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Hi Oliver,

EOQ

EOQ stands for “economic order quantity”.  It’s a decision model represented by the equation EOQ = sqrt (2DP/C).  Solving the equation will give the optimal quantity of inventory that a company should order given a set of assumptions.  The assumptions are:

·The same quantity is ordered at each re-order point.

·Demand, lead times, ordering costs, and carrying costs are certain.

·Quantity ordered does not affect the purchasing costs per unit

·No stockouts (situations where inventory has been exhausted)

·Costs of quality and shrinkage are only considered if they affect the ordering or carrying costs

Example:  Oliver runs a stall in the Byward market during the summer, selling gourmet olives.  He sells 10,000 Olives per summer (D) and the costs to hold one olive is $0.12 (C).  It costs him $80 per purchase order (P) from his supplier in Europe.  What is his EOQ?

EOQ = sqrt (2*10,000*80/.12)

EOQ = 3651 olives

Transfer Pricing

1. Market based:

The transfer price is set at the market price (i.e. the cost of a similar product or service that is also on the open market.  This method is best used when the selling division does not have idle capacity.

2. Cost based:

Transfer price is determined based on the costs of producing the intermediate product.  Transferring at full cost means the price will contain an allocation of fixed overhead; this might lead to suboptimal decisions in de-centralized organizations. Transferring at variable cost might lead divisions to record large losses and income due to the transfer pricing decision.

3. Negotiated transfer price (NTP):

An NTP comes from discussions between the selling and buying parties.  This method is generally used when the market is more volatile, and it allows managers autonomy, as they will often have the most accurate information about what is going on in their respective divisions.

To calculate the minimum transfer price (MTP):

Use MTP = Variable cost + lost contribution margin

Example:

A T-shirt company has two divisions. P Division makes printed T-shirts and buys 30,000 (plain t-shirts) a month from an outside supplier for $11 each.  C Division makes t-shirts with slogans on them.  C Division sells 40,000 T-shirts each month; VC per shirt is $2 and CM is $28. Idle capacity is 5,000.

If P Division wants to transfer their 30,000 shirts to C Division, what is the MinTP and MaxTP?

MTP = 2 + (28* (40000-30000)/40000) = $9

Hope that helps

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Oliver's 5th Question - Chapter 21: Transfer Pricing Methods

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Oliver's 5th Question - Chapter 21: Transfer Pricing Methods

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Hi Oliver,

To build further on each of the transfer pricing methods as described in further detail by Jay, Melissa, and Kimberley, I created a sort of spectrum that can be used to visualize how minimum and maximum transfer price is determined. Hope this helps!

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Hi Oliver,

My group members did a good job explaining units-transferred-in and spoilage, so I’ll go over rework and how it applies to a job costing system.

-Normal rework attributable to a specific job refers to rework that is not out of the ordinary for the manufacturing process of a specific job and can therefore be charged to the work in process for that job.

Example: Say a mining equipment company is building some excavators with diamond tipped teeth for a customer.  Unfortunately, the excavators are accidentally fitted with regular steel teeth.  The teeth can be switched out but it will cost the company in terms of direct labour and overhead.  The extra costs of doing this would be charged to the WIP for that specific job.

-Normal rework common to all jobs refers to rework that is not out of the ordinary for the manufacturing process of all jobs currently being undertaken, and therefor can be charged to MOH in order to spread the cost over all the jobs.

Example: The mining company installs plexiglass shields on the cabs of all its excavators.  Unfortunately these were slightly scratched during the manufacturing process and now must be cleaned off in order to be brought up to safety standards.  The rework costs associated with doing this for all the excavators are charged to MOH and spread across all the different jobs.

-Abnormal rework refers to rework that is out of the ordinary for the manufacturing process, and is therefore charged to a loss account:

Example:  The company is installing transmissions on the excavators.  Unfortunately the crane installing the transmission malfunctions and the transmission falls to the ground, cracking all the gears.  The rework costs of doing this are abnormal for the company and the costs associated with doing so are charged to the Loss from Abnormal Rework account.

