Note On Variable and Absorption Costing

HBSP Product Number TCG 323
THE CRIMSON PRESS CURRICULUM CENTER

THE CRIMSON GROUP, INC.
Note on Absorption and Variable Costing

In Stage 1 of a cost accounting system, some basic decisions that get made. These include defining a cost
object, determining cost centers, distinguishing between direct and indirect costs, choosing allocation bases for
service center costs, selecting an allocation method, and choosing between process and job order cost systems.
Upon completion of this stage, costs have been allocated from service centers to production centers.
During Stage 2, production center costs must be “attached” to the products (or services) that are worked on
(or delivered by) the organization. In many organizations, but especially in manufacturing ones, attaching costs
to products can be especially tricky. Indeed, some organizations spend considerable effort determining precise
allocation bases to allocate service center costs to production centers, but then use a highly simplistic approach
to attach production center costs to products. As a result, they may be deceived about the accuracy of their
product’s costs.1
This Note addresses Stage 2 of a cost accounting system. In particular, it focuses on some complexities in
cost accounting that arise in manufacturing companies, and introduces some concepts that are useful in both
manufacturing and service organizations, such as standard costs and overhead variance analysis. Both are rela-
tively old but powerful ideas. It also discusses the concept of variable costing, which is a technique that some
organizations use to avoid the complexities associated with manufacturing overhead.
ORGANIZATION OF THE NOTE
The note begins with some terminology that is especially important in manufacturing organizations, and
shows the financial statements that report the results of manufacturing activities. Next, we turn to the computa-
tion of costs in a manufacturing context. This requires understanding the various manufacturing inventories, and
bringing them into the cost accounting context. We look at these ideas in both job order and process systems of
accounting.
We next address the question of overhead, relating it to the allocation bases used in Stage 1. This leads to
the idea of standard costs, which is an important aspect of both cost measurement and control. Next, we take up
absorption costing (sometimes called full costing), a technique used by manufacturing organizations to account
for costs as raw materials move through the production effort to become finished goods. In most situations, ab-
sorption costing requires the use of standard costs, which creates the need to look at the variances between them
and actual production costs. We examine three important variances in overhead costs: volume, efficiency, and
spending.
The note then turns to the topic of variable costing, a technique that removes fixed manufacturing overhead
from the absorption process, treating it as a period cost rather than a product cost. In so doing, it relies on the
distinction between fixed and variable costs. While not permitted by GAAP for external reporting purposes, this
technique frequently is used internally by managers to help them better understand how manufacturing costs are
being incurred. The note compares absorption costing with variable costing, identifies the differences between
the approaches, and discusses the advantages and disadvantages of each. The note’s learning objectives are con-
tained in Exhibit 1.
A FUNCTIONAL CLASSIFICATION OF MANUFACTURING COSTS
In a manufacturing environment, there are several elements that make up the cost of the product. These are
shown in Exhibit 2, and discussed below.
1 A great deal has been written about this problem. These issues are explored more fully in David W. Young, Note on Activity-Based
Costing,Cambridge, The Crimson Press Curriculum Center. That note contains references to the accounting literature on the topic.
TCG 323 • Note on Absorption and Variable Costing 2 of 35
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Exhibit 1. LEARNING OBJECTIVES

Upon completing this note, you should know about:
• The various types of costs that exist in manufacturing settings
• Computing cost of goods manufactured and cost of goods sold with job order and process systems
• Overhead rates, including predetermined overhead rates
• Flexible overhead budgets and the computation of overhead variances
• The managerial uses of overhead variances
• The distinction between absorption costing and variable costing, and the advantages and disadvantages of each
• The cause of a difference between income under absorption costing and variable costing under the same set of manufactur-
ing and selling circumstances
• The reason why there can be an overhead volume variance under absorption costing, but not under variable costing.
• The impact of just-in-time (JIT) manufacturing operations on the differences between absorption and variable costing.
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Exhibit 2. MANUFACTURING COST TERMINOLOGY
CONVERSION
COST
Direct DIRECT Direct
Labor MANUFACTURING Materials
COST
Other
Items FULL
Indirect Indirect
Labor Materials PRODUCTION
INDIRECT COST
MANUFACTURING
COST (OR
MANUFACTURING
OVERHEAD )
Selling
Costs
FULL Ad ministrative
and General
COST Costs
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Direct Manufacturing Costs

Direct manufacturing costs consist of direct labor and direct materials. They are the costs that are traceable
to the product. Direct materials (sometimes called raw materials ) actually become part of the product; exam-
ples are steel, wires, upholstery, and plastic in an automobile. Direct labor comprises the individuals in the work
force who actually lay hands on the product (or on the machines that produce the product). These people mix
the ingredients in an ice cream factory, pour the molds in an extruding plant, tighten the bolts in an automobile
assembly plant, operate the robots in an electric motor manufacturing plant, and so forth.
Indirect Manufacturing Costs
Indirect manufacturing costs (sometimes called “manufacturing overhead”) consist of both labor and mate-
rials, and include all manufacturing costs other than direct costs. Indirect labor comprises a variety of people
who are needed for the operation of a factory, but who ordinarily do not actually produce the product, such as
supervisors, the maintenance crew, schedulers, material handlers, and janitors
Indirect materials comprise two kinds of items: (1) materials needed for the smooth operation of the factory
but that don’t go into the product, such as cleaning solvents, rags, and paper supplies, and (2) items that go into
the finished product but are so small that it is not worth keeping track of them separately, such as grease on ball
bearings, or glue in toys. The decision to include some of these latter items as direct materials is a matter of
judgment, and different companies producing similar products may treat the same items differently.
Other Items. In addition to labor and materials, indirect manufacturing costs typically include equipment
depreciation as well as the cost of a variety of items needed to operate the factory, such as heat, electricity,
maintenance, insurance, and rent. In general, indirect manufacturing costs include both the service center costs
that are allocated to the plant as part of Stage 1 of the full-cost allocation effort, as well as a variety of costs that
are direct costs of the factory but indirect with respect to any given product manufactured in it.
This latter point can be a little tricky. To understand it, consider the case of a plant that manufactures text-
books. The plant is a production center. The textbooks are manufactured in batches of 5,000 to 10,000. With re-
spect to a batch of textbooks, there are two general categories of indirect costs, as the following examples dem-
onstrate.
Example #1. Janitorial services. These are provided to all cost centers (of which the plant is one) by the cleaning department,
which is a service center. The plant is allocated its “fair share” of the cleaning department’s costs. These costs frequently are
called indirect (or overhead) costs of the plant. Once they have been allocated to the plant, a portion of these costs also must be
attached to each batch of books produced. Thus, they are indirect manufacturing costs.
Example #2. The salary of a supervisor in the plant. This is a direct cost of the plant; that is, it is unambiguously associated
with the plant, and was not allocated to the plant from a service center. The salary is an indirect manufacturing cost with re-
spect to any particular batch of books, however. Just as with the janitorial services, we must find a way to attach a portion of
this salary to each batch of books produced.
Conversion Costs
Accountants and managers sometimes use the term conversion cost. This is the cost of transforming raw
materials into a finished product. Conversion costs do not include the cost of the raw materials themselves;
rather, they include direct labor and all indirect manufacturing costs associated with a product.
Full Production Cost
When direct materials are added to conversion costs, the result is the full production cost of a product. Al-
ternatively, full production cost might be thought of as the sum of all direct and indirect costs in the factory. The
two totals are the same.
Selling Costs and Administrative and General Costs
To obtain the cost of the product, accountants add selling costs and administrative and general costs to the
full production cost. Selling costs, as the name suggests, include those costs that the organization incurs to sell
its products, such as advertising, salaries and commissions of the sales force, travel costs of the sales force,
market research activities, and rent and utilities in sales offices.
Less obviously, selling costs also comprise the activities (logistical and otherwise) that are used to get the
product to the customer: These activities include the cost of holding the product in a warehouse until it is
shipped (which includes the rent of the warehouse, shipping and handling clerks, and so forth), as well as the
costs of order processing, shipping, and customer service.
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Everything else is included in administrative and general costs (A&G). Even if there is an interest expense
associated with a loan to nance a speci c piece of equipment in the factory, the expense ordinarily is included
in A&G costs. A&G also includes, the costs of personnel, accounting, legal, staff analysts, and the salary of the
chief executive of cer of the company.
Period and Product Costs
Recall from nancial accounting that costs can be either period or product costs. Product costs are those that
are associated with producing the company’s products: direct materials, direct labor, and manufacturing over-
head (or just overhead, as it frequently is called). Period costs are all other costs, usually selling plus A&G
costs.
This distinction is an important one because product costs are held in inventory until a product is sold,
whereas period costs are expenses of each accounting period; that is, they are not attached to products. The ac-
counting process deals with this distinction as follows:
• The Work in Process Inventory is used to add value to raw materials. Using the terminology discussed
above, it is here that conversion costs are added to the cost of direct materials to obtain full production
cost. In the accounting system, this is done by (a) increasing the work in process inventory for the direct
materials introduced into the manufacturing process, and (b) increasing work in process, rather than an
expense account, for all conversion costs. 2
• When a product has been completed, it moves to the Finished Goods Inventory. The Work In Process
Inventory decreases and the Finished Goods Inventory increases by the product’s full production cost.
• When a product is sold, the Finished Goods Inventory decreases, and Cost of Goods Sold increases by
the product’s full production cost.
• Cost of Goods Sold is an expense account. In accordance with the matching principle, an item’s product
cost becomes part of Cost of Goods Sold when the item is sold,, not before.
If you are unclear about this accounting process, you should review those chapters in a nancial accounting
text that discuss accounting for inventories and cost of goods sold.
Some Terminology Cautions
Terminology in cost accounting can be tricky. Throughout this Note, for example, the terms overhead, and
indirect manufacturing costs mean the same thing. Accountants frequently use other terms in similar ways, such
as apply, allocate, and assign. Many terms such as these tend to be used somewhat interchangeably in manufac-
turing organizations, and one must be careful to deduce the precise meaning either from the context or by ask-
ing.
COMPUTING COST OF GOODS SOLD
A question that arises in the context of preparing an organization’s nancial statements is “How do the ac-
countants obtain the amount of cost of goods sold?” One of the principal tasks of the cost accounting effort is to
compute this amount. To do so, we must know both the number of units of products that were sold and the cost
of each unit. Let’s look at this under two cost accounting scenarios: a job order system and a process system.
Job Order System
A job order system is used when each product is unique, or when products are produced in batches and each
batch is unique. Let’s look at this for Buzzard Woodworks (BW), a company that produces custom-made furni-
ture. Each time BW begins a job, it sets up a job ticket. Its job ticket might look like that shown in Exhibit 3. As
materials are requisitioned for jobs, and as employees work on jobs, the employees record the information, and
the accounting staff enters the appropriate cost information on the job ticket. When the job is complete, the job
ticket shows its cost.
2 This Note does not include the accounting transactions, i.e., the debits and credits, that are associated with the various activities
under discussion. Debits and credits for these activities can be found in most cost accounting textbooks.
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Exhibit 3. JOB TICKET FOR BUZZARD WOODWORKS
BUZZARD WOODWORKS
JOB TICKET
3226 3 Aug 99 24 Aug 99

Job No. ________ Date Begun___________ Date Completed _____________
Desk and bookcase for Sanford residence

Description of Work__________________________________________
Week Materials Direct Labor Overhead Total
3 Aug $550.00 $275.00 $137.50 $962.50
10 Aug 350.00 175.00 525.00
17 Aug 100.00 200.00 100.00 400.00
24 Aug 125.00 62.50 187.50
TOTAL $650.00 $950.00 $475.00 $2,075.00

