CHAPTER 20

PRODUCTION COST VARIANCES

Changes from Tenth Edition

All changes to Chapter 20 were minor.

Approach
This chapter has a heavy technical content. It is probably desirable to proceed quite slowly with it,
making sure that each variance is understood. The successful student is one who can "reinvent" the
formulas as needed, rather than needing to memorize them. A good understanding from Chapter 19 of the
flow of costs through the T-accounts in a standard cost system obviously is important in mastering the
techniques of variance analysis.

Throughout the sessions on this chapter, it is important to stress the uses of variances. I feel it particularly
important for students to realize that (1) the overriding goal is to identify all of the elements that caused
actual net income to differ from budget (or another useful comparison standard); (2) the labels
"favorable" and "unfavorable" are algebraic and do not necessarily reflect whether something "good" or
"bad" happened; (3) despite the mathematical formulas that isolate variance components, the components
in some instances are interdependent; and (4) the monthly overhead volume variance is not useful for
control purposes.

Cases
SunAir Boat Builders, Inc. asks students to calculate a full set of production cost variances for a simple
production company.

Medi-Exam Health Services, Inc. involves both break-even analysis and questions requiring an
understanding of overhead variances.

Cotter Company, Inc. is a deceptive case that tests whether the student has really "internalized" the
concepts of overhead variance analysis.

Lupton Company is a challenging(!) review case on the application of standard costing and variance
analysis concepts.

Problems
Problem 20-1: Beta Company
a. Material variance:
Price variance = Price x Actual Quantity
X Price variance = ($13 - $12.40) x 39,000 = $23,400 F
Y Price variance = ($8.50 - $8.70) x 11,000 2,200 U
21,200 F

Usage variance = Quantity x Standard Price

X Usage variance = (4 x 4,200 + 6 x 3,600 - 39,000) x $13.00 = $7,800 U
Y Usage variance = (1 x 4,200 + 2 x 3,600 - 11,000) x $ 8.50 = 3,400 F

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$4,400 U
b. Labor variances

Rate variance = ($14 - $13.60) x 2,025 = $810 F

Efficiency variance = (1/5 x 4,200 + 1/3 x 3,600 2,025) x $14 = 210 F

c. There would be no changes in the answers to 1 and 2. Prime cost variances are always based on actual
production volume, not planned volume. (Some students need frequent reminding of this fact.)

d. Again, there would be no change; sales volume has no direct impact on production volume, and
hence, not on production cost variances.

Problem 20-2: Delta Company

b. Budgeted overhead at standard volume = $100,000 + $26.00 (5,000) = $230,000
c. Overhead absorption rate = $230,000 5,000 units = $46.00/unit
d. May absorbed overhead = $46.00/unit x 6,000 units = $276,000
e. Volume variance = Absorbed - Budgeted
= $276,000 - [$100,000 + $26.00 (6,000)] = $20,000 F
f. Spending variance = Budgeted - Actual
= $256,000 - $280,000 = $24,000 U
g. Net variance = Absorbed - Actual
=$276,000 - $280,000 = $4,000 U
Check: $20,000 F + $24,000 U = $4,000 U

Problem 20-3: Kolb Company

a. (1) Cost system A is the actual variable cost system because $10,000 of factory indirect costs have
been charged out as an expense of the period in which incurred. Cost of goods sold is carried
at a lower value than B or C, indicating the inclusion of only variable costs.

(2) Cost system B is the standard full cost system. The presence of variances indicates this, and
the total costs of goods sold plus variances equals full cost ($96,000).

(3) Cost system C is the actual full cost system (using a predetermined overhead rate) showing the
cost of goods sold charged with its fair share of the factory indirect costs of the period, and
showing the same total full costs of goods sold as B. (Both are $96,000.)

b./c. One cannot determine how much of the overhead was variable because we do not know how much
of the $66,000 actual variable cost represented prime costs (direct material and direct labor). We can
say that actual fixed factory overhead was $30,000 ($110,000 - $80,000 difference in other operating
expenses), but we cannot determine the amount of actual variable factory overhead.

d. $80,000, the operating expenses are nonfactory costs.