Hope that helps!

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Hi Oliver,
I will answer your question regarding chapter 19.
The Economic Order Quantity (EOQ) equation is used to determine the optimal quantity of goods to be purchased. EOQ aims to minimize the costs associated with ordering, storingor holding inventory and inventory costs overall.
The formula to calculate EOQ is the squareroot of 2DP/C where D is demand in units, P is purchase order costs , and C is carrying costs.

Example
Sandy's Bakery needs 500 cooling racks during the year. The cost of each cooling rack is $30 and order costs are $50 per order. In addition, the carrying cost is $10. What is the optimal order quantity?

Solution
D= 500 cooling racks
P= $50
C= $10
therefore,
EOQ= the square root of (2 x 500 x $50) / $10 = 70.71
The optimal quantity Sandy's Bakery should order is 71 cooling racks

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Hi Oliver,
I will be adding onto Lynn's explanation of transferred-in costs in chapter 17.
Transferred-in costs are typically used in the process costing system and are incurred when the production is switched between various departments within the company. For example, in a company with two production departments; Department A transfers to Department B. The transferred-out costs from department A will be equal to the transferred-in costs in department B.
Beginning inventory refers to the cost of inventory which the company has at the beginning of an accounting period.
To deal with transferred-in costs, all costs are carried over from a previous production process to the next required production process.

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Hey everyone, good job at answering the question so far as a team! I like how you've each covered a part and added on to others explanations. Keep up the good work.

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Hi Oliver, to build onto Kimberley and Jay's response, I can tell you about Negotiated TP.

This is where both parties (buyer and seller) can negotiate a transfer price, there are no conditions that have to be met, its commonly used when there is no market price.

With this method of transfer pricing, you want to look at the relevant range of pricing that both the buyer and seller can agree between.

The Max TP is equal to what the buyer can go buy from an external supplier. While the Min TP is the minimum amount that the supplier is willing to sell the item for, making sure they cover all there costs incurred for production.

Therefore it makes sense that Min TP= VC + CM per unit lost.

Some advantages of Negotiated TP are:

-Give managers power to decide on price

-Divisional managers probably have the best information on the costs incurred for each product, and can help when setting the TP.

Hope this helps!

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Olivers 5th Question - Chapter 21:Cost Based Transfer Pricing

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Olivers 5th Question - Chapter 21:Cost Based Transfer Pricing

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Cost Based Transfer price

Cost based Transfer Price is a effective policy to use when there’s no market or when there’s not enough information or its too difficult to determine what the market price is. The transfer costs in this case is based on the cost incurred to actually produce the product. Cost based transfer prices can either be in the form of just variable cost, variable cost and fixed costs, full costs and lastly full cost + a markup.

The formula used to calculate transfer price is incremental cost(Variable Cost) + Lost in Contribution Margin(Opportunity costs). I’ve attached a short video that goes through an example of how to calculate min and max transfer price.

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Advanced Management Accounting Video Satellite

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Management Accounting 16: Transfer Pricing

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Ken Boyd, owner of St. Louis Test Preparation (www.stltest.net) presents part 16 of his course on Understanding Management Accounting. Boyd points out that students can have success with Management Accounting concepts by making connections to actual examples from business. As a former CPA, College Accounting professor, Auditor and Tax Preparer, Ken has a wealth of experience to bring to the subject.

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Oliver's 5th Question - Chapter 19 w/ example

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Oliver's 5th Question - Chapter 19 w/ example

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Hi Oliver,

The Economic Order Quantity (EOQ) is the number of units that a company should add to inventory with each order to minimize the total costs of inventory—such as holding costs, order costs, and shortage costs. The EOQ is used as part of a continuous review inventory system in which the level of inventory is monitored at all times and a fixed quantity is ordered each time the inventory level reaches a specific reorder point. The EOQ provides a model for calculating the appropriate reorder point and the optimal reorder quantity to ensure the instantaneous replenishment of inventory with no shortages. It can be a valuable tool for small business owners who need to make decisions about how much inventory to keep on hand, how many items to order each time, and how often to reorder to incur the lowest possible costs.