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Overhead. While the direct material and direct labor costs on the job ticket are pretty clear, the overhead may
be less so.
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Problem: Spend a few minutes now looking at the job ticket. How was overhead calculated? Write your answer below before
reading further.
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Answer: Overhead is 50 percent of the direct labor amount charged.
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While it is relatively easy in situations such as this to gure out how overhead was calculated, it is much
more dif cult to determine why it was calculated in this way. There are several aspects to the answer to the why
question. We will return to these later in the Note.
Process System
A process system typically is used when there is continuous production, or when all units produced are
identical, such that it is not necessary to identify the costs associated with any speci c product or batch of prod-
ucts. Oil re neries are perhaps the classic example of a process system, but most factories with assembly lines
also use a process system. A company that produces only one product in a particular plant, such as, say, a vac-
uum cleaner, would use a process system.
The dividing line between process and job order systems sometimes is fuzzy, and companies can be found
with systems that contain elements of both. In most instances, the choice depends on the size of the batch. When
production runs are long, such as in a bottling plant, it does not matter that different runs produce different types
of bottles. Each run is a separate process.
One also can imagine a company manufacturing, say, circuit boards. It would be rather foolish to attach a
job ticket to each circuit board since the actions of each worker in the manufacturing process are the same for
any given board. If the batch of boards were small, say 100 or so, however, we might attach a ticket to the
batch, and use a job order system. But if the batch were several thousand, we would simply keep track of the
total amount of time spent during the period when the units were manufactured.
Unit Costs
With either a job order or a process system, the computation of unit costs is relatively easy. We add up the
total costs and the number of units, and then divide the two. In a job order system such as that shown above for
Buzzard Woodworks, where only one unit (the desk and bookcase) is involved, we don’t even need to divide. If
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a job order system is used for batches of products, such as a batch of 5,000 textbooks, and the job ticket shows
that the batch cost $125,000, it is a relatively simple matter to divide the two items and determine that each
textbook cost $25 to manufacture.
Equivalent Units. A complexity in calculating unit costs arises in a process system when units are still in
process at the end of an accounting period. Imagine, for example, shutting down a production line manufactur-
ing vacuum cleaners at the end of the last day of the accounting period. Some units might be 50 percent com-
plete, others only 10 percent complete, and others 90 percent complete. To calculate a unit cost, the accountants
need to know how many units were involved in the production effort that generated a certain level of costs.
To make this determination, they use the concept of equivalent units. The details of the method are covered
in cost accounting texts, but essentially entail of adding percentages of completion. Thus, if 10 units are in a
stage of production where they are approximately 20 percent complete, this is the equivalent to having two units
fully completed. Of course, the accountants also must deduct the equivalent unit amount as of the beginning of
the accounting period, since some of the units that were completed during the period were partially completed at
the beginning.
In this manner, the accountants are able to determine how many equivalent units were produced during the
accounting period. The process becomes somewhat more complicated when several different departments work
on a single product, when raw material and other inventory costs are changing due to changing prices, or when
there are other complexities. But this is the essence of the approach.
Inventory Cost and Cost of Goods Sold
Once we know the unit cost of an item that has been produced, or the average unit cost of each batch of
items, that amount stays with the unit until it is sold. Thus, if we wish to know the cost of our inventory, we
simply need to count the number of units in it and multiply by the unit cost. Sometimes this requires speci c
identi cation of items in the inventory, such that each unit has its own unit cost. This would happen if the units
were large and unique, such as the desk and bookcase in Buzzard Woodworks. Sometimes the unit cost is an
average for a batch. In a process system, it would be an average per unit, such as a cost per gallon in a paint
manufacturing factory.
When items are sold, the accounting staff determines which ones were removed from inventory. It multi-
plies this total by price to determine revenue, and by unit cost to calculate cost of goods sold.
Financial Statements
An expanded version of the income statement frequently is used in a manufacturing organization. The prin-
cipal characteristic of this statement is that it incorporates a computation of the cost of good manufactured as
well as the cost of goods sold. As the term suggests, the cost of goods manufactured is the cost of all items
manufactured during the accounting period, regardless of whether they were sold.
Exhibit 4 contains a sample statement of the cost of goods manufactured. Exhibit 5 shows how the cost of
goods manufactured would be included on an income statement using a “functional classi cation.”
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Exhibit 4. STATEMENT OF COST OF GOODS MANUFACTURED
For the Quarter Ended March 31, 1997
Direct materials:
Beginning balance of raw materials inventory $700,000
Plus: Purchases 1,200,000
Equals: Raw materials available $1,900,000
Less: Ending balance of raw materials inventory 500,000
Equals: Direct materials used $1,400,000
Direct labor 2,300,000
Manufacturing Overhead:
Indirect labor 300,000
Depreciation 800,000
Supplies and materials 100,000
Rent and utilities 200,000
Maintenance and repair 400,000
Taxes 50,000 1,850,000
Total Manufacturing Costs this Period $5,550,000
Plus: Beginning balance of work in process inventory 850,000
Equals: Total manufacturing costs this plus prior periods $6,400,000
Less: Ending balance of work in process inventory 650,000
Cost of Goods Manufactured $5,750,000
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Exhibit 5 INCOME STATEMENT: FUNCTIONAL CLASSIFICATION

For the Quarter Ended 31 March 1997
Sales revenue $8,900,000
Less: Cost of goods sold:
Beginning balance of finished goods inventory $200,000
Plus: Cost of goods manufactured 5,750,000
Equals: Goods available for sale $5,950,000
Less: Ending balance of finished goods inventory 300,000
Equals: Cost of goods sold 5,650,000
Gross margin $3,250,000
Less: Non-manufacturing expenses
Selling expenses 1,200,000
Administration and general 900,000 2,100,000
Operating income $1,150,000
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Problem: In an economy with stable prices, do you think cost of goods manufactured is bigger or smaller than cost of goods
sold? Write out your answer and reasoning below before continuing. Careful: this is a little tricky.
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Answer: It could be either, depending upon whether the company is building or reducing inventories. If the company is build-
ing inventories, more will be manufactured than sold; therefore cost of goods manufactured will be bigger. If the company is
reducing inventories, more will be sold than manufactured; therefore cost of goods manufactured will be smaller. Of course, if
production and sales are more or less equal, the two cost amounts will be about the same.
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Problem: Curtainworks produces custom made curtains and drapes. Its direct materials consist of fabric that it purchases by
the yard. Unless a special order is received, the company always uses the same quality fabric, which costs $5.00 per yard. Cur-
tainworks had the following items in its inventories at the beginning of April:

Inventory No. of Units Unit Cost Total Cost
Direct Materials 1,000 $5 $5,000
Work in Process 0 0
Finished Goods 1 $2,000 2,000
Total $7,000
During April, the company (a) purchased an additional 2,000 yards of fabric at $5 per yard, (b) sold for $3,000 the item that
was in finished goods inventory, and (c) worked on the following three jobs:

Job Direct Material Direct Labor Overhead Total Sales Price*
#1 $500 $1,200 $500 $2,200 $3,300
#2 800 1,500 800 3,100 4,650
#3 1,000 2,000 1,000 4,000 6,000

* Or, with Job #3, the price quoted to the customer.
Jobs #1 and #2 were sold. Job #3 remained in finished goods inventory at the end of April.
For the month of April, prepare a Statement of Cost of Goods Manufactured, and an Income Statement (functional classifi-
cation) through the gross margin line. What kind of a cost system do you think Curtainworks uses? How does it attach over-
head to jobs?
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Curtainworks. Statement of Cost of Goods Manufactured

Direct materials:
Beginning balance of direct materials inventory
Plus: Purchases
Equals: Raw materials available
Less: Ending balance of direct materials inventory
Equals: Direct materials used
Direct labor
Manufacturing Overhead:
Total Manufacturing Costs this Period
Plus: Beginning balance of work in process inventory
Equals: Total manufacturing costs this plus prior periods
Less: Ending balance of work in process inventory
Cost of Goods Manufactured
Curtainworks. Income Statement: Functional Classi cation
Sales revenue
Beginning balance of nished goods inventory
Plus: Cost of goods manufactured
Equals: Goods available for sale
Less: Ending balance of nished goods inventory
Equals: Cost of goods sold
Gross margin
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Answer: The statements for Curtainworks would look as follows (with information sources shown in parentheses):
Curtainworks. Statement of Cost of Goods Manufactured

Direct materials:
Beginning balance of raw materials inventory (Given) $5,000
Plus: Purchases (2000 yards @ $5) 10,000
Equals: Raw materials available $15,000
Less: Ending balance of raw materials inventory* 12,700
Equals: Direct materials used $2,300
Direct labor 4,700
Manufacturing Overhead: 2,300
Total Manufacturing Costs this Period $9,300
Plus: Beginning balance of work in process inventory 0
Equals: Total manufacturing costs this plus prior periods $9,300
Less: Ending balance of work in process inventory 0
Cost of Goods Manufactured $9,300
* Since we keep track of each job individually, we can make the following computation: BB + Purchases - Uses = EB, or
$5,000 + $10,000 - ($500 + $800 + $1,000) = $12,700. A physical count of the inventory might help to ascertain whether
there had been any shrinkage.
Curtainworks. Income Statement: Functional Classi cation

Sales revenue ($3,000 + $3,300 + $4,650) $10,950
Beginning balance of nished goods inventory (Given) $2,000
Plus: Cost of goods manufactured (From above) 9,300
Equals: Goods available for sale $11,300
Less: Ending balance of nished goods inventory # 4,000
Equals: Cost of goods sold (i.e., $2,000 + $2,200 + $3,100) 7,300
Gross margin $ 3,650
# Reconciles to $4,000 unsold order
Cost System. Since it treats each job separately, Curtainworks appears to use a job order system.
Assignment of Overhead. Curtainworks assigns $1 of overhead to a job for every $1 of direct materials used on that job.
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THE OVERHEAD RATE

