# Management Accounting: Concepts, Techniques & Controversial Issues

## Chapter 4Normal Historical Full Absorption Job Order Costing

James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida

CONTENTS

Learning Objectives | Introduction | Recording Transactions & Cash Flows | The T-Accoung Approach | The Journal Entry Approach | Predetermined Overhead Rates | Choosing an Allocation Basis | Choosing an Activity Level | Estimating Cost for the Activity Level | Calculating and Using the Rate | But Why Use a Predetermined Overhead Rate? | More Detailed Overhead Analysis | Closing Variances at the End of a Period | Normal Historical Costing Related to Systems Functions | Accounting for Spoilage Rework and Scrap | Footnotes | Questions | Problems | Problem Solutions | Extra MC Questions | Extra Problem for Demo or Self Study

LEARNING OBJECTIVES

After you have read and studied this chapter, you should be able to:

1. Discuss how the combination of normal historical, full absorption and job order costing form the major sub-components of a cost accounting system.
2. Describe a generic set of general ledger accounts for the system discussed in objective 1.
3. Discuss the cost flow concept as it relates to accounting entries.
4. Explain how various transactions are recorded in the ledger accounts discussed in objective 2.
5. Describe the source documents needed to record the various transactions that relate to materials, labor, overhead and individual jobs.
6. Provide both conceptual and operational definitions for the term "predetermined overhead rate."
7. Discuss the concept of accounting control.
8. Explain how the accounting control concept is used in normal historical costing.
9. Discuss how well the system described in this chapter satisfies the four purposes, or functions of an information system discussed in Chapter 2.
10. Provide conceptual definitions for the terms spoilage, rework and scrap.
11. Explain how to account for the costs associated with spoilage, rework and scrap.
12. Compare the accounting and statistical control concepts.

INTRODUCTION

In this chapter we move from the abstract concepts described in Chapter 2 towards an operational cost accounting system. The main focus of the chapter is to show how the concepts of accounting are put into practice. This is accomplished by combining five of the sub-components presented in Exhibit 2-1 to form a generic cost accounting system. More specifically, this system combines normal historical, full absorption and job order costing where costs are accumulated by jobs and flow through perpetual inventory records. An overall view of these system choices appears in Exhibit 4-1.

The chapter includes five sections. The first section illustrates how various transactions are recorded and how the costs flow through a generic set of inventory accounts. The accounting techniques are described and illustrated by example using T-accounts and journal entries. The second section provides a conceptual definition for predetermined overhead rates and includes an explanation of why they are used. Section three introduces the concept of accounting control as it relates to factory overhead costs. This section includes the types of variance analysis that can be performed in normal historical costing and illustrations of the variances by example. The fourth section provides a discussion of the normal historical, full absorption, job order cost system in terms of the four purposes, or functions of an information system previously outlined in Exhibit 2-4. The last section introduces the concepts of spoilage, rework and scrap and provides illustrations of some of the applicable accounting techniques. This section also includes a comparison of the statistical and accounting control concepts from the perspective of monitoring spoilage costs.

RECORDING TRANSACTIONS AND COSTS FLOWS

In a normal historical, full absorption, job order cost system, costs flow through the perpetual inventory accounts in a specific manner. There are two ways to illustrate the technique. One very revealing method uses T-accounts to represent the general ledger accounts involved. The second method illustrates the same transactions using general journal entries. Both methods are presented below.

THE T-ACCOUNT APPROACH

The T-account approach is illustrated in Exhibit 4-3 using a generic set of accounts. The accounts presented in the exhibit are fairly common, although the account structure and terminology tends to vary somewhat from company to company. The numbers that are circled in Exhibit 4-3 refer to twelve typical transactions that occur during an accounting cycle.1 These transactions are presented in Exhibit 4-2.

 EXHIBIT 4-2 Twelve Typical Transactions That Occur Frequently During an Accounting Cycle Number Transaction 1 The purchase of direct and indirect materials. 2 The distribution of direct material to work in process. 3 The distribution of indirect material to factory overhead. 4 The purchase of direct and indirect labor resulting in factory payroll costs. 5 The payment of the payroll to the factory employees. 6 The distribution of indirect labor to factory overhead. 7 The distribution of direct labor to work in process. 8 The purchase of other indirect resources resulting in additional overhead costs. 9 The application of factory overhead to the inventory. 10 The transfer of completed jobs to finished goods. 11 The transfer of inventory costs to cost of goods sold. 12 The sales of finished products.

Cost Flow Versus Cost Creation

Note that the entries identified with two way arrows in Exhibit 4-3 indicate a simultaneous increase, or decrease, in the accounts affected. For example, when an inventory cost is originally incurred, the asset (unexpired cost) and liability simultaneously increase, as in entries 1 and 4. On the other hand, entries identified with one way arrows indicate a flow of costs from one account to another. Most of the entries in the exhibit represent this type of one way flow of costs towards finished goods and cost of goods sold.

Control Versus Subsidiary Accounts

Observe that several of the accounts in Exhibit 4-3 are labeled control accounts. These include: materials, factory overhead, work in process, and finished goods. Each of these control accounts is supported by a subsidiary ledger. The subsidiary ledger accounts contain information about each type of material and each job or order. This sub-account approach is much the same as that used for accounts payable and accounts receivable. For example, the sum of the balances of the individual sub-accounts for materials must be equal to the balance in the control account.

Explanation Of the Entries

Entry 1. The costs of materials purchased are charged to the materials control account. The offsetting credit is to accounts payable, or cash. A subsidiary ledger supports the materials control account as indicated above. These sub-accounts can be represented by a manual card file or a separate computer file. In a manual card file, a separate card is used for each type of material. In a computerized system, random access records replace the card files. However, in either case, the balance in the control account is equal to the sum of the balances in these sub-accounts or files.

Entries 2 and 3. A requisition (form) showing the type, quantity and cost of material is completed as various materials are issued. The information needed to distribute materials costs in entries 2 and 3 comes from a summary of these requisitions. The amount representing direct material costs is charged to work in process. The individual requisitions are also used to record the distribution in the subsidiary ledger accounts, including the materials sub-accounts and the job cost sheets. The job cost sheets represent the sub-accounts that support the work in process control account. Indirect materials are charged to factory overhead as indicated by entry 3.

Entries 4 and 5. The factory payroll account is used as a clearing account in the approach illustrated in Exhibit 4-3. All factory labor costs are charged to this account (entry 4) until the necessary information is available to distribute the payroll. The wages and salaries payable account represents the liability for net pay, i.e., gross pay less withholding. The amounts withheld for federal income taxes (FIT), federal insurance contributions act tax (FICA), and other deductions are credited to the appropriate liability accounts. Entry 4 reflects the fact that the employer acts as a collection agent for the federal and state governments. Entry 5 records the payment to factory employees. Note that the amount is equal to the net pay and the credit is to cash.

Entries 6 and 7. Records are frequently kept indicating the amount of time factory workers spend in the factory (e.g., time clock cards) and where they spend their time (e.g., labor time tickets). A summary of this information is used to determine the amount of direct and indirect labor to distribute and the individual amounts of direct labor to charge to each job. The direct labor costs are charged (or distributed) to work in process and the individual jobs (i.e., job cost sheets). Indirect labor costs are charged to the factory overhead account because these costs cannot easily be identified with any particular job.2

Entry 8. The credits in entry 8 include accounts such as accumulated depreciation, accounts payable, prepaid insurance, pension cost, and several others. Remember that all factory costs, other than direct material and direct labor, are charged to factory overhead.

Entry 9. Overhead is applied on the basis of a predetermined overhead rate in a normal historical, full absorption costing system. Assuming the overhead rate is based on direct labor hours, then applied overhead is calculated by multiplying the total overhead rate by the actual direct labor hours used during the period. This amount is charged to work in process and the offsetting credit is to the factory overhead control account.3 An appropriate amount of overhead cost is also calculated and charged to each job based on the number of direct labor hours associated with the job. More details on the treatment of factory overhead are provided below, and in subsequent chapters.

Entry 10. The cost of goods manufactured is represented by the cost of completed jobs in a job order cost accumulation system. This amount flows out of work in process into finished goods inventory. Note that finished goods is also a control account, i.e., it is supported by a subsidiary ledger of completed job cost sheets.

Entries 11 and 12. These entries are made to record the sale of completed products or jobs. The COGS flows out of finished goods into the cost of goods sold account transforming these costs from assets (unexpired costs) to expenses (expired costs). The last entry simultaneously records the increase in the asset (accounts receivable or cash) and revenue (sales) accounts.

THE GENERAL JOURNAL ENTRY APPROACH

Journal entries for the twelve transactions appear in Exhibit 4-4. Of course debits appear on the left and credits appear on the right. Although Materials, Factory overhead, Work in process and Finished goods represent control accounts, the term "control" is frequently dropped from the account titles for convenience. It is added to the account titles in Exhibits 4-3 and 4-4 to emphasize the nature of the accounts. The term "clearing" is added to the factory payroll account title for the same reason, but the shorter term factory payroll is used in subsequent illustrations. A somewhat more revealing example is presented in the next section with numerical data.