e. Since there was an unfavorable overhead variance in system C, not all the factory indirect costs were
absorbed into the product, meaning factory volume was not as expected. If two-thirds of the fixed
factory indirect costs were absorbed into the cost of goods sold (2/3 x $30,000 = $20,000), then the
remaining $10,000 was not absorbed, indicating volume of only 2/3, or 66 2/3%, of the normal
factory volume anticipated when the overhead rate was set. This assumes there was no overhead
spending variance; without this assumption, the answer is indeterminate.
f. Cost system A, the actual variable cost system, is not prepared in accordance with generally accepted

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accounting principles, because full costs must be used to comply with these principles.
g. Direct material actual costs were $4,000 more than planned costs. This is known because the
materials variance is unfavorable, indicating actual cost to be greater than planned costs.

h. Problem 20-4: Doyle Company

a. Molders Trimmers Variance

(1) Labor rate [3,800($9.00 9.25)]=$950U [1,600 ($6.00 6.15)]=$240U $1,190U

(2) Labor substitution

(shift of molders to
trimming operation) [200 (6.00 9.00)] 600U

(3) Material substitution

(additional labor due 7,000 7,000
to discarded cases) x$4.50 3,150U x$1.50 1,050U 4,200U
10 10

(4) Operating efficiency

variance* (25 x $9.00)=225U (15 x $6.00)=90U 315U

(5) Idle time (75 x 9.00)=675U (35 x $6.00)=210U 885U

Total variance..........................................................................................................................................................
$7,190U

*Determination of operating efficiency variance.

Molders Trimmers
Actual hours charged to production..........................................................................................................................................
3,800 1,600
Labor substitution (shift of molders to trimming operation).....................................................................................................
(200) 200
7,000 7,000
.5 (350) .25 (175)
Additional labor hours due to inferior plastic...........................................................................................................................
10 10
Idle time...................................................................................................................................................................................
(75) (35)
Actual hours spent producing good cases.................................................................................................................................
3,175 1,590
.5 .25
3,150
Standard hours allowed for the production of good cases........................................................................................................
63,000 63,000 1,575

10 10
Variance in hours......................................................................................................................................................................
25U 15U

b. The supervisor of the molding department has a valid argument in both cases. The labor substitution
variance was the consequence of poor scheduling which is controlled by the production scheduling
department. The supervisor of the molding department apparently has no responsibility for or control
over the overall scheduling but has been required to compensate for the production scheduling
department's error. Consequently, the molding department should not be charged for the necessary
shift of workers within the department because the supervisor could not control the activities that
caused the shift.

The molding department uses the raw materials (plastic) that are acquired by the purchasing department.

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The acquisition of plastic is the responsibility of the purchasing department and the supervisor of the
molding department neither controls nor is responsible for this activity. The purchasing department made
the switch to the inferior plastic, and they should be held accountable for this action and resulting
variance.

Cases
Case 20-1: SunAir Boat Builders, Inc
Note: This case is unchanged from the Eleventh Edition.

Approach
This case provides a straightforward exercise in the calculation of material, labor, and overhead valances.
It also can be used to raise the more important issues of how variance information can/should be utilized
in operational control. I have found this little case can easily generate enough discussion for a full class
session.

Variance Calculations (Question 1)Parentheses denote unfavorable variances:

Materials
Price Variance:
If calculated materials enter inventory:
(Std. Pr.Act. Pr.) * Act. Qty. =
Cloth (2.001.80) * 60,000......................................................................................................................................................
= $12,000

= ($6,800)
If calculated as materials leave inventory:
} $ 5,200
Mix (3.754.09) * 20,000........................................................................................................................................................

Cloth (2.001.80) * 54,000 = $ 10,800

Mix (3.754.09) * 19,000

Usage Variance:
= ($6,460) } $ 4,340

(Std. Qty.Act. Qty.) * Std. Pr. =

Cloth (430 * 12054,000) * 2.00 = ($4,800)

Mix (430 * 4019,000) * 3.75

Labor
= ($6,750) } ($11,550)

Rate Variance:
(Std. RateAct. Rate) * Act. Hrs. =
Mixing (20.2521.37) * 210 = ($235.20)

Molding (20.2520.25) * 480

Efficiency Variance:
= 0 } ($235.20)

(Std. Hrs. Act. Hrs.) * Std. Rate =

Mixing (430 * 0.5210) * 20.25 = $101.25

Molding (430 * 1.0480) * 20.25

Overhead
= ($1,012.50) } ($911.25)

Actual = $11,140.00
Budgeted = $9.72 (430 hulls) + $6,561 = $10,740.60

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Absorbed = $24.30 * 430 hulls = $10,449.00

Spending Var. = Budget Actual = 10,740.60 - 11,140.00 = (399.40)
Vol. Var. = Abs. Budget = 10,449.00 - 10,740.60 = (291.60)
Net Var. = Abs. Actual = 10,449.00 - 11,140.00 = ($691.00)
[You will probably want to review the overhead budget/absorbed graph (Exhibit A) at this point.]
Total Variance
Based on materials purchased ($8,187.45)
Based on materials used ($9,047.45)
Exhibit A
Overhead Analysis

Possible Reasons
Material price: Good (bad) purchasing; pessimistic (optimistic) standard; substandard
quality cloth (a "favorable" variance perhaps the cause of the unfavorable
usage variance).
Material usage: Optimistic standard or poor "eyeball" control; fear of running out of
mixed material for a hull; defects; poor quality materials.
Labor rate: Optimistic standard; higher than planned labor skill utilized; overtime
Labor efficiency: Optimistic standard; slow workers; perhaps slowdown caused by
substandard materials (cloth?) or equipment; defects.
Another way of looking at labor efficiency;
690 hrs.
Input : 460 hulls input @ standard
1.5 hrs./hull
(actually, 420 hulls for mixing; 480 for molding)
Output: 430 hulls actual output
Overhead Actual overhead costs may be related more to hours worked than to hulls
spending: produced. Since budgeted hours were 645, and 690 hours actually were
worked, this labor inefficiency may explain at least part of the spending
variance. Also, the supervisor simply may not be adequately controlling
overhead costs.

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Overhead volume: Under absorbed because planned volume was 450 hulls and actual was 430.

Total cost per hull produced

Act. Std. Var.
(54,000 * 1.80) (19,000 * 4.09) = $406.77 $390.00 $(16.77)
Materials:...........................................................................................................................................................................................
430
(210 * 21.37) (480 * 20.25) = 33.04 30.37 (2.67)
Labor:.................................................................................................................................................................................................
430
Overhead:...........................................................................................................................................................................................
$11,140 / 430 = 25.91 24.30 (1.61)
Total per hull $465.72 $444.67 $(21.05)

Standards (Question 2)
There is not much specific information in the case concerning the validity of standards. Certainly one
would want to investigate the mixing operation. If the material and labor standards for mixing were based
on an assumption of zero waste and defects, then unfavorable variances would be inevitable. At this point,
some discussion of how defects and waste should be accounted for is appropriate. For example, should
the materials standard include a standard wastage? Should there be a budget for defects?

If it is determined that performance is not really inferior, but instead that the standards need revision, how
should the new standards be set? Alternatives include using past experience (perhaps reduced by some
desired productivity increase), getting comparative data from an industry association or materials
supplier, consulting a methods engineer, and so on.

In any case, the student should be left with the realization that unfavorable variances do not automatically
signal poor performance (or favorable variance, good performance); questioning the appropriateness of
the standard is a part of any variance investigation.

Question 3 (Other formats are, of course, acceptable):

SUNAIR BOAT BUILDERS, INC.
Statement of Gross Margin
Month of___
Budget Actual Variance
Sales revenues (@ $2,265)..............................................................................................................................................................
$1,019,250 $973,950
Std. cost of sales (@ $1,359)...........................................................................................................................................................
611,550 584,370
Std. gross margin (@ $906).............................................................................................................................................................
$ 407,700 $389,580 $18,120 U
Production cost variances:
Materials price............................................................................................................................................................................
-- $ 5,200 5,200 F
Materials usage...........................................................................................................................................................................
-- (11,550) 11,550 U
Labor rate...................................................................................................................................................................................
-- (235) 235 U
Labor efficiency.........................................................................................................................................................................
-- (911) 911 U
Overhead spending.....................................................................................................................................................................
-- (399) 399 U
Overhead volume.......................................................................................................................................................................
-- (292) 292 U
(8,187) 8,187 U
Gross margin...................................................................................................................................................................................
$ 407,700 $381,393 $26,307 U

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Case 20-2: Medi-Exam Health Services, Inc.*

Note: This case is unchanged from the Eleventh Edition.

