Mowen ch10

Examples of Managerial Accounting
Seventh Edition
Chapter 10
Standard Costing
and Variance
Analysis
© 2019 Cengage. All rights reserved.

Learning Objectives (1 of 2)
1. Explain how unit standards are set, explain why

standard cost systems are adopted, and describe the
purpose of a standard cost sheet
2. Describe the basic concepts underlying variance
analysis, and explain when variances should be
investigated
3. Compute the materials and labor variances, and
explain how they are used for control
4. Compute the overhead variances, and explain how
they are used for control

Learning Objectives (2 of 2)
5. (Appendix 10A) Prepare journal entries for materials

and labor variances

Unit Standards and Basic Concepts of
Standard Costing
• Budgets set standards that are used to control and
evaluate managerial performance
• To determine the unit standard cost for a particular
input, two decisions must be made:
– The quantity decision: The amount of input that should
be used per unit of output
– The pricing decision: The amount that should be paid
per unit of the input to be used

Quantity and Price Standards
• The quantity decision produces quantity standards

• The pricing decision produces price standards
• The unit standard cost can be computed by multiplying
these two standards:
Standard Cost per Unit = Quantity Standard × Price
Standard

How Standards Are Developed (1 of 2)
• Three potential sources of quantitative standards are

as follows:
– Historical experience: Provides an initial guideline for
setting standards, but should be used with caution
because it can perpetuate existing inefficiencies
– Engineering studies: Identifies efficient approaches
and can provide rigorous guidelines, but engineered
standards often are too rigorous

How Standards Are Developed (2 of 2)
• Input from operating personnel: Since operating

personnel are accountable for meeting standards, they
should have significant input in setting standards

Types of Standards (1 of 2)
• Standards are generally classified as either ideal or

currently attainable
– Ideal standards demand maximum efficiency and can
be achieved only if everything operates perfectly
– Currently attainable standards can be achieved under
efficient operating conditions. Allowance is made for
normal breakdowns, interruptions, less than perfect skill,
and so on

Types of Standards (2 of 2)
• Of the two types, currently attainable standards
offer the most behavioral benefits

Why Standard Cost Systems are Adopted
(1 of 2)
• Two reasons for adopting a standard cost system are
frequently mentioned:
– To improve planning and control
 Comparing actual costs with budgeted costs identifies
variances, the difference between the actual and planned
costs for the actual level of activity
 Overall variances can be further broken down into a price
variance or a usage or efficiency variance if unit price
or quantity standards have been developed

Why Standard Cost Systems are Adopted
(2 of 2)
– To facilitate product costing
 Costs are assigned to products using quantity and price
standards for all three manufacturing costs: direct
materials, direct labor, and overhead
• Standard costing and variance analysis for controlling
cost and evaluating performance can have strong
ethical implications

Cost Assignment Approaches
Standard Normal Actual

Costing System Costing System Costing System
Direct materials Standard Actual Actual
Direct labor Standard Actual Actual
Overhead Standard Budgeted Actual

Advantages of Standard Product Costing
• Standard product costing has several advantages over

normal costing and actual costing
– Greater capacity for control
– Provides readily available unit cost information that can
be used for pricing decisions at any time throughout the
period because actual costs do not need to be known
– No unit cost calculations for each equivalent unit
category in process costing
– No need to distinguish between FIFO and weighted
average methods of accounting for beginning inventory
costs

Standard Product Costs
• In manufacturing firms, standard costs are developed

for direct materials, direct labor, and overhead
• Using these costs, the standard cost per unit is
computed
• The standard cost sheet provides the production data
needed to calculate the standard unit cost

The Standard Cost Sheet (1 of 2)
• The standard cost sheet also shows the quantity of

each input that should be used to produce one unit of
output
• A manager should be able to compute the standard
quantity of materials allowed (SQ) and the standard
hours allowed (SH) for the actual output, where:
SQ = Unit Quantity Standard × Actual Output
and
SH = Unit Labor Standard × Actual Output

The Standard Cost Sheet (2 of 2)

Example 10.1: How to Compute Standard
Quantities Allowed (SQ and SH) (1 of 2)
Assume that 100,000 packages of corn chips are
produced during the first week of March. Recall from
Exhibit 10.3 that the unit quantity standard is 18 ounces of
yellow corn per package, and the unit quantity standard
for machine operators is 0.01 hour per package produced.
Required:
How much yellow corn and how many operator hours
should be used for the actual output of 100,000
packages?

Example 10.1: How to Compute Standard
Quantities Allowed (SQ and SH) (2 of 2)
Solution:
Corn allowed:
SQ = Unit Quantity Standard × Actual Output
= 18 × 100,000
= 1,800,000 ounces
Operator hours allowed:
SH = Unit Labor Standard × Actual Output
= 0.01 × 100,000
= 1,000 direct labor hours

Variance Analysis: General Description
(1 of 2)
• Actual input cost can be calculated as:
Actual Cost = AP × AQ
where
AP = Actual Price per Unit
AQ = Actual Quantity of Input Used

(2 of 2)
• It is also possible to calculate the costs that should have
been incurred for the actual level of activity
Planned Cost = SP × SQ
where
SP = Standard Price per Unit
SQ = Standard Quantity of Input Allowed for the Actual
Output

