Under a normal costing system, prime costs (direct materials and direct labor) are still assigned to prod-ucts each quarter as the items are being produced, the same as an actual costing system. Overhead, however, is applied to products based on predetermined overhead rates when using a normal costing system. These rates are derived from the budgeted overhead and production numbers estimated at the beginning of the year.
Overhead is then applied to actual units produced each quarter based on the actual usage of the cost driver for production multiplied by the predetermined overhead rate. Since direct labor is not a major factor in production, Forest determines that machine hours is the most ap-propriate cost driver for the company.
Each quarter the differences between actual overhead and overhead applied (that is, the amount of under/over applied overhead) are determined but are not closed at that time. Forest decides to show the under/over applied overhead amounts at the bottom of the quar-terly and annual income statements, shown in Table A4, but they are not included in the calculation of operating income for each quarter.
The periodic differences are accumulated for all four quarters, and the accumulated difference is closed to Cost of Goods Sold at year-end, and is only then included in the calculation of operating income.
At the end of each quarter, except the fourth quarter, the interim under/over applied overhead amounts are recorded as either a deferred debit (under applied overhead) or a deferred credit (over applied overhead) on the balance sheet. At the end of the year the balances in the deferred debit and deferred credit accounts are applied to annual income.
Quarterly variances are not closed to income because variances can be either favorable or unfavorable and variances in one quarter could be offset by variances in the next quarter. Therefore, they are kept on the balance sheet as deferred debits or deferred credits during the year. At the end of the year, companies have to make a choice on which method to use to close the variance accounts to annual income.
Finest Watch Company has chosen to write off the total under/over applied overhead to cost of goods sold because the amount is con-sidered to be immaterial. The amount of under/over applied overhead amount at year end could be prorated between the work-in-process, finished goods, and cost of goods sold accounts, rather than simply closing the entire amount to cost of goods sold.
Table A3 illustrates how Forest calculates the predetermined overhead rates for normal costing. Since Forest will be comparing results for normal and standard costing systems, he separates total over-head into its variable and fixed components, as is typically done under standard costing.
Forest uses the former controller’s estimates of annual variable ($400,000) and fixed ($200,000) overhead that were provided to him. The former controller based the budgeted variable and fixed overhead amounts on an estimated 40,000 units (80,000 machine hours) being produced in 2016. Forest then prepares quarterly and annual income statements for 2016 using normal costing, presented in Table A4.
Table A3
Budgeted production and sales, budgeted annual overhead costs, normal costing predetermined over-
head rates, and actual cost-driver information.
Budgeted production and sales 40,000 units (80,000 machine hours)
Budgeted annual overhead costs
Variable $400,000
Fixed $200,000
Predetermined overhead cost rates
Variable $400,000/80,000 machine hours = $5.00/machine hour
Fixed $200,000/80,000 machine hours = $2.50/machine hour
Actual cost-driver usage
Quarter I Quarter II Quarter III Quarter IV Full Year
Machine hours 1,900 hours 5,200 hours 24,900 hours 52,000 hours 84,000 hours
Note: In each quarter, and for the year as a whole, production = sales (i.e., no change in inventory).
Table A4
Quarterly and annual income statements – normal costing.
*** To be prepared using excel file. ***
Next, Forest decides to prepare quarterly and annual income statements using standard costing. Under standard costing, all inventoriable costs (direct materials, direct labor, and factory overhead) are applied to products based on predetermined standard rates. As illustrated in Table A5, the predetermined stan-dard rate is the amount applied for each cost. It is calculated by multiplying the standard rate per unit of the cost driver by the standard quantity allowed of the cost driver for the units produced. Table A6 presents the quarterly and annual income statements under standard costing constructed using in-formation from Tables A1 and A5.
Table A5
Expected selling price, standard product and period cost information, and
predetermined standard fixed overhead rate calculation data.
Expected selling price $75 per watch
Standard product cost information
Prime costs $40 per watch
Variable manufacturing overhead $10 per watch
Fixed manufacturing overhead $200,000 per year
Standard operating cost information
Variable operating costs $5 per watch
Fixed operating costs $40,000 per year
Denominator level (annual) 40,000 units
Standard machine hours 2 machine hours/unit
Predetermined fixed overhead rate per standard machine hour = Budgeted fixed overhead/denominator level of machine hours = $200,000/(40,000 units × 2 standard machine hours/unit)
= $200,000/80,000 standard machine hours
= $2.50/standard machine hour
Table A6
Quarterly and annual income statements – standard costing.
*** To be prepared using excel file. ***
The standards for the variable costs were determined based upon input from and analysis by en-gineers, statisticians, operating personnel and accounting staff. The budgeted fixed costs were based on 2015 results, adjusted for changes expected for 2016. The denominator level for production of 40,000 units, needed for determining the predetermined fixed overhead application rate, is the same as the number of units budgeted for 2016. The predetermined fixed application rate of $2.50 per standard machine hour is calculated in Table A5.
Standard costing allows management to conduct more in-depth variance analysis for each product cost. Total Under/Over Applied Variable Overhead can be broken down into a spending variance and an efficiency variance, while total Under/Over Applied Fixed Overhead can be broken into a spending variance and a production volume variance.
Just as with normal costing, variances are determined each quarter; however, they are not closed until year-end, when the accumulated amounts for each variance are closed to Cost of Goods Sold. Each quarterly variance is recorded as either a deferred debit (under applied overhead) or a deferred credit (over applied overhead) on the balance sheet. At the end of the year these deferred debits and credits are applied to the annual income. If the amount of the total under/over applied overhead is immaterial, which is the case for Finest Watch Company, the total under/over applied overhead amount is closed to cost of goods sold. If the amount is not immaterial, then Finest Watch Company would prorate the total under/over applied overhead variance between work-in-process, finished goods, and cost of goods sold.9 The resulting quarterly and annual income statements based on standard costing for 2016 are shown in Table A6.
Management was certainly more pleased with the income in Quarters I and II when the quarterly income statements were created using normal and standard costing systems, and still quite happy with the overall results for the year. Management is intrigued that the results for normal and standard costing are quite similar and asks Forest to write a memo explaining the differences. Management also wants Forest to write a memo regarding the annual variable spending and efficiency variances as well as the annual fixed spending and production volume variances that were calculated under standard costing
Requirements
After reviewing the quarterly and annual income statements based on actual costing, the firm’s management had considered shutting down operations for the two quarters showing losses. Bob Forest was concerned with this possibility. Why?
Make a convincing argument as to why management should not base its decision to cease operations on financial statements based on actual costing.
Bob Forest also prepared the quarterly and annual 2016 income statements based on normal costing and based on standard costing. Write a memo to management describing how these two costing systems differ. Discuss which of the two approaches would be more helpful in controlling operations during the year.
Assuming that total under/over applied overhead is only closed at the end of the year, explain why the quarterly operating incomes under normal and standard costing do not add up to the operating income for the full year.
Assuming that total under/over applied overhead is closed to cost of goods sold, all three costing methods end up with the same operating income at the end of the year. Why then do companies use different costing methods if the operating income at the end of the year is always the same?
Based on the standard costing income statement, calculate the individual vari-ances for variable and fixed factory overhead. (This should include the spending and efficiency variances for variable overhead, and spending and production volume variances for fixed overhead.)
Write a memo to management defining, explaining, and interpreting each of the variances you calculated in Requirement 5.
Explain how the predetermined overhead rates (for either normal or standard costing) are used to assist the firm’s management for inventory-costing purposes.
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