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STANDARD ABSORPTION COSTING

EXHIBIT 17.4 Reconciliation of budgeted and actual profits for a standard variable costing system (£) Budgeted net profit Sales variances: Sales margin price Sales margin volume Direct cost variances: Material: Price Usage Labour: Rate Efficiency Manufacturing overhead variances: Fixed overhead expenditure Variable overhead expenditure Variable overhead efficiency Actual profit

(£)

(£) 80 000

18 000F 20 000A

2 000A

8 900A 26 500A 17 100A 13 500A

30 600A

4 000F 5 000F 3 000A

6 000F

35 400A

62 000A 18 000

These variances are not particularly useful for control purposes. If your course does not relate to the disposition of variances to meet financial accounting requirements, you can omit pages 443–46. With a standard absorption costing system, predetermined fixed overhead rates are established by dividing annual budgeted fixed overheads by the budgeted annual level of activity. We shall assume that in respect of Example 17.1, budgeted annual fixed overheads are £1 440 000 (£120 000 per month) and budgeted annual activity is 120 000 units (10 000 units per month). The fixed overhead rate per unit of output is calculated as follows: budgeted fixed overheads ð£1 440 000Þ ¼ £12 per unit of sigma produced budgeted activity ð1 200 000 unitsÞ Where different products are produced, units of output should be converted to standard hours. In Example 17.1 the output of one unit of sigma requires three direct labour hours. Therefore, the budgeted output in standard hours is 360 000 hours (120 000 # 3 hours). The fixed overhead rate per standard hour of output is: budgeted fixed overheads ð£1 440 000Þ ¼ £4 per standard hour budgeted standard hours ð360 000Þ By multiplying the number of hours required to produce one unit of sigma by £4 per hour, we also get a fixed overhead allocation of £12 for one unit of sigma (3 hours # £4). For the remainder of this chapter output will be measured in terms of standard hours produced. We shall assume that production is expected to occur evenly throughout the year. Monthly budgeted production output is therefore 10 000 units, or 30 000 standard direct labour hours. At the planning stage an input of 30 000 direct labour hours (10 000 # 3 hours) will also be planned, as the company will budget at the level of efficiency specified in the calculation of the product standard cost. Thus the budgeted hours of input and the budgeted hours of output (i.e. the standard hours produced) will be the same at the planning stage. In contrast, the actual hours of input may differ from the actual standard hours of output. In Example 17.1 the actual direct labour hours of input are 28 500, and 27 000 standard hours were actually produced. With an absorption costing system, fixed overheads of £108 000 (27 000 standard hours of output at a standard rate of £4 per hour) will have been charged to products for the month of April. Actual fixed overhead expenditure was £116 000. Therefore, £8000 has not been allocated to products. In other words, there has been an under-recovery of fixed overheads. Where the fixed overheads allocated to products exceeds the overhead incurred, there will be an over-recovery of fixed overheads. The under- or over-recovery

443

444

CHAPTER 17 STANDARD COSTING AND VARIANCE ANALYSIS 1

of fixed overheads represents the total fixed overhead variance for the period. The total fixed overhead variance is calculated using a formula similar to those for the total direct labour and total direct materials variances: the total fixed overhead variance is the difference between the standard fixed overhead charged to production (SC) and the actual fixed overhead incurred (AC): SC ð£108 000Þ " AC ð£116 000Þ ¼ £8000A Note that the standard cost for the actual production can be calculated by measuring production in standard hours of output (27 000 hours $ £4 per hour) or units of output (9000 units $ £12 per unit). The under- or over-recovery of fixed overheads (i.e. the fixed overhead variance) arises because the fixed overhead rate is calculated by dividing budgeted fixed overheads by budgeted output. If actual output or fixed overhead expenditure differs from budget, an under- or over-recovery of fixed overheads will arise. In other words, the under- or over-recovery may be due to the following: 1 A fixed overhead expenditure variance of £4000 arising from actual expenditure (£116 000) being different from budgeted expenditure (£120 000). 2 A fixed overhead volume variance arising from actual production differing from budgeted production. The fixed overhead expenditure variance also occurs with a variable costing system. The favourable variance of £4000 was explained earlier in this chapter. The volume variance arises only when inventories are valued on an absorption costing basis.

VOLUME VARIANCE This variance seeks to identify the portion of the total fixed overhead variance that is due to actual production being different from budgeted production. In Example 17.1 the standard fixed overhead rate of £4 per hour is calculated on the basis of a normal activity of 30 000 standard hours per month. Only when actual standard hours produced are 30 000 will the budgeted monthly fixed overheads of £120 000 be exactly recovered. Actual output, however, is only 27 000 standard hours. The fact that the actual production is 3000 standard hours less than the budgeted output hours will lead to a failure to recover £12 000 fixed overhead (3000 hours at £4 fixed overhead rate per hour). The formula for the variance is the volume variance is the difference between actual production (AP) and budgeted production (BP) for a period multiplied by the standard fixed overhead rate (SR): ðAP " BPÞ $ SR The volume variance reflects the fact that fixed overheads do not fluctuate in relation to output in the short-term. Whenever actual production is less than budgeted production, the fixed overhead charged to production will be less than the budgeted cost, and the volume variance will be adverse. Conversely, if the actual production is greater than the budgeted production, the volume variance will be favourable. When the adverse volume variance of £12 000 is netted with the favourable expenditure variance of £4000, the result is equal to the total fixed overhead adverse variance of £8000. It is also possible to analyze the volume variance into two further sub-variances – the volume efficiency variance and the capacity variance.

VOLUME EFFICIENCY VARIANCE If we wish to identify the reasons for the volume variance, we may ask why the actual production was different from the budgeted production. One possible reason may be that the labour force worked at a different level of efficiency from that anticipated in the budget.

VOLUME CAPACITY VARIANCE

The actual number of direct labour hours of input was 28 500. Hence one would have expected 28 500 hours of output (i.e. standard hours produced) from this input, but only 27 000 standard hours were actually produced. Thus one reason for the failure to meet the budgeted output was that output in standard hours was 1500 hours less than it should have been. If the labour force had worked at the prescribed level of efficiency, an additional 1500 standard hours would have been produced, and this would have led to a total of £6000 (£1500 hours at £4 per standard hour) fixed overheads being absorbed. The inefficiency of labour is therefore one of the reasons why the actual production was less than the budgeted production, and this gives an adverse variance of £6000. The formula for the variance is: the volume efficiency variance is the difference between the standard hours of output (SH) and the actual hours of input (AH) for the period multiplied by the standard fixed overhead rate (SR): ðSH

AHÞ # SR

You may have noted that the physical content of this variance is a measure of labour efficiency and is identical with the labour efficiency variance. Consequently, the reasons for this variance will be identical with those previously described for the labour efficiency variance.

VOLUME CAPACITY VARIANCE This variance indicates the second reason why the actual production might be different from the budgeted production. The budget is based on the assumption that the direct labour hours of input will be 30 000 hours, but the actual hours of input are 28 500 hours. The difference of 1500 hours reflects the fact that the company has failed to utilize the planned capacity. If we assume that the 1500 hours would have been worked at the prescribed level of efficiency, an additional 1500 standard hours could have been produced and an additional £6000 fixed overhead could have been absorbed. Hence the capacity variance is £6000 adverse. Whereas the volume efficiency variance indicated a failure to utilize capacity efficiently , the volume capacity variance indicates a failure to utilize capacity at all. The formula is: the volume capacity variance is the difference between the actual hours of input (AH) and the budgeted hours of input (BH) for the period multiplied by the standard fixed overhead rate (SR): ðAH

BHÞ # SR

A failure to achieve the budgeted capacity may be for a variety of reasons. Machine breakdowns, material shortages, poor production scheduling, labour disputes and a reduction in sales demand are all possible causes of an adverse volume capacity variance. The volume efficiency variance is £6000 adverse, and the volume capacity variance is also £6000 adverse. When these two variances are added together, they agree with the fixed overhead volume variance of £12 000. Exhibit 17.5 summarizes the variances we have calculated in this section. You should note that the volume variance and two sub-variances (capacity and efficiency) are sometimes restated in non-monetary terms as follows: standard hours of actual output ð27 000Þ # 100 budgeted hours of output ð30 000Þ ¼ 90%

production volume ratio ¼

standard hours of actual output ð27 000Þ # 100 actual hours worked ð28 500Þ ¼ 94:7%

production efficiency ratio ¼

actual hours worked ð28 500Þ # 100 budgeted hours of input ð30 000Þ ¼ 95%

capacity usage ratio ¼

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446

CHAPTER 17 STANDARD COSTING AND VARIANCE ANALYSIS 1

EXHIBIT 17.5 Diagram of fixed overhead variances

Total fixed overhead variance SC – AC £108 000 – £116 000 £8000A Volume variance (AP – BP) × SR (27 000SH – 30 000SH) × £4 £12 000

Fixed overhead expenditure variance BFO – AFO £120 000 – £116 000 £4000F Volume capacity variance (AP – BH)×SR (28 500 – 30 000) ×£4 £6000A

Volume efficiency variance (SH – AH)×SR (27 500 – 28 500) ×£4 £6000A

RECONCILIATION OF BUDGETED AND ACTUAL PROFIT FOR A STANDARD ABSORPTION COSTING SYSTEM The reconciliation of the budgeted and actual profits is shown in Exhibit 17.6. You will see that the reconciliation statement is identical with the variable costing reconciliation statement, apart from the fact that the absorption costing statement includes the fixed overhead volume variance and values the sales margin volume variance at the standard profit margin per unit instead of the contribution per unit. If you refer back to page 432, you will see that the contribution margin for sigma is £20 per unit sold whereas the profit margin per unit after deducting fixed overhead cost (£12 per unit) is £8. Multiplying the difference in budgeted and actual sales volumes of 1000 units by the standard profit margin gives a sales volume margin variance of £8000. Note that the sales margin price variance is identical for both systems. EXHIBIT 17.6 Reconciliation of budgeted and actual profit for a standard absorption costing system (£) Budgeted net profit Sales variances: Sales margin price Sales margin volume Direct cost variances: Material – Price: Material A Material B – Usage: Material A Material B Labour – Rate Efficiency Manufacturing overhead variances: Fixed – Expenditure Volume Variable – Expenditure Efficiency Actual profit

(£)

(£)

(£) 80 000

18 000F 8 000A 19 000A 10 100F 10 000A 16 500A

4 000F 12 000A 5 000F 3 000A

10 000F

8 900A 26 500A 17 100A 13 500A

35 400A 30 600A

8 000A 2 000F

6 000A

62 000A 18 000...