Total Budget Variance (1 of 2)
• The total budget variance is the difference between

the actual cost of the input and its planned cost:
Total Variance = Actual Cost – Planned Cost
= (AP × AQ) – (SP × SQ)

Total Budget Variance (2 of 2)
• Because responsibility for deviations from planned

prices tends to be located in the purchasing or
personnel department and responsibility for deviations
from planned usage of inputs tends to be located in the
production department, it is important to separate the
total variance into price and usage (quantity) variances

Price and Usage Variances (1 of 2)
• For labor, the price variance is usually called a rate
variance
• Price (rate) variance is the difference between the
actual and standard unit price of an input multiplied by
the number of inputs used:
Price Variance = (AP – SP) × AQ
• The usage (quantity) variance is called an efficiency
variance

Price and Usage Variances (2 of 2)
• Usage (efficiency) variance is the difference between

the actual and standard quantity of inputs multiplied by
the standard unit price of the input:
Usage Variance = (AQ – SQ) × SP


Unfavorable and Favorable Variances
• Unfavorable (U) variances occur whenever actual
prices or actual usage of inputs are greater than
standard prices or standard usage
• When the opposite occurs, favorable (F) variances
are obtained
• Favorable and unfavorable variances are not
equivalent to good and bad variances. The terms
merely indicate the relationship of the actual prices (or
quantities) to the standard prices (or quantities)

The Decision to Investigate (1 of 2)
• As a general principle, an investigation should be
undertaken only if the expected benefits are greater
than the expected costs
• Managers determine whether variances are significant,
based on an acceptable range that has top and bottom
measures called control limits
• Because of random variations around the standard,
actual costs rarely equal standard costs

The Decision to Investigate (2 of 2)
• When variances are in an acceptance range of

performance, they are assumed to be caused by
random factors
• The acceptable range is the standard, plus or minus an
allowable deviation
• Control limits are used as a means to tell managers
when variances fall outside an acceptable range and
thus should be investigated so that corrective action
can be taken

Example 10.2: How to Use Control Limits
to Trigger a Variance Investigation (1 of 2)
Standard cost: $100,000; allowable deviation: ±
$10,000. Actual costs for 6 months are:
June $ 97,500 September $102,500

July 105,000 October 107,500
August 95,000 November 112,500
Required:
Plot the actual costs over time against the upper and
lower control limits. Determine when a variance should
be investigated.

Example 10.2: How to Use Control Limits
to Trigger a Variance Investigation (2 of 2)
The control chart reveals that the last variance should be

investigated. The chart also reveals a short-term increasing trend
that suggests the process is moving out of control. A nongraphical
approach is to calculate the difference between the actual cost and
the upper or lower limit and see if it exceeds $10,000.
Here’s How It’s Used: IN YOUR LIFE
(1 of 7)
Kylee Hepworth had just been hired as a tutor by Lisa
Gardner. Kylee was in her last semester of a Masters of
Accounting program. Lisa, on the other hand, was just
beginning her study of accounting and although she had
done very well in the financial accounting course (she had
earned an A), managerial accounting was proving to be
more challenging for her. Yet she was determined to do
well and so had acted on a recommendation of an advisor
to hire a tutor. For her first, lesson, Lisa had asked Kylee
to explain variances in standard costing.

(2 of 7)
Kylee drew the following diagram on the white board
and then explained it as follows:
• “Notice that the length of the rectangle is SP and the

width is SQ. Thus, SP × SQ is the standard cost and
is represented by the area of the rectangle, shaded in
orange.”
(3 of 7)
“Now suppose that actual price of the input is AP and
the actual quantity is AQ, where AP and AQ are both
more than SP and SQ.”
Kylee then drew another diagram and continued with
her explanation.

(4 of 7)
“The area of the large rectangle is AQ × AP, which is the
actual cost of the input and is the sum of the green and
orange areas. The difference between the total actual cost
AQ × AP (green + orange areas) and the orange area is
the green area [(AQ × AP) − (SP × SQ)] and is the total
variance. Lisa, do you have any questions?”
Lisa responded: “Not about the total variance. In this case,
I can see that it is caused by the actual price being more
than the standard price and the actual usage of the input
being more than

(5 of 7)
the amount allowed. But we have to calculate both price
and usage variances. Can you explain those with a
diagram like this?”
“Absolutely, and it involves one more step. Just extend the
SP line all the way over to the AQ axis and it divides the
green area into two pieces: one for the price variance
(colored yellow) and one for the quantity variance (colored
blue). The length of the yellow rectangle is (AP − SP) and
its width is AQ. Thus, the yellow area is the price variance
(PV) and is equal to (AP − SP) × AQ. For the quantity
variance, the length of the blue rectangle is SP and the

(6 of 7)
width is (AQ − SQ); thus, the area is (AQ − SQ) × SP and
that gives the quantity variance.”
“Lisa, in concluding, there are two points I want to make.

First, the sum of the price variance and the quantity
variance is the total variance for the input (yellow + blue
= orange).
(7 of 7)
Second, once you know the price and quantity variance
formulas they are essentially the same for labor and
material inputs. So, in reality, you only have to remember
these two formulas instead of four. I’ll explain this last
point more thoroughly in our next session.”