In the Woodworks example, overhead was attached to jobs at a rate of $.50 for every $1.00 of direct labor.
In Curtainworks, the rate was $1.00 per $1.00 of raw materials. While it may appear that these are a pretty sim-
plistic approaches to overhead attachment, the determination of these rates is anything but simple.
To understand the complications associated with determining an overhead rate, recall that in Stage 1, con-
siderable time is spent determining allocation bases, which are means to distribute service center costs to pro-
duction centers. Recall, also, that the cost accounting effort does not stop once service center costs have been
allocated to production centers. At that point, we begin the second stage of the cost accounting effort, during
which manufacturing overhead costs are attached (or assigned) to products (or jobs) that pass through each pro-
duction center. To do this, we need a rate. We also could use several rates. In this Note, however, we will stay
with only one rate.
To understand the difficulty in determining the overhead rate, assume that Curtainworks is a production
center in a large company, and that $10,000 of the company’s service center costs have been allocated to it. Cur-
tainworks also has $20,000 in indirect manufacturing costs, i.e., costs that, while direct for the department, are
indirect for the jobs it works on. Together, these two categories of costs comprise its manufacturing overhead.
Curtainworks now must find a way to attach a portion of this manufacturing overhead to individual jobs,
such as Job #2. In the above example, the company chose to do so by using the rate of $1 of overhead for every
$1 of raw materials. The questions we must answer are (1) why did it choose raw materials as the basis? and (2)
how did it make the computation?
The Basis
With regard to the first question, just as it was important to select appropriate bases to allocate service cen-
ter costs to production centers, it also is important to use an appropriate basis to attach a production center’s
manufacturing overhead to its products. Here, as with allocation of service center costs, we are seeking a good
cause and effect relationship. That is, we are attempting to answer the question “What activity in the department
drives the use of the department’s manufacturing overhead?
In most instances, this is a quite difficult question to answer. Woodworks said it was direct labor; Curtain-
works said raw materials. Other departments, particularly ones that are capital intensive, might use machine
hours. Still others might use direct labor hours (as opposed to direct labor dollars). If management decides to
use only one basis per production center for attaching overhead to products, it must exercise considerable judg-
ment in selecting the one that measures cause and effect as accurately as possible.
An activity-based costing (ABC) system uses multiple bases. For the moment, it is worth noting that a de-
partment manager could expand the number of bases by dividing the department into several cost centers, each
of which would have its own basis. The goal in this part of the process is to have the activities in each cost cen-
ter as homogeneous as possible. When this is the case, the allocation basis usually is a better indicator of the use
of overhead than when the cost center’s activities are heterogeneous.
The Computation
Once we have selected the basis, and have the total amount of overhead to be attached, we then must deter-
mine the amount in the denominator of the ratio. That is, in the Curtainworks example, we know the numerator
is $30,000, and we know the basis is dollars of raw materials used. Thus, to compute the rate we need to know
how many total dollars of raw materials were used during the year. Since the rate Curtainworks used was $1 of
overhead for every $1 of raw materials, the company must have used $30,000 of raw materials during the year.
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Problem. Assume the machining department in a company is highly capital intensive, and that it has $100,000 in manufacturing
overhead. The department has had 10,000 direct labor hours for a total cost of $80,000, $5,000 of raw material costs, and 20,000
machine hours. How would you attach the $100,000 of overhead to the products worked on by the department? Specify the basis
you would use, and compute the rate.
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Answer: Since the department is highly capital intensive, it probably makes sense to attach overhead on the basis of machine
hours. With $100,000 in overhead and 20,000 machine hours, the overhead rate is $5.00 ($100,000 ÷ 20,000) per machine
hour. Thus, for every hour a product spends on a machine, it receives $5 of overhead.
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Predetermined Overhead Rates

The above process works when we can wait until the end of the accounting period to calculate overhead
rates and attach overhead to products. There are two reasons why we ordinarily do not want to do this, however.
First, we would need to compute overhead rates every time we wanted to prepare a set of nancial statements.
Although spreadsheet and other software packages have greatly simpli ed this task compared to, say, ten or f-
teen years ago, the effort nevertheless is time-consuming and costly in many organizations.
Second, when overhead rates are computed on a monthly or quarterly basis, they tend to have seasonal
variations embedded in them. When products are manufactured in the winter, for example, they will have the
cost of heating included in the computation; those manufactured in summer will have the cost of air condition-
ing; and those manufactured in the spring and fall will have little of either. Ideally, of course, each product will
bear its fair share of the overhead incurred at the time of its manufacture. But when managers are attempting to
analyze the relative pro tability of certain products or product lines, the inclusion of overhead costs that vary
because of seasonality can make the analysis unnecessarily complicated.
The problem of seasonal changes in overhead rates can be especially troublesome for a company using a
process system. In a company manufacturing, say, oppy disks for microcomputers, there no doubt would be
some reluctance by managers to accept the idea that disks manufactured in the summer or winter cost more than
those manufactured in the spring or fall, even though this technically is true. Some managers faced with cost
cutting mandates might be tempted to adjust production so it peaked in the spring and fall, and was minimal in
the summer and winter. This could create a variety of problems with nished goods inventory storage costs, de-
livery schedules, and customer satisfaction.
For reasons of time, cost, and comparability, therefore, many companies do not use actual overhead rates to
attach overhead costs to products. Instead, they use predetermined overhead rates, which are overhead rates set
as part of a budget. Although predetermined overhead rates have some problems, most companies feel that their
advantages outweigh their disadvantages.
Advantages of Predetermined Overhead Rates. The main advantage of a predetermined overhead rate is
its ease of use. Overhead can be attached to products without the need to undertake a cost allocation effort. Fi-
nancial statements showing the cost of goods manufactured and gross margin can be prepared relatively quickly.
This is important if managers are asked to use nancial information as a basis for exercising cost control. Fi-
nally, companies that use a cost-plus basis for pricing (such as specialty machine shops, made-to-order manu-
facturers, and building contractors), need a way to include overhead costs in a bid; predetermined overhead
rates allow this.
Disadvantages of Predetermined Overhead Rates. The main disadvantage of a predetermined overhead
rate is its possible lack of accuracy. Because the numerator (a department’s overhead) and the denominator (the
actual number of, say, machine hours) can both vary from predetermined levels, the rate will not provide man-
agement with a completely accurate measure of the amount of overhead actually used by a product. To under-
stand why this is true, consider the following problem.
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Problem. Computex, a division of a large company, manufactures wristwatches that feature small computers. Computex’s ex-
pected and actual production plans, as well as its expected and actual overhead costs, for a year were as shown on below.
Review the information carefully. Which number is the predetermined overhead rate? Circle the appropriate number below
before reading further. What is the rationale for your choice?
Number Machine Total Overhead Overhead

of Units Hours per Machine Per Machine Per Watch
Produced Watch Hours Overhead (#) Hour Produced
Column No.(*) 1 2 3=1*2 4 5=4 ÷ 3 6=5*2
Expected 5,000 2.0 10,000 $50,000 $5.00 $10.00
Actual 3,000 2.5 7,500 $41,250 $5.50 $13.75
* For reference purposes. For example, Column 3 is Column 1 multiplied by Column 2.
# As discussed earlier, overhead consists of allocated service center costs, plus indirect labor, indirect materials, and items such as
depreciation in a particular production center.
Your rationale:
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Answer: The predetermined overhead rate is the $5.00 in column 5. It is based on the expected overhead amount in column 4 and
the expected number of machine hours in column 3. Note that the predetermined overhead rate is per machine hour, not per unit of
production (a watch in this instance).
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This is usually the case. That is, the overhead rate is based on inputs to the production process rather than its
outputs. The reason for this is that the inputs, not the outputs, drive the costs. The tricky part, of course, is de-
termining which inputs drive which costs.
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Problem: Given the predetermined overhead of $5.00, how much overhead do you think was attached to products? Write your
answer below before reading further. Careful; this is a little tricky.
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Answer: The amount of overhead attached to products was $30,000 (3,000 watches x 2 machine hours per watch (i.e., the stan-
dard number of machine hours per watch) x $5.00 per machine hour). This compares with actual overhead of $41,250, $11,250
higher than expected.
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Problem. Why was attached overhead not equal to actual overhead? Write your answer below before continuing.
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Answer: attached overhead (or applied, or absorbed overhead—the terms are used interchangeably) is not equal to actual over-
head because two numbers differed from what was expected: (1) the number of machine hours and (2) the actual overhead
amount. Note that the number of machine hours we used in the computation was based on the standard of two hours per watch.
Thus, the attached overhead was based on the number of machine hours at standard for the actual number of watches manufac-
tured. We will see later how to deal with the different number of machine hours used per watch manufactured.
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Some people consider this difference between attached and actual overhead to be a disadvantage of prede-
termined overhead rates. They reason that such a difference does not exist in a system without predetermined
rates. It thus adds an unnecessary complication to the accounting effort. However, as we will see below, a prede-
termined overhead rate, coupled with some additional analytical techniques, can produce useful information for
management.
OVERHEAD VARIANCES
The $11,250 difference discussed above between actual overhead and the overhead attached to products is
an important gure for Computex’s managers, especially if they are concerned about controlling manufacturing
costs. Analyzing the causes of this difference is a little tricky. The analysis rests on two new concepts: a exible
overhead budget and variance analysis. Let’s look at each brie y.
Flexible Overhead Budgets
The allocation of service center costs to production centers can be a relatively complicated process, espe-
cially in selecting homogeneous cost centers and determining appropriate bases of allocation. Once that effort
has been completed, all costs reside in production centers. They then must be attached to products. It is rela-
tively easy to do so with direct costs, but indirect costs (or manufacturing overhead) present some complica-
tions.
____________________________________________________________________________________________________________
As discussed earlier, many companies tend to use a single basis of allocation to attach a production center’s
manufacturing overhead to its products. Let’s look at how such a process works. Imagine that Computex ex-
pected its $50,000 in annual manufacturing overhead costs to be classified as follows:
Service center Basis of Allocation Amount
Cleaning Square feet $2,000
Utilities Machine hours 1,000
Property taxes Square feet 500
Insurance Book value of assets 200
Rent Square feet 1,500
Department indirect costs
Indirect materials 3,000
Indirect labor (part-time employees) 14,000
Supervision 20,000
Maintenance and repairs 1,600
Equipment depreciation 6,200
Total $50,000
Note that the second category on this list (department indirect costs) actually consists of costs that are direct for
the department as a whole, but indirect with regard to a watch that is produced in the department.
As we saw above, to attach these costs to watches, Computex divided the $50,000 by the estimated number
of machine hours to obtain a predetermined overhead rate. Recall that actual overhead for the year was $41,250.
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Problem: What are some of the possible reasons why actual overhead fell to $41,250. Write your answer below before continu-
ing. Assume that the allocation bases for service center costs were as expected for the year.
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Answer: There are four broad reasons why these costs may have fallen: (1) service centers spent less so that the amount allo-
cated to the production center was less, (2) Although the cost of utilities did not fall, the production center received a lower
allocation from the utilities service center because its number of machine hours (the basis of allocation) fell during the year, (3)
the production center may have had lower costs for items such as indirect materials and indirect labor as a result of having
fewer machine hours, and (4) the production center could have saved costs in maintenance and repair, indirect labor, supervi-
sion, and so forth, not as a result of fewer machine hours, but simply because of increased efficiency.
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If they are to control overhead costs, Computex’s managers need to be able to identify the costs that are as-
sociated with changes in volume of activity (here, the number of watches produced) as contrasted with changes
in spending or efficiency. The flexible overhead budget helps in this effort. It works as follows:
Identify Fixed/Variable Cost Splits. For each line, we identify the fixed and variable components, result-
ing in a cost formula. For the above costs, the formulas might look as follows:
Variable Cost per Total Cost for
Fixed Cost Machine Hour 10.000 machine hours
Service center allocations Basis of Allocation
Cleaning Square feet $2,000 -- $2,000
Utilities Machine hours 300 $ .07 1,000
Property taxes Square feet 500 -- 500
Insurance Book value of assets 200 -- 200
Rent Square feet 1,500 -- 1,500
Department direct costs that are indirect to products
Non-product materials (e.g. cleaning solvents) 0 .30 3,000
Non-product labor (part-time employees) 5,000 .90 14,000
Supervision 20,000 -- 20,000
Maintenance and repairs 1,000 .06 1,600
Equipment depreciation 6,200 -- 6,200
Total $36,700 1.33 $50,000
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We can now say that manufacturing overhead is computed according to the formula: $36,700 + 1.33x,
where x is the number of machine hours.
Flex the Budget with Actual Production Levels. When actual production is known, we adjust the original
budget using the cost formula. Thus, if our actual production is 3,000 watches, as it was above, our total over-
head should be
$36,700 + [1.33 x (3,000 x 2)] = $44,680
Note that, since each watch should use two machine hours, we multiplied the 3,000 watches by 2 to obtain
the standard (or expected) number of machine hours.
Compute the Overhead Volume Variance. The overhead volume variance can be determined by subtract-
ing the flexed budget from the amount of overhead attached to products using the predetermined overhead rate
(which is known as applied manufacturing overhead).
The applied manufacturing overhead computation is pretty straightforward. We did this earlier by multiply-
ing 6,000 standard machine hours (3,000 watches x 2 hours per watch) by the predetermined overhead rate, as
follows:
6,000 x $5.00 = $30,000
The budget based on standard hours is $44,680, as calculated above. The difference between the two is the
overhead volume variance, or $30,000 - $44,680 = ($14,680). It is caused by the change in volume (expected to
actual), holding everything else constant (variable costs per machine hour, machine hours per watch, and fixed
costs).
In this situation, all else equal, the decline in volume had a negative effect on profit of $14,680. In general,
we will use parentheses to indicate a situation where the impact on profit is negative. This is sometimes called a
negative or unfavorable variance.
Distinguish Between Volume and Budget Variances. The flexed budget tells us how much overhead we
should have had given our actual volume of production. The difference between this number and actual over-
head is called the overhead budget (or, sometimes, the controllable ) variance. It consists of two parts: (1) an
efficiency variance, which is based on the actual versus expected number of machine hours used per watch, and
(2) a spending variance, which is the actual versus the expected cost per machine hour. Let’s look at these dif-
ferences.
Overhead Efficiency Variance. The overhead efficiency variance isolates the effect of using more (or fewer)
machine hours per unit of output than budgeted. It is a result of the difference between the budget based on
standard machine hours and the budget based on actual machine hours.
The budget based on actual hours is $36,700 + [1.33 x (7,500)] = $46,675
The difference is $44,680 - $46,675 = ($1,995)
Overhead Spending Variance. The overhead spending variance is calculated by subtracting the actual
amount spent from the budget based on actual hours, as follows: $46,675 - $41,250 = $5,425
That is, at the actual number of machine hours, our overhead should have been $46,675, but we spent only
$41,250. The result was a positive effect on profits.
The sum of these three variances is the total variance $(14,680) + ($1,995) + $5,425 = ($11,250). That is,
actual overhead was $11,250 higher than the amount that was attached to products. These computations are
shown in Exhibit 6.
____________________________________________________________________________________________________________
Exhibit 6. SUMMARY OF MANUFACTURING OVERHEAD (MOH)