The basic EOQ relationship is shown below
EOQ = square root of (2DP/C)

D = Demand in units for a specified period

P = Ordering costs per purchase order

C = Carrying costs of one unit in stock for the time period used for Demand.

Assume, for example, a retail clothing shop carries a line of men’s shoes and the shop sells 1,500 pairs of shoes each year. It costs the company $5 per year to hold a pair of shoes in inventory, and the fixed cost to place an order is $2. The EOQ formula is the square root of: (2 X 1,500 pairs X $2 order cost) / ($5 holding cost), or 34.641 with rounding. The ideal order size to minimize costs and meet customer demand is 35 pairs of shoes.

That should help you out Oliver, let me know if you have any more questions!

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Chapter 21 - Transfer Pricing (Market Based Transfer Pricing)

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Chapter 21 - Transfer Pricing (Market Based Transfer Pricing)

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Hi Oliver,

Market Based Transfer Pricing is the most commonly used method. It's optimal for decision making when the intermediate market is perfectly competitive, interdependencies of subunits are minimal, and there are no additional costs or benefits to the corporation as a whole in using the market instead of transacting internally.

The minimum price is the market price and the maximum price is the market price. This is because the the division can always sell or purchase the output/input in the external market at that price.

TP = IC + OC = MP
TP = Transfer Price
IC = Incremental Cost
OC = Opportunity Cost
MP = Minimum Price

There should be no idle capacity when using this method

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Hi Oliver,

EOQ stands for Economic Order Quantity. It represents the number of units a company should add to inventory in order to minimize the total costs. The optimal quantity of units can be found by using the formula
EOQ = SQRT(2DP/H)

D = Units demanded

P = Order cost

C = Carrying cost

Examples include; order costs, holding costs, and shortage costs.

I found a simplified example that you can use to better understand: https://www.youtube.com/watch?v=AYpjPWmlyHM

All the best! -Gordon

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Hi Oliver,

To build onto April and Jay's response for your chapter 18 question.. I found two helpful sources.

The first is an article that explains spoilage, and the second link is a real life example. The second link is a video showing how Ford's F150 truck uses spoilage and scrap costs in there production. I think it is valuable as it apply's the content learned from this chapter to a real life example, which helps put the content in perspective!

Link one: https://www.managementstudyguide.com/spoilage-and-rework-in-job-order-costing-system.htm

Link two: https://www.youtube.com/watch?v=Fte2o9_v-T0

Hope this helps!

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Hi Oliver,

I will expand on Jay's reply and explain how to account for spoilage in a job costing system.
As Jay mentioned, there are two types of spoilage abnormal, and normal spoilage.
Normal Spoilage is the unavoidable spoilage that occurs when manufacturing a product. For example 1 or 2 units from a batch of 1000 granola bars break when moving from the oven to wrapping.
Normal spoilage is treated as part of the standard cost of the goods, and therefore is considered part of the asset (inventory), until the products are sold.
Abnormal Spoilage is spoilage in excess to the average or expected rate of normal spoilage. For example the wrong setting on the oven is set and an entire batch of 1000 granola bars are ruined. This cost is expensed immediately (Loss from Abnormal Spoilage Account), and not treated as part of the unit costs.

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Hi Oliver,
Just to add on to Kimberley's point regarding transferred-in costs, these costs are conceptually similar to the beginning inventory you are getting mixed up with since for example, ending inventory of period 1 = beginning inventory of period 2 (which is similar to transferred-out of department 1 = transferred-in department 2). However, transferred-in costs are not actually beginning inventory or ending inventory costs as they are simply costs that move from one department to the next, rather than from one period to the next. Each department has a different function, and the first department would not incur any transferred-in costs because there are no costs being transferred-in from a product that is currently getting worked on as the production is starting with this department. The next department and each subsequent department would incur these transferred-in costs since production is being passed on to this department in order to continue the process.