 EXHIBIT 4-4 General Journal Entries for Normal Historical Job Order Costing 1. Entry to record materials purchases Materials Control xxx Accounts Payable xxx 2. Entry to record direct material usage Work in Process Control xxx Materials Control xxx 3. Entry to record indirect material usage Factory Overhead Control xxx Materials Control xxx 4. Entry to record the factory payroll Factory Payroll Clearing xxx Wages & Salaries Payable xxx FIT Withheld xxx FICA Withheld xxx Other Withholding Accounts xxx 5. Entry to record the payment of the factory payroll Wages & Salaries Payable xxx Cash xxx 6. Entry to record the indirect labor costs Factory Overhead Control xxx Factory Payroll Clearing xxx 7. Entry to record the direct labor costs Work in Process Control xxx Factory Payroll Clearing xxx 8. Entry to record the other overhead costs Factory Overhead Control xxx Miscellaneous Accounts xxx 9. Entry to record the factory overhead applied Work in Process Control xxx Factory Overhead Control xxx 10. Entry to record the cost of goods manufactured Finished Goods Control xxx Work in Process Control xxx 11. Entry to record the cost of goods sold Cost of Goods Sold xxx Finished Goods Control xxx 12. Entry to record sales Cash xxx Accounts Receivable xxx Sales xxx

EXAMPLE 4-1

The following example is used to provide an illustration of normal historical, full absorption, job order costing with numerical data. The purpose of the illustration is to help strengthen your understanding of the major concepts involved. For this reason, emphasis is placed on summary entries for an accounting period, rather than the detailed source documents (e.g., invoices, material requisitions, labor time tickets, clock cards and job cost sheets) and repetitive entries that are required to maintain perpetual records in an operational cost system.

The Comfort Furniture Company uses a normal historical, full absorption, job order cost system to manufacture home and office furniture for a number of retail chain stores. Transactions for a typical month are provided in Exhibit 4-5. These transactions are recorded in Exhibit 4-6 using the T-account approach. The journal entries for these transactions are presented in Exhibit 4-7.

 EXHIBIT 4-5 Beginning Balances and Transactions for Example 4-1 Beginning balances: Materials \$10,000 Work In Process 1,000,000 Finished Goods 500,000 Transactions: 1. Purchases of materials 300,000 2. Direct material used 204,510 3. Indirect material used 98,000 4. Factory payroll costs; Total payroll costs 1,246,685 FIT withheld 240,000 FICA withheld 100,000 5. Paid Payroll Distribution of factory payroll costs; 6. Indirect labor 642,200 7. Direct labor 604,485 8. Other factory overhead 2,870,800 9. Factory overhead is applied on the basis of direct labor hours. The total overhead rate is \$80 per hour and 39,900 actual direct labor hours were incurred during the period. 10. The cost of jobs transferred to finished goods 4,100,000 11. The cost of jobs sold 4,220,385 12. Sales (80% credit, 20% cash) 5,700,000

Explanation of Exhibits 4-6 and 4-7

The beginning balances are entered in Exhibit 4-6 for the materials, work in process and finished goods control accounts. Then the entries are recorded in the sequence in which the transactions occurred.

Entry 1 records the purchase of materials. Entry 2 distributes, or charges the cost of direct material used to work in process. Entry 3 distributes, or charges the indirect material costs to the factory overhead account. Entry 4 records the payroll. The total factory payroll is charged to the factory payroll clearing account until enough information is available to distribute these costs to the work in process and factory overhead accounts. This may be a little confusing since the data provides a summary of the transactions for an entire month. However, the entries to record the payroll are normally made on a weekly basis as the employees are paid.

Entry 5 records the payment of the factory payroll. The credit to cash is for the net payroll, i.e., gross payroll less withholding. Entries 6 and 7 distribute the payroll costs. The information needed for these entries comes from a summary of the labor time tickets and other labor records. Indirect labor costs are charged to factory overhead in entry 6. Direct labor costs are charged to work in process in entry 7.

The other factory overhead costs are recorded with entry 8. Of course this entry represents a summary of many different transactions. Entry 9 records the factory overhead applied. The amount, \$3,192,000, is found by multiplying the \$80 overhead rate by the 39,900 actual direct labor hours used. This leaves a balance in the factory overhead account. What the balance means and what we do with it are discussed below in the next section.

Entry 10 records the cost of completed goods that are transferred from work in process to finished goods. Cost of goods sold is recorded with entry 11 and the sales revenue is recorded with entry 12.

 EXHIBIT 4-7 General Journal Entries for Example 4-1 1. Entry to record materials purchases Materials Control 300,000 Accounts Payable 300,000 2. Entry to record direct material usage Work in Process Control 204,510 Materials Control 204,510 3. Entry to record indirect material usage Factory Overhead Control 98,000 Materials Control 98,000 4. Entry to record the factory payroll Factory Payroll Clearing 1,246,685 Wages & Salaries Payable 906,685 FIT Withheld 240,000 FICA Withheld 100,000 5. Entry to record the payment of the factory payroll Wages & Salaries Payable 906,685 Cash 906,685 6. Entry to record the indirect labor costs Factory Overhead Control 642,200 Factory Payroll Clearing 642,200 7. Entry to record the direct labor costs Work in Process Control 604,485 Factory Payroll Clearing 604,485 8. Entry to record the other overhead costs Factory Overhead Control 2,870,800 Miscellaneous Accounts 2,870,800 9. Entry to record the factory overhead applied (\$80)(39,900) Work in Process Control 3,192,000 Factory Overhead Control 3,192,000 10. Entry to record the cost of goods manufactured Finished Goods Control 4,100,000 Work in Process Control 4,100,000 11. Entry to record the cost of goods sold Cost of Goods Sold 4,220,385 Finished Goods Control 4,220,385 12. Entry to record sales Cash 1,140,000 Accounts Receivable 4,560,000 Sales 5,700,000

Since there are many types of manufacturing costs that fall into the indirect category, (i.e., common or shared costs that cannot easily be traced to any particular product or job) some method is needed to charge, allocate or apply these costs to the products manufactured.4 A predetermined overhead rate provides a convenient way to accomplish this system requirement. Developing an overhead rate involves four steps that include: 1) choosing an activity measurement, or allocation basis, 2) choosing an activity level, 3) estimating indirect costs for the activity level chosen, and 4) calculating the rate.

CHOOSING AN ALLOCATION BASIS

The first step involves choosing the manner in which activity will be measured. This activity measurement becomes the allocation basis. In traditional cost systems, production volume is assumed to be the only major activity. Therefore, it seems logical that the number of units produced should be used as the activity measurement, or allocation basis. However, in a job order cost system, the units produced cannot serve as the activity measure because each unit, or group of units, tends to be different. For this reason, a measurement related to production volume such as direct labor hours, direct labor costs, or machine hours is normally used to represent production activity. Direct labor costs and hours are the two most popular allocation bases because this information is already captured by the payroll system. However, the overhead allocation basis should be closely associated with the overhead costs to be estimated. The techniques discussed in Chapter 3 can be used to look for an activity measure that is highly correlated with the various types of overhead costs and also meets the other requirements discussed in Chapter 3. Of course more than one allocation basis may be needed to accurately allocate (trace) the many different types of indirect costs to products.

CHOOSING AN ACTIVITY LEVEL

Before the period starts, cost estimates are made for each type of indirect resource based on a particular activity level chosen by management. This activity level can represent practical productive capacity, planned production, or some other level of capacity. These alternatives are discussed in more detail in subsequent chapters and other parts of the MAAW web site (e.g., see the note on denominator activity levels). For now, we will assume that planned production for the year is used for this purpose.

ESTIMATING COST FOR THE ACTIVITY LEVEL CHOSEN

Before an overhead rate can be calculated, the analyst must estimate the indirect costs for the period based on the activity level chosen in the previous step. Any of the techniques discussed in Chapter 3 can be used for this purpose. Regression analysis is very useful for cost estimating. Learning curve analysis is also useful, particularly where the process, or work to be performed is relatively new to the company.

CALCULATING AND USING THE RATE

The overhead rate is calculated by dividing the total estimated overhead costs by the quantity of the activity measure estimated for the activity level chosen. The result is a dollar amount of overhead costs per measure of activity, e.g., per direct labor hour, or per dollar of direct labor costs. Then each job is charged with an amount of overhead costs determined by multiplying the overhead rate by the actual quantity of the activity measure identified with the job. Typically this is a rate per direct labor hour multiplied by the number of direct labor hours associated with the job.

BUT WHY USE A PREDETERMINED OVERHEAD RATE?

At this point you might be wondering, why not simply divide the actual total overhead costs incurred during the period by the actual total number of the activity measure used during the period and then use this rate to apply overhead to the jobs produced? This intuitively appealing approach works okay for a textbook problem, where all the data for the entire accounting period are given at once. However, there are three important reasons why using a predetermined overhead rate is more appropriate in practice. These include: 1) to average or normalize unit overhead cost, 2) to provide more timely information and 3) to provide a method for monitoring, evaluating and controlling overhead costs.