VARIANCE COMPUTATIONS FOR COMPUTEX COMPANY
BUDGETED MOH BUDGETED MOH APPLIED
ACTUAL BASED ON BASED ON (OR ABSORBED)
MOH ACTUAL HOURS STANDARD HOURS MOH
$36,700 + ($1.33 x 7,500) $36,700 + ($1.33 x 6,000) $5.00 x 6,000
$41,250 $46,675 $44,680 $30,000
| Spending Variance | | Ef ciency Variance | | Volume Variance |

$46,675 - $41,250 $44,680 - $46,675 $30,000 - $44,680
$5,425 ($1,995) ($14,680)
| Budget Variance |
$5,425 + ($1,995)
$3,430
or
| Budget Variance |
$44,680 - $41,250
$3,430
| Total Variance |
$3,430 + ($14,680)
($11,250)
or
| Total Variance |
$30,000 - $41,250
($11,250)
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You should spend a few minutes reviewing Exhibit 6. Note that all variance computations begin with the
number on the right (the budget) and subtract the number on the left (where actual experience is introduced)
from it. For example, the total variance is the Applied MOH minus Actual MOH. (This does not happen, of
course, when two variances are summed.) In particular, note the following:
• Spending Variance. If the manufacturing manager spends less on manufacturing overhead than the exible
budget based on actual hours calls for, as is the case here, the result is a positive spending variance. That is,
actual manufacturing overhead (Actual MOH) is less than Budgeted MOH Based on Actual Hours.
• Ef ciency Variance. If the budget based on actual hours is greater than the budget based on standard hours,
as is the case here, there is a negative ef ciency variance. That is, the production effort was less ef cient
(more machine hours per unit of output) than anticipated.
• Budget Variance. The total of the spending and ef ciency variances is the budget variance.
• Volume Variance. If the volume of output is below expectations, as is the case here, less will be applied via
the predetermined overhead rate than the budget based on standard hours calls for. Since, other things equal,
the company would like to produce the volume that it expected to produce, the result is a negative volume
variance. 3 That is, the Budget Based on Standard Hours is greater than applied manufacturing overhead
(Applied MOH).
Calculation Steps
Understanding the various pieces at work in these computations is tricky. For some people, the computa-
tions are aided by thinking of them as a sequence of steps. The entire process of developing a predetermined
overhead rate, applying it to production, computing the exible budget, and calculating the variances can be
thought of in terms of eleven steps, as follows:
1. Using xed and variable breakdowns, calculate total expected costs based on the expected volume of
output. Be sure to specify the standard input hours (e.g. machine hours) per unit of output.
3 Mathematically, the negative volume variance is because some xed costs ($36,700 in this example) were not absorbed into prod-
ucts via the overhead rate. This was because actual volume was below budgeted volume. We return to this point later in the Note.
____________________________________________________________________________________________________________
2. Divide total expected costs by expected input hours to obtain the Predetermined Manufacturing Over-
head (MOH) rate.
3. Once the actual volume of output (or production) is known, multiply it by the standard input hours per
unit of output to obtain the total standard input hours at actual volume. Multiply this gure by the Prede-
termined MOH rate to obtain Applied Manufacturing Overhead (Applied MOH).
4. Use total standard input hours at actual volume in conjunction with the initial xed and variable cost
breakdowns, to calculate total expected costs based on actual volume of output. This is the Budgeted
MOH based on Standard Hours
5. Subtract the Budgeted MOH based on Standard Hours from Applied MOH to determine the Volume
Variance. (This will be negative if actual volume is below expected volume.)
6. Using actual input hours (e.g., machine hours or direct labor hours), calculate the Budgeted MOH based
on Actual Hours.
7. Subtract the Budgeted MOH based on Actual Hours from the Budgeted MOH based on Standard Hours
to determine the Ef ciency Variance. This will be negative if more input hours per unit of output were
used than was budgeted.
8. Obtain Actual Manufacturing Overhead (Actual MOH) from the accounting system.
9. Subtract Actual MOH from the Budgeted MOH based on Actual Hours to determine the Spending Vari-
ance. (This will be negative if Actual MOH is greater than the amount the Budget says should be spent.)
10. Add the Ef ciency Variance and the Spending Variance to determine the Budget (or Controllable) Vari-
ance.
11. Add the Volume Variance and the Budget Variance to determine the Total Variance. The total variance
also can be computed by subtracting Actual MOH from Applied MOH. (This also provides a veri cation
of the computations of volume and spending variances.)
Now test yourself on the above material by working through the following problem. This material is a little
tricky. Try to work through it using either the eleven steps listed above or the format in Exhibit 6. Don’t look at
the solution until you have nished computing all the variances.
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Problem: Silverado, Inc. manufactures silver belt buckles for Western-style out ts. Each belt buckle is supposed to use one
machine hour to manufacture. The company’s expected costs for the upcoming year are as follows:
Fixed Variable Cost

Cost Item Cost (per Machine Hour)
Service center allocations Basis of Allocation
Cleaning Square feet $5,000 --
Utilities Machine hours 800 $ 0.50
Property taxes Square feet 700 --
Insurance Book value of assets 400 --
Rent Square feet 2,500 --
Department indirect costs
Indirect materials 1,300 1.50
Indirect labor 10,000 7.50
Supervision 40,000 --
Maintenance and repairs 5,000 .70
Equipment depreciation 10,500 --.
Total for year $76,200 $10.20
Total for a typical month (1/12 of a year) $6,350 $10.20
Silverado expected to manufacture 12,000 buckles for the year, spaced evenly over the entire 12 months. In March, how-
ever, they produced only 800 buckles, and used 900 machine hours. In April, they more than made up for this decline by pro-
ducing 1,500 buckles, using 1,400 machine hours.
Actual overhead in March was $16,000. In April, actual overhead was $22,000. In the space below (and on the next page if
necessary), prepare an overhead variance analysis for each of the two months. Explain in your own words what happened.
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Analysis: Your analysis should have followed the 11-step process as follows:
1. Using xed and variable breakdowns, calculate total expected costs based on expected volume.
$76,200 +( $10.20/hr * 12,000 units * 1 hr/unit) = $198,600
2. Divide total expected costs by expected volume of inputs to obtain the predetermined overhead rate.
$198,600 ÷ 12,000 hours = $16.55
3. Multiple the predetermined overhead rate by actual volume to obtain Applied Manufacturing Overhead (Applied MOH).
March = 800 units * 1 hr/unit * $16.55/hr = $13,240

April = 1,500 units * 1 hr/unit * $16.55/hr = $24,825
4 Using the original xed and variable breakdowns, calculate total expected costs based on actual volume. This is the-
Budgeted MOH based on Standard Hours. Since this is by month, we need to use monthly xed costs of $6,350. The
Budgeted MOH based on Standard Hours for each month therefore can be computed as follows:
March = $6,350 + ($10.20 * 800 hours) = $14,510

April = $6,350 + ($10.20 * 1,500 hours) = $21,650
5. Subtract the Budgeted MOH at Standard Hours from Applied MOH to determine the Volume Variance. This will be
negative if actual volume is below expected volume:
March = $13,240 - $14,510 = ($1,270)

April = $24,825 - $21,650 = $3,175
6. Using actual machine hours, calculate the Budgeted MOH at Actual Hours:
March = $6,350 + ($10.20 * 900 hours) = $15,530

April = $6,350 + ($10.20 * 1,400 hours) = $20,630
7. Subtract Budget MOH at Actual Hours from Budgeted MOH at Standard Hours to determine the Ef ciency Variance:
March = $14,510 - $15,530 = ($1,020)

April = $21,650 - $20,630 = $1,020
8. Obtain Actual Manufacturing Overhead (Actual MOH) from the accounting system. This was given as:
March = $16,000
April = $22,000
9. Subtract Actual MOH from the Budgeted MOH at Actual Hours to determine the Spending Variance. (This will be nega-
tive if Actual MOH is greater than the amount the Budget says should be spent.)
March = $15,530 - $16,000 = ($470)

April = $20,630 - $22,000 = ($1,370)
10. Add the Ef ciency Variance and the Spending Variance to determine the Budget Variance:
March = ($1,020) + ($470) = ($1,490)

April = $1,020 + ($1,370) = ($350)
11. Add the Volume Variance and the Budget Variance to determine the Total Variance.
Month Volume Variance Budget Variance Total Variance