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Hi Oliver,
Transferred in costs are the accumulated costs that a product has incurred before it has to travel on to the next department or process in the production cycle (process costing system). As products move through each department or process in the production cycle, their related costs in equivalent units are transferred with them. The exact amount that was transferred in the department is exactly what was transferred out from the previous department or process. I’ve attached a link to a video that further explains the whole transferred in cost process and how it works in a actual production cycle.

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Process Costing - Second (of future) department: how to deal with transferred in costs from an earlier department or process Accounting lecture notes: http://tiny.cc/nw1enw Process Costing videos: Process Costing versus Job Costing: http://youtu.be/tVY3OXlIHsk Process Costing and Equivalent Units: https://www.youtube.com/watch?v=0VyAu20e-BA Steps 1 & 2: https://www.youtube.com/watch?v=yGWtHwQGT1U Steps 3, 4, & 5: https://www.youtube.com/watch?v=KiCSDkciiuI Journal Entries with Examples: https://www.youtube.com/watch?v=Q67b-AN80gE Second (or future) Department: https://www.youtube.com/watch?v=g8zabJpHOBU -- Thank you all for your wonderful support.

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Hi Oliver,

Spoilage is when inventory is wasted or wrecked. This is typical as all companies have damaged goods at one point or another.

Rework is when there is a correction made to a product that has already been finished or returns to a certain section of production that it has already passed through.

Here's a link to help explain abnormal and normal spoilage.

http://www.investopedia.com/terms/n/normal-spoilage.asp

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Hi Oliver,

Concrete examples of absorption vs. variable costing in the real world are hard to come by, but I found a (pretty dense) textbook excerpt from a few years ago.  Don't worry I'm not going to make to read it...I did that for you.  Here are some key points detailing as to why managers might choose to use either absorption or variable costing:

http://www.mheducation.ca/college/hiltoncost/graphics/hilton1cmh_information/1cmh_sample.pdf

managers being evaluated (and compensated) on reducing per unit costs are going to gravitate to absorption costing. They are able to spread the total manufacturing costs across many units simply by producing more units.  Some of these units may go unsold in the long run, but in the short run the balance sheet is inflated by all the built up inventory, and operating profit is increased.

companies that want to have a very good idea about how costs are actually being used, and/or want to be able to keep easily keep track of all the different types of costs should use variable costing.  Under this method, variable costs, fixed manufacturing overhead costs, and period costs all get their own lines on the income statement and are easily identifiable from each other.  As April's second article suggests, this might be better for smaller companies who want to simplify their cost tracking methods, cash flow, and financial statements.

Gl on the test!

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Hi Oliver,
My team members have done a great job with explaining the difference between absorption costing and variable costing. I found a link to a post which further explains both concepts and gives an example and solution. The link also gives some advantages and disadvantages of both inventory methods. Here is the link http://www.accountingformanagement.org/variable-vs-absorption-costing/
Hope this helps!

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Hi Oliver,

Absorption Costing
Under a Absorption Cost System product costs are all variable and fixed manufacturing costs are all included in inventory costs. All costs are transferred from inventory to Cost of Goods Sold once the goods are sold. At that point Cost of Goods Sold is matched up with the revenue that is coming in. All non manufacturing costs (includes variable and fixed) are all classified as period costs.

Variable Costing
Under a Variable Cost System only variable manufacturing costs are included as inventorial costs. Meaning that all fixed costs (manufacturing and non manufacturing overhead) are classified as period costs. The costs flow from inventory to Cost of Goods Sold just like in an absorption cost system but within those costs there’s not fixed components whereas in absorption costs system there is.

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Hi Oliver & Team,

I focused on finding a few examples of business' that use absorption and variable costing.
Absorption Costing
This link explains how auto companies have used absorption costing to help spread fixed costs over large inventories. Although it helped them to appear profitable in the short run, producing excess inventory to spread out their fixed expenses hurt them in the long run with more inventory then there was demand.

http://ww2.cfo.com/management-accounting/2012/02/why-the-big-three-put-too-many-cars-on-the-lot/

Variable Costing
In contrast smaller manufacturers can benefit from using variable costing. It prevents management from over producing and holding inventory, and gives a more accurate picture of cash flow. This link does a great job of explaining the benefits of variable costing and how it can be an advantage to use in smaller business'

http://smallbusiness.chron.com/pros-cons-variable-costing-accounting-43136.html

Hopefully those resources help you better understand the different costing methods in real life examples.

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Hi Oliver,

Absorption Costing provides a company with a situation where it can manufacture more products and increase its net income at the same time. This is the case because fixed costs are allocated to products costs. This allows the company to produce more units and reduce the amount of fixed costs attributed to each unit. This costing method will result in a larger net income than variable costing.

Variable costing is great for when companies are looking to make an incremental pricing decision because it only factors variable manufacturing costs into product costs. This also method also would correct the issues of over production that absorption costing would produce.

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Team 10: I will focus on Oliver's first question, talking about the main difference between the 2 costing methods!
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Hi Oliver, I can help you with apart of your question.

Absorption Costing (Also called Full Costing) is a cost method where product costs are capitalized.

Under Absorption costing, inventorial costs include all variable and fixed manufacturing costs.

Under Variable costing (Also called Direct Costing) product costs are also capitalized as well, however only variable manufacturing costs are included as inventorial costs.

Essentially that is the main difference between the two costing methods, where the fixed manufacturing costs are allocated.

When I learnt this topic seeing the difference on an Income Statement helped, I included one below as well as a link to a video supporting Absorption costing and a mini example which may be beneficial to watch!
-To see the video, please click the link, and then on padlet click "view original".

Absorption cost

Revenue

(COGS- including fixed manufacturing OH)

=Gross Profit

(Operation Expense)

=Operating Income

Variable costing

Revenue

(Variable costs)

=CM

(FC- including fixed manufacturing OH)

=Operating Income

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What is 'Absorption Costing'

Absorption costing is a managerial accounting cost method of expensing all costs associated with manufacturing a particular product and is required for Generally Accepted Accounting Principles (GAAP) external reporting. Some of the direct costs associated with manufacturing a product include wages for workers physically manufacturing a product; the raw materials used in producing a product; and all of the overhead costs, such as all utility costs, used in producing a good. Absorption costing includes anything that is a direct cost in producing a good as the cost base.

BREAKING DOWN 'Absorption Costing'

Absorption costing is also called full costing as all costs - including fixed overhead charges - are included as product costs. As opposed to the other alternative costing method called variable costing, every expense is allocated to products manufactured whether or not they are sold.

Absorption Costing vs. Variable Costing

Absorption costing entails allocating fixed overhead costs across all units produced for the period. Variable costing, on the other hand, lumps all fixed overhead costs together and reports the expense as one line item. Variable costing does not determine a per-unit cost of fixed overhead while absorption costing does. Variable costing will yield one lump-sum expense for fixed overhead costs when calculating net income. Meanwhile, absorption costing will result in two categories of fixed overhead costs: those attributable to cost of goods sold and those attributable to inventory.

Advantages of Absorption Costing

Absorption costing does not account for all fixed expenses which reflects certain situations in which all the inventory is not sold. Because assets remain part of the entity's books at the end of the period, absorption costing reflects more fixed costs attributable to those items within ending inventory. For some, absorption costing will result in more accurate accounting regarding ending inventory. In addition, more expenses are accounted for in unsold products, which reduces actual expenses reported. This results in a higher net income calculation when compared to variable costing calculations.

Disadvantages of Absorption Costing

Because absorption costing includes overhead costs, it is unfavorable when compared to variable costing when making internal incremental pricing decisions. This is because variable costing will only include the extra costs of producing the next incremental unit of a product. In addition, the use of absorption costing generates a unique situation in which simply manufacturing more items will increase net income. Because fixed costs are spread across all units manufactured, the unit fixed cost will decrease as more items are produced. Therefore, as production increases, net income naturally rises because the fixed cost aspect of the cost of goods sold will decrease.

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Absorption costing is a managerial accounting cost method of expensing all costs associated with manufacturing a particular product and is required for Generally Accepted Accounting Principles (GAAP) external reporting. Some of the direct costs associated with manufacturing a product include wages for workers physically manufacturing a product; the raw materials used in producing a product; and all of the overhead costs, such as all utility costs, used in producing a good.

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NOTE TO TEAM:
Melissa and Nicole already provided good links to videos for question three. I'm going to add a little for 1) and 2), and then focus on 4), particularly explaining the FMOH sales-volume and FMOH efficiency variances that Oliver said he was having trouble with.  That way all our answers are not just different versions of each other.

Hi Oliver,

1)  A static budget is one where the level of output is not changed once it is set, even if the circumstances change.  In a flexible budget, for any changes in the actual level of output, cost drivers are adjusted and a new budget at the adjusted levels is made.

2) Under normal costing, DM and DL costs are valued based on actual amounts incurred, and overhead is allocated based on an estimated allocation rate and the actual quantity of the allocation base.  Under standard costing, standards ( a.k.a target amounts) are set for direct materials and direct labour.  The standard costs are recorded in the accounting system. Variance analysis is then done comparing the targets to the actual costs, and adjustments may be made based on the differences.

4) You said you were having trouble with the FMOH variances, so I'll explain why the efficiency variance and sales-volume variance do not apply to fixed overhead costs.  The key here is to remember that fixed overhead is fixed, it can't change!

I'll illustrate this with an example. Say a company employs an engineer to do two monthly safety inspections on a machine at a budgeted rate of $1000 per month. It's a fixed overhead cost because they pay the engineer to do the checkups regardless of unit output.  The budgeted input quantity, which in this case is the engineer's two monthly inspections, will always be the same as the actual quantity used up (two inspections). The company cannot be more or less efficient with the cost of employing the engineer. Efficiency = (actual - budgeted) * 1000
= (2-2)*1000 = 0

A sales volume variance could also not be calculated because the company's sales volume is completely independent from whether or not the engineer does his inspections.

Hope that helps!

Teammates feel free to build on my answer.

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Hi Oliver,

Sorry it took me so long to get back to you with answers..apparently computer science is a very labour intensive elective to take.

Under a job costing system we can either use actual costing or normal costing as a way of allocating overhead to different jobs.  Normal costing uses the estimated overhead cost/estimated quantity of an allocation base (for example direct labour hours) to get the overhead allocation rate.  This rate is then used to calculate the overhead allocation by using: estimated allocation rate*actual quantity of allocation base.

Because we are using estimates, it would be very hard for managers to guess exactly the actual overhead incurred for the year and come up with the correct allocation rate to apply to the allocation base.  Therefor the overhead will either be under-applied (amount actually incurred > amount applied) or over-applied (amount actually incurred < amount applied).

Traditional vs Activity Based Costing (ABC):

-traditional costing allocates overhead uniformly using averages, regardless of how it is incurred
-results in either over-costing: product uses a low level of resources but allocated high costs per unit, making them seem less profitable
-or under-costing: product uses a high level of resources but allocated low costs per unit, making them seem more profitable
the allocation rate for traditional costing is:
budgeted OH cost pool/budgeted quantity of allocation base

Under ABC, overhead costs are separated out based on their specific activities or functions.  The accumulated total of all the costs related to a specific activity is known as a cost pool. Getting the activity cost rate of the different pools is done by dividing them by the amount of their respective activity cost drivers. Activity cost drivers are simply any activities that cause changes in the total costs of a cost object.  For example machine cleaning might be driven by hours spent cleaning the machine, or box stacking activity might be driven by the number if boxes stacked.  The activity cost rate is then used to allocate the indirect costs.