Variance Analysis: Materials
• The total materials variance can be due to a difference

between actual and planned prices or between actual
and standard quantities or both and is defined as the
difference between the actual cost of materials and the
materials cost allowed for the actual level of activity:
Total Materials Variance = Actual Cost – Planned Cost
= (AP × AQ) – (SP × SQ)

Example 10.3: How to Calculate the
Total Variance for Materials (1 of 2)
Refer to the unit standards from Exhibit 10.3 (p. 526).
The actual results for the first week in March are:
Actual production 48,500 bags of corn chips

Actual cost of corn 780,000 ounces at $0.015 = $11,700
Actual cost of inspection labor 360 hours at $8.35 = $3,006
Required:
Calculate the total variance for corn for the first week in
March.
Total Variance for Materials (2 of 2)
Solution:
Actual Costs Budgeted Costs* Total Variance
AP × AQ SP × SQ (AP × AQ) − (SP × SQ)
Corn $11,700 $8,730 $2,970 U
*The standard quantities for materials and labor are computed

as unit quantity standards from Exhibit 10.3:
Corn: SQ = 18 × 48,500 = 873,000 ounces.
Multiplying these standard quantities by the unit standard
prices given in Exhibit 10.3 produces the budgeted amounts
appearing in this column:
Corn: $0.01 × 873,000 = $8,730
Direct Materials Variances (1 of 2)
• Computing the direct materials price variance (MPV)

and the direct materials usage variance (MUV) tells
managers how much of the total direct materials
variance is due to price and how much is due to usage
• The more detailed information then enables a manager
to exercise better control over this input

Direct Materials Variances (2 of 2)
• The materials price variance is computed by using

the actual quantity of materials purchased, and the
materials usage variance is computed by using the
actual quantity of materials used, calculated as:
MPV = (AP – SP) × AQ
MUV = (AQ – SQ) × SP

Example 10.4: How to Calculate Materials
Variances: Formula and Columnar
Approaches (1 of 3)
Actual Production 48,500 bags of corn chips

Actual cost of corn 780,000 ounces @ $0.015
Required:
Calculate the materials price and usage variances by
using the 3-pronged (columnar) and formula
approaches.
Example 10.4: How to Calculate Materials Variances:
Formula and Columnar Approaches (2 of 3)
Solution:
1. Formulas (recommended approach for materials
variances because materials purchased may differ
from materials used):
MPV = (AP – SP) × AQ
= ($0.015 – $0.01) × 780,000
= $3,900 U
= (780,000 – 873,000) × $0.01
= $930 F

Example 10.4: How to Calculate Materials
Approaches (3 of 3)
2. Columnar (this approach is possible only if the
materials purchased equal materials used):

Materials Price Variance (1 of 2)
• The materials price variance (MPV) measures the

difference between what should have been paid for raw
materials and what was actually paid and is calculated
as:
MPV = (AP × AQ) – (SP × AQ)
– Where
 AP = Actual price per unit
 SP = Standard price per unit
 AQ = Actual quantity of material purchased

Materials Usage Variance (2 of 2)
• The materials usage variance (MUV) measures the

difference between the direct materials actually used
and the direct materials that should have been used for
the actual output
• The formula is:
– Where
 AQ = Actual quantity of materials used
 SQ = Standard quantity of materials allowed for the actual
output
 SP = Standard price per unit

Using Materials Variance Information
• Calculating materials variances is only the first step

• Using the variance information to exercise control is
fundamental to a standard cost system
• Responsibility must be assigned, variance significance
must be assessed, and the variances must be
accounted for and disposed of at the end of the year

Responsibility for the Materials Price
Variance
• The responsibility for controlling the materials price
variance usually belongs to the purchasing agent
• Admittedly, the price of materials is largely beyond the
agent’s control and can have undesirable outcomes
from an evaluation perspective
• Pressure to produce favorable variances may result in
the purchase of materials of lower quality than desired
or excessive inventory purchases in order to get
quantity discounts

Analysis of the Materials Price Variance
(1 of 2)
• The first step in variance analysis is to decide whether
or not the variance is significant
• If so, what is its cause?
• Once the reason is known, corrective action can be
taken if necessary—and if possible
• For example, if high quality materials were purchased
due to a supply shortage of usual materials, no action
is needed. A firm has no control over the supply
shortage; it will simply have to wait until market
conditions improve

Analysis of the Materials Price Variance
(2 of 2)
• If the variance is judged insignificant, no further steps
are needed

Responsibility for the Materials Usage
Variance
• The responsibility for controlling the materials usage
usually belongs to the production manager
• Minimizing scrap, waste, and rework are all ways in
which the manager can ensure that the standard is met
• At times, the cause of the variance is attributable to
others outside of the production area
• Pressure to produce a favorable variance might allow a
defective unit to be transferred to finished goods and
ultimately cause customer relation problems

Analysis of the Materials Usage Variance
• If variance is significant, investigation is needed to find

out the causes for the deviation
• It is important to note that standards are not static
• As improvements in production take place and
conditions change, standards may need to be revised
to reflect the new operating environment
• The importance of evaluating current business
conditions and updating standards to reflect any
changes in these conditions cannot be
overemphasized

Accounting and Disposition of Materials
Variances
• Recognizing the price variance for materials at the
point of purchase also means that the raw materials
inventory is carried at standard cost
• In general, materials variances are not inventoried
• Typically, materials variances are added to cost of
goods sold if unfavorable and are subtracted from cost
of goods sold if favorable

(1 of 6)
Lisa Gardner was meeting for a second time with her tutor,
Kylee Hepworth. In this tutoring session, Lisa wanted help
with the materials and labor variances. Kylee began her
instruction by putting the formulas on the white board and
then made the following statement:
“Lisa, to help you understand how labor and materials
variances work, let me give you an example from my own
life. Recently, Beta Alpha Psi had a bake sale and I
committed to making 5 dozen cupcakes.