To Average or Normalize Unit Overhead Cost

Assuming direct labor hours are used to apply overhead costs, a job is charged with an annual average amount of overhead per hour (i.e., per measure of activity) multiplied by the number of hours required to finish the job. The alternative is to charge the job with an average amount of overhead for the day, week, or month in which it is produced. However, if the quantity produced each period varies, then similar jobs produced in different periods will have very different costs. The reason for this is that many manufacturing cost are fixed and some variable costs are rather erratic, i.e., they do not increase in an even continuous manner. Without a predetermined overhead rate, jobs produced in low volume periods will be charged with large amounts of fixed and erratic variable overhead, while jobs produced in high volume periods will be charged with small amounts of these types of overhead. This will distort inventory costs, and cause prices to be very inconsistent where the company uses cost plus pricing.5 Allowing prices for similar work to vary significantly from period to period will confuse and irritate customers. In addition, estimating costs for price quotes or contract bids will be very difficult. Note, however that if production is continuous and spread evenly throughout the year, a predetermined overhead rate will not be needed to normalize unit costs because normalization will occur automatically.

To Provide More Timely Information

When a predetermined overhead rate is used, the cost of a job can be determined when the job is finished. Then the job can be priced and the customer can be billed in a timely manner without having to wait until the end of the period to obtain the necessary information.

To Provide a Method for Monitoring, Evaluating and Controlling Overhead Costs

Why are Actual and Applied Overhead Costs Different?

The reasons actual and applied overhead costs are different are frequently separated into two categories. Overhead variances occur when: 1) the actual quantities used and actual prices paid for the various indirect resources are different from the prices and quantities estimated or budgeted for the overhead rate calculation and 2) the actual level of activity is different from the activity level used to calculate the overhead rates. The first category of differences causes variances for both variable and fixed overhead costs. The second category is only related to fixed costs.

To use this accounting control methodology, we need to separate the total overhead variance into two categories as indicated above. To do this, the total overhead rate must be separated into a variable overhead rate and a fixed overhead rate. Then separate variances can be calculated as follows.

Variable Overhead Spending Variance

The variable overhead spending variance is calculated by comparing the actual amount of variable overhead costs incurred with a revised, or flexible budget based on the actual activity level achieved. The calculation is as follows:

Variable Overhead Spending Variance = Actual variable overhead costs - A flexible budget for variable overhead costs based on actual hours used.

= Actual Variable overhead costs - (Variable overhead rate)(Actual DL Hours)

Or using a few symbols to represent the quantities involved, the spending variance is:

Variable Overhead Spending Variance
= AVO - (VOR)(AHU)

where:
AVO = Actual variable overhead costs incurred.
VOR = Variable overhead rate (predetermined).
AHU = Actual direct labor hours used.

It is best to ignore the signs and think about the purpose of the variance when labeling a variance as favorable or unfavorable. If the actual costs are greater than the flexible budget costs, the variance is unfavorable, i.e., the company spent more than the budget allows. If actual overhead costs are less than the flexible budget, the variance is favorable. These designations are helpful, but not as useful as they might appear. Favorable and unfavorable do not always represent good and bad. Aside from the randomness that occurs in any measurement, (discussed below) a favorable variance can indicate that something is wrong. For example, assume that less experienced indirect laborers are hired for equipment maintenance than originally estimated in the budget. Paying these workers a lower than budgeted wage per hour will cause a favorable variable overhead spending variance. However, this can be very costly if the equipment breaks down because of inadequate maintenance.

Why use a flexible budget?

Why use a flexible budget in the above calculation? Why not compare the actual variable overhead costs for the month with the original budget for the month? Because the two are not likely to be comparable. The original budget is usually based on a different level of activity than the actual activity level achieved. This difference (caused by unexpected events and normal variation within the system) may be large or small, but to evaluate the actual costs we need to compare the actual variable overhead costs with a budget estimate for the actual activity level, i.e., compare the cost of the actual work performed with a budget for the actual work.

What does the variable overhead spending variance mean?

The meaning of the variable overhead spending variance is confusing because the variance cannot be interpreted precisely. This is because it is a mixed price and quantity variance, and normally there is no way to separate the price and quantity elements. Why not? Because when we calculate the flexible budget amount, we are using the actual inputs of the activity measure (actual direct labor hours in our example) to estimate the actual quantities of the indirect resources. If the activity measure used to allocate overhead costs is not perfectly correlated with the indirect costs, (i.e., if r2 < 1) then the spending variance will include a variance related to the quantity estimate involved in the calculation. In fact, the variable overhead spending variance will always include a variance caused by an estimating error, i.e., difference between the actual quantities of the indirect resources and the quantity estimates included in the flexible budget. Therefore, further investigation is needed to interpret the variance precisely. We will return to this problem in Chapter 10.

Graphic Analysis of Variable Overhead Costs

Although a graphic approach is not very useful for solving problems, graphs can be very useful for visualizing the concepts involved. With this in mind, examine the graphic analysis presented in Figure 4-1. Point A represents the actual variable overhead costs. Point B represents a flexible budget based on actual direct labor hours used. The vertical difference between these two points represents the variable overhead spending variance. When point A is above the flexible budget line, the variance is unfavorable. When point A is below the flexible budget line, the variance is favorable. Also observe that applied variable overhead and flexible budget variable overhead based on actual direct labor hours are represented by the same point. These two calculations are identical in normal historical job order costing.6

Fixed Overhead Spending Variance

There are two variances for fixed overhead. These include the fixed overhead spending variance and the idle capacity variance. A fixed overhead spending variance is calculated in essentially the same manner used for the variable overhead spending variance calculation, except the budget amount for fixed overhead is static, not flexible. The variance is calculated by comparing the actual amount of fixed overhead costs to the original amount budgeted for fixed overhead. More specifically, the calculation is as follows:

Fixed Overhead Spending Variance = Actual fixed overhead costs - Original static amount budgeted for fixed overhead costs.

Using symbols, the variance can be expressed as,

Fixed overhead spending variance = FOSV = AFO - BFO

where: FOSV = Fixed overhead spending variance.
AFO = Actual fixed overhead incurred.
BFO = Budgeted fixed overhead.

Now, make a mental note of a very important point. There is only one amount for budgeted fixed overhead. This is the original static amount. A flexible budget is not applicable to fixed overhead because, by definition, fixed overhead costs are not affected by the level of activity in the short run. Thus, the amount of budgeted fixed overhead is the same for any level of activity that may be achieved in the current period.

Relationship between the overhead rate and the static amount

In some problems, the static amount for budgeted fixed overhead is not available. However, the fixed overhead rate and the denominator activity chosen to calculate the rate can be used to find the missing amount. In such cases, budgeted fixed overhead is calculated as follows:

Budgeted fixed overhead = (FOR)(DH)

where:

FOR = Fixed overhead rate.
DH = Denominator hours used to calculate the rate.

To understand why this works, consider the original rate calculation.

FOR = Budgeted fixed overhead ÷ DH

If we multiply each side of this equation by DH we have Budgeted fixed overehead = (FOR)(DH). This is not a flexible budget calculation. It is simply a way to reconstruct the original (and only) budget amount for fixed overhead if it is not available. Information is occasionally lost for a variety of reasons including fire, flood, storm, computer virus, hard disk failure and carelessness.

Why fixed costs are not constant

How can a fixed overhead spending variance occur? How can fixed costs be different from the budget if they are fixed? Remember, fixed does not mean constant. Fixed simply means that the costs do not vary as a result of changes in the activity. However, actual fixed overhead costs can be different from budgeted fixed overhead costs for some other reason. For example, a salaried factory employee may resign, die, or be promoted to an administrative position. Any cost can change in the short run. It is the reason that costs change that separates variable costs from fixed costs.

What does the fixed overhead spending variance mean?

The meaning of the fixed overhead spending variance is somewhat different from the meaning of the variable overhead spending variance. Although both spending variances measure the difference between actual overhead cost incurred and budgeted overhead cost, the budgeted amounts are calculated differently. The budget amount included in the calculation of the fixed overhead spending variance can not contain an estimating error because the calculation is based on the original budgeted amount. This is because the quantities of the resources represented by fixed overhead are not related to the level of activity. For this reason, a new flexible budget estimate of the fixed resource quantities is not needed, or appropriate, in the fixed overhead spending variance calculation. Thus, the fixed overhead spending variance is a combined price and quantity variance that is not influenced by a potential flexible budget estimating error. In that sense, it is more easily interpreted than the variable overhead spending variance, although the price and quantity elements of the variance cannot be separated without further analysis.

The Idle Capacity Variance

The idle capacity variance is a measure that relates to the second category of reasons why actual overhead costs may differ from applied overhead costs. This variance measures the difference between budgeted fixed overhead costs and applied fixed overhead costs as follows:

Idle Capacity Variance = Original static budget for fixed overhead costs - Applied fixed overhead costs

= Budgeted Fixed Overhead Costs - (Fixed Overhead Rate)(Actual DL Hours)

= BFO - (FOR)(AHU)

An alternative calculation for the idle capacity variance is:

Idle capacity variance = (Denominator Hours - Actual Hours)(Fixed Overhead Rate)

= (DH - AHU)(FOR)

What does the idle capacity variance measure?

The idle capacity variance measures the over or under applied fixed overhead caused by the difference between the two activity or volume levels, i.e., the one used to set the overhead rates, referred to as denominator hours (DH), and the actual activity level achieved represented by actual hours (AHU). This variance is caused by normalizing (averaging) fixed overhead costs.