Approach
This case provides a review of break-even analysis and profitgraphs, while at the same time linking profit
budgets and actual results in a way that involves understanding overhead variances. Exhibit 1 illustrates a
more detailed profitgraph format than is described in the text; some instructors may wish to take a few
minutes to develop the algebraic expressions for the total cost and revenue lines (12,000 + 32X and 80X
respectively) before starting the case discussion. Proceeding in order with the questions should move
smoothly until Question 3, where the conceptual difference between a period's overhead costs (debits to
the Overhead clearing account) and overhead expenses (the amount charged to the period's income
statement) will cause difficulties for many students. This is one of several opportunities to reinforce the
notion that the overhead production volume variance is a function of production volume (tests
performed), not sales volume (tests billed).

Answers to Questions
Question 1: Break-even
Fixed Costs
Break-even volume =
Unit Contribution Margin
Fixed costs = Fixed Lab. Overhead + Fixed Admin.
= $20,000 + $4,000 = $24,000
Unit contribution margin = Sales revenue/Unit - Variable cost/Unit
= $160- ($32,000* / 500)
= $160-$64
= $96

*Variable costs at 500 exams/month =

Supplies.......................................................................................................................................................................................
$ 8,000
Labor...........................................................................................................................................................................................
6,000
Variable Lab. Overhead...............................................................................................................................................................
10,000
Variable Admin............................................................................................................................................................................
8,000
$32,000

$24,000
Break-even volume = = 250 exams
$96
At this point or in Question 2, it is also worthwhile to develop the full standard cost of an exam, based
on a normal volume of 500:
$24,000 vbl. $20,000 fixed
= $88 / exam
500 Exams

Note that the administrative expenses, which are period rather than product costs, are excluded. This
number can be used to verify the August standard cost of services billed: 310 exams @$88 = $27,280.

*
This teaching note was prepared by Professor James S. Reece. Copyright by James S. Reece.

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Question 2: Profit per Profitgraph

Total pretax profit = Revenue - Variable costs - Fixed costs
Total pretax profit for X exams = $160X - $64X - $24,000
Total pretax profit for 310 exams = $160(310) - $64(310) - $24,000
= $49,600 - $19,840 - $24,000
= $5,760

Question 3: August Production Volume

Fixed laboratory overhead is absorbed at the rate of $40.00 per physical administered:
Fixed laboratory overhead $20,000
$40
Normal month' s number of examination 500
There is a volume variance (debit) of $1,600 for the period, indicating that overhead has been
underabsorbed (number of examinations given was less than formal). Fixed laboratory overhead
absorbed by examinations given must total $20,000 - $1,600 = $18,400. If $18,400 was absorbed and
the absorption rate is $40/physical, then 460 examinations must have been given this period.
Alternatively, if the approach described in the chapter's first appendix is used, the production volume
variance is $1,600U, and the absorption rate for first overhead is $40/exam; so $1,600/$40 = 40 fewer
exams than normal (460 = 500 - 40) must have been performed.
Question 4: Profit Reconciliation
Net profit indicated by break-even chart for 310 examinations (Question 2) = $ 5,760
Add (items which increased the profit shown above):........................................................................................................
Fixed laboratory overhead assigned to unbilled Summations.............................................................................................
6,000*
$11,760
Subtract (items which decked the profit shown above):.....................................................................................................
Revenue less than expected................................................................................................................................................
(400)+
Other variances (per income statement).............................................................................................................................
(1,120)
Overspending on administrative expenses..........................................................................................................................
(240)
$10,000

*460 examinations were performed but only 310 were billed. Therefore 150 examinations were still unbilled (an
intangible WIP inventory). Each of these is allocated $40 of laboratory overhead ($40 * 150 = $6,000).
+$160 * 310 examinations = $49,600. Actual revenue was $49,200.
Expected Administrative expenses were $4,000 fixed + $8,000/500 variable or $4,000 + $16 per exam. For 310
examinations, planned costs are $4,000 + ($16 * 310) = $8,960. Actual costs were $9,200.

Case 20-3: Cotter Co., Inc.

Note: This case is unchanged from the Eleventh Edition.