(2 of 6)
However, I didn’t have time to do this so I hired my
younger sister to make the cupcakes. I agreed to pay her
$10 per hour for making them. Thus, the standard rate of
labor is $10 per hour (SR = $10.) Following my chosen
recipe, it takes two batches to make 60 cupcakes, and
each batch should take 2 hours of labor from start to finish
(mixing, baking, and frosting the cupcakes). Thus, the
hours allowed or the standard quantity of labor would be 4
hours (SH = 4 hours.)

(3 of 6)
To illustrate the standards for materials, I will only use the
ingredient of butter. I had all the needed ingredients on
hand except for butter. The recipe called for 2 sticks of
butter per batch. Thus, for two batches, the butter allowed
is 4 sticks (SQ = 4.) I gave my sister $4.80 to buy a pound
of butter (buying my preferred brand). Since there are 4
sticks of butter in a pound, the standard price per stick of
butter was $1.20 (SP = $1.20.)
Now we need the actual outcomes. As it turned out, my
sister brought our little brother with her. And just as she
finished

(4 of 6)
mixing the first batch, he reached into the bowl to grab a
lick of the dough and knocked the bowl to the floor,
breaking it and losing all the mix. My sister then had to go
to the store and buy another pound of butter (also costing
$4.80 or $1.20 per stick.) She ended up actually using 6
sticks of butter, 4 from the original package and 2 from the
second package (AQ = 6). Because of having to redo a
batch and make a special trip to the store, the actual time
for producing two good batches was 5.5 hours (AH = 5.5.)

(5 of 6)
I expected to pay $10 per hour for labor and I did. Thus,
LRV = (AR − SR)AH
= ($10 − $10)5.5 = 0
I also expected to pay $1.20 per stick of butter and I did; thus,
MPV = (AP − SP)AQ
= ($1.20 − $1.20)6 = 0
However, I didn’t do so well when it came to the usage of labor
and materials. I expected to pay for 4 hours of work from my
sister but I paid for 5.5 hours; thus, the labor usage (efficiency)
variance for me

(6 of 6)
was $15:
LEV = (AH − SH)SR = (5.5 − 4.0)$10 = $15 U
Similarly for butter, 6 sticks were used instead of 4,costing
me $2.40 more than expected:
MUV = (AQ − SQ)SR
= (6 − 4)$1.20 = $2.40 U
Notice I have labeled these variances unfavorable
because I paid more than I should have.

Total Variance Analysis: Direct Labor
• The total direct labor variance can be due to a difference
between actual and planned wage rates, or between actual
hours worked, or a combination of both. The total labor
variance measures the difference between the actual costs
of labor and the costs allowed for the actual level of activity:
Total Labor Variance = (AR × AH) – (SR × SH)
– Where
 AH = Actual Direct Labor Hours Used
 SH = Standard Hours Allowed
 AR = Actual Hourly Wage Rate
 SR = Standard Hourly Wage Rate

Total Variance for Labor (1 of 2)

Actual cost of inspection labor 360 hours @ $8.35 = $3,006
Required:
Calculate the total labor variance for inspection labor
for the first week in March.

Example 10.5: How to Calculate the Total
Variance for Labor (2 of 2)
Solution:
Actual Costs Budgeted Costs* Total Variance
AR × AH SR × SH (AR × AH) − (SR × SH)
Inspection labor $3,006 $3,880 $874 F
*The standard quantities for inspection labor are computed as

unit quantity standards from Exhibit 10.3:
Labor: SH = 0.01 × 48,500 = 485 hours
Multiplying these standard quantities by the unit standard prices
given in Exhibit 10.3 produces the budgeted amounts
appearing in this column:
Labor: $8.00 × 485 = $3,880
Direct Labor Variances (1 of 2)
• Computing the direct labor rate variance (LRV) and the

direct labor efficiency variance (LEV) tells managers
how much of the total labor variance is due to
differences in wage rates and how much is due to
differences in hours worked
• This more detailed information allows a manager to
exercise better control over the labor input
• Labor hours cannot be purchased and stored for future
use as can be done with materials (i.e., there can be
no difference between the amount of labor purchased
and the amount of labor used)

Direct Labor Variances (2 of 2)
• The labor rate and labor efficiency variances always

will add up to the total labor variance
• The rate (price) and efficiency (usage) variances for
labor can be calculated by using either the columnar
approach or the associated formulas
Total Labor Variance = Labor Rate Variance + Labor
Efficiency Variance

Labor Rate Variance
• The labor rate variance (LRV) computes the

difference between what was paid to direct laborers
and what should have been paid:
LRV = (AR – SR) × AH
– Where
 AR = Actual hourly wage rate
 SR = Standard hourly wage rate
 AH = Actual direct labor hours used

Labor Efficiency Variance
• The labor efficiency variance (LEV) measures the

difference between the labor hours that were actually
used and the labor hours that should have been used:
LEV = (AH – SH) × SR
– Where
 AH = Actual direct labor hours used
 SH = Standard direct labor hours that should have been
used
 SR = Standard hourly wage rate

Example 10.6: How to Calculate Labor
Approaches (1 of 3)

Actual cost of inspection labor 360 hours @ $8.35
Required:
Calculate the labor rate and efficiency variances by using
the 3-pronged (columnar) and formula approaches.