Controllable versus Uncontrollable

The spending variances are referred to as controllable variances because they involve actual costs. Management is assumed to have some control (i.e., influence) over actual costs, both fixed and variable. However, the idle capacity variance is referred to as an uncontrollable variance because there are no actual overhead costs involved in the calculation. It measures the difference between budgeted fixed costs and applied fixed costs. The variance will be different if a different level of activity is chosen as a basis for calculating the overhead rates, but this has nothing to do with controlling actual costs. Note, again, that budgeted fixed costs are the same for any activity level. However, applied fixed costs increase as output increases. Why? Because applied fixed costs are used to assign costs to products and jobs. When the company produces below the activity, or output level used to set the overhead rates, this causes an unfavorable idle capacity variance, i.e., less fixed overhead is applied than budgeted. When the company produces above the output level used to set the overhead rates, this causes a favorable idle capacity variance, i.e., more fixed overhead is applied than budgeted.

The idle capacity variance is a relative measurement, i.e., it is favorable or unfavorable relative to the activity level used to set the overhead rates. For example, if the activity level used to set the overhead rates is based on fifty percent of practical capacity, the company will show a favorable idle capacity variance when it produces at fifty-five percent of practical capacity. The variance is favorable even though forty-five percent of the company’s capacity is idle. However, an advantage obtained by calculating the idle capacity variance is that the controllable and uncontrollable variances are isolated. The uncontrollable part of the total variance is separated from the part that may require more detailed analysis, i.e., the spending variances.

A Graphic Analysis For Fixed Overhead Cost

Figure 4-2 provides a graphic illustration for fixed overhead costs. The budget line is horizontal indicating the static nature of budgeted fixed overhead. As the number of direct labor hours changes, budgeted fixed overhead remains constant. However, the applied fixed overhead line is upward sloping indicating that applied fixed overhead costs increase as the number of direct labor hours increases. Note that the slope of the applied fixed overhead line is the fixed overhead rate (FOR). The two lines, budget and applied, intersect at a point (E) vertically above denominator hours (DH). The vertical difference between the two lines (B-C) measures the idle capacity variance. If more actual direct labor hours are used, points B and C will be further to the right than illustrated in the graph. When actual hours used (AHU) are equal to denominator hours (DH), then C, B and E will be represented by the same point at the intersection of the two lines and the idle capacity variance will be equal to zero. When actual hours used are greater than denominator hours, then AHU will be to the right of the intersection and the idle capacity variance will be favorable. The fixed overhead spending variance is measured by the vertical difference between points A and B. When the actual costs (A) are above the budget (B), the spending variance is unfavorable. When the actual costs are below the budget line, the spending variance if favorable.

Idle Capacity Variance Distortion Caused by Labor Efficiency

Although the idle capacity variance is a measure of capacity utilization, it is based on an input measurement, not an output measurement. As mentioned earlier, a company cannot use the units of output as the activity measurement because the products tend to be different in a job order cost system. For this reason, actual direct labor hours provide a convenient substitute for allocating overhead and measuring capacity utilization. However, a problem arises because all direct labor hours do not generate the same amount of output. What this means is that variations in labor efficiency distort the idle capacity variance. When direct labor is inefficient, i.e., uses time without producing very much, the idle capacity variance is less unfavorable, or more favorable that it would be if output were used to measure capacity utilization instead. When labor is efficient, the idle capacity variance is more unfavorable, or less favorable than it would be if output were used to measure capacity. This may sound like the opposite of what you might expect, but in normal historical job order costing, actual time consumed is the measure of capacity utilization, not output. The inability to distinguish between productive time and unproductive time tends to make the idle capacity variance less useful as a measurement. A better measure of capacity utilization referred to as the production volume variance is available in a standard cost system. This variance is discussed in Chapters 9 and 10.7

MORE DETAILED OVERHEAD ANALYSIS

How can the analyst use the spending variances after they are calculated? To be useful in evaluating costs, the spending variances must be subdivided into individual spending variances for each type of overhead cost, i.e., the actual amounts and budgeted amounts must be compared for the various types of indirect resources such as indirect material, indirect labor, repair cost, electric power and materials handling. The idea is to examine each type of cost to monitor the overall performance of the related activities during the period.

As indicated above, the idle capacity variance is not a controllable variance. For this reason no useful purpose would be served by separating it into pieces. There is no reason to investigate the individual types of fixed costs to uncover the cause of the variance. We know it is caused by a difference between the activity level used to calculate the overhead rates and the actual activity level achieved during the period. Although individual idle capacity variances do not serve a useful purpose, management needs to know whether the volume difference that created the idle capacity variance is caused by expected seasonal fluctuations in monthly sales and production, or by unexpected changes in demand or other problems such as a breakdown on the production line. Of course, the distortion discussed above related to labor efficiency tends to confuse the issue.

CLOSING THE VARIANCES AT THE END OF A PERIOD

There are a number of ways to handle the variances at the end of an accounting period. A convenient approach involves recording the overhead variances when the factory overhead account is closed. The idea is illustrated in Exhibit 4-8 where factory overhead is assumed to be underapplied, i.e., there is a debit balance in the account at the end of the period. Unfavorable variances are recorded with debits and favorable variances are recorded with credits as indicated in Exhibit 4-8. Although the variances are normally closed at the end of the year, they are not necessarily closed on a monthly or quarterly basis when there is a great deal of variation in production from period to period. Closing the idle capacity variance on a monthly basis will distort the inventory cost, cost of goods sold and net income from month to month if there are large seasonal differences in capacity utilization. Closing the variances on a monthly basis will eliminate the normalizing effect discussed earlier and tend to confuse rather than enlighten management concerning the company’s performance. The entries in Exhibit 4-8 are illustrated with some actual data in the example presented below.

EXAMPLE 4-2

The following example extends Example 4-1 to illustrate the factory overhead variance analysis discussed in the previous sections. As indicated previously, the Comfort Furniture Company applies overhead on the basis of actual direct labor hours. The overhead rates are based on 48,000 direct labor hours of capacity per month, referred to as denominator hours. The budgeted amounts for each type of overhead and the rate calculations are presented in Exhibit 4-9.The Company's actual overhead costs for the period appear in Exhibit 4-10.

Requirements

The requirements associated with recording and analyzing the overhead costs are as follows:
1. Calculate the total variance in factory overhead.
2. Calculate the total spending variance for variable overhead.
3. Calculate the total spending variance for fixed overhead.
4. Calculate the idle capacity variance.
5. Record the actual factory overhead costs.
6. Record applied factory overhead.
7. Close the factory overhead account to the three variance accounts.
8. Calculate spending variances for each type of variable overhead.
9. Calculate spending variances for each type of fixed overhead.

 EXHIBIT 4-9 Overhead Rate Calculations for Example 4-2 Type of Overhead Rate Calculation: Budgeted Overhead Denominator Hours Overhead Rate Per DL Hour Variable Overhead: Indirect material \$120,000 ÷ 48,000 \$2.50 Indirect labor 480,000 ÷ 48,000 10.00 Overtime premiums 48,000 ÷ 48,000 1.00 Repairs & Maintenance 360,000 ÷ 48,000 7.50 Utilities 120,000 ÷ 48,000 2.50 Unemployment taxes 24,000 ÷ 48,000 .50 Idle time 24,000 ÷ 48,000 .50 FICA taxes 24,000 ÷ 48,000 .50 Vacations & holidays 72,000 ÷ 48,000 1.50 Pensions 120,000 ÷ 48,000 2.50 Hospitalization insurance 48,000 ÷ 48,000 1.00 Total variable overhead \$1,440,000 ÷ 48,000 \$30.00 Fixed Overhead: Indirect labor 240,000 ÷ 48,000 5.00 Repairs & maintenance 120,000 ÷ 48,000 2.50 Utilities 48,000 ÷ 48,000 1.00 Unemployment taxes 72,000 ÷ 48,000 1.50 Supervisors salaries 660,000 ÷ 48,000 13.75 Depreciation 720,000 ÷ 48,000 15.00 Property insurance 60,000 ÷ 48,000 1.25 Property taxes 84,000 ÷ 48,000 1.75 FICA taxes 48,000 ÷ 48,000 1.00 Vacations & holidays 144,000 ÷ 48,000 3.00 Pensions 144,000 ÷ 48,000 3.00 Hospitalization insurance 60,000 ÷ 48,000 1.25 Total fixed overhead 2,400,000 ÷ 48,000 \$50.00 Total Overhead rate per DL hour \$3,840,000 ÷ 48,000 \$80.00

The calculations needed to satisfy requirements 1 through 4 are presented in Exhibit 4-11 using the equation approach presented earlier in the chapter.

 EXHIBIT 4-10 Actual Overhead Costs for Example 4-2 Actual Overhead Cost Incurred* Variable Fixed Indirect material \$98,000 - Indirect labor 409,500 \$232,700 Overtime premiums 30,000 - Repairs and maintenance 314,910 120,000 Utilities 106,600 48,000 Unemployment taxes 21,300 72,000 Supervisors salaries - 660,000 Depreciation - 720,000 Property insurance - 61,000 Idle time 19,450 - Property taxes - 83,000 FICA taxes 20,470 46,800 Vacations and holidays 61,400 142,500 Pensions 102,370 142,000 Hospitalization insurance 41,000 58,000 Totals \$1,225,000 \$2,386,000 * 39,900 actual direct hours were used.

A Budget Diagram Approach

An alternative approach for calculating the overhead variances appears in Exhibit 4-12. This method provides an advantage in that all four variances are included in a combined analysis. The analysis in Exhibit 4-12 shows that budgeted overhead costs are used to isolate the two types of variances, i.e., spending (or controllable) and idle capacity (or uncontrollable). The key to performing the analysis correctly is to remember that the budget formula has a static element for fixed overhead and a flexible element for variable overhead, i.e., budgeted overhead costs equal 2,400,000 + (30)(AHU).

T-Accounts and Journal Entries

Requirements 5 through 7 are presented in T-account form in Exhibit 4-13. Journal entries for these requirements appear in Exhibit 4-14. These entries summarize all of the transactions associated with overhead. Entry 5 combines the three entries 3, 6 and 8 from the original example that involve recording actual overhead costs. The original entries appear in Exhibit 4-7. Entry 6 for applied factory overhead is the same as entry 9 in the original example. Entry 7 closes the factory overhead control account to the three overhead variance accounts based on the variances that are calculated in Exhibits 4-11 and 4-12.

Discussion of the Idle Capacity Variance

The analysis presented in Exhibits 4-11, 4-12 and 4-13 shows that most of the total variance in factory overhead costs is related to capacity utilization. Although the overhead rates are based on 48,000 direct labor hours per month, the company used only 39,900 hours. This underutilization of capacity, relative to the dominator capacity level chosen, automatically causes \$405,000 of fixed overhead costs to be underapplied. If planned activity for the entire year is used as the basis for the overhead rates, then the 48,000 hours represents an average monthly activity level. If we assume that the month illustrated in this example is typically a low volume month, then the \$405,000 could easily represent a planned variance. If 39,900 direct labor hours were planned for the month, the actual idle capacity variance is exactly as planned and requires no further investigation. Therefore, what management really needs to know in connection with capacity utilization, is whether the company achieved the planned capacity for the month. The difference between the actual variance and the planned variance provides the information needed to answer this question. The idea of planned, actual and unplanned variances related to capacity utilization is pursued in more depth in Chapters 9 and 10.

 EXHIBIT 4-14 General Journal Entries For Example 4-2 5. Summary Entry to record all factory overhead costs. Factory Overhead 3,611,000 Miscellaneous Accounts 3,611,000 6. Entry to record applied overhead. (\$80)(39,900 direct labor hours) Work in Process 3,192,000 Factory Overhead 3,192,000 7. Entry to record the overhead variances and close the factory overhead control account. Idle Capacity Variance 405,000 Variable Overhead Spending Variance 28,000 Fixed Overhead Spending Variance 14,000 Factory Overhead 419,000

Discussion of the Spending Variances

The spending variances that appear in Exhibits 4-11 and 4-12 are not very revealing because this level of analysis still includes several types of cost aggregation. First, many different types of indirect resource costs are combined (11 for variable overhead and 10 for fixed overhead). In addition, price and quantity variations for the various indirect resources are lumped together and then aggregated for an entire month. Analysis involves dis-aggregating, or dissecting the variances until the analyst feels that the additional benefits would not exceed the additional costs of further analysis. The next step is to calculate individual variances for each type of indirect resource as indicated in requirements 8 and 9. This analysis is presented in Exhibits 4-15 and 4-16.

 EXHIBIT 4-15 Individual Spending Variances For Variable Overhead Type of Variable  Overhead Costs A. Actual Overhead Costs B. Flexible Budget Based on 39,900 Hours* Spending Variance = Difference between A and B Indirect Material \$98,000 \$99,750 \$1,750 F Indirect Labor 409,500 399,000 10,500 U Overtime Premiums 30,000 39,900 9,900 F Repairs & Maintenance 314,910 299,250 15,660 U Utilities 106,600 99,750 6,850 U Unemployment Taxes 21,300 19,950 1,350 U Idle Time 19,450 19,950 500 F FICA Taxes 20,470 19,950 520 U Vacations & Holidays 61,400 59,850 1,550 U Pensions 102,370 99,750 2,620 U Hospitalization Insurance 41,000 39,900 1,100U Totals \$1,225,000 \$1,197,000 \$28,000 U * Predetermined overhead rates from Exhibit 4-8 multiplied by 39,900 hours. For example the flexible budget for indirect material is (2.50)(39,900) = 99,750.

 EXHIBIT 4-16 Individual Spending Variances For Fixed Overhead Type of Fixed Overhead Costs A. Actual Overhead Costs B. Static Budget Amount Spending Variances = Difference Between A and B Indirect Labor \$232,700 \$240,000 \$7,300 F Repairs & Maintenance 120,000 120,000 - Utilities 48,000 48,000 - Unemployment Taxes 72,000 72,000 - Supervisors salaries 660,000 660,000 - Depreciation 720,000 720,000 - Property insurance 61,000 60,000 1,000 U Property taxes 83,000 84,000 1,000 F FICA Taxes 46,800 48,000 1,200 F Vacations & Holidays 142,500 144,000 1,500 F Pensions 142,000 144,000 2,000 F Hospitalization Insurance 58,000 60,000 2,000F Totals \$2,386,000 \$2,400,000 \$14,000 F

Analysis Beyond Individual Spending Variances

To decide whether or not to investigate a specific variance beyond the level indicated in Exhibits 4-15 and 4-16, the analyst must think in terms of control limits, although the accounting methodology is not designed to produce this type of information. The accounting control concept does not include establishing control limits, therefore it cannot indicate whether a variance is outside the limits. Although the analyst might attempt to establish control limits using the statistical process control technique discussed in Chapter 3, the SPC method is not designed for this purpose. The SPC technique is applicable to real time process measurements from a single distribution. The SPC technique measures the variations that occur in the means of samples drawn from a repetitive operation. A single type of overhead costs, such as repair and maintenance involves many different prices, quantities, activities, operations and tasks that are aggregated into one amount. Statistically, a single type of overhead cost represents many different distributions.8

Even though the accounting analyst cannot establish statistical control limits for aggregated cost categories, middle level managers are likely to request an explanation for large variances, e.g., over five or ten percent of the budgeted amount. What these managers and the accounting analyst must understand is that most of the variations in overhead costs are likely to be related to common (system) causes rather than special causes. Therefore, only large suspicious variances should be investigated beyond the level indicated in Exhibits 4-15 and 4-16. Production managers and operating personnel can usually provide the necessary information.

Accounting Control: Art Versus Science

Before moving on to the next section, it is important to understand that the accounting control method described above is more of an art than a science. It provides a general way to help middle level managers monitor overall performance, but it is not a substitute for controlling processes and work on a real time basis. In fact, the information provided in monthly variance reports is likely to be old news to lower level managers who monitor their processes on a day to day basis. Finally, any attempt to force lower level managers to create favorable variances is likely to cause more harm than good. Avoiding this type of mismanagement requires that everyone involved understands the concept of variability. They also need to understand that reducing costs in the long run requires improvements in the system and that this is the responsibility of middle and upper level management.

Overhead Allocations: A Two Stage Process

The illustration presented in this chapter is a relatively simple example provided to help introduce the concepts and techniques involved. However, overhead costs are normally allocated in two stages. In the first stage, overhead costs generated in the various service departments such as, power, maintenance, engineering and plant depreciation are allocated to the producing departments using various bases such as kilowatt hours of electricity, maintenance repair hours, engineering change orders, and the size (square or cubic footage) of each department. Then in the second stage, the overhead costs allocated to each department are allocated to the products or jobs produced in the individual departments. This more involved allocation process is discussed in Chapter 6.

NORMAL HISTORICAL COSTING RELATED TO SYSTEM FUNCTIONS

The four functions of an information or cost accounting system are discussed in Chapter 2 and summarized in Exhibit 2-4. The relevant question here is how well do normal historical, full absorption, job order cost systems meet the various requirements? The answer ranges from adequately to not at all, depending on which function one considers. Normal historical, full absorption costing is perfectly adequate for external reporting (Function 1 in Exhibit 2-4), at least from the GAAP perspective. However, it is inadequate for planning and controlling activities and process (Function 2 in Exhibit 2-4) because of the timing lags and the various cost aggregations involved. Although the method provides some general information that is useful for monitoring overhead costs, it does not provide similar information concerning direct material and direct labor. In addition, the method falls far short of satisfying the requirements for short term and long term strategic decisions (Functions 3 and 4 in Exhibit 2-4). Product costs are distorted by using a single allocation basis for overhead when a company produces many different types of products that consume different proportions of the indirect resources. Therefore, normal historical, full absorption, job order costing is frequently inadequate for pricing decisions and for decisions concerning which suppliers, products, distribution channels and customers to keep and which ones to discontinue. Although some information obtained from a normal historical cost system is relevant to long term strategic decisions, (Function 4 in Exhibit 2-4) most long term decisions require special study and analysis.

