible budgets & standard costs
Chapter 08 Flexible budgets & standard costs Atef Abuelaish

Budgetary Control and Reporting
Budgets are an important cost control tool. Actual results are compared with budgets and differences are investigated and analyzed. Revise objectives and prepare a new budget. Management uses budgets to monitor and control operations. Develop the budget from planned objectives. Compare actual to budget and analyze any differences. Take corrective and strategic actions. Budgets are an important cost control tool. Actual results are compared with budgets and differences are investigated and analyzed. This process may result in corrective action to restore progress toward budgeted objectives. If the operating environment has changed the investigation and analysis may lead to budget revisions. Budget reports are sometimes viewed as progress reports, or report cards, on management’s performance in achieving planned objectives. These reports can be prepared at any time and for any period. The budgetary control process involves at least four steps: (1) develop the budget from planned objectives, (2) compare actual results to budgeted amounts and analyze any differences, (3) take corrective and strategic actions, and (4) establish new planned objectives and prepare a new budget. Atef Abuelaish

Fixed Budget Performance Report
A fixed budget, also called a static budget, is based on a single predicted amount of sales or other activity measure. If unit sales are higher, should we expect costs to be higher? How much of the higher costs are because of higher unit sales? U = Unfavorable variance Actual cost is greater than budgeted cost. Optel’s fixed budget was prepared for January at an expected sales level of 10,000 units. However, Optel actually sold 12,000 units during the month. All of the expense variances are unfavorable because actual expenses are greater than budgeted expenses. As a result of the increase in sales from 10,000 units to 12,000 units, variances for sales and income are favorable. Since the cost variances are unfavorable, has Optel done a poor job controlling costs? But wait, if sales volume is greater than expected, shouldn’t we expect Optel’s costs to be higher? If so, what portion of the higher costs is due to activity and what portion is due to poor cost control? The question is really difficult to answer using a fixed budget. The sales level was higher than the budgeted level, so it follows that variable expenses should be higher to support the higher level of sales. We actually don’t have a grip on cost control. One of the ways we can answer the question about the effectiveness of cost control is to use flexible budgeting. We will prepare a budget at the actual level of activity. In other words, we will flex Optel’s fixed budget up to the actual level of sales. F = Favorable variance Actual revenue and income are greater than budgeted revenue and income. Atef Abuelaish

Purpose of Flexible Budgets
Show revenues and expenses that should have occurred at the actual level of activity. May be prepared for any activity level in the relevant range. Reveal variances due to good cost control or lack of cost control. A flexible budget shows us the revenue and expenses that should have been incurred at the actual level of activity, rather than just the budgeted level of activity. One of the real strengths of flexible budgeting is that it helps us get a firm grasp on cost control. In addition, performance evaluation is improved using flexible budgeting. The central concept behind flexible budgeting is that if you can tell me what your activity was during the period, I can tell you what your revenue and expenses should have been at that level of activity. Improve performance evaluation. Atef Abuelaish

Preparation of Flexible Budgets
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To a budget for different activity levels, we must know how costs behave with changes in activity levels. Total variable costs change in direct proportion to changes in activity. Total fixed costs remain unchanged within the relevant range. Fixed Variable In order to prepare an effective flexible budget, we have to know that total variable costs change directly and proportionately with the level of activity, and that total fixed costs remain unchanged as long as we stay within the relevant range of activity. Recall that in Chapter 16, we studied fixed and variable costs along with methods to determine the fixed and variable components of mixed costs. P 1 Atef Abuelaish

Variable costs are a constant amount per unit. Total variable cost = $4.80 per unit × budget level in units Let’s see how flexible budgeting works by preparing flexible budgets for 10,000 units, 12,000 units, and 14,000 units for Optel. Notice that Optel’s costs have been classified by behavior, either variable or fixed, in the flexible budget. The first thing we do is express the variable costs in per unit amounts. For example, we divide the $57,600 variable cost by 12,000 units to obtain a unit variable cost of $ Next we multiply the $4.80 unit variable cost times each of the budgeted levels of activity to get the total variable costs at each activity level. For example, at 14,000 units of activity, the budgeted variable cost of $67,200 is computed by multiplying $4.80 per unit times 14,000 units. Total fixed costs remain unchanged in the budgeting process as long as we operate within the relevant range of activity. Next, after we examine these flexible budgets for Optel for a few minutes, we will compare the flexible budget for 12,000 units with the actual costs at 12,000 units. Total Fixed costs do not change within the relevant range. P 1 Atef Abuelaish

Flexible Budget Performance Report
A flexible budget performance report compares actual performance and budgeted performance based on actual sales. In Optel’s case, January’s sales are 12,000 units. Favorable sales variance indicates that the average selling price was greater than $10.00 per unit. Unfavorable cost variances indicate costs are greater than expected for 12,000 units. A flexible budget performance report compares actual performance and budgeted performance based on actual sales volume (or other activity level). In Optel’s case, we prepare this report after January’s sales volume is known to be 12,000 units. Part I At 12,000 units, we would expect sales revenue to be $120,000. Since the actual sales revenue was $125,000, we conclude that Optel’s average selling price was greater than $10 per unit. Now we can begin to analyze cost control. Part II Comparing actual costs at 12,000 units with a flexible budget prepared at 12,000 units reveals that Optel has unfavorable cost variances. These variances are due to cost control issues because we have removed the activity differences by flexing the fixed budget from 10,000 units up to the actual activity of 12,000 units. Part III The favorable variances for contribution margin and income indicate that the favorable sales variance is larger than the unfavorable cost variances. Favorable variance because favorable sales variance is greater than unfavorable cost variances. P 1 Atef Abuelaish

NEED-TO-KNOW 8.1 A manufacturing company reports the fixed budget and actual results for the year as shown below. The company’s fixed budget assumes a selling price of $40 per unit. The fixed budget is based on 20,000 units of sales, and the actual results are based on 24,000 units of sales. Prepare a flexible budget performance report for the year. Fixed Budget Actual Results (20,000 units) (24,000 units) Sales $800,000 $972,000 Variable costs 160,000 240,000 Fixed costs 500,000 490,000 Budget assumptions: Selling price per unit $40.00 ($800,000 divided by 20,000 units) Variable cost per unit $8.00 ($160,000 divided by 20,000 units) Budget Assumptions Flexible Budget (24,000 units) A manufacturing company reports the fixed budget and actual results for the year as shown below. The company’s fixed budget assumes a selling price of $40 per unit. The fixed budget is based on 20,000 units of sales, and the actual results are based on 24,000 units of sales. Prepare a flexible budget performance report for the year. First, let’s look at the assumptions that were used to create the fixed budget (20,000 units). The selling price per unit is $40 per unit ($800,000 divided by 20,000 units). The variable cost per unit is $8 per unit ($160,000 in variable costs divided by 20,000 units). We use these budget assumptions to create the flexible budget for the actual number of units sold, 24,000 units. Had the company known they were going to sell 24,000 units, total sales would have been budgeted at $960,000 ($40.00 per unit multiplied by 24,000 units). Variable costs would have been budgeted at $192,000 ($8.00 per unit multiplied by 24,000 units). Fixed costs remain constant, regardless of the production volume, $500,000. Sales $40.00 x 24,000 units = $960,000 Variable costs $8.00 x 24,000 units = 192,000 Fixed costs 500,000 P 1 Atef Abuelaish

NEED-TO-KNOW 8.1 A manufacturing company reports the fixed budget and actual results for the year as shown below. The company’s fixed budget assumes a selling price of $40 per unit. The fixed budget is based on 20,000 units of sales, and the actual results are based on 24,000 units of sales. Prepare a flexible budget performance report for the year. Fixed Budget Actual Results (20,000 units) (24,000 units) Sales $800,000 $972,000 Variable costs 160,000 240,000 Fixed costs 500,000 490,000 Budget Assumptions Flexible Budget (24,000 units) Sales $40.00 x 24,000 units = $960,000 Variable costs $8.00 x 24,000 units = 192,000 Fixed costs 500,000 FLEXIBLE BUDGET PERFORMANCE REPORT The flexible budget performance report compares the company's actual results with the predicted results from the flexible budget. $960,000 of sales in the flexible budget vs. $972,000 in actual sales is a $12,000 favorable variance, as additional sales increase net income. $192,000 of variable costs in the flexible budget vs. $240,000 in actual variable costs is a $48,000 unfavorable variance, as additional costs decrease net income. Contribution margin, Sales minus Variable Costs, $768,000 per the flexible budget vs. $732,000 actual is a $36,000 unfavorable variance. $490,000 in actual fixed costs vs. budget fixed costs of $500,000 is a $10,000 favorable variance. Net income $242,000 actual vs. $268,000 in the flexible budget is an overall unfavorable variance of $26,000. Flexible Budget Actual Results (24,000 units) (24,000 units) Variances Sales $960,000 $972,000 $12,000 Favorable (F) Variable costs 192,000 240,000 48,000 Unfavorable (U) Contribution margin 768,000 732,000 36,000 Unfavorable (U) Fixed costs 500,000 490,000 10,000 Favorable (F) Net income 268,000 242,000 26,000 Unfavorable (U) P 1 Atef Abuelaish

Standard Costs Atef Abuelaish

Standard Costs Based on carefully predetermined amounts.
Standard costs can be used in a flexible budgeting system to enable management to better understand the reasons for variances Based on carefully predetermined amounts. Standard costs are Used for planning materials, labor, and overhead requirements. In the next few slides, we show how standard costs can be used in a flexible budgeting system to enable management to better understand the reasons for variances. Standard costs are preset costs for delivering a product or service under normal conditions. We can think of standard costs as budgeting on a per unit basis. We expect to operate within the standard cost allowances under normal conditions. The expected level of performance. Benchmarks for measuring performance. C 1 Atef Abuelaish

Identifying Standard Costs
Managerial accountants, engineers, personnel administrators, and other managers combine their efforts to set standard costs. Practical standards should be set at levels that are currently attainable with reasonable and efficient effort. Managerial Accountant Engineer When managerial accountants, engineers, personnel administrators, and other managers combine their efforts to set standard costs, perhaps the first question they have to answer is, do they want to develop a practical standard or an ideal standard. Most members of the team would argue that the standards should be practical; they should be attainable with a reasonable amount of efficient effort. An ideal standard is based upon perfection, and is thus unattainable. This can have the effect of discouraging and demoralizing employees. Human Resources Manager Production Manager Ideal standards, that are based on perfection, are unattainable and discouraging to most employees. C 1 Atef Abuelaish

Setting Standard Costs
Quantity Standards Price Standards Direct Materials Time Standards Rate Standards Direct Labor Direct materials standards are based on the final delivered cost of materials, net of any applicable discounts. Standard quantities are amounts needed to meet the production designs. The standard materials cost for a unit of product is the standard price for one unit of material multiplied by the standard quantity of materials required for each unit of product. Instead of the terms price and quantity used for materials, we use rate and time when we apply standard cost concepts to direct labor. Labor rates are determined by wage surveys of rates paid in comparable companies or by labor contracts. Time standards are developed by production and manufacturing experts such as industrial engineers. The standard labor cost for a unit of product is the standard rate for one hour of direct labor multiplied by the standard time required for each unit of product. The rate standard for variable overhead is the variable portion of the predetermined overhead rate. The activity standard is the units of activity in the base used to apply the predetermined overhead. Examples of the activity base might be direct labor hours or machine hours. The standard variable overhead cost for a unit of product is the standard variable overhead rate multiplied by the standard number of activity units for each unit of product. Activity Standards Rate Standards Variable Overhead C 1 Atef Abuelaish

Setting Standard Costs
The standard costs of direct materials, direct labor, and overhead for one bat, manufactured by ProBat, are shown below. This is called a standard cost card. The standard costs of direct materials, direct labor, and overhead for one bat, manufactured by ProBat, are shown on this slide. This is called a standard cost card. In the first column, we see a standard quantity. In this case, direct materials is expressed in terms of kilograms, direct labor in hours, and manufacturing overhead in hours. In the second column, we have a standard price or standard rate, and finally, in the last column, we have a standard cost per unit. These standard cost amounts are then used to prepare manufacturing budgets for a budgeted level of production. C 1 Atef Abuelaish

Cost Variance Analysis
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Manufacturing Overhead
Cost Variances This variance is favorable (F) because the actual cost is less than the standard cost. A standard cost variance is the amount by which an actual cost differs from the standard cost. This variance is unfavorable (U) because the actual cost exceeds the standard cost. Direct Materials Standard cost Direct Labor $ Amount Part I You can see from this diagram that direct labor cost is equal to the standard cost for labor, while direct materials cost is above standard and manufacturing overhead cost is below standard. The difference between actual cost and standard cost is called a standard cost variance. Part II In the example shown, the material variance is unfavorable because the actual cost exceeds the standard cost. The manufacturing overhead cost is favorable because the actual cost is less than standard cost. Manufacturing Overhead C 2 Type of Product Cost Atef Abuelaish