Example 10.6: How to Calculate Labor Variances:
Formula and Columnar Approaches (2 of 3)
Solution:
Formulas:
LRV = (AR – SR) × AH
= ($8.35 – $8.00) × 360
= $126 U
LEV = (AH – SH) × SR
= (360 – 485) × $8.00
= $1,000 F

Example 10.6: How to Calculate Labor
Approaches (3 of 3)

Using Labor Variance Information
• Calculating labor variances initiates the feedback

process
• Using the labor variance information to exercise control
is fundamental
• Responsibility must be assigned, variance significance
must be assessed, and the variances must be
accounted for and disposed of at the end of the year

Responsibility for the Labor Rate Variance
• Labor rates are determined by such external forces as

labor markets and union contracts
• Departures of actual rates from standard rates are rare
and variances are usually due to unexpected overtime
or the use of higher paid employees for less skilled
tasks
• The use of labor is controllable by the production
manager, so responsibility for the labor rate variance
generally is assigned to the individuals who decide how
labor will be used

Here’s How It’s Used: SMALL
MANUFACTURING FIRM (1 of 5)
As plant manager, you have been approached by the
purchasing manager and the production manager and
provided the following input. Kent Bowman, the purchasing
manager, is unhappy with the quality of the electronic
components being purchased. He claims that the quality of
the component from the current supplier makes it
impossible to meet the materials usage standard of 1.05
components per unit produced (one component out of
every hundred must be replaced before a good product is
obtained). Laura Shorts, the purchasing agent, on the other
hand, claims that the current supplier is the only supplier
available that will sell the needed component for $2.00,
which exactly meets the current price standard. There are
two alternative suppliers that sell higher quality
components, but the prices are higher.
To obtain more information, you ask Laura to buy the
component from each of the alternative suppliers, 1 week
at a time. That way, the MPV and MUV can be compared
for all three suppliers. Laura provides the following results
(there are no beginning or

suppliers):
Supplier AP SP AQ SQ* MPV MUV
Current $2.00 $2.00 11,000 10,500 $0 $1,000 U
Alternative 1 $2.05 $2.00 10,500 10,500 $525 U $0
Alternative 2 $2.10 $2.00 10,010 10,500 $1,001 U $980 F
*1.05×10,000.
As plant manager, how would you interpret these results? If

they are expected to continue, what actions would you
take?
There is a definite relationship between the MPV and MUV.
Since the quality of materials purchased can affect the usage
through
rejects and waste, it is important to look at the trade-offs
for the two variances. Relative to the current standard,
higher quality improves the materials usage variance but
causes the materials price variance to deteriorate. Adding
the two together reveals the best outcome for the
company:
Supplier MPV + MUV
Current $1,000 U
Alternative 1 525 U
Alternative 2 21 U

The best outcome is for the Alternative 2 supplier. Thus,
the purchasing manager should be instructed to buy from
this supplier, and the price standard should be changed to
$2.10 and the unit materials standard to 1.001.
Managers often have to consider the perspectives of both
the purchasing and production departments. It’s important
to understand how each department measures success
(MPV versus MUV) in order to make the best decision for
the company.

Responsibility for the Labor Efficiency
Variance (1 of 2)
• Production managers are responsible for the
productive use of direct labor
• As is true of all variances, once the cause is
discovered, responsibility may be assigned elsewhere
• Production managers may be tempted to engage in
dysfunctional behavior if too much emphasis is placed
on the labor efficiency variance

Responsibility for the Labor Efficiency
Variance (2 of 2)
• For example, to avoid losing hours or using additional
hours because of possible rework, a production
manager could deliberately transfer defective units to
finished goods

Analysis of the Labor Efficiency Variance
• If variance is significant, investigation is needed to find

out the causes for such variance
– Based on the findings, corrective actions may be taken,
if necessary

Additional Cost Management Practices
(1 of 2)
• In addition to standard costing, some companies
choose to employ other cost management practices,
such as kaizen costing and target costing to control
production costs
– Kaizen costing focuses on the continuous reduction of
the manufacturing costs of existing products and
processes

Additional Cost Management Practices
(2 of 2)
• Target costing focuses on the reduction of the design
costs of existing and future products and processes
– A target cost is the difference between the sales price
needed to capture a predetermined market share and
the desired per-unit profit:
Target Cost per Unit = Expected Sales Price per Unit –
Desired Profit per Unit

Overhead Analysis
• Total variances for direct materials and direct labor

were broken down into price and efficiency variances
• In a similar way, the total overhead variance, or the
difference between applied and actual overhead, is
also broken down into component variances
• There are several methods of overhead variance
analysis, only the 4-variance method is presented

Variable Overhead Analysis
• First, overhead is divided into fixed and variable

categories Next, two variances are calculated for each
category
– Variable overhead variances
 Variable overhead spending variance
 Variable overhead efficiency variance
– Fixed overhead variances
 Fixed overhead spending variance
 Fixed overhead volume variance