ACCOUNTING FOR SPOILAGE REWORK AND SCRAP

The previous illustrations ignore the possibility of producing units that do not meet product, or customer, specifications. This is a convenient way to introduce these topics, but it is not very realistic. Spoilage, defective units, rework and scrap are common in the typical manufacturing environment and should be accounted for and monitored. The purpose of this section is to define these cost categories and to illustrate some of the applicable accounting techniques. This section also includes a comparison of the statistical and accounting control concepts from the perspective of monitoring spoilage costs.

CONCEPTUAL DEFINITIONS

The following conceptual definitions are commonly used for spoilage, normal spoilage, abnormal spoilage, defective units, rework and scrap.

Spoilage: Spoilage refers to units that do not meet product specifications because of damage or other reasons, and that cannot be reworked into good units.

Normal Spoilage: Spoilage up to an acceptable level defined by management is referred to as normal spoilage. Statistically, normal spoilage falls within the control limits on a control chart, although the statistical process control methodology is not always used for this purpose. It is assumed however, that normal spoilage results from common causes. Therefore, normal spoilage is considered to be unavoidable, uncontrollable and part of the cost of producing, i.e., a product or inventoriable cost. These concepts are illustrated in Exhibit 4-17.

Abnormal Spoilage: Spoilage above an acceptable level is referred to as abnormal spoilage. Statistically, it is outside the control limits and interpreted as an out of control condition. Thus, abnormal spoilage is considered to be controllable. Management should be able to keep the amount of spoilage within the control limits. As a result, spoilage cost above the upper limit is charged to a loss account.

Spoilage: Spoilage within the control limits on the chart is considered to be uncontrollable because it is caused by the normal variations within the system. Spoilage above the upper control limit is considered to be controllable because it is caused by a special, or abnormal event or situation that does not occur when the process is stable. Spoilage below the lower control limit is treated as normal spoilage and does not represent a problem.

Defective Units: A defective unit is a term used to indicate a unit that does not originally meet product specifications, although it can be reworked into a good unit of product.

Rework: Rework refers to the costs associated with reworking the defective units to convert them into good products.

Scrap: Raw material fragments such as wood shavings, sawdust, metal filings, cloth cuttings, and other leftover, but unusable, pieces of material are defined as scrap.

METHODS OF ACCOUNTING FOR SPOILAGE

Normal Spoilage

There are two methods of accounting for normal spoilage that are applicable in different situations. When spoilage is common to all jobs, i.e., when it is just as likely to occur on one job as another, spoilage costs are treated like any other overhead cost. The second method is used where the spoilage is caused by the customer's exact specifications. Then the spoilage cost is charged to the customer’s job where it occurred. More specific explanations for these two methods are provided below.

1. Normal Spoilage Common To All Jobs

When spoilage is common to all jobs (i.e., caused by the system) an estimate of spoilage cost (excluding any estimated disposal value) is included in the numerator when the factory overhead rate is calculated. Then some spoilage costs will be charged to each job when overhead is applied to work in process and to each job. The normal spoilage that occurs during the period is charged to factory overhead, less any estimated disposal value. The estimated disposal value is charged to an account for spoilage inventory. For example, assume spoilage in the amount of \$500 was detected during the period. The disposal value is estimated to be \$100 and the spoilage was caused by defects in the raw materials within control limits. The entry to record the spoilage is:

 Factory Overhead 400 Spoilage Inventory 100 Work in Process 500

Note that in this method, actual spoilage is charged to factory overhead and applied spoilage is charged to each job, just like any other type of factory overhead costs. When the spoilage is sold, an entry is made to debit cash and credit spoilage inventory for the \$100 disposal value. If accurate estimates of the disposal values cannot be made at the time the spoilage is detected, the following entries will accomplish the same purpose.

The entry when the spoilage is detected is:

 Factory Overhead 500 Work in Process 500

The entry when the spoilage is sold is:

 Cash 100 Factory Overhead 100

2. Normal Spoilage Caused by Job Specifications

This method is used only in cases where the customer's specifications causes the spoilage. The idea is that the customer's requirements are rather unusual, or more precise than the normal product specifications. The spoilage costs that occur as a result of a particular customer's special requirements should not be shared by other customers. Therefore, this method simply leaves the spoilage cost in work in process and on the job where it has already been charged. Any disposal value would be charged to the spoilage inventory account. Using the example above, the entry is:

 Spoilage Inventory 100 Work in Process 100

This entry leaves the unrecovered costs, i.e., \$400, in Work in Process and on the job cost sheet where it has already been charged. To be fair to this customer, the manufacturer might eliminate the spoilage charge from the overhead rate when applying overhead to this job to avoid overcharging the customer for spoilage.

Abnormal Spoilage

Spoilage above an acceptable level (statistically above the upper control limit) should be charged to a loss account. Assuming the spoiled units in the example above were classified as abnormal spoilage, the applicable entry is:

 Loss From Abnormal Spoilage 400 Spoilage Inventory 100 Work in Porcess 500

Abnormal spoilage results from a special cause other than a customer’s precise or unusual specifications. For example, abnormal spoilage can occur when production line equipment is not adjusted properly, when inferior raw materials are purchased, or by fire, explosion, or other unusual events.

METHODS OF ACCOUNTING FOR REWORK

Normal Rework

The two methods of accounting for normal rework are based on the same logic used to account for spoilage. Normal rework that is common to all jobs is treated like any other factory overhead cost. Rework caused by a customer's specifications is charged to that particular customer's job.

1. Normal Rework Common To All Jobs

When rework is as likely to occur on one job as another, an estimate of the rework (cost) that is expected to occur during the period under normal conditions is included in the numerator when the factory overhead rate is calculated. Then, each job is charged with some rework cost when overhead is applied. Actual rework cost is charged to factory overhead. For example, assume various jobs had to be reworked during the period that required \$1,000 of additional direct material, and \$800 of direct labor for 80 additional hours. Also assume that overhead is applied at a rate of \$20 per direct labor hour. The entry to record these costs is as follows.

 Factory Overhead 3,400 Materials Control 1,000 Factory Payroll 800 Factory Overhead* 1,600

* Factory overhead applied = (80)(\$20)

2. Rework Caused by Job Specifications

In cases where the rework is caused by the customer's specifications, the costs of reworking the units is charged to the job where it occurred. Using the amounts in the example above, the entry is as follows:

 Work in Process 3,400 Materials Conrol 1,000 Factory Payroll 800 Factory Overhead 1,600

The \$3,400 is also charged to the specific job cost sheet where it occurred. It would be appropriate to eliminate the rework charge from the overhead rate when applying overhead to this job to avoid overcharging the customer for rework.

Abnormal Rework

Rework costs that exceed the control limits are charged to a loss account. Conceptually, the approach is the same as that used for abnormal spoilage. Assuming the rework in the example above is considered to be abnormal, the following entry is appropriate.

 Loss from Abnormal Rework 3,400 Materials Control 1,000 Factory payroll 800 Factory Overhead 1,600

METHODS OF ACCOUNTING FOR SCRAP

There are many ways to account for scrap. The estimated disposal value of scrap may be charged to a scrap inventory account if the value is significant. However, if the value of the scrap is relatively minor, an inventory account for scrap is not needed. Two methods are illustrated below that are variations of an approach referred to as the cost reduction method.

Cost Reduction Method Where Normal Scrap Is Common To All Jobs

Scrap frequently has a disposal value. When scrap is common to all jobs produced, an estimate of the revenue expected from the sale of normal scrap is subtracted from the numerator in the overhead rate calculation. This causes the overhead rate to be lower than it would be otherwise. Then overhead applied to work in process is somewhat less than it would be without the benefit of this cost reduction. If an inventory account is not used, no entry is made until the scrap is sold. Then the actual amount received when the scrap is sold is treated as an overhead cost reduction. For example, assume scrap that accumulated during the period is sold for \$300. The appropriate entry is:

 Cash 300 Factory Overhead 300

Cost Reduction Method Where Normal Scrap Is Caused by Job Specifications

When scrap is caused by the customer's requirements, the credit for scrap revenue is given to the customer. The entry is as follows:

 Cash 300 Work in Process 300

The \$300 credit is also made on the appropriate job cost sheet. When overhead is applied to the job involved, the estimate of scrap revenue that was subtracted in the overhead rate calculation should be added back to the rate. This avoids giving the customer an extra cost reduction for scrap.

Alternative Methods of Accounting For Scrap

If an inventory account is used for scrap, an additional entry is required in both of the previous illustrations. An estimate of the disposal value of the scrap is charged to the Scrap inventory account. The credits are made to the same accounts as above, depending on whether the scrap is common to all jobs or caused by specific job specifications. When the scrap is sold, the entry includes a debit to cash and a credit to the Scrap inventory account.

Another method of accounting for scrap treats the revenue from scrap sales as other revenue, rather than as a cost reduction. The credit in the entry to record the sale is to an account called "Other Revenue" or "Revenue From the Sale of Scrap". This method is conceptually different from the cost reduction method because the revenue from disposal is sometimes recorded before the sale. This unorthodox entry is made in cases where the value of scrap is significant, and an inventory account is used for control purposes. Then when the revenue method is used, the disposal value is recorded with a debit to the scrap inventory account and a credit to revenue from the sale of scrap. The method is unorthodox from a GAAP perspective because the credit to the revenue account is recorded before the sale takes place. This is not only confusing, it violates the concept of revenue recognition. For this reason, the revenue method is not recommended.

1 The accounting cycle refers to the process of recording the transactions that occur during a period, posting to the appropriate ledger accounts, closing the revenue and expense accounts at the end of the period and preparing financial statements.

2 Activity based costing attempts to trace these indirect costs to specific products and customers, but this more involved cost tracing is not part of a traditional cost system.

3 Some companies use a separate account for factory overhead applied.

4 Recall that these allocations are needed for a number of purposes. See Exhibit 2-4 in Chapter 2 to review the information needs of the various audiences.

5 In a multi-industry survey conducted in 1993, 69.5 percent of the respondents reported pricing products based on full cost, plus a certain percentage for profit. See Shim, E. and E. F. Sudit, 1995. How Manufacturers Price Products. Management Accounting. (February): 37-39.

6 In a standard cost system, overhead is applied on the basis of standard hours. Then, applied overhead is no longer equal to the flexible budget based on actual direct labor hours. This is discussed in Chapter 10.

7 In a standard cost system, standard time (an output measure) is used rather than actual time (an input measure). Theoretically, this removes the distortion caused by variations is efficiency if the actual output is equal to the desired output.

8 A flexible budget estimate is essentially a point estimate on a regression line. Recall from Chapter 3 that every point on a regression line represents a different distribution.

QUESTIONS

1. Why are Materials, Factory Overhead, Work in Process and Finished Goods referred to as control accounts? (See Control vs. Subsidiary accounts and Exhibit 4-3).

2. What do subsidiary ledger accounts look like?

3. Why is Factory Payroll not considered a control account? (See Exhibit 4-3).

4. What is the difference between recording material purchases and recording material usage? (See Exhibit 4-3).

5. Why would a company use a Materials control account combining direct material and indirect material?

6. Conceptually, what is indirect material? (See Manufacturing Costs, Terminology).

7. How do we know how much direct material to charge to each job? (See Entries 2 & 3).

8. What is the difference between recording the factory payroll and distributing the factory payroll? (See Entries 4 & 5 and Exhibit 4-3).

9. What is the difference between the amount of the debit to Factory Payroll and the amount of the credit to Wages and Salaries Payable? (See Entries 4 & 5 and Exhibit 4-3).

10. Conceptually, what is indirect labor? (See Manufacturing Costs, Terminology).

11. Why are indirect material and indirect labor charged to Factory Overhead rather than Work in Process? (See Terminology related to indirect costs).

12. How does the payroll department know how much to pay each worker? (See Entries 6 & 7).

13. How do we know how much of the payroll is direct labor and how much is indirect labor and how do we know how much direct labor to charge to each job? (See Entries 6 & 7).

14. Which accounts in Exhibit 4-3 represent asset accounts and which do not? What are the others? (See Exhibit 2-8 and Exhibit 4-3).

15. Why do we record the Finished Goods inventory at cost rather than sales prices, i.e., market value? (See the Matching Concept).

16. How can you tell when a firm is using normal historical costing? (See Chapter 2, Entry 9 and Predetermined overhead rates).

17. Why do we use a predetermined overhead rate? (See Why use predetermined overhead rates).

18. Explain the timing reason? (See Why use predetermined overhead rates).

19. Explain the normalizing unit overhead cost reason? (See Why use predetermined overhead rates).

20. Explain the accounting control reason? (See Method for monitoring ...).

21. What is the total overhead variance? (See Method for monitoring ...).

22. What does underapplied and overapplied overhead mean? (See Method for monitoring ...).

23. What are three causes of overhead variances in normal historical costing? (See Why actual and applied costs are different).

24. What causes underapplied overhead? (See Why actual and applied costs are different).

25. Why is underapplied overhead considered unfavorable? (See Variable overhead spending variance).

26. Why is overapplied overhead considered favorable? (See Variable overhead spending variance).

27. What is a flexible budget? (See Variable overhead spending variance and Figure 4-1).

28. What is the variable overhead spending variance, i.e., how is it calculated and how is it interpreted? (See Variable overhead spending variance and Figure 4-1).

29. What is the idle capacity variance and how is it interpreted? (See Idle capacity variance and Figure 4-2).

30. What could we compare with the idle capacity variance to make the analysis more meaningful and useful? (See Discussion of idle capacity variance).

31. Why do we refer to the spending variance as controllable and the idle capacity variance as uncontrollable? (See Controllable vs. Uncontrollable and Figures 4-1 and 4-2).

32. How do we measure capacity utilization in normal historical costing? (See Idle Capacity variance distortion and Figure 4-2).

33. Assuming that direct labor hours are used as the basis of the overhead rate, how does labor efficiency affect capacity utilization and the idle capacity variance? (See Idle Capacity variance distortion and Figure 4-2).

34. Does this mean that we would never need to investigate the idle capacity variance except for the effect of labor efficiency? (See Discussion of idle capacity variance).

35. What do you think are some other things that could cause an unfavorable unplanned idle capacity variance? (See Discussion of idle capacity variance).

36. What are some things that could cause a favorable unplanned idle capacity variance? (See Discussion of idle capacity variance).

37. Compare the accounting control method illustrated in this chapter to the statistical process control (SPC) method illustrated in Chapter 3.

38. Do you think the statistical control chart approach can be applied to overhead costs? ;Can you think of any problems?

39. What do we mean by normal and abnormal spoilage? Relate these terms to the SPC concept. (See Accounting for Spoilage and Exhibit 4-17).

40. Discuss how well a normal historical, full absorption, job order cost system satisfies the requirements of a management information system. (See Exhibit 2-4 to review the requirements and Normal Historical ...).

PROBLEMS

PROBLEM 4-1

The Custom Light Company uses normal historical full absorption job order costing. Record the following summary transactions for January with general journal entries.

1. Purchases of materials \$125,000.
2. The total factory payroll amounted to \$200,000.
3. The cost of direct material used was \$50,000. The cost of indirect material used amounted to \$40,000.
4. The cost of direct labor used was \$135,000 for 12,000 direct labor hours. Indirect labor costs were \$60,000.
5. Other indirect manufacturing costs or factory overhead incurred during the month amounted to \$115,000. This included \$50,000 for power costs, 15,000 for materials handling equipment, 5,000 for overtime premiums, 10,000 for fringe benefits, \$15,000 for depreciation, and \$20,000 for repair and maintenance.
6. Factory overhead is applied at rate of \$10.125 per direct labor hour.
7. The cost of jobs completed during the month amounted to \$290,000.
8. The completed jobs were sold for \$435,000. Record cost of goods sold and sales.

PROBLEM 4-2

Assume Millrun Company uses normal historical costing and a predetermined overhead rate based on budgeted direct labor hours. The calculations below are based on estimates for the year.

Variable overhead rate = \$1,200,000 ÷ 600,000 D.L. hours = \$2
Fixed overhead rate = \$1,800,000 ÷ 600,000 D.L. hours = \$3

The actual total overhead costs incurred during January are \$250,000. Actual variable overhead costs are \$98,000 and actual fixed overhead costs are \$152,000. The actual direct labor hours used during the month are 46,000.

Required:
1. Calculate the total overhead variance.
2. Calculate the variable overhead spending variance and explain what the variance means.
3. Calculate the fixed overhead spending variance and explain what this variance means.
4. Calculate the idle capacity variance and explain what it means.
5. What is meant by the term controllable variance?
6. Which of the variances above are controllable? Explain.
7. Which of the variances above are not controllable? Why?

PROBLEM 4-3

Record the following transactions for the JM Company with general journal entries. The following data is for the month of June.

1. Purchases of materials \$150,000 on credit.
2. The total factory payroll amounted to \$250,000. Amounts withheld include \$25,000 in federal income taxes and \$20,000 in FICA taxes. The net pay was paid out in cash.
3. Direct material used amounted to \$75,000. Indirect material used amounted to \$40,000.
4. Direct labor used amounted to \$180,000 as indicated by the labor time tickets. Indirect labor costs were equal to the remainder of the factory payroll.
5. Other factory overhead costs incurred amounted to \$500,000. Credit miscellaneous accounts. This includes both variable and fixed overhead costs.
6. Factory overhead rates were developed as follows based on estimates for the current year. Variable overhead \$3,840,000 ÷192,000 D.L. hours = \$20.00. Fixed overhead \$3,600,000 ÷192,000 D.L. hours = \$18.75. The company used 15,000 direct labor hours during the current month. Record applied factory overhead.
7. The cost of completed jobs is \$800,000.
8. The cost of jobs sold is \$750,000.
9. Sales of \$1,500,000 were all credit sales.
10. What is the total variance in factory overhead ? Indicate if it is favorable or unfavorable.
11. Calculate the total spending variance and indicate if it is favorable or unfavorable.
12. Calculate the idle capacity variance and indicate if it is favorable or unfavorable.

PROBLEM 4-4
Given:

 Hours Dollars Budgeted direct labor hours 80,000 Budgeted factory overhead costs: Variable \$400,000 Fixed 320,000 Total \$720,000 Actual direct labor hours 65,000 Actual factory overhead costs: Variable \$285,000 Fixed 315,000 Total \$600,000

Required: Calculate the following:

1. The predetermined overhead rate based on direct labor hours.
2. Applied factory overhead for the period.
3. The amount of underapplied or overapplied factory overhead cost for the period, and indicate whether it is under or over applied.
4. The spending variance for variable overhead.
5. The spending variance for fixed overhead.
6. The idle capacity variance.
7. If property taxes were budgeted at \$1,000 and actual property taxes amounted to \$1,200 where would the \$200 difference appear in the variances above, i.e., in which of the three variances ?