Approach
After a more mechanical variance analysis case like SunAir Boat Builders, I find it helpful to use Cotter
to remind students that detailed cost variance analysis is simply an extension of the overall notion of
explaining profit variance. My personal preference is to defer teaching the Landau Company case (#19-4)
on variable costing until the session that follows Cotter. The comments on questions that follow reflect
this approach. The Cotter case is very instructive by itself, however, even if not followed by Landau.

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Comments on Questions
Question 1
Students typically will develop the analysis shown below. The three footnoted comments should be
emphasized in this discussion. I defer further comment on the analysis until later.

Variance Analysis
Budget Actual Variance
Sales............................................................................................................................................................................
$200,000 $140,000 $(60,000)
Cost of sales (75% @ std.)..........................................................................................................................................
150,000 105,000 45,000
50,000 35,000 (15,000)1
Gross margin (@ std.).................................................................................................................................................
Mfg. Variances:...........................................................................................................................................................
-- (3,500) (3,500)2
Prime cost....................................................................................................................................................................
Overhead spending......................................................................................................................................................
-- 1,000 1,000
Overhead volume........................................................................................................................................................
-- (12,500) (12,500)
Actual gross margin.....................................................................................................................................................
50,000 20,000 (30,000)
30,000 27,000 3,0003
Selling and general overhead.......................................................................................................................................
Income before taxes.....................................................................................................................................................
$ 20,000 $ ( 7,000) $(27,000)
1
No unit margin variance, since actual gross margin percent = budgeted = 25%. Sales volume margin variance = (60,000
units) * $0.25 = $(l5,000). Is this volume variance serious? We're told the business is seasonal. (These observations can be
ignored if the instructor uses this case before assigning Chapter 21.)
2
Cant tell price/usage components without using the information given in Question 6.
3
Probably a volume variance on sales commissions: 5% * $60,000 underbudget sales = $3,000.

Question 2
Break-even volume is determined as follows:
Sales............................................................................................................................................................................
100% Fixed costs:
Prime costs..................................................................................................................................................................
40% Mfg. overhead..............................................................................
$50,000
Variable overhead........................................................................................................................................................
10% Selling and general.......................................................................
20,000
Commissions...............................................................................................................................................................
5% $70,000
Contribution................................................................................................................................................................
45%
$70,000
$155,556 break - even sales level
.45
Question 3
Students have less difficulty with this question if you have them call one dollar of sales value, "one unit."
I anticipate three approaches to this question, as shown below. A student who uses the "alternative
intuitive approach" really understands overhead variance analysis, and I try to get as many students as
possible to understand this approach. Although not shown here, I always end up with an overhead graph
like Illustration 20-7 on the board, on which I mark not only the cost levels, but also slopes of .10 for the
variable cost rate, .35 for the full absorption rate, and .25 for fixed cost absorption (a line from the origin
to the $50,000 fixed cost line at a volume of 200,000).

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Algebraic approach:
Let X= January volume
Volume variance = Absorbed - Budgeted
70,0001
12,500 X (50,000 0.1X )
200,000 2
.25 X = 37,500
X = l50,000 units (More general answer: 75% of normal volume.)

1
Est. overhead: $840,000 / 12 months
2
Est. volume per month

Intuitive approach:
Volume variance arises solely due to over- or underabsorbed fixed costs (i.e., there would never be a
volume variance if all overhead costs were variable).
Thus, we have:
Absorbed fixed overhead = Fixed budget + Volume variance
=50,000 + (-12,500) = 37,500
37,500
Thus we absorbed = 75% of fixed costs; hence volume was 3/4 of normal:
50,000

3/4 * 200,000 = l50,000 units

Alternative intuitive approach:
$70,000 $840,000
Overhead rate = = $.35 per unit or =
200,000 2,400,000

Of this, $.10 per unit is for variable overhead and $.25 per unit is for average fixed overhead. We
know from the above calculation that absorbed fixed overhead = $37,500.
$37,500
Hence, Volume = $.25 = 150,000 units
unit
Questions 4 and 5
These questions are relatively easy, once Question 3 has been dealt with correctly.
January inventory change:
Sales = 140,000 units
Pds. = 150,000 (from Question 3)
Invent = 10,000 units = $7,500 @ std.
Actual January production overhead costs:
Budgeted = .10(150,000) + 50,000 = $65,000
Spending variance (given) = 1,000 (favorable)
Actual $64,000

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Question 6
Material price variance..........................................................................................................................................
($0.10 - $0.09) * 390,000 lbs. = $3,900 F
Material usage variance.........................................................................................................................................
(150,000 * 2.5 lbs. - 390,000 Ibs.) * $0.10 = $1,500 U $3,500 U
Labor rate variance................................................................................................................................................
($9.00 - $28,400/2,500) * 2,500 hrs. = $5,900 U net prime cost
Labor efficiency variance......................................................................................................................................
(150,000 * 1/60 - 2,500) * $9.00 = $0 variance

"Lecturette" to set up the Landau Company case

If using Landau immediately after Cotter, I then present the following, which I call a "nonconventional"
variance analysis. Actually, this material is useful even if Landau has been used previously, or will not be
used at all.

1. Inventory is carried @ $.75/unit full cost, but variable cost per unit is $.50 ($.40 prime costs + $.10
variable overhead); hence there is a "contribution" of $.25 per unit for each unit "sold" to inventory
(because $.25 fixed cost is temporarily capitalized for each unit made). This phenomenon can be
further explained using the Overhead (clearing) T-account: Each additional unit causes only $.10
more overhead cost (debit) but creates $0.35 more absorption (credit, thus creating a $.25 credit to
Overhead Variance which, if closed to the income statement each month, increases reported income
by $.25.

2. When a unit is actually sold, there is an additional contribution of $.20/unit ($1.00 price - $.75 std.
cost - $.05 commission). Thus we have this January analysis:

Production.............................................................................................................................................................
(50,000) * $.25 = $(12,500)
Sales contribution variance....................................................................................................................................
(60,000) * $.20 = (12,000)
Spending variances:
mfg. overhead........................................................................................................................................................
1,000
prime costs............................................................................................................................................................
(3,500)
Total variance........................................................................................................................................................
$(27,000)

To me, this is a much more informative analysis of the $27,000 profit variance than was the one we
developed in question 1.

Note: This decomposition of the $.45 per unit contribution in the earlier break-even calculation shows that
the calculation assumes sales volume = production volume, a fact usually overlooked by students. Three
example which illustrate this appear below:

(A) (B) (C)

Sales......................................................................................................................................................................
$155,556 $155,556 $155,556
Fixed costs.............................................................................................................................................................
$ 70,000 $ 70,000 $ 70,000
Production vol. (units)...........................................................................................................................................
100,000 155,556 200,000
Income(details below)...........................................................................................................................................
$ (13,889) $ 0 $ 11,111
From sales: 155,556 * $.20................................................................................................................................................
$ 31,111 $ 31,111 $ 31,111
From pdn: vol. * $.25.........................................................................................................................................................
25,000 38,889 50,000
"Contribution"....................................................................................................................................................
56,111 70,000 81,111
Less: Fixed costs...................................................................................................................................................
70,000 70,000 70,000
Income...............................................................................................................................................................
$ (13,889) $ 0 $ 11,111

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These examples lead to the following questions, which I leave for students to consider in working
Landau:

1. Does a firm really earn a profit by production, sales, or both?

2. What would we have to do to the cost system so that income would vary with sales but not with
production volume?

Case 20-4: Lupton Company*

Note: This case is unchanged from the Eleventh Edition.

Approach
This case provides an excellent review of standard costing and variance analysis concepts. Students
cannot plug numbers into formulas to quickly arrive at most of the answers; rather, basic concepts and
procedures have to be carefully thought through. Many students find the case frustrating because it is too
challenging for them; the instructor should therefore warn students not to get discouraged if some
questions seem beyond them. (The case makes an excellent exam, if the instructor prefers difficult exams
to more straightforward ones.) I suggest devoting two class sessions to this case, trying to get through
question 11 in the first session.

Comments on Questions
1. We can definitely say that material usage and total labor costs were not up to expectations (although
without further detailed analysis, we do not know the rate and efficiency components of the labor
variance). We also know that actual prices of materials purchases exceeded standard; but this tells us
nothing about the prices of materials used in production, which is the connotation of "did we spend
more for our production operations?" Also, without the detailed analysis called for in questions 14-17,
we cannot say that the unfavorable overhead variances represent overruns of spending budgets;
conceivably, favorable spending variances could have been more than offset by unfavorable
production volume variances.

2. Since net overhead variance = absorbed - actual, and actual was the same both months, then more
overhead must have been absorbed in May than in April. This means that production volume,
however defined for overhead absorption purposes (see question 9), was higher in May than in April.
Note that overhead in Cost of Goods Sold was lower in May, but overhead absorbed into Work in
Process was higher. Students often forget the distinction between production volume and sales
volume when answering this sort of question.

3. Without reference to the supplementary data, we cannot determine whether April's overhead volume
variance was favorable or unfavorable (question 16). Some students will incorrectly state that
production volume was above standard, based on the $184,500 direct labor portion of cost of goods
sold.

4. For the reason given in the answer to question 2, we know that May's production volume was higher
than April's. For the reason given in the response to question 3, we do not know if May's production
volume was above or below standard volume. Some students will incorrectly infer that production
volume was $123,000 DL$ because direct labor in cost of goods sold was $123,000.

*
This teaching note was prepared by Professor James S, Reece. Copyright by James S. Reece.

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5. Sales revenues dropped 25 percent while total standard gross margin fell 11.8 percent. This could
have been caused by two factors: (1) an increase in weighted-average per-unit selling price obtained,
or (2) a change in product mix that increased the proportion of sales of the product having the higher
unit margin. Either of these would increase the standard gross margin percentage, which went from
28.3 percent in April to 33.3 percent in May. (Chapter 21 describes techniques for isolating these two
factors.)

6. The easy explanation is that Lupton buys more than one raw material, and other materials' price
increases more than offset the decrease on this one particular material. However, the phenomenon
could occur if Lupton had only one raw material: if May's purchase price, though lower than April's,
was above the standard, and if the increase in quantity purchased in May versus April more than
offset the decrease in unit price variance, then the unfavorable price variance would increase. For
example:

April May
Standard price per lb..............................................................................................................................................
$ 5.00 $ 5.00
Actual price per lb.................................................................................................................................................
$ 5.25 $ 5.20
Price variance per lb..............................................................................................................................................
$ (.25) $ (.20)
Quantity purchased................................................................................................................................................
1,000 lbs. 1,300 lbs.
Total price variance...............................................................................................................................................
$ (250) $ (260)

7. Actual total gross margin in Lupton (and many other companies having standard cost systems and
preparing monthly income statements), is based on standard cost per unit sold and on the month's
production variances. Total gross margin at standard is not affected by any production activity, nor by
purchasing. The May materials price variance was less unfavorable than it would have been had the
price of this material not dropped; but note that the impact is the same, whether or not the lower-
priced material enters the production process in May. The unfavorable material price variance
resulted in an increase in total actual gross margin.

8. The effect is exactly the same as explained for question 7. It is caused by the act of purchasing the
lower-priced materials, not by issuing these materials or selling the goods containing them.
9. Although overhead is absorbed based on production volume, not sales volume, the standard cost
sheets used to determine cost of goods sold at standard nevertheless will incorporate the absorption
basis. For the April and May statements, it can be seen that standard overhead is 80 percent of
standard labor for both months, whereas it is 75 percent of standard materials dollars in April and 66
2/3 percent in May. Therefore overhead absorption must be based on direct labor dollars, not material
dollars. (One would surmise this, of course, since standard volume is expressed in terms of direct
labor dollars.)
10. From supplementary note 5, we know that the sum of Product A's standard labor and overhead is
$33.21 ($45.51 - $12.30). From question 9, we know that overhead is absorbed at 80 percent of direct
labor. Thus, letting X = standard direct labor per unit, we have:
X + 0.8X = 33.21
X = 18.45
11. The following calculation can be performed:

April May
Debits @ std. to WIP.............................................................................................................................................
36,900 110,700
Materials usage variance (dr.)................................................................................................................................
1,230 3,690
Variance as percent of standard.............................................................................................................................
3.3% 3.3%

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Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