March ($1,270) ($1,490) ($2,760)
April $3,175 ($350) $2,825
Explanation. In March, volume that was below expectations led to a negative $1,270 volume variance. This was exacerbated by a
negative ef ciency variance ($1,020) caused by the use of more machine hours than expected (900 versus 800) and a negative spend-
ing variance ($470), indicating that we spent more on MOH than the number of machine hours would suggest was appropriate.
In April, volume was up, giving us a $3,175 favorable volume variance. Ef ciency was up also (it took only 1,400 machine hours
to produce 1,500 buckles), but spending was still a problem: we spent $1,370 more than the number of machine hours indicated was
appropriate. Overall, April’s total positive variance more than compensated for March’s negative one.
____________________________________________________________________________________________________________
Terminology Issues
Apart from some of the terminology differences discussed throughout this section, there are two terms that
need to be explained in the context of overhead variances: standard costs and over(under)applied overhead.
Both of these terms appear frequently in the cost accounting information that managers and others see in many
organizations, not just manufacturing companies.
Standard Costs. Occasionally, you will see the term standard cost used in conjunction with an overhead
variance analysis. In general, a standard cost is the same as an expected cost: It is what senior management be-
lieves the cost will be based on discussions that take place as part of a planning and budgeting effort. Some-
times standards are set using ideal or optimum conditions, and thus are not “expected,” as such. Rather, they are
the goal for the involved managers. When this is the case, senior management needs to make its performance
expectations clear; otherwise, production managers may become frustrated.
In a manufacturing environment, standard costs are established not only for overhead, but for many of the
elements that make up a product’s cost as de ned in Exhibit 2. The result is that there can be a variety of vari-
ances between standard costs and actual results, such as in the use of direct materials or labor and in the rates
paid for these two factors of production.
Overapplied and Underapplied Overhead. When a predetermined overhead rate is used, the overhead
that is attached to products can be either underapplied (sometimes called underabsorbed or unabsorbed), or it
can be overapplied (sometimes called overabsorbed). Overhead is underapplied when Applied MOH is less
than Actual MOH. That is, not enough of the overhead that was incurred was attached to (or absorbed into) the
products. Overhead is overapplied when Applied MOH exceeds Actual MOH. That is, more overhead was at-
tached to the products than actually was incurred. This is not a new concept; you saw it at work in both the
Computex and Silverado problems. It is just new terminology, illustrated in Exhibit 7.
____________________________________________________________________________________________________________
Exhibit 7. OVERAPPLIED AND UNDERAPPLIED OVERHEAD
Overapplied Underapplied
Applied versus Actual MOH Applied MOH Applied MOH
is greater than is less than
Actual MOH Actual MOH
Total OH Variance Total OH variance is positive Total OH variance is negative
Computation Applied MOH Applied MOH
minus minus
Actual MOH Actual MOH
=+ =—
____________________________________________________________________________________________________________
Accounting Implications of an Overhead Variance
From an accounting perspective, the total overhead variance is the result of the difference between actual
and applied overhead. The cause of this difference may be in the underlying conditions that give rise to over-
head, such as changes in the volume of output. Alternatively, the variance may be due to unexpected inef cien-
cies in the use of indirect items or changes in factor prices for indirect labor and materials.
The exact reasons for this overhead budget variance usually are dif cult to discern from the accounting sys-
tem. Nevertheless, most manufacturing managers will have a feel for the causes. Thus, senior management
needs to discuss the variances with the manufacturing manager to determine possible corrective actions.
From an accounting perspective, the overhead variance account in the accounting system must be closed
out. Usually, this is done in one of two ways: (1) making a transaction that closes the overhead variance account
to cost of goods sold, or (2) making a transaction that closes the overhead variance account to a combination of
cost of goods sold, work in process inventory, and nished goods inventory.
Technically, the second is more accurate (and abides by the matching principle), since portions of the vari-
ance are represented in all three accounts. From a practical perspective, the rst approach often is used since it
is easier, and the overhead variances generally are not suf ciently large to have a material effect on the overall
results on the nancial statements. Thus, materiality is used as the justi cation for a technical violation of the
matching principle.
MANAGERIAL USES OF OVERHEAD VARIANCES
Few managers have either the time or the inclination to calculate manufacturing variances, as you have done
here. Instead, they receive reports from their accounting staffs with these computations already made. Thus, the
real question from a managerial perspective is “What is the value of the variances?”
____________________________________________________________________________________________________________
The main value of the variances is the information they provide for cost control. In particular, we can see
that the overhead variances are the result of two quite different forces:
• The volume variance arises because production volume was not as anticipated. While there probably is lit-
tle that the manufacturing manager can do about this, it nevertheless is a concern of senior management.
If the entire overhead variance were due to volume effects, senior management would probably wish
to have some discussions with the marketing and sales forces rather than the manufacturing manager. Of
course, there is always the possibility that delays and breakdowns in the plant prevented the manufacturing
manager from delivering the orders placed by the sales staff, and this possibility would need to be investi-
gated also.
• The efficiency and spending variances arise because actual overhead differed from what overhead should
have been at the actual level of volume produced. If the variances are negative, they suggest that the indi-
viduals responsible for the various activities that make up overhead costs spent more than they should
have. While there may be good reasons for this, a large negative efficiency or spending variance neverthe-
less provides an indication to senior management that some discussions need to take place with the manu-
facturing manager.
Because of the complications associated with volume variances and absorbed overhead, senior management
in some organizations choose not to use an absorption costing system, as the system we have been discussing is
called, for management reporting purposes. Instead, they use an absorption costing system to value inventory
and compute cost of goods sold, but another system, called variable costing, for internal reporting purposes.
VARIABLE COSTING
Both generally accepted accounting principles and tax regulations require manufacturing companies to use
an absorption costing system of the sort described above. Under an absorption system, fixed manufacturing
costs—both direct and indirect—are treated as product costs. That is, they are assigned (or attached) to products
during the manufacturing process, and absorbed into inventory. They remain attached to the products in the
work-in-process inventory, and, subsequently, in the finished goods inventory, until the products are sold. At
that time they are removed from finished goods inventory, and placed on the income statement as part of cost of
goods sold.
A company that treated its fixed manufacturing costs as period costs, i.e., did not assign them to products
but expensed them on the income statement in the period when they were incurred, ordinarily would receive a
qualified opinion on its audited financial statements. In effect, by not attaching these costs to products, and ex-
pensing them when the products are sold, it is violating the matching principle.
Absorption costing therefore must be used to value inventories for financial statements prepared under Gen-
erally Accepted Accounting Principles (GAAP), and it must be used for tax computing purposes. This does not
mean that it must be used for managerial purposes, however. For internal reporting and control purposes, man-
agement can use any kind of information it wishes. There is only one criterion: the information must be useful.
Because of the complexities associated with absorption costing, many companies have chosen to use something
somewhat more intuitive, and therefore useful, for internal purposes: variable costing.
The difference between the two types of costing lies exclusively in the treatment of the fixed portion of
manufacturing overhead. This is illustrated in Exhibit 8. As this exhibit indicates, absorption costing treats fixed
manufacturing overhead as a product cost, whereas variable costing treats it as a period cost.
As the following example shows, the difference between these two forms of costing can have a significant
impact on an organization’s financial statements.
Example: Two companies are identical in every respect except one: Company A uses absorption costing, while Company V uses
variable costing. In Month 1, both companies produce and sell 1,000 units of their product. In Month 2, both companies produce
1,500 units of their product, but sell only 1,000 units. In Month 3, both companies produce 500 units, but sell 1,000 units (obtain-
ing the remaining 500 units from the finished goods inventory left over at the end of Month 2).
To keep things simple, we will use only variable and fixed manufacturing overhead (i.e., no direct manufacturing cost), plus
selling, general, and administrative costs. Assume the following:
Company A Company V
Selling price (per unit) $220 $220
Variable manufacturing overhead (per unit of production) $100 $100
Fixed manufacturing overhead $60,000 $60,000
Selling, general, and administrative costs $20,000 $20,000
Production, sales, and finished goods inventory during
Month 1 Beginning balance 0 0
Production 1,000 1,000
Sales 1,000 1,000
Ending balance 0 0
____________________________________________________________________________________________________________

Production 1,500 1,500
Sales 1,000 1,000
Ending balance 500 500
Production 500 500
Sales 1,000 1,000
Ending balance 0 0
Let’s prepare a statement of the cost of goods manufactured for each company for Month 1. It will take a slightly different form from
the way it ordinarily looks because we have simplified the cost structure, using only variable and fixed manufacturing overhead costs.
____________________________________________________________________________________________________________
Exhibit 8. ABSORPTION COSTING VERSUS VARIABLE COSTING

ABSORPTION VARIABLE
COSTING COSTING
COSTS
SALES
SALES Direct
Labor
FINISHED Direct FINISHED

GOODS Materials GOODS
INVENTORY INVENTORY
COST COST
OF Variable OF
GOODS MOH GOODS
SOLD SOLD
Other
Indirect Items Indirect
Labor Materials
MANUFACTURING
OVERHEAD
Fixed
MOH
Selling PERIOD
Costs COSTS
PERIOD
COSTS
A&G
Costs
____________________________________________________________________________________________________________
____________________________________________________________________________________________________________
Cost of Goods Manufactured For Month 1

Costs
Product Company A Company V
Variable manufacturing overhead ($100 x 1,000) $100,000 $100,000
Fixed manufacturing overhead 60,000 0
Total Manufacturing Costs this Period $160,000 $100,000
Plus: Beginning balance of work in process inventory 0 0
Equals: Total manufacturing costs this plus prior periods $160,000 $100,000
Less: Ending balance of work in process inventory 0 0
Cost of Goods Manufactured $160,000 $100,000
Period Costs: Fixed manufacturing overhead 0 $60,000
We also can calculate a product cost per unit for each unit manufactured, as follows:
Total costs = $160,000 $100,000
Total units manufactured = 1,000 1,000
Cost per unit = $160.00 $100.00
We can now prepare an income statement:
Income Statement: Functional Classification For Month 1
Company A Company V
Sales revenue ($220 x 1,000 units) $220,000 $220,000
Beginning balance of finished goods inventory $ 0 $0
Plus: Cost of goods manufactured 160,000 100,000
Equals: Goods available for sale $160,000 $100,000
Less: Ending balance of finished goods inventory 0 0
Equals: Cost of goods sold 160,000 100,000
Gross margin $60,000 $120,000
Less: Period costs:
Fixed manufacturing overhead 0 60,000
Selling, general, and administrative 20,000 20,000
Income before taxes $40,000 $40,000
As we might expect, given identical sales and costs, and no building of inventories, the two income statements show the same
income before taxes. Now the plot thickens, however.
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Problem: In the space below, prepare a set of statements for Month 2 comparable to those above.

Company A Company V
Product Costs
Variable manufacturing overhead

Fixed manufacturing overhead


Period Costs: Fixed manufacturing overhead
Calculate
a product cost per unit for each unit manufactured:
Total costs =

Total units manufactured =

Cost per unit =
____________________________________________________________________________________________________________

Company A Company V
Sales revenue
Beginning balance of finished goods inventory



Less: Ending balance of finished goods inventory
Gross margin

Less: Period costs:

Selling, general, and administrative

Income before taxes
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Answer: The two statements would look as follows:
Company A Company V
Product Costs
Variable manufacturing overhead ($100 x 1,500) $150,000 $150,000
Product cost per unit for each unit manufactured is as follows:

Total costs = $210,000 $150,000
Total units manufactured = 1,500 1,500
Cost per unit = $140.00 $100.00
The income statement would look as follows:

Company A Company V
Beginning balance of finished goods inventory $ 0 $0
Less: Ending balance of finished goods inventory* 70,000 50,000
Gross margin $80,000 $120,000
Less: Period costs:
* For Company A, this is 500 units x $140.00 per unit = $70,000
For Company B, this is 500 units x $100.00 per unit = $50,000
••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
____________________________________________________________________________________________________________
Problem: Why is income before taxes higher for Company A? . As part of your explanation, prepare calculations to reconcile
the $20,000 difference ($60,000 - $40,000) between the two statements.
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Answer: The difference is in the fixed manufacturing overhead. With $60,000 of fixed overhead in Company A and 1,500 units
produced, each unit carries $40 of fixed overhead ($60,000 ÷ 1,500). Since 500 of those units are in inventory, there is $20,000
of fixed overhead (500 x $40) in inventory. By contrast, all $60,000 of fixed overhead has been expensed during the period (the
month) in Company V.
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Problem: Now prepare a similar analysis for Month 3, including an explanation for any difference between the two Income-
before-taxes figures.
Company A Company V
Product Costs
Variable manufacturing overhead




Period Costs: Fixed manufacturing overhead

Calculate a product cost per unit for each unit manufactured:
Total costs =
Total units manufactured =
Cost per unit =

Company A Company V
Sales revenue
Beginning balance of finished goods inventory

Less: Ending balance of finished goods inventory

Gross margin
Less: Period costs:
Selling, general, and administrative
Income before taxes

••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
____________________________________________________________________________________________________________
Answer: The cost of goods manufactured statement would look as follows:

Company A Company V
Product Costs
Variable manufacturing overhead ($100 x 500) $ 50,000 $50,000
Product cost per unit for each unit manufactured is as follows:
Total costs = $110,000 $50,000
Total units manufactured = 500 500
Cost per unit = $220.00 $100.00
The income statement would look as follows:

Company A Company V
Beginning balance of finished goods inventory $ 70,000 $ 50,000
Less: Ending balance of finished goods inventory 0 0
Gross margin $40,000 $120,000
Less: Period costs:
The 500 units that Company A had placed in inventory during Month 2 came out this month, and were sold. They carried
$20,000 of fixed costs (500 x $40 per unit) with them. These costs were added to the $60,000 in fixed costs that were included
in the 500 units manufactured and sold this month, meaning that a total of $80,000 in fixed costs were included on Company
A’s income statement. This compares to $60,000 of fixed costs on Company V’s income statement, and accounts for the
$20,000 difference between the two income statements.
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Reasons for Differences
As the examples above indicate, the reason for the differences between absorption and variable costing lies
in the treatment of fixed manufacturing costs. The more general question, however, is why fixed costs behave in
the way they do.
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Problem: Review the above three months of data and see if you can extract a general principle that you would use to determine
if income before taxes, other things equal, would be higher or lower under absorption costing than under variable costing. Write
your answer below.
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Answer: The general principle is stated in Exhibit 9. As this exhibit indicates, when production exceeds sales, a company builds
inventory. When a company builds inventory, as both did in Month 2, some fixed costs will enter inventory under absorption
costing. This means that income under absorption costing will be higher than under variable costing.
Similarly, when sales exceed production, a company is reducing inventory. When this happens, fixed costs that had been
placed in inventory come out and go on the income statement, and income under absorption costing will be less than under
variable costing.
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____________________________________________________________________________________________________________
Exhibit 9. RELATIONSHIP AMONG PRODUCTION, SALES, AND INCOME:

ABSORPTION VERSUS VARIABLE COSTING
IF PRODUCTION EXCEEDS SALES
then
INCOME HIGHER WITH ABSORPTION COSTING THAN WITH VARIABLE COSTING
IF PRODUCTION IS LESS THAN SALES

then
INCOME LOWER WITH ABSORPTION COSTING THAN WITH VARIABLE COSTING
IF PRODUCTION IS THE SAME AS SALES

then
INCOME IS THE SAME IN BOTH APPROACHES
____________________________________________________________________________________________________________
As the above example demonstrates, this relatively simple difference—the treatment of xed manufacturing
overhead—can have a profound effect on a company’s income statements and balance sheets (via the inventory
account). Thus, the decision to use variable costing instead of absorption costing is one that managers need to
consider carefully. Managers who choose to use variable costing also should recognize that the information they
see for internal management purposes will not correspond to the information that appears on the nancial state-
ments prepared according to GAAP.
Product Costs Versus Overhead Volume Variances
In considering the use of variable costing, many managers confuse two issues:
1. The impact of having xed costs treated as product costs under absorption costing and as period costs
under variable costing, and
2. The impact of overhead volume variances when using an absorption system.
In reality, these are two quite separate issues. Speci cally:
• There will be a difference between income under absorption costing and variable costing when produc-
tion is not the same as sales. When this is the case, xed manufacturing overhead will either enter or
leave of inventory under absorption costing.
• There can be an overhead volume variance under absorption costing only. This will happen when the ac-
tual volume of production differs from the expected volume of production. Recall that an overhead volume
variance is associated with the xed manufacturing overhead, which does not exist as a product cost in a
variable costing system. (The overhead budget variance, if there is one, will be the same under either ap-
proach.)
Advantages of Variable Costing
Many managers believe that variable costing has three important advantages over absorption costing:
1. It is easier to understand. There is no need to absorb xed manufacturing overhead into products, and there-
fore no confusion associated with the expansion of contraction of manufacturing inventories.
2. Sales and net income tend to move in the same directions. Note, for instance, that in the above example,
sales remained constant in all three months. Net income also remained constant under variable costing, but
it uctuated considerably under absorption costing, depending on whether production was greater or less
than sales.
3. The separation of xed and variable costs in the relatively clean way used in variable costing is intuitively
more understandable to production managers and other middle managers. If these individuals are being
asked to exert control over costs, it is helpful to have cost information that they can easily understand.
Implications for Just-in-Time Manufacturing Environments. While the third reason is an important one
in any company, the rst two reasons are important only if a company expects to build or reduce inventory. In-
creasingly, companies are moving toward just-in-time (JIT) manufacturing. A JIT manufacturing system is one
____________________________________________________________________________________________________________
in which all inventories are kept close to zero, so as to minimize the company’s inventory carrying costs. Fre-
quently, under a JIT system, raw materials are received the day before (or of) their use, and nished goods are
shipped immediately upon completion. Thus, the only inventory of any potential consequence is the work-in-
process one.
The nancial statements for companies using JIT manufacturing will be approximately the same under either
absorption or variable costing. The fact that xed costs are held in a nished goods inventory until the product
is sold is of little consequence to a company whose nished goods inventory is very small. Thus, when a com-
pany uses JIT, there is little practical signi cance whether xed manufacturing overhead costs are treated as
product costs or period costs.
Disadvantages of Variable Costing
Variable costing has three disadvantages:
1. As discussed above, for companies that do not have JIT manufacturing systems, variable costing results in
nancial statements that differ from those used for external reporting purposes. When the changes in inven-
tory are slight from one period to the next, and when expected and actual production levels are about the
same, these differences are not great. Nevertheless, managers who decide to use variable costing need to be
aware of these potential differences.
2. Since variable costing treats xed manufacturing overhead as a period cost, it understates the full produc-
tion cost. To the extent that full production cost is used as a basis for setting prices, as it is in many organi-
zations, variable costing may lead managers to set prices that are unrealistically low. However, keep in
mind that even absorption costing excludes non-manufacturing costs, and these too need to be considered in
setting prices.
3. Organizations that use variable costing still must use absorption costing for nancial statements prepared
according to GAAP and for tax reporting purposes. Therefore,when variable costing is used, an organiza-
tion’s accounting system must provide both sets of information. Such a system may be more costly to oper-
ate.
Overall, as with many management accounting decisions, there is no correct answer to the decision as to
whether an company should to supplement absorption costing with variable costing. Most organizations use ab-
sorption costing, however. In this regard, the most important questions for senior management to address in its
decision are:
1. Will variable costing provide useful information for senior management decisions?
2. Will variable costing assist middle managers to better understand and/or control costs?
If the answers to either of these questions is yes, the argument for developing a variable costing system is a
strong one.
You are now ready to work on the two practice cases for this Note. Red Clay will help you sharpen your ab-
sorption costing skills. Mickey’s Mowers will help you develop your skills in absorption versus variable cost-
ing.
____________________________________________________________________________________________________________
PRACTICE CASE A: RED CLAY, INC.

I don’t get it. Production was way below budget in January and way above in February, and yet we had negative
variances in both months. I can understand January, but February doesn’t make sense. Either we need a new ac-
countant or a new production manager. Maybe both.
The speaker was Mike Larson, president of Red Clay, Inc. Mr. Larson had founded Red Clay three years
ago when friends told him that his pottery work was exceptional and he should sell it retail rather than simply
giving it away, as he had been doing. Now he wondered about his decision to start the business:
When I gave it away at least I had some fun. Now, after three years of trying to build a business, I nd myself star-
ing at accounting data and not having much fun. This is crazy!
Background
Red Clay, Inc. manufactured decorative urns that used a special clay found only in the Argentinean Andes.
Each urn was manufactured on a potter’s wheel and then red in a special kiln at temperatures about double
those of normal kilns, giving the urns both a very high luster and extreme durability. When all labor was in-
cluded, each urn was supposed to take two direct labor hours to complete.
The company had enjoyed remarkable success. Its urns were in high demand, with prices that re ected the
combination of this demand and the limited availability of the special red clay. Production was reasonably con-
stant throughout each month, and, given the high demand, virtually no urns remained in nished goods inven-
tory at the the end of each month.
Although the supply of red clay was limited, Mr. Larson had managed to increase it gradually, and the
company had been able to expand its labor force each year to meet the demand. The current labor force con-
sisted of several potters, each of whom worked only a few days each week. Most aspired to be world-class pot-
ters, and had studios where they produced their own pottery. They saw Red Clay as a source of income until
they made it big.
As the company grew, Mr. Larson had shifted his activities away from direct production, and had moved
into sales, marketing, and purchasing. Indeed, he frequently made trips to Argentina to purchase the clay. Be-
cause he was away a great deal of the time, he had hired a production manager to oversee the manufacture of
the urns, and, with the growth of the business, also had hired a part-time accountant to prepare monthly nan-
cial statements.
Data
The company’s budgeted overhead costs for the current year (January-December) are shown in Exhibit 1.
The source of Mr. Larson’s concern was the accountant’s report for January and February, shown in Exhibit 2.
As it shows, in January, although the company had expected to manufacture 100 urns, it had made only 80. This
was mainly because several potters had left the company unexpectedly, and Red Clay had used only 140 direct
labor hour.
In February, when some new potters had been hired, production had increased to 120 urns, bringing the
year-to-date total up to 200 urns. The company had used 280 direct labor hours during the month. The report
contained a memo from the accountant, which read in part:
It looks as though we need to increase production a bit to eliminate these variances. Sam [the production manager]
spent a lot of overtime in February training the new people, and I needed to spend a lot of time getting the new
people on payroll and teaching them about time cards and the like.
Mr. Larson was not satis ed with the explanation:

We couldn’t do much about people leaving in January, but we made up for it in February. With the increased produc-
tion, we should be on track for the year, but we’re not. On top of that, actual overhead was $15,000 in January and
$16,000 in February. The February number seems pretty good by comparison, considering that production was up by
50 percent over January. I guess the negative variance of $1,080 for January is okay given the reduced production,
but the confusing part is the negative variance of $880 for February. Why in February, when production was way up,
is there still a negative variance. It just doesn’t make sense.
Here’s another problem. Our budget called for $12,600 in overhead in each month. So, from my perspective the
variances are pretty easy to calculate. You can see my computations right here [Exhibit 3]. The total of $5,800 for
the two months is the same as Charlie’s [the accountant], but look at the differences between the individual months.
Something doesn’t add up here . . . literally!
Questions
1. Do you agree with the calculations in Exhibit 1 for the overhead budget for a typical month and the absorption
rate? Why or why not?
____________________________________________________________________________________________________________
2. Prepare an overhead variance analysis of the sort discussed in the text. Your totals should agree with the account-
ant’s totals. What is missing from his analysis? How important do you think it is? What do you think are the
causes of the variances?
3. Reconcile Mr. Larson’s computations in the last paragraph of the case with those of the accountant in Exhibit 2.
Why do these differences exist? Will they always agree over a two month period? Why or why not?
4. How would you explain to Mr. Larson the differences between his computations and those of the accountant?
5. Do you agree with the accountant’s proposed solution to the problem? Why or why not? What else should Mr.
Larson do?
Exhibit 1. Overhead Budget for Current Year