Total Variable Overhead Variance (1 of 2)
• The total variable overhead variance is the difference

between the actual variable overhead and applied
variable overhead
• VOH is applied by using hours allowed in a standard
cost system
Total VOH Variance = Actual VOH – SVOR × SH
• Where
– VOH = Variable Overhead
– SVOR = Standard Variable Overhead Rate

Total Variable Overhead Variance (2 of 2)
• The total variable overhead variance can be divided

into spending and efficiency variances
• Variable overhead spending and efficiency variances
can be calculated by using either the 3-pronged
(columnar) approach or formulas

Variable Overhead Variance (1 of 2)
Assume that Crunchy Chips had the following data for
the first quarter (ending March 31):
Standard variable overhead rate (SVOR) $4.00 per direct labor hour
Actual variable overhead costs (AH) $38,750
Standard hours allowed per unit 0.02 hour
Actual direct labor hours worked (AH) 10,500 hours
Actual production (packages) 500,000 units
Required:
Calculate (1) the standard direct labor hours for actual
production and (2) the total variable overhead variance.
Variable Overhead Variance (2 of 2)
Solution:
1. Standard direct labor hours = 0.02 × 500,000 units
= 10,000 direct labor hours

Variable Overhead Variances
• The total variable overhead variance can be broken

down into the variable overhead spending and
efficiency variances
• These variances give managers a better understanding
of the underlying causes of the overall variance, and
this provides information that allows better control of
variable overhead

Variable Overhead Spending Variance
(1 of 2)
• The Variable overhead spending variance measures
the aggregate effect of differences between the actual
variable overhead and the standard variable overhead
rate (SVOR)
• The formula for computing the variable overhead
spending variance is:
VOH Spending Variance = Actual VOH – (AH × SVOR)

Variable Overhead Spending Variance
(2 of 2)
• VOH is assumed to vary in proportion to changes in the
direct labor hours used
• Measures the change in the actual variable overhead
cost (VOH) that occurs because of efficient (or
inefficient) use of direct labor
• The variable overhead efficiency variance is
computed by using the following formula:
VOH Efficiency Variance = (AH – SH) × SVOR

Example 10.8: How to Calculate Variable
Overhead Spending and Efficiency Variances:
Columnar and Formula Approaches (1 of 3)
Assume that Crunchy Chips had the following data:
Actual variable overhead $38,750
Actual hours worked (AH) 10,500 hours
Number of 16-oz. packages produced 500,000 units
Hours allowed for production (SH) 10,000 hours*
*0.02×500,000.
Required:
Calculate the variable overhead spending and
efficiency variances.
Example 10.8: How to Calculate Variable Overhead
Spending and Efficiency Variances: Columnar and
Formula Approaches (2 of 3)

Example 10.8: How to Calculate Variable Overhead
Spending and Efficiency Variances: Columnar and
Formula Approaches (3 of 3)
Formulas:
a
VOH Spending Variance = Actual VOH – (AH × SVOR)
= $38,750 – (10,500 × $4)
= $3,250 F
b
VOH Efficiency Variance = (AH – SH) × SVOR
= (10,500 – 10,000) × $4.00
= $2,000 U

Comparison: Price Variances of Materials
and Labor
• While the variable overhead spending variance is
similar to the price variances of materials and labor,
there are some conceptual differences
• VOH is not a single input—it is made up of a large
number of individual items
• The standard variable overhead rate represents the
weighted cost per direct labor hour that should be
incurred for all variable overhead items

and Labor (1 of 2)
• The difference between what should have been spent
for actual direct labor hours worked and what actually
was spent is a type of price variance
• One reason that a variable overhead spending
variance can arise is that prices for individual variable
overhead items have increased or decreased

and Labor (2 of 2)
• The second reason for a variable overhead spending
variance is the use of the items that comprise variable
overhead
• Waste or inefficiency in the use of VOH increases the
actual variable overhead cost
• The variable overhead spending variance is the result
of both price and efficiency

Responsibility for the Variable Overhead
Spending Variance (1 of 2)
• Variable overhead items may be affected by several
responsibility centers
• If consumption of VOH can be traced to a responsibility
center, it can be assigned
• Controllability is a prerequisite for assigning
responsibility

Spending Variance (2 of 2)
• Price changes of variable overhead items are
essentially beyond the control of supervisors. If price
changes are small, then the spending variance is
primarily a matter of the efficient use of overhead in
production
• Responsibility for the variable overhead spending
variance is generally assigned to production
departments

Efficiency Variance
• The variable overhead efficiency variance is directly
related to the direct labor efficiency or usage variance
• If variable overhead costs change in proportion to
changes in direct labor hours, then responsibility for the
variable overhead efficiency variance should be
assigned to the individual who has responsibility for the
use of direct labor: the production manager

Performance Report: Variable Overhead
Spending and Efficiency Variances
• Recall that Example 10-8 showed a favorable $3,250
variable overhead spending variance and an unfavorable
$2,000 variable overhead efficiency variance
• The $3,250 F spending variance means that overall
Crunchy Chips spent less than expected on variable
overhead
• The reasons for the $2,000 unfavorable variable
overhead efficiency variance are the same as those
offered for an unfavorable labor usage variance
• Control of VOH requires line-by-line analysis for each
item
Example 10.9: How to Prepare a
Performance Report for the Variable
Overhead Variances (1 of 2)
• Crunchy Chips had the following data for the first quarter
(ending March 31):
Actual costs:
Maintenance $535
Power $170
Actual hours worked (AH) 10,500 hours
Number of packages produced 500,000 units
Variable overhead (VOH):
Maintenance 0.02 hr. @ $2.75
Power 0.02 hr. @ $1.25

Example 10.9: How to Prepare a
Performance Report for the Variable
Overhead Variances (2 of 2)
*0.02×500,000.
Required:
Prepare a performance report that shows the variances on an
item-by-item basis.

