CHAP 8 PRESEN

Subject AKMEN

Production-Volume Variance and Sales-Volume Variance

As we complete our study of variance analysis for Webb Company, it is helpful to

step back to see the “big picture” and to link the accounting and performance
evaluation functions of standard costing. Exhibit 7-1, page 272, first identified a
static-budget variance of $93,100 U as the difference between the static budget
operating income of $108,000 and the actual operating income of $14,900. Exhibit
7-2, page 274, then subdivided the static-budget variance of $93,100 U into a
flexible-budget variance of $29,100 U and a sales-volume variance of $64,000 U.
In both Chapter 7 and this chapter, we presented more detailed variances that
subdivided, whenever possible, individual flexible-budget variances for the selling
price, direct materials, direct manufacturing labor, and variable overhead. For the
fixed overhead, we noted that the flexible-budget variance is the same as the
spending variance. Where does the production- volume variance belong then? As
you shall see, the production-volume variance is a component of the sales-
volume variance. Under our assumption of actual production and sales of 10,000
jackets, Webb’s costing system debits to Work-in-Process Control the standard
costs of the 10,000 jackets produced. These amounts are then transferred to
Finished Goods and finally to Cost of Goods Sold :

Direct Material ($60 per jacket x

10.000 jackets) $600.000
chap 7, 282, entry 1b

Direct Manufacturing Labor ($16 per

jacket x 10.000 jackets) $160.000
chap 7,283, entry 2

Variable Overhead ($12 per jacket x

10,000 jackets) $120.000
chap 8, 316, entry 2

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 Fixed Overhead ($23 per jacket x
10,000 jackets) $230.000
Chap 8, page 320, entry 2

Cost of goods sold at standard cost

$1,110,000
($111 per jacket x 10,000 jackets)

Webb’s costing system also records the revenues from the 10,000 jackets sold at
the budgeted selling price of $120 per jacket. The net effect of these entries on
Webb’s budgeted operating income is as follows:

Revenues at budgeted selling price

$1,200,000
($120 per jacket x 10,000 jackets)

Cost of goods sold at standard cost

$ 1,110,000
($111 per jacket * 10,000 jackets)

Operating income based on budgeted

profit per jacket $ 90,000
($9 per jacket * 10,000 jackets)

A crucial point to keep in mind is that under standard costing, fixed overhead
costs are treated as if they are a variable cost. That is, in determining the
budgeted operating income of $90,000, only $230,000 ($23 per jacket * 10,000
jackets) of the fixed overhead costs are considered, whereas the budgeted fixed
overhead costs are $276,000. Webb’s accountants then record the $46,000
unfavorable production-volume variance (the difference between the budgeted
fixed overhead costs, $276,000, and allocated fixed overhead costs, $230,000,
page 320,entry 2), as well as the various flexible-budget variances (including the
fixed overhead spending
variance) that total $29,100 unfavorable (see Exhibit 7-2, page 274). This results in
actual operating income of $14,900 as follows:

Operating income based on

$ 90,000
budgeted profit per jacket

Unfavorable production-volume
(46,000)
variance

Flexible-budget operating income

44,000
(Exhibit 7-2)

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 Unfavorable flexible-budget variance
(29,100)
for operating income

Actual operating income (Exhibit 7-2) $ 14,900

In contrast, the static-budget operating income of $108,000 (page 272) is not

entered in Webb’s costing system because standard costing records budgeted
revenues, standard costs, and
variances only for the 10,000 jackets actually produced and sold, not for the
12,000 jackets that
were planned to be produced and sold. As a result, the sales-volume variance of
$64,000 U,
which is the difference between the static-budget operating income of $108,000
and the flexible-budget operating income of $44,000 (Exhibit 7-2, page 274), is
never actually recorded under standard costing. Nevertheless, the sales-volume
variance is useful because it helps managers understand the lost contribution
margin from selling 2,000 fewer jackets (the sales-volume variance assumes fixed
costs remain at the budgeted level of $276,000).
The sales-volume variance has two components. They are as follows

1. A difference between the static-budget operating income of $108,000 for

12,000 jackets and the budgeted operating income of $90,000 for 10,000
jackets. This is the operating
income volume variance of $18,000 U ($108,000 − $90,000). It reflects the
fact that Webb produced and sold 2,000 fewer units than budgeted.

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 Variance Level Variance Type Amount (USD) Explanation

Difference between actual

Total Variance Static-budget variance 93,100 U
results and static budget

Difference between actual

→ Breakdown 1 Flexible-budget variance 29,100 U
and flexible budget

Actual price lower than

→ Selling price variance 50,000 U
budgeted price

→ -Direct materials
21,600 U
variances: Total

- Direct materials Price Higher material cost per

44,400 U
variance unit

- Direct materials Materials used more

(22,800) F
Efficiency variance efficiently

→ Direct manuf labor

38,000 U
variances: Total

⇨ Direct manuf labor 18,000 U Higher labor rate per hour

Price variance

⇨ Direct manuf labor 20,000 U

Less efficient use of labor
Efficiency variance time

→ Variable manuf
10,500 U
overhead variances: Total

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 ⇨ Variable manuf Higher variable overhead
overhead Spending 4,500 U
costs
variance

⇨ Variable manuf Less efficient use of cost

overhead Efficiency 6,000 U
driver
variance

→ Fixed overhead
9,000 U
variances: Total

⇨ Spending variance 3,000 U

Actual fixed costs
exceeded budget

⇨ Production-volume 46,000 U
Fewer units produced than
variance planned

→ Breakdown Lower unit sales than

Sales-volume variance 64,000 U
2 budgeted

⇨ Operating income 18,000 U

Loss in income due to
volume variance lower sales volume

⇨ Fixed overhead Overhead applied to fewer

production-volume 46,000 U
units produced
variance

A difference between the budgeted operating income of $90,000 and the flexible-
budget operating income of $44,000 (Exhibit 7-2, page 274) for the 10,000 actual
units. This difference arises because Webb’s costing system treats fixed costs as
if they behave in a variable manner and assumes fixed costs equal the allocated
amount of $230,000, rather than the budgeted fixed costs of $276,000. Of
course, this difference is precisely the production-volume variance of $46,000 U.

In summary, we have the following

Operating-income volume variance $18,000 U
Production-volume variance $46,000 U
Sales-volume variance
$64,000 U

We next describe the use of variance analysis in activity-based costing systems.

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 What is the relationship between the sales volume variance and
the production-volume variance?

Variance Analysis and

Activity-based costing (ABC)
Activity based costing (ABC) systems focus on individual activities as the
fundamental cost objects. ABC systems classify the costs of various activities into
a cost hierarchy—output unit-level costs, batch-level costs, product-sustaining
costs, and facility-sustaining costs (see pages 182–183). In this section, we show
how a company that has an ABC system and batch-level costs can benefit from
variance analysis. Batch-level costs are the costs of activities related to a group of
units of products or services rather than to each individual unit of product or
service. We illustrate variance analysis for variable batch-level direct costs and
fixed batch-level overhead costs.4

Consider Lyco Brass Works, which manufactures many different types of faucets
and brass fittings. Because of the wide range of products it produces, Lyco uses
an activity-based costing system. In contrast, Webb uses a simple costing system
because it makes only one type of jacket. One of Lyco’s products is Elegance, a
decorative brass faucet for home spas. Lyco produces Elegance in batches. For
each product Lyco makes, it uses dedicated materials-handling labor to bring
materials to the production floor, transport items in process from one work center
to the next, and take the finished goods to the shipping area. Therefore, materials-
handling labor costs for Elegance are direct costs of Elegance. Because the
materials for a batch are moved together,
materials-handling labor costs vary with the number of batches rather than with
the number of units in a batch. Materials-handling labor costs are variable direct
batch-level costs. To manufacture a batch of Elegance, Lyco must set up the
machines and molds.
Employees must be highly skilled to set up the machines and molds. Hence, a
separate setup department is responsible for setting up the machines and molds
for different batches of products. Setup costs are overhead costs. For simplicity,
assume that setup costs are fixed with respect to the number of setup-hours. The

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 costs consist of salaries paid to engineers and
supervisors and the costs of leasing setup equipment.

Information regarding Elegance for 2017 follows:

Flexible Budget and Variance Analysis for Direct

Materials-Handling Labor Costs

To prepare the flexible budget for the materials-handling labor costs, Lyco starts
with the actual units of output produced, 151,200 units, and proceeds with the
following steps.

Step 1: Using the Budgeted Batch Size, Calculate the Number of Batches that
Should Have Been Used to Produce the Actual Output.

At the budgeted batch size of 150 units per batch, Lyco should have produced the
151,200 units of output in 1,008 batches (151,200 units , 150 units perbatch).

Step 2: Using the Budgeted Materials-Handling Labor-Hours per Batch, Calculate

the Number of Materials-Handling Labor-Hours that Should Have Been Used.
At the budgeted quantity of 5 hours per batch, 1,008 batches should have required
5,040 materials-handling labor-hours

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 (1,008 batches * 5 hours per batch).

Step 3: Using the Budgeted Cost per Materials-Handling Labor-Hour, Calculate the
Flexible Budget Amount for the Materials-Handling Labor-Hours.

The flexible-budget amount is 5,040 materials-handling labor@hours * the $14

budgeted cost per materials-handling labor@hour = $70,560.

Note how the flexible-budget calculations for the materials handling labor costs
focus on batch-level quantities (materials-handling labor-hours per batch rather
than per unit). The flexible-budget quantity computations focus at the appropriate
level of the cost hierarchy. For example, because materials handling is a batch-
level cost, the flexible-budget quantity calculations are made at the batch level—
the quantity of materials-handling labor-hours that Lyco should have used based
on the number of batches it should have used to produce the actual quantity of
151,200 units. If a cost had been a product-sustaining cost—such as product
design cost—the flexible-budget quantity computations would focus at the
product-sustaining level by, for example, evaluating the actual complexity of the
product’s design relative to the budget.

The flexible-budget variance for the materials-handling labor costs can now be
calculated as follows:

📌 Flexible Budget Variance

= Actual Cost - Flexible Budget Costs

=(5.670 hours x $14.50 hour) - (5.040 hours x $14 per hour)
=$82,215-$70,560

=$11,655U

The unfavorable variance indicates that materials-handling labor costs were

$11,655 higher than the flexible-budget target. We can get some insight into the

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 possible reasons for this unfavorable outcome by examining the price and
efficiency components of the flexible-budget variance. Exhibit 8-6 presents the
variances in columnar form.

📌 Price Variance = (Actual Price of Input - Budgeted Price of Input ) x

Actual Quantity of Input

= ($14.50 per hour- $14 per hour) x 5,670 hours

= $0.50 per hour * 5,670 hours
= $2,835 U

The unfavorable price variance for materials-handling labor indicates that the
$14.50 actual cost per materials-handling labor-hour exceeds the $14.00
budgeted cost per materials handling labor-hour. This variance could be the result
of Lyco’s human resources manager negotiating wage rates less skillfully or of
wage rates increasing unexpectedly due to a scarcity of labor.

📌 Efficiency Variance = ( Actual Quantity of Input Used - Budgeted

Quantity of input allowed for actual output) x Budgeted Price of Input

=(5,670 hours-5,040 hours) x $14 per hour

=630 hours x $14 per hour
=$8,820 U

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 The unfavorable efficiency variance indicates that the 5,670 actual materials-
handling labor hours exceeded the 5,040 budgeted materials-handling labor-
hours for the actual output. Possible reasons for the unfavorable efficiency
variance are as follows:

■ Smaller actual batch sizes of 140 units, instead of the budgeted batch sizes of
150 units, resulted in Lyco producing the 151,200 units in 1,080 batches instead of
1,008 (151,200 , 150) batches
■ The actual materials-handling labor-hours per batch (5.25 hours) were higher
than the budgeted materials-handling labor-hours per batch (5 hours)

Reasons for smaller-than-budgeted batch sizes could include quality problems

when batch sizes exceed 140 faucets and high costs of carrying inventory.

Possible reasons for the larger actual materials-handling labor-hours per batch are
as follows:
■ Inefficient layout of the Elegance production line
■ Materials-handling labor having to wait at work centers before picking up or
delivering materials
■ Unmotivated, inexperienced, and underskilled employees
Very tight standards for materials-handling time

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 Identifying the reasons for the efficiency variance helps Lyco’s managers develop
a plan for improving its materials-handling labor efficiency and take corrective
action that will be incorporated into future budgets.

We now consider fixed setup overhead costs.

Flexible Budget and Variance Analysis for Fixed Setup Overhead

Costs

Exhibit 8-7 presents the variances for fixed setup overhead costs in columnar
form. Lyco’s fixed setup overhead flexible-budget variance is calculated as
follows:

📌 Fixed Setup Overhead Flexible-Budget Variance = Actual Costa Incurred

- Flexible Budget Cost
= $220.000- $216.000
=$4.000 U

Note that the flexible-budget amount for the fixed setup overhead costs equals
the static-budget amount of $216,000. That’s because there is no “flexing” of
fixed costs. Moreover, because the fixed overhead costs have no efficiency
variance, the fixed setup overhead spending variance is the same as the fixed
overhead flexible-budget variance. The spending variance could be unfavorable
because of higher leasing costs of new setup equipment or higher salaries paid to
engineers and supervisors. Lyco may have incurred these costs to alleviate some
of the difficulties it was having in setting up machines. To calculate the
production-volume variance, Lyco first computes the budgeted cost allocation
rate for the fixed setup overhead costs using the same four-step approach
described on page 311.

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 Step 1: Choose the Period to Use for the Budget. Lyco uses a period of 12 months
(the year 2017).
Step 2: Select the Cost-Allocation Base to Use in Allocating the Fixed Overhead
Costs to the Output Produced. Lyco uses budgeted setup-hours as the cost-
allocation base for fixed setup
overhead costs. Budgeted setup-hours in the static budget for 2017 are 7,200
hours.
Step 3: Identify the Fixed Overhead Costs Associated with the Cost-Allocation
Base. Lyco’s fixed setup overhead cost budget for 2017 is $216,000.

Step 4: Compute the Rate per Unit of the Cost-Allocation Base Used to Allocate
the
Fixed Overhead Costs to the Output Produced.

Dividing the $216,000 from Step 3 by the 7,200 setup-hours from Step 2, Lyco
estimates a fixed setup overhead cost rate of $30 per
setup-hour

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 📌 Budgeted fixed setup overhead cost per unit of
cost allocation base =
=Budgeted total costs in fixed overhead cost pool/Budgeted total
quantity of
cost allocation base
=$216,000/ 7,200 setup hours

=$30 per setup hour

Production volume variance for fixed setup overhead costs = Budgeted

fixed setup overhead costs - Fixed setup overhead allocated using
budgeted input allowed for actual output units produced
= $216,000- (1,008 batches x 6 hours/batch x $30 / hour)
= $216,000- (6,048 hours x $30 / hour)
= $216,000- $181,440
= $34,560 U

During 2017, Lyco planned to produce 180,000 units of Elegance but actually
produced 151,200 units. The unfavorable production-volume variance measures
the amount of extra fixed setup costs Lyco incurred for setup capacity it did not
use. One interpretation is that the unfavorable $34,560 production-volume
variance represents an inefficient use of the company’s setup capacity. However,
Lyco may have earned higher operating income by selling 151,200 units at a higher
price than 180,000 units at a lower price. As a result, Lyco’s managers should
interpret the production-volume variance cautiously because it does not consider
the effect of output on selling prices and operating income

Overhead Variances in Nonmanufacturing Settings

Our Webb Company example examined variable and fixed manufacturing

overhead costs. Managers can also use variance analysis to examine the
overhead costs of the nonmanufacturing areas of the company and to make

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 decisions about (1) pricing, (2) managing costs, and (3) the mix of products to
make. For example, when product distribution costs are high, as they are in the
automobile, consumer durables, cement, and steel industries, standard costing
can provide managers with reliable and timely information on variable distribution
overhead spending variances and efficiency variances. What about service-sector
companies such as airlines, hospitals, hotels, and railroads? How can they benefit
from variance analyses? The output measures these companies commonly use
are passenger-miles flown, patient-days provided, room-days occupied, and ton
miles of freight hauled, respectively. Few costs can be traced to these outputs in a
cost-effective way. Most of the costs are fixed overhead costs, such as the costs
of equipment, buildings, and staff. Using capacity effectively is the key to
profitability, and fixed overhead variances can help managers in this task. Retail
businesses, such as Kmart, also have high-capacity–related fixed costs (lease and
occupancy costs). In the case of Kmart, sales declines resulted in unused
capacity and unfavorable fixed-cost variances. Kmart reduced its fixed costs by
closing some of its stores, but it also had to file for Chapter 11 bankruptcy.
Consider the following data for United Airlines for selected years from the past 15
years. Available seat miles (ASMs) are the actual seats in an airplane multiplied by
the distance the plane traveled.