Cost Variance Analysis
Variance analysis involves preparing a standard cost performance report and comparing actual costs with standard costs. We then investigate variances by asking for explanations and possible causes for the variances. We should correct problems that caused unfavorable variances and possibly adopt and reward the practices that resulted in favorable variances. This slide shows the flow of events in variance analysis: Variance analysis involves comparing actual costs with standard costs. If variances exists, we investigate by asking appropriate managers for explanations and possible causes for the variances. Our objective is to correct problems that caused unfavorable variances and to possibly adopt and reward the practices that resulted in favorable variances. C 2 Atef Abuelaish

Cost Variance Computation
Management needs information about the factors causing a cost variance, but first it must properly compute the variance. In its most simple form, a cost variance (CV) is computed as: Cost Variance (CV) = Actual Cost (AC) - Standard Cost (SC) where: Actual Cost (AC) = Actual Quantity (AQ) x Actual Price (AP) Standard Cost (SC) = Standard Quantity (SQ) x Standard Price (SP) Actual quantity (AQ) is the input (material or labor) used to manufacture the quantity of output. Standard quantity (SQ) is the standard input for the quantity of output. Actual price (AP) is the actual amount paid to acquire the input (material or labor). Standard price (SP) is the standard price. Management needs information about the factors causing a cost variance, but first it must properly compute the variance. In its most simple form, a cost variance (CV) is computed as: Actual Cost (AC) minus Standard Cost (SC). We can break the formula down even further by defining how to calculate Actual Cost and how to calculate Standard Cost. The formulas for both are listed on this screen. A cost variance is further defined by its components. Actual quantity (AQ) is the input (material or labor) used to manufacture the quantity of output. Standard quantity (SQ) is the standard input for the quantity of output. Actual price (AP) is the actual amount paid to acquire the input (material or labor), and standard price (SP) is the standard price. Price variances result when we pay an actual price for a resource that differs from the standard price that should have been paid. Quantity variances are caused by using an actual amount of a resource that differs from the standard amount that should have been used. C 2 Atef Abuelaish

Two main factors cause a cost variance: Cost Variance Quantity Variance Price Variance The difference between the actual price and the standard price. The difference between the actual quantity and the standard quantity. Two main factors cause a cost variance: 1. The difference between actual price per unit of input and standard price per unit of input results in a price (or rate) variance. 2. The difference between actual quantity of input used and standard quantity of input used results in a quantity (or usage or efficiency) variance. To assess the impacts of these two factors in a cost variance, let’s look at the model on the next slide. To assess the impacts of these two factors in a cost variance, let’s look at the model on the next slide. C 2 Atef Abuelaish

Standard quantity is the quantity that should have been used for the actual good output. Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Quantity Variance Standard price is the amount that should have been paid for the resources acquired. Here’s a general model for computing standard cost variances. We multiply the actual quantity times the actual price and compare that to the actual quantity times the standard price. The difference is the price variance. Then we compare the actual quantity times the standard price to the standard quantity at the standard price. The difference is the quantity variance. The standard quantity is the standard quantity for one unit multiplied times the number of good units produced. It is the amount of a resource that should have been used given the actual good output achieved. The standard price is the amount we should pay for the resource acquired. C 2 Atef Abuelaish

Actual Cost Standard Cost Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price Variance Quantity Variance (AP - SP) x AQ (AQ - SQ) x SP AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity We can reduce these relationships to mathematical equations. For example, we can determine the material price variance by multiplying the actual quantity times the difference between the actual price and the standard price, and we can determine the material quantity variance by multiplying the standard price times the difference between the actual quantity and the standard quantity. C 2 Atef Abuelaish

Computing Materials and Labor Variances
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Computing Materials and Labor Variances
G-Max Company makes golf club heads with the following standard cost information: We illustrate the computation of the materials and labor cost variances using data from G-Max, a company that makes specialty golf equipment and accessories for individual customers. This company has set the following standard quantities and costs for direct materials and direct labor per unit for one of its handcrafted golf clubheads: The direct materials standard allows one-half pound per club head at $20.00 per pound. The direct labor standard allows one hour per club head at $8.00 per hour. P 2 Atef Abuelaish

Materials Cost Variances
During May, G-Max produced 3,500 club heads using 1,800 pounds of material. G-Max paid $21.00 per pound for the material. Compute the material price and quantity variances. During May, G-Max purchased and used 1,800 pounds of material to make 3,500 club heads. G-Max paid $21.00 per pound for the 1,800 pounds of material. Use this information to compute the material price and quantity variances before you go to the next slide. Use this information to compute the material price and quantity variances before you go to the next slide. P 2 Atef Abuelaish

SQ = 3,500 units × 0.5 lb. per unit = 1,750 lbs. Actual Cost Standard Cost Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price 1,800 lbs ,800 lbs ,750 lbs × × × $21.00 per lb $20.00 per lb $20.00 per lb. $37, $36, $35,000 Now you can check your work. The total actual price paid for the material was $37,800. Since the standard price was $20.00 per pound, G-Max should have paid only $36,000 for the material. The difference between $37,800 and $36,000 is the $1,800 unfavorable price variance. G-Max actually used 1,800 pounds of material, 50 pounds more than the standard quantity of 1,750 pounds. Using an extra 50 pounds resulted in the $1,000 unfavorable quantity variance. If we add the unfavorable price variance of $1,800 plus the unfavorable quantity variance of $1,000, we get a total cost variance of $2,800. Price Variance $1,800 Unfavorable + Quantity Variance $1,000 Unfavorable P 2 $2,800 Total Cost Variance (U) Atef Abuelaish

Who is responsible for material cost variances?? You used too much material because of poorly trained workers and poorly maintained equipment. Also, your poor scheduling requires me to rush order material at a higher price, causing unfavorable price variances. I am not responsible for this unfavorable material quantity variance. You purchased cheap material, so my people had to use more of it. Detailed price and quantity variances allow management to ask the responsible individuals for explanations and corrective actions. The production manager is responsible for material usage. Since his performance evaluation is negatively impacted by the unfavorable material quantity variance, he is trying to find reasons for the unfavorable variance other than his own production operation. Now that we have computed material variances, we can apply the same concepts to labor. P 2 Atef Abuelaish

NEED-TO-KNOW 8.2 A manufacturing company reports the following for one of its products. Compute the direct materials (a) price variance and (b) quantity variance and indicate whether they are favorable or unfavorable. Direct materials standard 8 $6.00 per pound Actual direct materials used 83,000 $5.80 per pound Actual finished units produced 10,000 AQ 83,000 lbs. AP $5.80 per lb. SQ 80,000 lbs. (10,000 units x 8 lbs. per unit) SP $6.00 per lb. Actual Cost Standard Cost AQ X AP AQ x SP SQ x SP 83,000 x $5.80 83,000 x $6.00 [10,000 x 8] x $6.00 $481,400 $498,000 $480,000 $16,600 Favorable $18,000 Unfavorable Materials Price Variance Materials Quantity Variance A manufacturing company reports the following for one of its products. Compute the direct materials price variance and quantity variance, and indicate whether they are favorable or unfavorable. Variance analysis compares the total actual cost of inputs with the total standard cost. The actual cost is equal to the actual quantity purchased multiplied by the actual price per pound. The total standard cost is the standard quantity of materials multiplied by the standard price per pound. In between these two values, we'll standardize the pricing first: Actual quantity multiplied by the standard price. The actual quantity of materials is 83,000 pounds. The actual price is $5.80 per pound. The standard quantity is 80,000 pounds, because each of the 10,000 units produced should have used exactly 8 pounds of materials. The standard price is $6.00 per pound. 83,000 pounds of materials purchased, at an actual rate of $5.80 per pound, is a total actual cost of $481,400. The actual quantity, 83,000, multiplied by $6.00 per pound is $498,000. The difference between the actual quantity at the actual price and the actual quantity at the standard price is the materials price variance, $16,600. This variance is favorable, as the company paid $0.20 less per pound for each of the 83,000 pounds purchased. The standard quantity, 80,000 pounds, (10,000 units multiplied by 8 pounds per unit) multiplied by the standard price of $6.00 per pound, is a total standard cost of $480,000. The difference between the actual quantity at the standard price and the standard quantity at the standard price is the materials quantity variance. The difference is $18,000, and this variance is unfavorable, as the actual quantity used, 83,000 pounds, exceeded the standard quantity of 80,000 pounds. 3,000 additional pounds at $6.00 per pound is an $18,000 unfavorable materials quantity variance. The total materials variance, the difference between the actual cost, $481,400, and the total standard cost, $480,000, is a $1,400 unfavorable total direct materials variance. Notice that when we combine the $16,600 favorable materials price variance with the $18,000 unfavorable materials quantity variance, the total variance is $1,400 unfavorable. $1,400 Unfavorable Total Direct Materials Variance P 2 Atef Abuelaish

Labor Cost Variances *Rate Variance *Efficiency Variance
Instead of price and quantity, for direct labor we use the terms rate and hours. Standard Cost Actual Cost Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate *Rate Variance *Efficiency Variance *NEW Instead of price and quantity, for direct labor we use the terms rate and hours. Also, instead of price and quantity variances, for labor, we use the terms rate and efficiency variances. The underlying concepts are the same as we saw for material. The standard rate is the amount we should pay per hour for the work performed. Standard hours are the hours that should have been worked for the actual good output achieved. Just as with material, we can reduce these relationships to mathematical equations. For example, we can determine the labor rate variance by multiplying actual hours times the difference between the actual rate and the standard rate, and we can determine the labor efficiency variance by multiplying the standard rate times the difference between actual hours and standard hours. AH(AR - SR) SR(AH - SH) AH = Actual Hours SR = Standard Rate AR = Actual Rate SH = Standard Hours P 2 Atef Abuelaish

Labor Cost Variances During May, G-Max produced 3,500 club heads working 3,400 hours. G-Max paid an average of $8.30 per hour for the hours worked. Compute the labor rate and efficiency variances. During May, G-Max employees worked 3,400 hours to make the 3,500 club heads. G-Max paid an average of $8.30 per hour to the employees for the 3,400 hours worked. Use this information to compute the labor rate and efficiency variances before you go to the next slide. Use this information to compute the labor rate and efficiency variances before you go to the next slide. P 2 Atef Abuelaish

Labor Cost Variances SQ = 3,500 units × 1.0 hour per unit = 3,500 hours. Actual Cost Standard Cost Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate 3,400 hours ,400 hours ,500 hours × × × $8.30 per hour $8.00 per hour $8.00 per hour. $28, $27, $28,000 Now you can check your work. The total actual wages paid for 3,400 hours were $28,220. Since the standard rate was $8.00 per hour, G-Max should have paid only $27,200 for 3,400 hours. The difference between $28,220 and $27,200 is the $1,020 unfavorable rate variance. G-Max employees actually worked 3,400 hours; 100 hours less than the standard of 3,500 hours. Working 100 hours less than allowed by the standard for labor time resulted in the $800 favorable efficiency variance. If we add the unfavorable rate variance of $1,020 minus the favorable efficiency variance of $800, we get a total unfavorable labor cost variance of $220. Rate Variance $1,020 Unfavorable + Efficiency Variance $800 Favorable P 2 $220 Total Cost Variance (U) Atef Abuelaish

Evaluating Labor Cost Variances
One possible explanation of G-Max’s labor rate and efficiency variances is the use of workers with different skill levels. High skill, high rate Low skill, low rate Using highly paid skilled workers to perform unskilled tasks results in an unfavorable rate variance. However, fewer labor hours might be required for the work resulting in a favorable efficiency variance. One possible explanation for G-Max’s unfavorable rate variance is that the production manager used highly paid, skilled workers to perform tasks that only required unskilled workers. We pay a higher rate for the same number of hours using workers with higher skills than required for the work. As a result, fewer labor hours might be required for the work, but the wage rate paid these workers is higher than standard because of their greater skills. P 2 Atef Abuelaish

Labor Cost Variances Who is responsible for material cost variances??
Production managers who make work assignments are generally responsible for labor cost variances. I am not responsible for the unfavorable labor efficiency variance. You purchased cheap material, so it took more time to process it. You used too much time because of poorly trained workers and poor supervision. If an unfavorable labor efficiency variances arises, the production manager is generally held responsible. Since his performance evaluation is negatively impacted by unfavorable labor variances, he may again be trying to find reasons for the unfavorable variance other than his own production operation. Now that we have mastered material and labor variances, we can apply the same concepts to overhead. P 2 Atef Abuelaish

NEED-TO-KNOW 8.3 The following information is available for York Company. Actual direct labor cost (6,250 per hour) $81,875 Standard direct labor hours per unit 2.0 hours Standard rate per hour $13.00 Actual production (units) 2,500 Budgeted production (units) 3,000 Compute the direct labor rate and efficiency variances. SQ (2,500 units x 2 hrs. per unit = 5,000 standard hrs. ) Actual Cost Standard Cost AQ X AR AQ x SR SQ x SR 6,250 x $13.10 6,250 x $13.00 (2,500 x 2) x $13.00 $81,875 $81,250 $65,000 $625 Unfavorable $16,250 Unfavorable Labor Rate Variance Labor Efficiency Variance The following information is available for York Company. Compute the direct labor rate and efficiency variances. Variance analysis identifies the reasons for the differences between total actual cost and total standard cost. The actual cost is calculated by multiplying the actual number of direct labor hours by the actual rate. The standard cost is equal to the standard number of direct labor hours multiplied by the standard rate. And, in between these two values, we standardize the rate first. The actual number of direct labor hours is 6,250 hours. The actual rate is $13.10 per hour. The total actual cost of direct labor is the $81,875. If we multiply the actual number of hours, 6,250, by the standard rate of $13.00 per hour the total is $81,250. The difference between these two values is the direct labor rate variance, a $625 unfavorable variance, as the company paid $0.10 per hour more for each of the 6,250 direct labor hours. The standard number of direct labor hours is calculated based on the number of units produced. Each of the 2,500 units produced should have required exactly 2 hours of direct labor, a total of 5,000 standard direct labor hours. When we multiply the standard hours, 5,000, by the standard rate, $13.00 per hour, the total standard cost of direct labor is $65,000. The difference between the actual quantity at the standard rate and the standard quantity at the standard rate is the labor efficiency variance. In this case, it's a $16,250 unfavorable variance, as the company used 1,250 more direct labor hours than was budgeted. 1,250 additional hours at $13.00 per hour explains the $16,250 unfavorable efficiency variance. The total direct labor variance is $16,875 unfavorable; the $81,875 actual cost minus the $65,000 standard cost. Notice that when we combine the $625 unfavorable labor rate variance with the $16,250 unfavorable labor efficiency variance, it explains the $16,875 unfavorable total direct labor variance. $16,875 Unfavorable Total Direct Labor Variance P 2 Atef Abuelaish

Computing Overhead Cost Variances
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Overhead Standards and Variances
Recall that overhead costs are assigned to products and services using a predetermined overhead rate (POHR): Estimated total overhead costs Estimated activity POHR = Recall from our work in previous chapters that the predetermined overhead rate is calculated by dividing estimated overhead costs for the operating period by the estimated activity for the operating period. We then use the predetermined overhead rate to assign overhead costs to products as they are manufactured. Assigned Overhead = POHR × Standard Activity P 3 Atef Abuelaish

Setting Overhead Standards
Standard overhead costs are the overhead amounts expected to occur at a certain activity level. To allocate overhead costs to products or services, management needs to establish the standard overhead cost rate. Contains a fixed overhead rate which declines as activity level increases. Contains a variable unit rate which stays constant at all levels of activity. Standard Overhead Rate Function of activity level chosen to determine rate. Standard overhead costs are the overhead amounts expected to occur at a certain activity level. Unlike direct materials and direct labor, overhead includes fixed costs and variable costs. This requires management to classify overhead costs as fixed or variable (within a relevant range), and to develop a flexible budget for overhead costs. The predetermined overhead rate contains both fixed and variable components of overhead. The variable overhead rate will be the same for all levels of activity. However, the fixed portion of the overhead rate will differ depending on the activity level used in the denominator of the predetermined overhead rate computation. Flexible budgets, showing budgeted amount of overhead for various levels of activity, are used to analyze overhead costs. We can develop a flexible overhead budget for G-Max Company to better analyze overhead variances. Let’s take a look at the next slide. Flexible budgets, showing budgeted amount of overhead for various levels of activity, are used to analyze overhead costs. Atef Abuelaish

Flexible Overhead Budgets
(Flexible budgets for overhead prepared at several levels of activity) G-Max predicted an 80 percent activity level. This standard overhead rate will be used in computing overhead cost variances. Here we see flexible budgets for overhead prepared at several levels of activity. The activity levels are expressed as a percentage of capacity. Notice that the variable overhead rate is $1.00 per unit for all levels of activity. Multiplying the $1.00 variable overhead rate times the number of units at each production level results in the flexible budget for variable overhead. For example, when G-Max is operating at 70% of capacity or the 3,500 unit level of activity, the variable overhead budget is $3,500, computed by multiplying $1.00 per unit times 3,500 units. The fixed portion of the overhead budget is unchanged at $4,000 for all levels of activity. Including the fixed overhead in the computation of the predetermined overhead rate results in a declining unit cost for overhead, from $2.14 per hour at the 3,500 unit level of activity to $1.80 per hour at the 100% of capacity activity level or 5,000 units. Because the predetermined overhead rate is different at each level of activity, G-Max must select an activity level for its predetermined overhead rate. In this case, G-Max selected 4,000 units. At 4,000 units of activity, the predetermined overhead rate is $2.00 per hour, made up of $1.00 per hour variable overhead rate, and $1.00 per hour fixed overhead rate. Choosing any other level of activity would have resulted in the same variable overhead rate, but a different fixed overhead rate. We now have the fixed and variable overhead rates for G-Max. Next, we can use these overhead rates in a standard cost system to calculate overhead variances. Standard overhead rate is: $8,000 ÷ 4,000 DL hours = $2.00 per DL hour P 3 Atef Abuelaish

Computing Overhead Cost Variances
When standard costs are used, a company applies overhead to the units produced using the predetermined standard overhead rate. The difference between the total overhead cost applied to products and the total overhead cost actually incurred is called an overhead cost variance. It’s defined as: Overhead Cost Variance (OCV) Actual Overhead Incurred (AOI) Standard Overhead Applied (SOA) = – When standard costs are used, the cost accounting system applies overhead to the good units produced using the predetermined standard overhead rate. At period-end, the difference between the total overhead cost applied to products and the total overhead cost actually incurred is called an overhead cost variance (total overhead variance). During May, G-Max produced 3,500 club heads working 3,400 hours. G-Max budgeted for 4,000 units (80%). Actual variable overhead was $3,650 and actual fixed overhead was $4,000. Ex: During May, G-Max produced 3,500 club heads working 3,400 hours. G-Max budgeted for 4,000 units (80%). Actual variable overhead was $3,650 and actual fixed overhead was $4,000. P 3 Atef Abuelaish

Total Overhead Cost Variance
Ex: During May, G-Max produced 3,500 club heads working 3,400 hours. G-Max budgeted for 4,000 units (80%). Actual variable overhead was $3,650 and actual fixed overhead was $4,000. Overhead cost variance (OCV) Actual overhead incurred (AOI) Standard overhead applied (SOA) = – $3,650 + $4,000 3,500 DLH × $2.00 per DLH = – (OCV) When standard costs are used, the cost accounting system applies overhead to the good units produced using the predetermined standard overhead rate. At period-end, the difference between the total overhead cost applied to products and the total overhead cost actually incurred is called an overhead cost variance (total overhead variance). The standard overhead applied is based on the standard number of hours that should have been used, based on the actual production, and the predetermined overhead rate. To illustrate, G-Max produced 3,500 units during the month, which should have used 3,500 direct labor hours. G-Max’s predetermined overhead rate at the predicted capacity level of 4,000 units was $2.00 per direct labor hour, so the standard overhead applied is $7,000 (computed as 3,500 x $2.00). Additional data from cost reports show that the actual overhead cost incurred in the month is $7,650; thus, G-Max’s total overhead variance is $650, computed as $7,650 less $7,000. This variance is unfavorable, as G-Max’s actual overhead was higher than it should have been based on budgeted amounts. To help identify factors causing the overhead cost variance, managers analyze this variance separately for controllable and volume variances. The results provide information useful for taking strategic actions to improve company performance. $7,650 $7,000 = – (OCV) = (unfavorable ) $650 (OCV) To help identify factors causing the overhead cost variance, let’s analyze this variance separately for controllable and volume variances. P 3 Atef Abuelaish

Controllable and Volume Variances
Overhead cost variance (OCV) Actual overhead incurred (AOI) Standard overhead applied (SOA) = – To help identify factors causing the overhead cost variance, managers analyze this variance separately for controllable and volume variances. The controllable variance is the difference between actual overhead costs incurred and the budgeted overhead costs based on a flexible budget. The controllable variance is so named because it refers to activities usually under management control. A volume variance occurs when a difference occurs between the actual volume of production and the standard volume of production. The budgeted fixed overhead amount is the same regardless of the volume of production (within the relevant range). This budgeted amount is computed based on the standard direct labor hours that the budgeted production volume allows. The applied overhead is based, however, on the standard direct labor hours allowed for the actual volume of production, using the flexible budget. When a company operates at a production level different from what it expected, the volume variance will differ from zero. P 3 Atef Abuelaish

Controllable and Volume Variances for G-Max
Overhead Controllable Variance Overhead Volume Variance G-Max’s flexible budget shows budgeted factory overhead of $7,500 at the production volume of 3,500 units during the month. Actual overhead is $7,650. The controllable variance is $150 unfavorable, computed as $7,650 less $7,500. The variance is unfavorable because actual overhead is greater than applied overhead. The volume variance is based solely on fixed overhead. G-Max’s budgeted fixed overhead at the predicted capacity level for the month was $4, Recall from G-Max’s flexible budget that the predetermined fixed overhead at the predicted capacity level of 4,000 units was $1 per hour. The applied fixed overhead is $3,500 (3,500 hours × $1.00 per hour). G-Max’s volume variance is $500 unfavorable, computed as $4,000 less $3,500. The volume variance is unfavorable because the actual level of activity is less than the predicted level of activity. P 3 Atef Abuelaish

NEED-TO-KNOW 8.4 A manufacturing company uses standard costs and reports the information below for January. The company uses machine hours to allocate overhead, and the standard is two machine hours per finished unit. Predicted activity level 1,500 units Variable overhead rate $2.50 per machine hour Fixed overhead budgeted $6,000 per month ($2.00 per machine hour at predicted activity level) Actual activity level 1,800 units Actual overhead costs $15,800 Compute the total overhead cost variance, overhead controllable variance, and overhead volume variance for January. Indicate whether each variance is favorable or unfavorable. Actual Overhead Flexible Budget 1,800 units Standard Cost SQ x SR VOH [(1,800 x 2) x $2.50] + FOH $6,000 (1,800 x 2) x $4.50 $15,800 $15,000 $16,200 $800 Unfavorable $1,200 Favorable Controllable Variance Overhead Volume Variance A manufacturing company uses standard costs and reports the information below for January. The company uses machine hours to allocate overhead, and the standard is two machine hours per finished unit. Compute the total overhead cost variance, overhead controllable variance, and overhead volume variance for January. Indicate whether each variance is favorable or unfavorable. The difference between total actual overhead and the amount of overhead in the flexible budget is the controllable variance. The difference between the flexible budget and the total amount of overhead applied is the overhead volume variance. The actual overhead incurred is $15,800. The flexible budget is the amount that would have been budgeted had they known that they were going to produce 1,800 units rather than the 1,500 units predicted. The flexible budget includes both variable and fixed overhead. Variable overhead is equal to 3,600 standard machine hours (2 machine hours per unit for each of the 1,800 units produced) multiplied by the variable overhead rate of $2.50 per machine hour; a total of $9,000 of variable overhead. Fixed overhead is constant, regardless of the amount of production. Fixed overhead in the flexible budget is $6,000. The total flexible budget for 1,800 units is $15,000. The difference between the flexible budget, $15,000, and the actual costs, $15,800, is an $800 unfavorable controllable variance. Overhead is applied based on the 3,600 machine hours at the total overhead rate of $4.50 per machine hour (the fixed overhead rate of $2.00 per hour plus the variable rate of $2.50 per hour) Work in process is charged for the total standard cost: 3,600 machine hours multiplied by $4.50 per machine hour, $16,200. The difference between the flexible budget, $15,000, and the standard cost, $16,200, is a $1,200 favorable overhead volume variance. Whenever the actual activity level exceeds the predicted activity level, the volume variance is favorable. The total overhead variance is a $400 favorable variance, as total actual costs are $400 less than the total standard cost. $400 Favorable Total Overhead Variance SQ 3,600 MHs (1,800 units x 2 MHs per unit = 3,600 standard hrs. ) SR $4.50 per MH (FOH $ VOH $2.50 = $4.50 per MH) P 3 Atef Abuelaish

Happiness is having all homework up to date
Homework assignment Using Connect – 6 Questions for 60 Points; Chapter 8. Prepare chapter 9 “Performance Measurement and Responsibility Accounting.” Happiness is having all homework up to date Atef Abuelaish

Thank you and See You On Thursday at the Same Time, Take Care
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Global View BMW, uses standard costing and variance analysis concepts.
Material must meet high quality standards, and the company sets quantity standards for each of its machine operations. BMW also sets standards for how much labor time should be used in the assembly of its automobiles and then monitors its employee performance. BMW, a German automobile manufacturer, uses concepts of standard costing and variance analysis. Production begins with huge rolls of steel and aluminum, which are then cut and pressed by large machines in its press shop. Material must meet high standards, and the company also sets standards for each of its machine operations. In the assembly department, highly trained employees complete the assembly of the painted car chassis, often to customer specifications. Again, BMW sets standards for how much labor should be used and monitors its employee performance. The company computes and analyzes materials price and quantity variances and labor rate and efficiency variances and takes action as needed. Atef Abuelaish

Sales Variances Atef Abuelaish

Consider the following sales data from G-Max:
Sales Variances A similar analysis can be applied to sales variances. We will use two additional G-Max products, Excel golf balls and Big Bert drivers, to illustrate. Consider the following sales data from G-Max: We can apply variance concepts to sales as well as costs. To illustrate, we will consider budget and actual sales data from G-Max for two additional products, Excel golf balls and Big Bert drivers. A 1 Atef Abuelaish

Computing Sales Variances for G-Max
First, look at the top part of this screen dealing with Excel golf balls. G-Max actually sold 1,100 golf balls at $10.50 each for a total revenue of $11,550. If 1,100 golf balls had been sold at the budgeted price of $10.00, revenue would have been only $11,000. The difference between $11,550 and $11,000 is the $550 favorable sales price variance for golf balls. G-Max actually sold 1,100 golf balls, 100 more than the budgeted amount of 1,000. Selling 100 more golf balls than originally budgeted resulted in the $1,000 favorable sales volume variance for golf balls. Next, look at the lower part of the screen that deals with Big Bert drivers. G-Max actually sold 140 drivers at $190 each for a total revenue of $26,600. If the 140 drivers had been sold at the budgeted price of $200 each, revenue would have been $28,000. The difference between $26,600 and $28,000 is the $1,400 unfavorable sales price variance for drivers. G-Max actually sold 140 drivers, 10 less than the budgeted amount of Selling 10 less drivers than originally budgeted resulted in the $2,000 unfavorable sales volume variance for drivers. A 1 Atef Abuelaish

(Appendix): Expanded Overhead Variances and Standard Cost Accounting System
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Expanded Overhead Variances and Standard Cost Accounting system
Appendix 8A: Expanded Overhead Variances and Standard Cost Accounting System Similar to analysis of direct materials and direct labor, both the variable and fixed overhead variances can be separately analyzed. A spending variance occurs when management pays an amount different than the standard price to acquire an item. For instance, the actual wage rate paid to indirect labor might be higher than the standard rate. Similarly, actual supervisory salaries might be different than expected. Spending variances such as these cause management to investigate the reasons that the amount paid differs from the standard. Both variable and fixed overhead costs can yield their own spending variances. Analyzing variable overhead includes computing an efficiency variance, which occurs when standard direct labor hours (the allocation base) expected for actual production differ from the actual direct labor hours used. This efficiency variance reflects on the cost effectiveness in using the overhead allocation base (such as direct labor). P 4 Atef Abuelaish

Variable Overhead Variances for G-Max
Spending Variance Efficiency Variance AH × SVR AH × AVR SH × SVR Actual Flexible Budget Applied Variable for Variable Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours When we compare actual hours times actual variable overhead rate to actual hours times the standard variable overhead rate, we get the spending 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. Let’s split the $150 unfavorable variance into spending and efficiency variances. . . AH = Actual Hours of Activity AVR = Actual Variable Overhead Rate SVR = Standard Variable Overhead Rate SH = Standard Hours Allowed P 4 Atef Abuelaish

Recall the G-Max information for May: During May, G-Max produced 3,500 club heads working 3,400 hours. G-Max budgeted for 4,000 units (80%). Actual variable overhead was $3,650 and actual fixed overhead was $4,000. Compute the variable overhead spending and efficiency variances Let’s continue with our G-Max example. Production volume and hours worked are the same as we used for the material and labor analysis. Recall that in our flexible budget information for G-Max, 4,000 units, 80 percent of capacity, was selected as the activity level used to compute the predetermined overhead rate. P 4 Atef Abuelaish

Actual Flexible Budget Applied Variable for Variable Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours AH × AVR 3,400 hrs. x $1.00 3,500 hrs. x $1.00 Spending Variance $250 Unfavorable Efficiency Variance $100 Favorable $3,650 $3,400 $3,500 Actual spending for variable overhead was $3,650. Since the standard variable overhead rate was $1.00 per hour, G-Max should have spent $3,400 for the 3,400 hours worked. The difference between $3,650 and $3,400 is the $250 unfavorable spending variance. G-Max actually worked $3,400; 100 hours less than the standard of 3,500 hours. Working 100 hours less than allowed by the standard for direct labor time resulted in the $100 favorable efficiency variance. P4 Atef Abuelaish

Fixed Overhead Variances for G-Max
Spending Variance Volume Variance AH × SVR AH × AVR SH × SFR Actual Budgeted Applied Fixed Fixed Fixed Overhead Overhead Overhead at (Given) (Flexible Budget) Standard Hours The spending variance for fixed overhead is determined by comparing the fixed overhead actually incurred to the budgeted fixed overhead. The volume variance for fixed overhead is determined by comparing the budgeted fixed overhead to the fixed overhead applied. The applied fixed overhead is the product of the fixed overhead rate times standard hours. Let’s split the $500 unfavorable variance into spending and volume variances. . . SFR = Standard Fixed Overhead Rate SH = Standard Hours Allowed P 4 Atef Abuelaish

Fixed Overhead Variance for G-Max
Recall the G-Max information for May: During May, G-Max produced 3,500 club heads working 3,400 hours. G-Max budgeted for 4,000 units (80%). Actual variable overhead was $3,650 and actual fixed overhead was $4,000. Compute the fixed overhead spending and volume variances. Let’s continue with our G-Max example. Production volume and hours worked are the same as we used for the material and labor analysis. Recall that in our flexible budget information for G-Max, 4,000 units, 80 percent of capacity, was selected as the activity level used to compute the predetermined overhead rate. P 4 Atef Abuelaish