PROBLEM 4-5 PART A.

The following data are applicable to the next 8 questions.

 Sales \$1,000 Cost of jobs completed and sold 800 Factory overhead rate multiplied by actual direct labor hours incurred 300 Purchases of materials 500 Cost of supplies used 60 Direct labor cost incurred 150 Sales salaries & other expenses 90 Other factory overhead costs incurred 100 Cost of direct material used 350 Indirect labor costs incurred 80 Net factory payroll after withholding 210

1. The entry to record the purchase of materials is:
a. Debit work in process 500, credit accounts payable 500.
b. Debit work in process 350, debit factory overhead 150, credit accounts payable 500.
c. Debit materials control 500, credit accounts payable 500.
d. Debit factory overhead 500, credit accounts payable 500.
e. None of these.

2. The entry to record material usage is:
a. Debit materials control 410, credit work in process 350, credit factory overhead 60.
b. Debit work in process 350, debit factory overhead 60, credit materials control 410.
c. Debit work in process 410, credit materials control 350, credit factory overhead 60.
d. Debit factory overhead 410, credit materials control 60, credit work in process 350.
e. None of these.

3. The entry to record the factory payroll is:
a. Debit factory overhead 230, credit factory payroll 230.
b. Debit work in process 150, debit factory overhead 80, credit wages & salaries payable 210, credit withholding accounts 20.
c. Debit factory payroll 230, credit work in process 150, credit factory overhead 80.
d. Debit factory payroll 230, credit wages & salaries payable 210, credit withholding accounts 20.
e. None of these.

4. The entry to record the distribution of payroll costs is:
a. Debit work in process 230, debit factory payroll 230.
b. Debit factory payroll 230, credit wages & salaries payable 210, credit withholding accounts 20.
c. Debit factory payroll 230, credit work in process 150, credit factory overhead 80.
d. Debit work in process 150, debit factory overhead 80, credit factory payroll 230.
e. None of these.

5. The entry to record applied factory overhead is:
a. Debit work in process 240, credit factory overhead 240.
b. Debit work in process 300, credit factory overhead 300.
c. Debit factory overhead 240, credit work in process 240.
d. Debit factory overhead 300, credit materials control 60, credit factory payroll 80, credit accounts payable 100, credit overhead variances 60.
e. None of these.

6. The entry to record cost of goods manufactured is:
a. Debit finished goods 800, credit work in process 800.
b. Debit finished goods 740, credit work in process 740.
c. Debit finished goods 830, credit work in process 830.
d. Debit work in process 800, credit materials control 350, credit factory payroll 150, credit factory overhead 300.
e. None of these.

7. The entry to record cost of goods sold is:
a. Debit cost of goods sold 740, debit net income 60, credit finished goods 800.
b. Debit cost of goods sold 800, credit net income 200, credit sales 1,000.
c. Debit cost of goods sold 800, credit finished goods 800.
d. Debit cost of goods sold 740, credit finished goods 740.
e. None of these.

8. The entry to record sales is:
a. Debit sales 1,000, credit finished goods 1,000.
b. Debit accounts receivable or cash 1,000, credit cost of goods sold 800, credit net income 200.
c. Debit accounts receivable or cash 1,000, credit finished goods 800, credit net income 200.
d. Debit accounts receivable or cash 1,000, credit sales 1,000.
e. None of these.

PROBLEM 4-5 PART B.

The information below is applicable to the next 5 questions. The company uses normal historical full absorption job order costing. Actual factory overhead incurred is \$11,000 (\$8,200 variable and \$2,800 fixed). Overhead rates are based on direct labor hours as follows:

\$7,500 ÷ 5,000 direct labor hours = \$1.50 per hour for variable overhead,
\$2,500 ÷ 5,000 direct labor hours = .50 per hour for fixed overhead.

Actual direct labor hours incurred during the period = 4,000.

9. The total overhead variance is:
a. \$2,000 underapplied.
b. \$3,000 unfavorable.
c. \$1,000 overapplied.
d. \$1,000 favorable.
e. None of these.

10. The total spending variance is:
a. \$2,500 unfavorable.
b. \$3,000 unfavorable.
c. \$1,000 unfavorable.
d. \$500 unfavorable.
e. None of these.

11. The variable overhead spending variance is:
a. \$2,500 unfavorable.
b. \$700 unfavorable.
c. \$2,200 unfavorable.
d. \$2,500 favorable.
e. None of these.

12. The fixed overhead spending variance is:
a. \$300 favorable.
b. \$500 unfavorable.
c. \$300 unfavorable.
d. Zero.
e. None of these.

13. The idle capacity variance is:
a. \$2,500 unfavorable.
b. \$500 favorable.
c. \$800 unfavorable.
d. \$500 unfavorable.
e. None of these.

14. Which variance is not controllable?
a. Total spending.
b. Variable overhead spending.
c. Fixed overhead spending.
d. Idle capacity.
e. Both c. and d.

PROBLEM 4-6

HISTORICAL FULL ABSORPTION JOB ORDER COSTING.

This is a comprehensive problem including spoilage, rework, scrap, and variance analysis.

PART A.
The following information is applicable to the next 13 questions.

 Beginning Materials 400 Beginning work in process 300 Beginning finished goods 1,500 Factory overhead rate per D.L. hour 20 Direct labor cost incurred excluding rework 1,450 Sales salaries & other expenses 2,000 Administrative salaries & expenses 1,000 Other factory overhead costs incurred excluding spoilage and rework 10,950 Sales 22,000 Ending work in process 800 Ending finished goods 1,200 Cost of direct material used excluding rework 4,000 Purchases of materials 5,800 Indirect labor costs incurred 1,400 Net factory payroll after withholding 2,500 Cost of indirect materials used 1,800 Normal spoilage common to all jobs 900 Disposal value of normal spoilage 200 Abnormal spoilage 100 Disposal value of abnormal spoilage 22

Note: The costs of rework are not included in the cost of direct material and direct labor given above.
Rework common to all jobs:
Direct material \$100
Direct labor (15 hours) 50
Sales of normal scrap common to all jobs \$400

Note: The cost reduction method is used and scrap is not inventoried.

Direct labor hours used during the period excluding rework 500 hrs.

Required: Record the following with general journal entries.

1. The entry to record the purchase of materials.
2. The entry to record material usage excluding rework.
3. The entry to record the factory payroll.
4. The entry to record the payment of the payroll to employees.
5. The entry to record the distribution of payroll costs excluding rework.
6. The entry to record other factory overhead costs excluding spoilage and rework.
7. The entry to record applied factory overhead excluding rework.
8. The entry to record spoilage.
9. The entry to record rework.
10. The entry to record the sale of scrap.
11. The entry to record cost of goods manufactured.
12. The entry to record cost of goods sold.
13. The entry to record sales.

PART B.

The following paragraph provides all the information you need to answer the next five questions. Ignore your previous answers and assume that the total actual overhead cost incurred was \$15,300 and included \$3,100 variable overhead and \$12,200 fixed overhead. Assume the \$20 factory overhead rate per direct labor hour represents \$5 of variable overhead and \$15 of fixed overhead. Also assume that these rates were based on 800 denominator direct labor hours. Assume that 500 total actual direct labor hours were used. Calculate the following variances.

14. The total overhead variance.
15. The total spending variance.
16. The variable overhead spending variance.
17. The fixed overhead spending variance.
18. The idle capacity variance.

PROBLEM 4-7

1. Job order costing may be used with
a. Historical costing.
b. Standard costing.
c. Absorption costing.
d. Direct costing.
e. Activity costing.
f. All of the above.

2. Which of the following are referred to as controllable?
a. The total overhead spending variance.
b. The idle capacity variance.
c. Normal spoilage.
d. Abnormal spoilage.
e. a and c.
f. a and d.

3. The fixed overhead spending variance is a
a. Price variance.
b. Quantity variance.
c. A capacity related variance.
d. Price and quantity variance.
e. Price, quantity and capacity variance.
f. None of these.

4. Net Normal spoilage costs that are common to all jobs would be
a. Charged to WIP.
b. Charged to factory overhead.
c. Charged to a loss account.
d. Charged to cost of goods sold.
e. Charged to a specific job.
f. None of these.

5. When we refer to the two stage cost allocation process, we mean that costs are allocated
a. To products, then to cost of goods sold.
b. From service departments to producing departments, then to products.
c. To the materials, payroll and overhead accounts, then to work in process.
d. To products, then to time periods.
e. None of these.

6. Abnormal spoilage
a. represents a loss and is considered controllable.
b. represents a loss and is considered uncontrollable.
c. represents a product cost and is considered controllable.
d. represents a product cost and is considered uncontrollable.
e. None of these.

7. According to Johnson and Kaplan, product cost would not be distorted by
a. volume based overhead rates.
b. plant wide overhead rates.
c. departmental overhead rates.
d. transactions based overhead rates.
e. predetermined overhead rates.

Problem Solutions

Extra MC Questions