Estimated Annual Production of 1,200 Urns
Variable Cost
Fixed per DLH (Direct
Overhead Cost Item Cost Labor Hour
Cleaning $10,000 --
Utilities 5,000 $ 0.10
Insurance 3,000 --
Rent 25,000 --
Indirect materials 14,000 2.00
Indirect labor 10,000 5.00
Supervision and accounting 50,000 --
Equipment depreciation 10,000 --
Maintenance and repairs 5,000 .90
Total for year $132,000 $8.00
Total for a typical month $11,000 $8.00
Overhead budget for a typical month: $11,000 + ($8.00 * 100 * 2) = $12,600
Absorption rate = $12,600 ÷ 200 DLH = $63
Exhibit 2. Accountant’s Report for January and February
January February Total
Production
Estimated (1/12 of annual total) 100 100 200
Actual production 80 120 200
Variance (20) 20 0
Direct Labor Hours
Standard (2 per unit) 160 240 400
Actual 140 280 420
Variance 20 (40) (20)
Overhead
Applied (@ $63 per standard DLH) $10,080 $15,120 $25,200
Standard at actual volume 12,280 12,920 25,200
Volume variance ($2,200) $2,200 0
Standard at actual volume 12,280 12,920 25,200
Actual 15,000 16,000 31,000
Spending variance ($2,720) ($3,080) ($5,800)
Total overhead variance ($4,920) ($880) ($5,800)
Exhibit 3. Mr. Larson’s Computations
January February Total
Budgeted overhead $12,600 $12,600 $25,200
Actual overhead 15,000 16,000 31,000
Total variance ($2,400) ($3,400) ($5,800)
____________________________________________________________________________________________________________
PRACTICE CASE B. MICKEY’S MOWERS

Mickey Snider, president and CEO of Mickey’s Mowers (MM), was considering changing his accounting
system. Increasingly, he had become dissatisfied with the panic he felt at the end of the third quarter of each fis-
cal year, when his cost of goods sold leapt out of sight. Of course, sales also increased, but he could not under-
stand why there was such a dramatic increase in cost of goods sold, especially, when it seemed as though such a
large portion of his costs were fixed. He resolved to examine the reasons for this sort of cost behavior, and then
to give his accountant some guidelines for developing a system that would provide him with better information.
Background
Mickey Mowers manufactured lawn mowers. It was the company’s only product, a fact that MM touted
highly in its promotional literature. “Lawn mowers are our product—our only product,” was MM’s theme. The
theme seemed to work. Sales had increased briskly over the past few years, and the company had become in-
creasingly profitable.
One of MM main problems was seasonality. The company was in northern Minnesota, where sales of lawn
mowers tended to fluctuate greatly during the four quarters of the year. Because the supply of qualified labor
was also scarce, MM maintained a relatively constant production schedule, putting lawn mowers into inventory
in the fall and winter (when demand was low), and selling them out of inventory in the spring and summer
(when demand was high). The company had a fiscal year that began in October and ended in September.
Other than storing unsold lawn mowers in finished goods inventory, MM maintained very tight control over
its inventories. At the end of each quarter, the company had no raw materials or work in process inventories.
That is, all raw materials purchased were used during the quarter in which they were purchased, and all unsold
lawn mowers were in finished goods inventory at the end of each quarter.
Cost Structure
The company made only one product, a rotary engine lawn mowers, which it sold for $170. Because of this,
all its costs were direct; that is, there were no manufacturing overhead costs as they usually are defined. Even
Mr. Snider’ office, along with the other administrative offices, was located inside the plant—in a small corner
on the second floor where he could look down on the assembly line and intervene if he saw any problems.
Since the company used a process costing system, its cost accounting was fairly simple: all costs were ac-
cumulated for each accounting period and divided by the number of lawn mowers produced. This became the
average cost per lawn mowers. The only difficulty MM’s accountant faced was in separating costs into their
fixed and variable components. To do this, she had undertaken several studies, with the following results:
Variable costs (per lawn mower) = $80 Fixed direct costs (per year) = $150,000
The Problem
As of the end of September, 1996, MM had completely sold out its inventory of lawn mowers. During the
first two quarters of fiscal year 1997 (October 1996-December 1996, and January 1997-March 1997), MM
manufactured 2,000 lawn mowers, but sold only 500. In the third quarter (April-June) the situation reversed it-
self somewhat. During this quarter, the company manufactured 2,000 lawn mowers, just as before, but it sold
3,500. It did the same during the fourth quarter.
As he thought about the panic he had felt in July upon receiving the third quarter financial statement, Mr.
Snider resolved to do something about it. He had read recently about something called variable costing, which
sounded as though it would give him a better picture of the true financial results of his operations, rather than
the muddied view he had been getting for the past several years. He asked his accountant to prepare a second set
of financial statements for the 1996-1997 fiscal year, using variable costing so that he could see the differences
between the two approaches.
Questions
1. Prepare income statements through the gross margin line for MM for each quarter. How much will be shown on the
balance sheet for finished goods inventory at the end of each quarter?
2. Why, despite a balance in the finished goods inventory at the beginning of the second quarter, and a much higher bal-
ance at the end of that quarter, is the gross margin for the second quarter exactly the same as for the first quarter?
3. Prepare income statements for all four quarters using variable costing. What are the differences between the bottom line
on these statements and the one on the absorption costing statements? Why do these differences exist?
4. What conclusions do you draw from this analysis? What advice would you give to Mr. Snider?
____________________________________________________________________________________________________________
SOLUTION TO PRACTICE CASE A: RED CLAY, INC.

Question 1
The overhead budget has been calculated correctly. The variable rate is $8.00 per DLH, and there are 2 di-
rect labor hours per urn produced. With an average of 100 urns per month, the variable component is $1,600
($8.00 per hour * 2 hours per urn * 100 urns). This is added to the $11,000 xed costs for a total of $12,600.
Similarly, since there are an estimated 200 DLH per month, the absorption rate is the $12,600 divided by 200,
or $63.00 per DLH.
Question 2
Your analysis might have followed the 11-step process as follows:
1. Using xed and variable breakdowns, calculate total expected costs based on expected volume.
$132,000 + ($8.00/hr * 1,200 units * 2 DLH/unit) = $151,200
2. Divide total expected costs by expected volume to obtain the predetermined overhead rate.
$151,200 ÷ 2,400 hours = $63.00 per DLH
3. Multiple the predetermined overhead rate by actual volume to obtain Applied Manufacturing
Overhead (Applied MOH).
January = 80 units * 2 DLH/unit * $63/DLH = $10,080
February = 120 units * 2 DLH/unit * $63.00/DLH = $15,120
4. Using the original xed and variable breakdowns, calculate total expected costs based on
actual volume. This is the Budgeted MOH based on Standard Direct Labor Hours.
Since this is by month, we need to use monthly xed costs of $11,000. The Budgeted
MOH based on Standard Hours for each month therefore can be computed as follows:
January = $11,000 + [$8/DLH * (80 * 2) DLH] = $12,280
February = $11,000 + [$8/DLH * (120 * 2) DLH] = $12,920
5. Subtract the Budgeted MOH at Standard Hours from Applied MOH to determine the Volume
Variance. This will be negative if actual volume is below expected volume:
January = $10,080 - $12,280 = ($2,200)
February = $15,120 - $12,920 = $2,200
6. Using actual DLH hours, calculate the Budgeted MOH at Actual DLH:
January = $11,000 + ($8/DLH * 140 DLH) = $12,120
February = $11,000 + ($8/DLH * 280 DLH] = $13,240
7. Subtract Budget MOH at Actual Hours from Budgeted MOH at Standard Hours to determine
the Ef ciency Variance:
January = $12,280 - $12,120 = $160
February = $12,920 - $13,240 = ($320)
8. Obtain Actual Manufacturing Overhead (Actual MOH) from the accounting system. This was
given as follows:
January = $15,000
February = $16,000
9. Subtract Actual MOH from the Budgeted MOH at Actual Hours to determine the Spending
Variance. (This will be negative if Actual MOH is greater than the amount the Budget says
should be spent.)
January = $12,120 - $15,000 =($2,880)
February = $13,240 - $16,000 = ($2,760)
10. Add the Ef ciency Variance and the Spending Variance to determine the Budget Variance:
January = $160 + ($2,880) = ($2,720)
February = ($320) + ($2,760) = ($3,080)
____________________________________________________________________________________________________________
11. Add the Volume Variance and the Budget Variance to determine the Total Variance.
Month Volume Variance Budget Variance Total Variance
January ($2,200) ($2,720) ($4,920)
February $2,200 ($3,080) ($880)
The accountant has not distinguished between ef ciency and spending. As indicated above, there is a small
positive ef ciency variance for January and a small negative one for February. Both spending variances are
comparatively large and negative.
This breakdown can be seen more easily by using a graphic approach, as follows:
For January
BUDGETED MOH BUDGETED MOH
ACTUAL BASED ON BASED ON ABSORBED
$11,000 + ($8 x 140) $11,000 + ($8 x 160) $63.00 x 160
$15,000 $12,120 $12,280 $10,080

$12,120 - $15,000 $12,280 - $12,120 $10,080 - $12,280
($2,880) $160 ($2,200)
| Budget Variance |
($2,880) + $160
($2,720)
or
| Budget Variance |
$12,280 - $15,000
($2,720)
| Total Variance |
($2,720) + ($2,200)
($4,920)
or
| Total Variance |
$10,080 - $15,000
($4,920)
For February
ACTUAL BASED ON BASED ON ABSORBED
$11,000 + ($8 x 280) $11,000 + ($8 x 240) $63.00 x 240

$16,000 $13,240 $12,920 $15,120
$13,240 - $16,000 $12,920 - $13,240 $15,120 - $12,920
($2,760) ($320) $2,200
| Budget Variance |
($2,760) + ($320)
($3,080)
or
| Budget Variance |
$12,920 - $16,000
($3,080)
| Total Variance |
($3,080) + $2,200
($880)
or
| Total Variance |
$15120 - $16,000
($880)
____________________________________________________________________________________________________________
Question 3
The easiest way to reconcile these is to note that the accountant’s “volume variance” is actually a variance in
the absorption of fixed manufacturing overhead when actual volume does not equal budgeted volume. If, for
example, 100 urns had been produced in January, the full $12,600 would have been absorbed ($63 per DLH * 2
DLH per urn * 100 urns). Stated somewhat differently, the fact that we were 20 urns below budget meant that
$2,520 did not get absorbed ($63 per DLH * 2 DLH per urn * 20 urns). If this were added to the $10,080 that
was absorbed, we get a total of $12,600. The same phenomenon happens in reverse in February. In effect, over-
head is under-absorbed in January and over-absorbed in February.
Mr. Larson is defining a “volume variance” differently. Since he wants to reconcile the original budget to the
actual overhead, his volume variance also includes the difference between the original budget and the amount
absorbed, i.e., both fixed and variable overhead. The easiest way to see this is to visualize it graphically, as
shown on the next page for January, using Volume Variance A as the difference between the original budget and
the amount that was absorbed, and Volume Variance B as the volume variance discussed in the note that reflects
the under-absorbed fixed MOH.
Note, incidentally, that when we combine Volume Variance A and Volume Variance B, we get a positive $320
($2,520 - 2,200). This is the amount we saved by having lower volume. How? By not incurring the variable
costs for 20 urns. That is, 20 urns * 2 DLH/urn * $8.00/DLH = $320. This is our only saving from the reduced
volume. The rest of MOH is fixed.
Clearly, the only reason these items net out over the two month period is that actual production for the two
months was right on budget. If this is unclear, simply imagine two months just like January. The accountant
would show a total overhead variance of $9,840 ($4,920 * 2 months) negative, whereas Mr. Larson would show
a total of $4,800 ($2,400 * 2 months).