Fixed Overhead Analysis
• Fixed overhead costs are capacity costs acquired in

advance of usage
• The fixed overhead rate changes as the underlying
production level changes
• To keep a stable fixed overhead rate throughout the
year, companies often use practical capacity to
determine the number of direct labor hours to use in
the denominator of the fixed overhead rate
Practical Capacity at Standard = SHp

Total Fixed Overhead Variance (1 of 2)
• The total fixed overhead variance is the difference

between actual fixed overhead and applied fixed
overhead
• When applied fixed overhead is obtained by multiplying
the standard fixed overhead rate (SFOR) times the
standard hours allowed for the actual output (SH)
Applied FOH = SH × SFOR

• The total fixed overhead variance is the difference

between the actual fixed overhead and the applied
fixed overhead:
Total FOH Variance = Actual FOH – Applied FOH

Standard fixed overhead rate (SFOR) $15.00 per direct labor hour
Actual FOH $160,000
Standard hours allowed per unit 0.02 hour
Actual production 500,000 units
Required:
Calculate the (1) standard hours for actual units
produced, (2) total applied FOH, and (3) total FOH
variance.

Solution:
1. SH = Actual Units × Standard Hours Allowed per Unit
= 500,000 units × 0.02 hour
= 10,000 hours
2. Applied FOH = SH × SFOR
= 10,000 × $15
= $150,000

Fixed Overhead Variances
• The total fixed overhead variance can be divided into

spending and volume variances
• Spending and volume variances can be calculated by
using either the 3-pronged (columnar) approach or
formulas
• The best approach to use is a matter of preference
• However, the formulas first need to be expressed
specifically for FOH

Fixed Overhead Spending Variance
• The fixed overhead spending variance is defined as

the difference between the actual fixed overhead
(AFOH) and the budgeted fixed overhead (BFOH):
FOH Spending Variance = AFOH – BFOH

Fixed Overhead Volume Variance (1 of 2)
• The fixed overhead volume variance is the difference

between budgeted fixed overhead (BFOH) and applied
fixed overhead:
Volume Variance = Budgeted FOH – Applied FOH
= BFOH – (SH × SFOR)
• The volume variance measures the effect of the actual
output differing from the output used at the beginning
of the year to compute the predetermined standard
fixed overhead rate

Fixed Overhead Volume Variance (2 of 2)
• If you think of the output used to calculate the fixed

overhead rate as the capacity acquired (practical
capacity) and the actual output as the capacity used,
then the volume variance is the cost of unused
capacity

Example 10.11: How to Calculate Fixed
Overhead Variances: Columnar and Formula
Approaches (1 of 3)
Actual fixed overhead (AH) $160,000

Standard fixed overhead rate (SFOR) $15.00 per direct labor hour
Budgeted fixed overhead (BFOH) $157,500
Number of packages produced 500,000 units

Example 10.11: How to Calculate Fixed
Overhead Variances: Columnar and Formula
Approaches (2 of 3)
*0.02×500,000.
Required:
Calculate the fixed overhead spending and volume
variances.

Example 10.11: How to Calculate Fixed Overhead
Variances: Columnar and Formula Approaches (3 of 3)
Formulas:
a
FOH Spending Variance = Actual FOH – BFOH
= $160,000 – $157,500
= $2,500 U
b
FOH Volume Variance = BFOH – Applied FOH
= BFOH – (SH × SFOR)
= $157,500 – (10,000 × $15)
= $157,500 – $150,000
= $7,500 U

Responsibility for the Fixed Overhead
Spending Variance
• Many fixed overhead items—long-run investments for
instance—cannot be changed in the short run
• Fixed overhead costs are often beyond the immediate
control of management
• Many fixed overhead costs are affected primarily by
long-run decisions, and not by changes in production
levels, the budget variance is usually small

Analysis of the Fixed Overhead Spending
Variance
• Because FOH is made up of many individual items, a
line-by-line comparison of budgeted costs with actual
costs provides more information concerning the causes
of the spending variance
• An investigation might reveal that these are due to
issues beyond management control like the weather

Brandt Gardner, the owner-manager of a small firm that
manufactures feed processing equipment and roundhay bailers,
is unhappy with the latest report on financial performance in the
Kansas City, Missouri, plant. The company had recently
installed a standard cost system in the Kansas City plant with
the objective of controlling manufacturing costs. The
performance report for the year ended revealed that the
variances for materials, labor, and variable overhead were all
within the desired ranges, but the fixed overhead spending and
volume variances were both significantly unfavorable. Brandt
wanted an explanation of the

fixed overhead variances and a recommendation for
improving fixed overhead cost performance. The following
is extracted from a memo sent by the controller of the
Kansas City plant:
Spending Variance Analysis Fixed overhead is made up
of both committed and discretionary costs. The committed
costs are fixed in level and span multiple years, and the
actual costs incurred typically correspond to the budgeted
costs. Examples include lease payments, rent,
depreciation, and union contracts.