Companies that use activity based costing likely have:
-overhead costs large in proportion to total costs
-activities that do not use overhead uniformly in the manufacturing process

Any company that has high overhead costs compared to total costs and that has to spend a significant amount of time at one or two stages of the manufacturing process should consider ABC.  For example aircraft companies would have to spend a lot of time working on their plane's safety systems.  Food and beverage manufacturers companies might have to spend a lot of time on quality control.

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Hey everyone, good job so far at answering the question. I like how you've presented examples and brought in some videos as well. Remember that all group members should be adding something to effectively answer the questions!

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Hi Oliver,
I found a12 minute video which explains and answers your questions about standard costing, normal costing, static budget and flexible budgets. It also explains how to determine if the variance is favourable or unfavourable. This video defines the terms, then explains them and solves some practice problem. Here is the link https://www.youtube.com/watch?v=mVI8RY5THvs

Hope this helps!

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Hi Oliver, I can help you with some of your questions.

1. Difference between a flexible and static budget

Static budget is basically using forecasted data to create a budget.

Where the Flexible budget uses all the same data as the static budget, but replaces the budgeted amount produced for the ACTUAL output produced to create its figures.

An example would be if at the beginning of the year you thought you would produce 5 units @ a sales price of $10, but at the end of the year you find out you actually produce 8 units.

Under Static budget, you would record 5x$10= $50

Under Flexible budget, you would record 8x$10=$80

2. Standard costing vs. Normal costing

Standard costing uses target amounts (predetermined figures) for the companies DL and DM. If the company is following standard costing they will use these targeted amounts for recording purposes.

However when time goes on, and when we know the ACTUAL amounts, we can find our variances.

So in standard costing, basically the variances are going to be a comparison of the actual amounts and the standards (targets) set at the beginning of the year. The variances allow the managers' how their predictions panned out, and using standard costing also helps managers see where they need to improve.

Relating standard costing to normal costing, the main difference between the two is that normal costing uses the actual figures right away, and does not set standards.

For your trouble with variances, I found this short video which explains conceptually why we use variances, I think it will help if you check it out:

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Calculating Variances in Budgets

Variances in budgets are differences between the company's actual revenues and expenditures and the planned or budgeted amounts. Companies generally create reports on a monthly basis showing the amounts of those variances, and then analyze the reasons for them. Calculating variances is just a subtraction process. Generally, the monthly financial reports will be in this format:

The variance column will be the difference between the budgeted and actual amount for that line in the report. Some companies will also use the formula Budget Amount - Actual Amount = Variance for all accounts. Others will reverse the order of calculation for revenue accounts. In other words, if revenues are higher than budget, that is a positive variance, and if revenues are lower than budget, then that is a negative variance (with this method, expenses still show up as negative variances if they are over budget and positive variances if they are under budget).

Either way, you'll end up with a column of differences that you can scan down to locate the biggest impacts. You'll want to note the outliers in both dollars and percentages, as the significance of the variance will depend on the size of the account.

Analyzing Variances

Analyzing variances to the budget is really the 'meat' of the process. If you run a business or function within a business, when you review your monthly reports you want to know how you're doing, and also if there is anything you need to do differently to have better results. The analysis process gives you that information.

Let's say, for example, that you've received your variance report, and you have actual revenues of $48,000 vs. the $65,000 in the budget. The analysis process is designed to tell you why that occurred. The most common way to look at a revenue variance is using price and volume (or quantity) details. To start with, we pull out our detailed budget to understand how the $65,000 was calculated. When we look into it, we find that it assumed we would sell Product X to 13 customers at $5,000 per installation that month, resulting in a $65,000 budget.

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calculations & analysis - video & lesson transcript | study.com

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Variances in Budgets: Definition, Calculations & Analysis - Video & Lesson Transcript | Study.com

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Variances in budgets are differences between the company's actual revenues and expenditures and the planned or budgeted amounts. Companies generally create reports on a monthly basis showing the amounts of those variances, and then analyze the reasons for them. Calculating variances is just a subtraction process.