ACTUAL BASED ON BASED ON ABSORBED ORIGINAL
MOH ACTUAL HOURS STANDARD HOURS MOH BUDGET

$11,000 + ($8 x 140) $11,000 + ($8 x 160) $63.00 x 160 $11,000 + ($8 x 200)
$15,000 $12,120 $12,280 $10,080 $12,600
| Spending Variance | | Efficiency Variance | | Volume Variance B | | Volume Variance A |
$12,120 - $15,000 $12,280 - $12,120 $10,080 - $12,280 $12,600 - $10,080
($2,880) $160 ($2,200) $2,520
| Absorption Costing Variances | | Volume Variance |

$10,080 - $15,000 $12,600 - $10,080
($4,920) $2,520
| Total Variance from Original Budget |

$12,600 - $15,000
($2,400)
or
($4,920) + $2,520
($2,400)
Question 4
This is quite tricky, and it goes directly to the fact that managers frequently have different information needs
than the accountants. Mr. Larson wants to know why the budget overhead of $12,600 was exceeded each
month. The accountant is concerned with the under-absorbed or over-absorbed fixed manufacturing overhead.
These are quite different needs.
Stated somewhat differently, since we produced 20 fewer urns than planned, we used 40 fewer DLH at stan-
dard. Using the $63 absorption rate, we failed to absorb $2,520 (40 DLH * $63) that we had planned to absorb.
This is distinct from the difference between what was absorbed at the actual volume or production and the over-
head that we should have incurred at that level of production (using standard DLH), which is what the account-
ants call a volume variance. In effect, their volume variance measures the under-absorbed overhead (or, in Feb-
ruary, the over-absorbed overhead) at the actual volume of production.
The accountant might explain these differences to Mr. Larson with either the graphical representation shown
above, or the following table:
____________________________________________________________________________________________________________
January February
Budgeted MOH $12,600 $12,600
Absorbed MOH 10,080 15,120
Volume variance A (result of production level) $2,520 ($2,520)
Absorbed MOH $10,080 $15,120
Budgeted MOH at actual output and standard DLH 12,280 12,920
Volume variance B (absorption of xed MOH) (2,200) 2,200
Budgeted MOH at actual output and standard DLH $12,280 $12,920
Budgeted MOH at actual output and actual DLH 12,120 13,240
Ef ciency variance 160 (320)
Budgeted MOH at actual output and actual DLH $12,120 $13,240
Actual MOH 15,000 16,000
Spending variance (2,880) ($2,760)
Total MOH variance (budget minus actual) ($2,400) ($3,400)
SOLUTION TO PRACTICE CASE B: MICKEY’S MOWERS

Question 1
Prior to preparing an income statement, we must prepare a statement of cost of goods manufactured. This is
somewhat simpler than the one in Exhibit 2 of the text, since it has fewer cost items, no manufacturing over-
head, and no work in process inventory.
Mickey’s Mowers
Statement of Cost of Goods Manufactured
For the Quarter Ended December 31, 1996
Direct costs:
Variable direct costs ($80 x 2,000) $160,000
Fixed direct costs (150,000 ÷ 4)* 37,500
Manufacturing Overhead: 0
Total Manufacturing Costs this Period $197,500
Plus: Beginning balance of work in process inventory 0
Equals: Total manufacturing costs this plus prior periods $197,500
Less: Ending balance of work in process inventory 0
Cost of Goods Manufactured $197,500
* Annual amount ÷ 4 = quarterly amount.
With this information, we can calculate a cost per unit for each lawn mower manufactured, as follows:
Total costs = $197,500
Total units manufactured = 2,000
Cost per unit = $98.75
We can now prepare an income statement:
Mickey’s Mowers
Income Statement: Functional Classi cation
For the Quarter Ended December 31, 1996
Sales revenue ($170 x 500 units) $85,000
Beginning balance of nished goods inventory $0
Plus: Cost of goods manufactured 197,500
Less: Ending balance of nished goods inventory* 148,125
Equals: Cost of goods sold 49,375
Gross margin $35,625
* 1,500 units at $98.75 each = $148,125
____________________________________________________________________________________________________________
Quarter 2. The cost of goods manufactured will be the same in the second quarter as the first, as will the unit
cost of a lawnmower. The income statement for the second quarter is as follows:
Mickey’s Mowers
Income Statement: Functional Classification
For the Quarter Ended March 31, 1997
Sales revenue ($170 x 500 units) $85,000
Less: Ending balance of finished goods inventory* 296,250
* 3,000 units at $98.75 each = $296,250
Quarter 3. The income statement for Quarter 3 is as follows:

Mickey’s Mowers
For the Quarter Ended June 30, 1997
Sales revenue ($170 x 3,500 units) $595,000
Less: Ending balance of finished goods inventory* 148,125
* Since we sold 1,500 units out of inventory, there are 1,500 units left at $98.75 each, or $148,125
Quarter 4. The Quarter 4 income statement is as follows:

Mickey’s Mowers
For the Quarter Ended September 30, 1997
Sales revenue ($170 x 3,500 units) $595,000
Less: Ending balance of finished goods inventory* 0
* Since we sold 1,500 units out of inventory, there now are no units left
Question 2
Because of the matching principle, the cost of goods sold is based on the number of units sold, not pro-
duced. In effect, cost of goods sold could be computed as follows:
500 units x $98.75 per unit = $49,375
Question 3
Under variable costing, fixed costs are not absorbed into inventory. Instead they are treated as period costs.
If Mickey’s Mowers were to use variable costing, its income statements would look as follows for the four quar-
ters:
____________________________________________________________________________________________________________
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total

Revenue $85,000 $85,000 $595,000 $595,000 $1,360,000
Less: Variable costs ($80/unit) 40,000 40,000 280,000 280,000 640,000
Contribution margin $45,000 $45,000 $315,000 $315,000 $720,000
Less: Fixed costs (150,000_4/quarter) 37,500 37,500 37,500 37,500 150,000
Contribution to selling and G&A $7,500 $7,500 $277,500 $277,500 $570,000
Percent of revenue 8.8% 8.8% 46.6% 46.6% 41.9%
This compares to the following income statements under absorption costing:
Revenue $85,000 $85,000 $595,000 $595,000 $1,360,000
Less: Cost of goods sold 49,375 49,375 345,625 345,625 790,000
Gross margin $35,625 $35,625 $249,375 $249,375 $570,000
Percent of revenue 41.9% 41.9% 41.9% 41.9% 41.9%
The following differences emerge between pro ts under the two approaches:
Variable costing - absorption costing ($28,125) ($28,125) $28,125 $28,125 0
Question 4
There are three general conclusions that can be drawn from this comparison:
1. With variable costing, the contribution to selling costs and G&A costs is more volatile than gross mar-
gin under absorption costing. Indeed, under absorption costing, the gross margin percentage is identi-
cal from one period to the next, whereas the contribution percentage uctuates quite widely.
2. Other things equal, net income under variable costing exceeds that of absorption costing when sales
exceed production (as was the case in the third and fourth quarters). When sales is less than production
(the rst and second quarters), net income under absorption costing exceeds that of variable costing.
3. The difference between the two methods lies in xed costs. Under variable costing, all xed costs are
expensed as period costs. Under absorption costing, xed costs are absorbed into inventory at the time
of production, and held in nished goods inventory until the goods are sold. In the above example, the
xed cost component of each item in inventory was $18.75. Thus, when inventory grew by 1,500
units, $28,125 ($18.75 x 1,500 units) of xed costs were put into inventory. This accounts for the dif-
ference between the pro ts under variable and absorption costing. That is, under variable costing
$28,125 of xed costs were included in the computation of net income. Under absorption costing,
these costs were “hidden” in inventory, and did not appear on the income statement in that quarter. As
a result, the net income under variable costing was $28,125 less than under absorption costing.
As the following table shows, the situation turns around during the year:
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Change in inventory from last quarter
(# of units) +1,500 +1,500 -1,500 -1,500
Fixed cost component of each item = ($98.75 - $80.00 = $18.75)
Change in inventory amount under absorption costing
($18.75 x change in units) $28,125 $28,125 ($28,125)($28,125)
Note that this offsets the pro t differences shown above.
Advice to Mr. Snider. While it is true that the variable costs for each quarter will show less uctuation than
the cost of goods sold, the bottom line (either contribution to Selling and A&G, or the gross margin, which must
cover Selling and A&G) shows greater uctuation under variable costing. It is 8.8 percent of revenue in the rst
two quarters and 46.6 percent of revenue in the last two. By contrast, under absorption costing, gross margin is
exactly 41.9 percent of revenue in each quarter. Earnings will uctuate quite naturally, since sales uctuate so
widely, but the matching of xed expenses with revenue results in a smoother pattern of earnings under absorp-
tion costing than under variable costing. If you want to minimize the uctuations in cost of goods sold (or vari-
able costs, its equivalent in a variable costing system), then a variable costing system is the preferred approach.
If you want to minimize the uctuations in earnings, an absorption system is the better approach.

Note On Variable and Absorption Costing

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Note On Variable and Absorption Costing

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HBSP Product Number TCG 323

THE CRIMSON PRESS CURRICULUM CENTER

Note on Absorption and Variable Costing

Exhibit 1. LEARNING OBJECTIVES

• Flexible overhead budgets and the computation of overhead variances

• The managerial uses of overhead variances

Exhibit 2. MANUFACTURING COST TERMINOLOGY

Direct Manufacturing Costs

Exhibit 3. JOB TICKET FOR BUZZARD WOODWORKS

3226 3 Aug 99 24 Aug 99

Desk and bookcase for Sanford residence

Week Materials Direct Labor Overhead Total

3 Aug $550.00 $275.00 $137.50 $962.50

10 Aug 350.00 175.00 525.00

17 Aug 100.00 200.00 100.00 400.00

24 Aug 125.00 62.50 187.50

TOTAL $650.00 $950.00 $475.00 $2,075.00

Exhibit 5 INCOME STATEMENT: FUNCTIONAL CLASSIFICATION

Curtainworks. Statement of Cost of Goods Manufactured

Curtainworks. Income Statement: Functional Classi cation

Curtainworks. Statement of Cost of Goods Manufactured

Curtainworks. Income Statement: Functional Classi cation

THE OVERHEAD RATE

Predetermined Overhead Rates

Number Machine Total Overhead Overhead

Exhibit 6. SUMMARY OF MANUFACTURING OVERHEAD (MOH)

| Spending Variance | | Ef ciency Variance | | Volume Variance |

Fixed Variable Cost

$76,200 +( $10.20/hr * 12,000 units * 1 hr/unit) = $198,600

March = 800 units * 1 hr/unit * $16.55/hr = $13,240

March = $6,350 + ($10.20 * 800 hours) = $14,510

March = $13,240 - $14,510 = ($1,270)

March = $6,350 + ($10.20 * 900 hours) = $15,530

March = $14,510 - $15,530 = ($1,020)

March = $15,530 - $16,000 = ($470)

March = ($1,020) + ($470) = ($1,490)

Month Volume Variance Budget Variance Total Variance

Month 2 Beginning balance 0 0

Exhibit 8. ABSORPTION COSTING VERSUS VARIABLE COSTING

FINISHED Direct FINISHED

Cost of Goods Manufactured For Month 1

Cost of Goods Manufactured For Month 2

Variable manufacturing overhead

Plus: Beginning balance of work in process inventory

Equals: Total manufacturing costs this plus prior periods

Less: Ending balance of work in process inventory

Income Statement: Functional Classification For Month 2

Less: Cost of goods sold:

Beginning balance of finished goods inventory

Equals: Cost of goods sold

Fixed manufacturing overhead

Period Costs: Fixed manufacturing overhead 0 $60,000

Product cost per unit for each unit manufactured is as follows:

The income statement would look as follows:

Cost of Goods Manufactured For Month 3

Total Manufacturing Costs this Period

Equals: Total manufacturing costs this plus prior periods

Cost of Goods Manufactured

Less: Ending balance of finished goods inventory

Answer: The cost of goods manufactured statement would look as follows:

The income statement would look as follows:

Income Statement: Functional Classification For Month 3

Exhibit 9. RELATIONSHIP AMONG PRODUCTION, SALES, AND INCOME: