Costing, Budgeting, and Variance Analysis in Accounting
Variable Costing
Definition
A method of calculating product costs where direct materials, direct labor, and variable manufacturing overhead are included in the cost of the product. Fixed overhead costs are considered a period expense, not a part of manufacturing overhead. This method is not GAAP for external financial reporting.
Benefits
- Shows incremental costs of production.
- Treats fixed overhead costs as period costs, independent of sales volume.
Absorption Costing
Definition
A method of calculating product cost where direct materials, direct labor, and all manufacturing overhead (both variable and fixed) are included. These costs are held in the finished goods inventory account on the balance sheet and flow to Cost of Goods Sold (COGS) on the income statement when products are sold. This method is required by GAAP for external financial reporting.
Benefits
- Provides a more accurate picture of total product cost.
- Accounts for all manufacturing costs of production.
Disadvantages
- Only sends fixed manufacturing costs to the income statement when products are sold.
- Can incentivize managers to overproduce to reduce the per-unit fixed manufacturing costs recognized in the current reporting period’s income statement.
Why Net Incomes May Differ
Net incomes calculated under variable and absorption costing will be the same if all units produced are sold. Differences arise when production volume does not equal sales volume (i.e., inventory levels change). Under variable costing, all fixed overhead appears on the income statement as a period cost.
Budgeting
Definition
The process of developing expectations and plans for how a company will operate and compete.
Benefits of Budgeting
- Quantifies plans and objectives.
- Facilitates communication of plans across the organization.
- Creates motivation and a sense of ownership.
- Allows for benchmarking and comparison to actual results.
- Supports performance management.
Variances
Definition
The quantitative difference between a budgeted (expected) amount and an actual amount.
Variance Analysis
Purpose
A crucial tool for managers. By understanding why actual results deviated from expectations, managers can make informed adjustments, improve future budgeting, and enhance budget execution.
Flex Budget Calculation
Step 1: Calculate the Flex Budget
The flex budget is a recalculation of the budget using all budgeted (standard) information, except for the number of units.
Purpose of the Flex Budget
The flex budget isolates the impact of differences in unit volume from other causes of variance. Without it, a significant portion of the difference between the static budget and actual results would simply be due to variations in units produced or sold.
Key Variances Explaining Operating Income Differences
- Selling Price Variance
- Direct Materials Variances:
- Price Variance: Did we pay more or less for materials?
- Efficiency Variance: Did we use more or less material per unit than planned?
- Direct Labor Variances:
- Rate Variance: Did we pay more or less for direct labor?
- Efficiency Variance: Did we use more or less labor per unit than planned?
Flex Budget Calculation Formulas
- Revenue: Actual Units × Budgeted Selling Price Per Unit
- Direct Materials: Actual Units × Budgeted Cost Per Pound × Budgeted Pounds Per Unit
- Direct Labor: Actual Units × Budgeted Rate Per Hour × Budgeted Hours Per Unit
Step 2: Examine and Label Variances
- Sales Volume Variance: Flex Budget Operating Income – Static Budget Operating Income
- Represents the difference in operating income solely due to differences in unit sales volume.
- Flex Budget Variance: Flex Budget Operating Income – Actual Operating Income
- Represents the difference in operating income due to factors other than unit sales volume (e.g., price, efficiency).
- Total Budget Variance: Actual Operating Income – Static Budget Operating Income
- The overall difference in operating income. This variance is explained by the sum of the Sales Volume Variance and the Flex Budget Variance.
Formulas for Flex Budget Variances
These variances explain the components of the Flex Budget Variance:
- Selling Price Variance (SPV):
- Actual Quantity Sold × (Actual Selling Price – Budgeted Selling Price)
- Direct Materials Price Variance (DMPV):
- Actual Quantity of Direct Materials Purchased × (Actual Price – Standard Price)
- Direct Materials Efficiency Variance (DMEV):
- Standard Price of Direct Materials × (Actual Quantity Used – Standard Quantity Allowed for Actual Output)
- Direct Labor Rate Variance (DLRV):
- Actual Hours of Direct Labor × (Actual Rate – Standard Rate)
- Direct Labor Efficiency Variance (DLEV):
- Standard Rate of Direct Labor × (Actual Hours Used – Standard Hours Allowed for Actual Output)
Variance Interpretation
- Favorable Variance: An outcome that increases operating income compared to the budgeted amount.
- Unfavorable Variance: An outcome that decreases operating income compared to the budgeted amount.
The Total Budget Variance is the sum of the Sales Volume Variance and the Flex Budget Variance.
Responsibility Accounting
Definition
A system that assigns responsibility for financial performance to specific individuals or departments (known as responsibility centers). It tracks their performance against budgets and expectations, focusing on costs and revenues that are controllable by that center.
Common Costs
Definition
Costs associated with operating a facility, activity, or cost object that is shared by two or more users.
Methods to Allocate Common Costs
- Stand-Alone Method:
- Determines allocation weights based on each user’s individual cost or usage, often using a pro-rata percentage method.
- Incremental Cost Method:
- Ranks individual users based on their responsibility for incurring the cost.
- The first-ranked user (primary user) is allocated costs up to their stand-alone cost of using the common resource.
- Subsequent ranked users (incremental users) are allocated the remaining costs, typically up to their stand-alone cost, until all common costs are allocated.
Department Types
- Support Department:
- Provides services that assist other internal departments (e.g., IT, Human Resources, Maintenance).
- They are necessary for the organization’s success but do not directly create the final product or service.
- Operating Department:
- Directly adds value to products and/or services.
- Often interacts directly with external customers (e.g., Production, Sales).
Support Department Cost Allocation
Direct Method
Allocates support department costs only to operating departments, completely bypassing allocations to other support departments.