Fixed Overhead Variances for G-Max
AH × SVR AH × AVR 3,500 hrs × $1.00 Actual Budgeted Applied Fixed Fixed Fixed Overhead Overhead Overhead at (Given) (Flexible Budget) Standard Hours Spending Variance $0 Volume Variance $500 Unfavorable $4,000 $3,500 Actual spending for fixed overhead was $4,000. The budget for fixed overhead was also $4,000, so the budget variance is zero. G-Max applied $3,500 of fixed overhead to products using the fixed overhead rate of $1.00 per standard hour. Since the 3,500 standard hours are less than the 4,000 hours used to compute the predetermined overhead rate, G-Max has an unfavorable $500 volume variance. P 4 Atef Abuelaish

Fixed Overhead Cost Variances
$4,000 expected fixed OH $3,500 applied fixed OH { $500 Volume Variance Unfavorable 3,500 units × $1.00 fixed overhead rate Fixed overhead applied to products Take a few minutes and pay particular attention to this graph of fixed overhead relationships where we have plotted fixed overhead costs on the vertical axis and volume on the horizontal axis. The fixed overhead applied line begins at the origin. At a volume of 3,500 units, we have applied $3,500 of fixed overhead costs. Since the original fixed overhead budget was $4,000 at a volume of 4,000, the unfavorable volume variance is $500 as shown on the vertical axis. Volume 3,500 Actual Units 4,000 Expected Units P 4 Atef Abuelaish

Variable and Fixed Overhead Variances
Variable Overhead Spending 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 cost driver. It does not reflect overhead control. Spending Variance Volume Variance Results from paying more or less than expected for fixed overhead items. Results from the inability to operate at the activity level planned for the period. It has no significance for cost control. Fixed Overhead The variable overhead spending variance results from paying more or less than expected for variable overhead items, or from the excessive use of those variable overhead items. The variable overhead efficiency variance is controlled through proper management of the overhead cost driver activity level, direct labor hours for G-Max. The fixed overhead spending variance results from paying more or less than expected for fixed overhead items. The fixed overhead volume variance results from operating at an activity level different from the activity level used to compute the predetermined overhead rate. P 4 Atef Abuelaish

(Appendix): Standard Cost Journal Entries
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Standard Cost Accounting System
Standard cost systems also record costs and variances in accounts. The entries in the next few slides briefly illustrate the important aspects of this process for G-Max’s standard costs and variances for May. Recording G-Max material costs for May In addition to the use of standard costs in management reports, most standard cost systems also record these costs and variances in accounts. This practice simplifies recordkeeping and helps in preparing reports. The entries in this section briefly illustrate the important aspects of this process for G-Max’s standard costs and variances for May. The first of these entries records standard materials cost incurred in May in the Goods in Process Inventory account. This part of the entry is similar to the usual accounting entry, but the amount of the debit equals the standard cost ($35,000) instead of the actual cost ($37,800). The actual cost is recorded with a credit to Raw Materials Inventory. The difference between standard and actual direct materials costs is recorded with debits to two separate materials variance accounts. Both the materials price and quantity variances are recorded as debits because they reflect additional costs higher than the standard cost (if actual costs are less than the standard, they are recorded as credits). This treatment (debit) reflects their unfavorable effect because they represent higher costs and lower income. * Many companies record the materials price variance when materials are purchased. For simplicity, we record both the materials price and quantity variances when materials are issued to production. P 5 Atef Abuelaish

Standard Cost Accounting System
Recording G-Max labor costs for May We record the labor cost by debiting Goods in Process Inventory for the standard labor cost of the goods manufactured during May ($28,000). Actual labor cost ($28,220) is recorded with a credit to the Factory Payroll account. The difference between standard and actual labor costs is explained by two variances. The direct labor rate variance is unfavorable and is debited to that account. The direct labor efficiency variance is favorable and that account is credited. The direct labor efficiency variance is favorable because it represents a lower cost and a higher net income. The difference between standard and actual labor costs is explained by two variances. The direct labor rate variance is unfavorable and is debited to that account. The direct labor efficiency variance is favorable and that account is credited. P 5 Atef Abuelaish

Standard Cost Accounting system
Recording G-Max overhead costs for May To assign the standard predetermined overhead to the cost of goods manufactured, we debit the $7,000 predetermined amount to the Goods in Process Inventory account. Actual overhead costs of $7,650 were debited to Factory Overhead when incurred during the period (entries not shown here). When Factory Overhead is applied to Goods in Process Inventory, the actual amount is credited to the Factory Overhead account. To account for the difference between actual and standard overhead costs, the entry includes a $500 debit to the Volume Variance, a $250 debit to the Variable Overhead Spending Variance, and a $100 credit to the Variable Overhead Efficiency Variance. Recall that the fixed overhead spending variance for May was zero. The balances of the different variance accounts accumulate until the end of the accounting period. As a result, the unfavorable variances of some months can offset the favorable variances of other months. The ending variance account balances, which reflect results of the period’s various transactions and events, are closed at period-end. If the amounts are immaterial, they are added to or subtracted from the balance of the Cost of Goods Sold account. This process is similar to that shown in the job order costing chapter for eliminating an underapplied or overapplied balance in the Factory Overhead account. (Note: These variance balances, which represent differences between actual and standard costs, must be added to or subtracted from the materials, labor, and overhead costs recorded. In this way, the recorded costs equal the actual costs incurred in the period; a company must use actual costs in external financial statements prepared in accordance with generally accepted accounting principles.) When Factory Overhead is applied to Goods in Process Inventory, the actual amount is credited to the Factory Overhead account. To account for the difference between actual and standard overhead costs, the entry includes a $500 debit to the Volume Variance, a $250 debit to the Variable Overhead Spending Variance, and a $100 credit to the Variable Overhead Efficiency Variance. P 5 Atef Abuelaish

NEED-TO-KNOW 8.5 A company uses a standard cost accounting system. Prepare the journal entry to record these direct materials variances: Direct materials cost actually incurred $73,200 Direct materials quantity variance (favorable) 3,800 Direct materials price variance (unfavorable) 1,300 General Journal Debit Credit Work in Process Inventory 75,700 Direct Materials Price Variance 1,300 Direct Materials Quantity Variance 3,800 Raw Materials Inventory 73,200 A company uses a standard cost accounting system. Prepare the journal entry to record these direct materials variances. The journal entry to record the usage of direct materials is a debit to Work in Process Inventory and a credit to Raw Materials. Raw Materials Inventory is credited for the actual materials used $73,200. The direct materials quantity variance is favorable. Favorable variances reduce costs and increase equity and therefore have a normal credit balance. The direct materials price variance is unfavorable. Unfavorable variances increase the costs and decrease equity unfavorable variance is our debits. The total standard cost of direct materials, the debit to Work in Process Inventory is $75,700. P 4 Atef Abuelaish

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