This shows that the rate at which material was wasted was the same for both months, even though the
total unfavorable variance was larger in May. Thus, whether the question is answered in absolute
terms or relative terms, there definitely was no improvement in materials usage performance.
12. In Lupton's system, as goods are moved from Work in Process to Finished Goods, the credit to the
former equals the debit to the latter. Thus, the combined accounts' balance is unaffected by this
transaction; so we can focus on May's debits to Work in Process for production costs and credits to
Finished Goods for cost of goods sold. To determine the debits, we must determine production
volume for May. May's actual production overhead was equal to budgeted overhead at standard
volume (supplementary item 4), which is 80% * $123,000 = $98,400. Since May's net overhead
variance was $18,460 U, May's absorbed overhead was $79,940. Dividing this by the overhead rate
gives May's volume: $79,940 / 0.8 = 99,925 DL$. This plus supplementary item 1 gives us the total
May debits to Work in Process: $31,365 + $79,335 + $99,925 + $79,940 = $290,565. This is less than
the $30,000 credits to Finished Goods for cost of goods sold, so the combined balance in the accounts
decreased.

13. From question 10 and Exhibit 1 we know:

Unit of CGS CGS

Standard Pdt. A April May
Materials............................................................................................................................................................................
12.30 196,800 147,600
Direct labor........................................................................................................................................................................
18.45 184,500 123,000
Full cost..............................................................................................................................................................................
45.51 528,900 369,000
Materials / Full cost............................................................................................................................................................
27%* 37% 40%
DL / Full cost.....................................................................................................................................................................
41%* 35% 33%

*These would be the percentages in cost of goods sold in a hypothetical month in which only Product A was sold.

Either the line of the ratios of materials to full cost or the line of the ratios of direct labor to full cost
shows that the proportion of A sold decreased from April to May. (I like to think this is a very subtle
analysis, since the first time I taught the case I thought the answer was, "You can't tell." The above
analysis was given by a student in that class.) Some students will say that the proportion of A
decreased because supplementary item 1 shows its production volume decreased; again, this is an
invalid inference, since one cannot determine sales volume from production volumes without
knowing changes in inventory.

14. The following sequence of logical steps is needed to answer this question (some calculations from
above are repeated for completeness):

a. The standard volume is $123,000 DL$ (given).

b. The absorption rate is 80% of DL$ (question 9).
c. These two facts imply that budgeted overhead at standard volume = 80% * $123,000 = $98,400.
Thus, we have one point on the budget line.
d. The budget for a volume of $135,300 DL$ is $102,090 (supplementary item 2); this is our second
point.
e. Slope = rise / run = ($102,090 - 98,400)/($135,300 - 123,000)= $3,690 / $12,300 = 0.30. Thus,
budgeted variable overhead is $0.30 per DL$.

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2007 McGraw-Hill/Irwin Chapter 20

f. Since TC = UVC * X, we have

$102,090 = TFC + 0.3($135,300)
TFC = $102,090 - 40,590
= $61,500 budgeted fixed
overhead
Check 98,400 = $61,500 + 0.3($123,000)
$98,400 = $98,400

g. May's actual overhead = April's actual overhead = $98,400 (supplementary items 3 and 4 and step
c. above).
h. Net overhead variance = absorbed - actual = absorbed - $98,400 - 18,460 in May. Thus May
absorbed overhead = $79,940.
i. But absorbed overhead = 0,80 * volume; thus May volume = $79,940 /0.8 = $99,925 DL$.
j. May's overhead budget therefore is $61,500 + 0.30 ($99,925) = $91,477.50.
k. Since spending variance = budget - actual, May's spending variance = $91,47 7.50 - 98,400 =
$6,922.50 U.
15. Since May's net overhead variance = $18,460 U, and the spending variance was $6,992.50 U, then the
production volume variance must have been $1,537.50 U. As a check, volume variance = absorbed -
budget = 0.8($99,925) - [61,500 + 0.3(99,925)] = $79,940 - 91,47750 = $11,537.50 U.

16. Using the same logic as in the answer to question 14:

a. Net overhead variance = absorbed - actual = absorbed - $98,400 = - $55,360. Thus April's
absorbed overhead = $43,040.
b. Therefore April volume = $43,040 / 0.8 = $53,800 DL$.
c. Volume variance = absorbed - budget = $43,040 - [61,500 + 0.3(53,800)] = $43,040 - 77,640 =
$34,600 U.
17. As in question 15, since we know the net variance and one component, the other can be deduced: -
$55,360 = -$34,600 + spending variance; therefore spending variance = $20,760 U.

Or, as a check spending variance = budget - actual = [$61,500 + 0.3(53,800)] - 98,400 = $77,640 -
98,400 = $20,760 U.

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