This year, however, two of these items caused an
unfavorable spending variance. We renewed the lease for
our forklifts and the lease cost was higher than expected.
The largest departure from budget though came from the
new 3-year union contract. The agreed-upon settlement
produced labor costs much higher than anticipated.
Discretionary fixed costs are another matter. The agreed-
upon amounts are short term and can vary more from year
to year. They are primarily salaries paid to line supervisors,
purchasing agents, personnel employees, etc. Interestingly,
the only variance for the discretionary items came

in the purchasing area. This is attributable to the
unexpected resignation of the purchasing department
manager. We had to pay a higher salary for his
replacement. Based on the nature of the variances, I see
no need to take any immediate actions. Perhaps we need
to consider how to develop a stronger negotiating position
for future contract renewals.
Volume Variance Analysis We use practical capacity for
calculating the SFOR. Since practical capacity is the most
we can produce if we operate efficiently, we will usually
have an unfavorable volume variance.

This is shown by expressing the formula in the following way:
Volume Variance = BFOH – SFOH
= (SFOR × SHp) – (SFOR × SH)
= (SHp – SH)SFOR
Since the hours allowed for practical volume (SHp) are always
greater than or equal to the hours allowed for the actual volume
(SH), then the variance is usually unfavorable. The volume
variance is therefore a measure of unused capacity. The large
unfavorable volume variance is because we operated at about

60% of capacity (SH = 0.60SHp.) The solution is to
increase sales and thus increase production. Much of the
unused capacity was caused by a drop in demand
because of drought conditions which depressed
agricultural production and decreased demand for our
product. Once the climate is back to normal, much of the
problem will be reversed.

Responsibility for the Fixed Overhead
Volume Variance
• Volume variance measures capacity utilization which
implies that the general responsibility for this variance
should be assigned to the production department
• A significant volume variance may be due to factors
beyond the control of production

Analysis of the Volume Variance (1 of 2)
• Notice that the volume variance occurs because fixed

overhead is treated as if it were a variable cost
• In reality, fixed costs do not change as activity
changes, as a predetermined fixed overhead rate
allows

Analysis of the Volume Variance (2 of 2)

Appendix 10A: Accounting for Variances
• The accounts containing the variances between

applied standard costs and actual costs are closed,
which allows the amount of actual costs to ultimately
impact the final cost of goods sold number that
appears in the financial statements
• In recording variances, unfavorable variances always
are debits, and favorable variances always are credits

Entries for Direct Materials Variances:
Materials Price Variance
• The entry to record the purchase of materials follows
(assuming an unfavorable MPV and that AQ is
materials purchased):
Materials SP × AQ
Materials Price Variance (AP − SP) × AQ
Accounts Payable AP × AQ

Entries for Direct Materials Variances:
Materials Usage Variance
• The general form for the entry to record the issuance
and usage of materials, assuming a favorable MUV,
is as follows:
Work in Process SP × SQ
Materials Usage Variance (AQ − SQ) × SP
Materials SP × AQ

Entries for Direct Labor Variances (1 of 2)
• Unlike the materials variances, the entry to record
both types of labor variances is made simultaneously
• If we assume an unfavorable labor rate variance and
an unfavorable labor efficiency variance, the
following entry will be made:
Work in Process SR × SH
Labor Efficiency Variance (AH ─ SH) × SR
Labor Rate Variance (AR ─ SR) × AH
Accrued Payroll AR × AH

Entries for Direct Labor Variances (2 of 2)
• Keep in mind that only standard hours and standard

rates are used to assign costs to Work in Process
• Actual prices or quantities are not used

Disposition of Materials and Labor
Variances
• At the end of the year, the variances for materials and
labor usually are closed to Cost of Goods Sold
• If the variances are material, they must be prorated
among various accounts
• Materials variances are prorated on the basis of the
materials balances in each of these accounts and the
labor variances on the basis of the labor balances in
the accounts

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Examples of Managerial Accounting

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1. Explain how unit standards are set, explain why

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5. (Appendix 10A) Prepare journal entries for materials

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• The quantity decision produces quantity standards

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• Three potential sources of quantitative standards are

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• Input from operating personnel: Since operating

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• Standards are generally classified as either ideal or

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Standard Normal Actual

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• Standard product costing has several advantages over

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• In manufacturing firms, standard costs are developed

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• The standard cost sheet also shows the quantity of

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• The total budget variance is the difference between

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• Because responsibility for deviations from planned

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• Usage (efficiency) variance is the difference between

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• When variances are in an acceptance range of

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June $ 97,500 September $102,500

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The control chart reveals that the last variance should be

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• “Notice that the length of the rectangle is SP and the

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“Lisa, in concluding, there are two points I want to make.

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• The total materials variance can be due to a difference

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Actual production 48,500 bags of corn chips

*The standard quantities for materials and labor are computed

• Computing the direct materials price variance (MPV)

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• The materials price variance is computed by using

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Actual Production 48,500 bags of corn chips

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