Airline Operating Performance Table

Operating Operating
Total ASMs Operating Cost
Year Revenue per Income per
(Millions) per ASM
ASM ASM

2000 175,493 10.2 cents 10.0 cents 0.2 cents

2003 136,566 8.6 cents 9.8 cents -1.2 cents

2006 143,085 10.6 cents 10.8 cents -0.2 cents

2008 135,859 11.9 cents 13.6 cents -1.7 cents

2011 118,973 13.1 cents 13.5 cents -0.4 cents

2015 219,956 13.1 cents 12.2 cents 0.9 cents

When air travel declined after the events of September 11, 2001, United’s revenues
fell. However, most of the company’s fixed costs—for its airport facilities,
equipment, personnel, and so on—did not. United had a large unfavorable

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 production-volume variance because its capacity was underutilized. As column 1
of the table indicates, United responded by reducing its capacity substantially.
Available seat miles (ASMs) declined from 175,493
million in 2000 to 136,566 million in 2003. Yet United was unable to fill even the
planes it had retained, so its revenue per ASM declined (column 2) and its cost per
ASM stayed roughly the same (column 3). United filed for Chapter 11 bankruptcy in
December 2002and began seeking government guarantees to obtain the loans it
needed. Subsequently, strong demand for airline travel, as well as productivity
improvements resulting from the more efficient use of resources and networks,
led to increased traffic and higher average ticket prices. By maintaining a
disciplined approach to capacity and tight control over growth, United saw over a
20% increase in its revenue per ASM between 2003 and 2006.The improvement
in performance allowed United to come out of bankruptcy on February 1, 2006.
Subsequently, however, the global recession and soaring jet fuel prices had a
significant negative impact on United’s performance, as reflected in the continued
negative operating incomes and the further decline in capacity. In May 2010, a
merger agreement was reached between United and Continental Airlines.
Continental was formally

dissolved in 2012. The merger is reflected in the 85% growth in United’s ASM
between 2011 and 2015. The revenue benefits from this greater scale and the
recent plunge in fuel prices have
led United to new heights of profitability.

Financial and Nonfinancial Performance Measures

The overhead variances discussed in this chapter are examples of financial

performance measures. As the preceding examples illustrate, nonfinancial
measures such as those related to capacity utilization and physical measures of
input usage also provide useful information. The nonfinancial measures that
managers of Webb would likely find helpful in planning and controlling its
overhead costs include the following:

1. Quantity of actual indirect materials used per machine-hour, relative to the

quantity of
budgeted indirect materials used per machine-hour

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 2. Actual energy used per machine-hour, relative to the budgeted energy used
per machine-hour

3. Actual machine-hours per jacket, relative to the budgeted machine-hours per

jacket

These performance measures, like the financial variances discussed in this

chapter and Chapter 7, alert managers to problems and probably would be
reported daily or hourly on
the production floor. The overhead variances we discussed in this chapter capture
the financial effects of items such as the three factors listed, which in many cases
first appear as nonfinan
cial performance measures. An especially interesting example along these lines
comes from Japan: Some Japanese companies have begun reining in their CO2
emissions in part by doing a
budgeted-to-actual variance analysis of the emissions. The goal is to make
employees aware of the emissions and reduce them in advance of greenhouse-
gas reduction plans being drawn up
by the Japanese government. Finally, both financial and nonfinancial performance
measures are used to evaluate
the performance of managers. Exclusive reliance on either is always too simplistic
because each gives a different perspective on performance. Nonfinancial
measures (such as those described previously) provide feedback on individual
aspects of a manager’s performance, whereas financial measures evaluate the
overall effect of and the tradeoffs among different nonfinancial performance
measures. We provide further discussion of these issues in Chapters 12, 19, and
23

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