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Teaching Suggestions
I most often cover this chapter in two days, and my focus is on the proper interpretation of the
overhead variances. On day one I generally try to cover three topics: (1) the difference between the
product-costing and control uses of standard costing for overhead; (2) the setting of standards for
overhead application, including the choice of the denominator activity level; and (3) traditional overhead
variance calculations. On day two I generally try to cover three topics: (1) the effect on standard costing
of changes in the manufacturing environment, (2) journal entries for recording standard overhead costs
and associated variances, (3) end-of-period disposition of overhead variances. Time permitting, I also
provide on day two an overview of the variance-investigation decision, including statistical control charts
and the decision-analysis approach explained in the appendix to the chapter.
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Lecture Notes
This chapter uses the concepts introduced in Chapter 13 to explain the key role flexible budgets and
variances play in the planning and control of factory overhead (i.e., indirect manufacturing) costs. The
chapter focuses on (1) the product-costing vs. control use of standard overhead costs, (2) how to
determine standard factory overhead costs, including choice of the denominator activity level for setting
the fixed overhead application rate, (3) how to compute traditional standard cost variances for variable
and fixed manufacturing overhead costs, (4) the interpretation of these variances, (5) journal entries for
standard overhead costs as well as end-of-period disposal of standard cost variances, (6) the effect on
standard costing of changes in the manufacturing environment, and (7) the variance-investigation decision
(based, fundamentally, on the management-by-exception philosophy).
Product-Costing vs. Control Purposes of Standard Overhead Costs
this discussion is new to the 4th edition of the text; the discussion can be built around two new
exhibits in the chapter: Exhibit 14.1 (variable factory overhead) and Exhibit 14.3 (fixed factory
overhead)
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overhead. New to the 4th edition is text Exhibit 14.4, which can be used to illustrate the total variable
overhead variance and its decomposition into spending and efficiency components.
o
Variable overhead spending variance (OSV) is the difference between actual variable overhead
costs incurred and budgeted variable overhead for the actual quantity of the cost driver for
applying variable factory overhead.
Variable overhead efficiency variance (OEV) is the difference between the budgeted variable
factory overhead for the actual quantity of the cost driver for applying variable factory overhead
and the budgeted variable factory overhead for the standard allowed activity units for the period.
Alternatively, this variance can be defined as the difference between the budgeted variable
overhead based on inputs and the budgeted variable overhead based on outputs. It is important to
point out to students that this variance does not reflect efficiency or inefficiency in using variable
overhead cost items. Rather, it relates to efficiency or inefficiency in use of the activity variable
(or cost driver) used to apply standard variable overhead to production.
Alternative Format for Variable Overhead Variances: the following diagram can be used as an
alternative to, or in conjunction with, text Exhibit 14.4 to illustrate the breakdown of the total
variable overhead variance into a spending and an efficiency variance.
Actual
Cost Incurred
or,
Efficiency Variance
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Determine the total budgeted fixed factory overhead for the period.
Select a cost driver for applying fixed factory overhead.
Calculate the denominator activity level (quantity) for the selected cost driver.
Compute the fixed factory overhead application rate.
The denominator activity level can be set at: theoretical capacity, practical capacity, normal capacity, or
budgeted capacity usage. For reasons discussed in the chapter, we prefer the use of practical capacity as
the denominator activity level for setting the fixed overhead application rate.
Analyzing Fixed Overhead Variances
Fixed factory overhead variances include the fixed overhead spending variance (FOSV) and the fixed
overhead production volume variance. New to the 4th edition is Exhibit 14.5, which provides a
diagrammatic representation of the determination of these two variances.
o Fixed overhead spending variance (FOSV) is the difference between the actual and the
budgeted fixed factory overhead for the period. This variance is also referred to as fixed overhead
flexible budget variance, or simply fixed overhead budget variance. Neither the actual units
produced nor the actual level of the cost driver incurred during the period has any effect on the
amount of the fixed factory overhead spending variance.
o Fixed overhead production volume variance (FOVV) is the difference between the budgeted
fixed overhead and the total fixed overhead applied to the units manufactured during the period.
Other terms for this variance are denominator variance, idle-capacity variance, and outputlevel variance.
o Alternative Representation of Fixed Overhead Variances: The difference between the actual
and the applied fixed factory overhead is referred to as underapplied or overapplied fixed factory
overhead. This is the total variance to be analyzed for product-costing purposes. The following
diagram can be used as an alternative to, or in conjunction with, text Exhibit 14.5:
Actual
Cost Incurred
Budgeted Total
Fixed Overhead
Spending Variance
(or, Flexible Budget Variance)
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prediction error
modeling error
measurement error
implementation error
The point here is that the cause of the controllable variance will dictate the appropriate course of
corrective action to take. On the other hand, variances judged to be uncontrollable (random) require no
corrective action on the part of management.
Control charts (e.g., Exhibit 14.17) and statistical control charts can be used to help identify random from
nonrandom (controllable) variances. As discussed in the Appendix to this chapter, the variance
investigation decision under uncertainty can be modeled through the use of payoff tables (see Table
14A.1 and 14A.2). Of particular importance in this model is the determination of the indifference
probability, as illustrated in Table 14A.3.
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