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Hi Oliver,

Chapter 4

The reason why there’s always an over or under applied over head is due to the fact that when we are calculating total cost using normal costing system we are using an budgeted overhead rate to calculate the estimated manufacturing Overhead. We have to use the Normal costing system because we don’t know what the actual overhead amount will be till year end. Once we do know the actual overhead amount we would recalculating total cost under the actual costing system. The concept of over and under applied comes from the difference between the total budgeted over head cost applied (total manufactured overhead under normal costing) and the actual overhead cost incurred. When overhead incurred > overhead applied à under allocated overhead. When overhead incurred < overhead applied à over allocated overhead.

Chapter 5

The difference between Activity based costing and traditional costing

·      Traditional Costing: Uses the estimated allocation rate to budget total Manufacturing Over head cost.

·      Activity based costing: allocates overhead to specific activities in the manufacturing process instead of to the whole product its self. Therefore, each activity has its own activity cost rate that is based on a cost driver

o   Activity cost rate: total cost related to the activity/activity cost driver

·      Under both methods total cost will be the same the only thing that’s different is the amount of manufacturing over head.

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Hey Oliver,

We have to first realize that we are using estimates when applying costs to overhead because you will never know the actual costs until they are incurred, and that is where over or under applied overhead comes into play. Over or under applied overhead refers to the difference between manufacturing overhead cost applied and manufacturing overhead cost incurred. When the estimated costs applied to manufacturing overhead ends up being greater than the manufacturing overhead cost we actually incurred then that's where over-applied overhead appears. Vice versa, when the manufacturing overhead cost applied is less than the actual manufacturing overhead cost incurred then that's where under-applied overhead appears. Therefore, in the normal costing system we must make periodic adjustments to reconcile the amount of Overhead we applied to the actual amount of overhead used.

Traditional vs ABC

Each method yields a different cost figure

Selection of the appropriate method and drivers should be based:
– Experience & industry practices
– Cost-benefit analysis of each option

Traditional Based Costing uses one average rate to allocate company's overhead to jobs relating to the product, this treats overhead costs as a single pool of indirect costs. Activity Based Costing however assigns overhead costs to each specific activity associated with a cost driver to, each at a different rate.

Traditional Based Costing

Pro:

Traditional costing systems are simpler and easier to implement, which makes them less costly than ABC systems

Con:

Since it uses one predetermined overhead rate it is less accurate than ABC systems which can lead to poor upper-management decisions and severe over/under costing.

Activity Based Costing

Pro:

ABC systems give a better and more accurate look into how costs are allocation and expands on each costs drivers, this will help managers look at the cost-benefit of running a certain operation and ultimately lead to good company decisions.

Con:

ABC systems are costly and require a lot of resources to implement. Which is why it is important to analyze company processes and decide if an ABC system is needed

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Oliver's First Question - Traditional Based vs. ABC 

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Oliver's First Question - Traditional Based vs. ABC 

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To add on to previous points mentioned,

Pros of ABC:
(1) By splitting and grouping activities together into separate cost pools, you can choose a cost allocation base (cost driver) that would best suit this or a group of activities. For instance, if you have overhead costs associated with a machine as well as set up costs, if you grouped these two together and choose one cost-allocation base such as machine hours, then you are not closely relating the cost driver to your cost pool which we aim to have a cause-and-effect relationship with.
(2) Make better decisions by reducing the risk of overcosting or undercosting a certain product from just using traditional costing. Using the previous example, if there are overhead costs with the machine and setup, under traditional based costing you could using machine hours as your cost allocation base. However, if in this case setup costs are very high for a certain product in comparison to another product, it would not yield the most accurate results for determining the cost of the activities if grouped together, which could result in undercosting in this case.

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Oliver's First Question - Under- vs. Over-applied Overhead

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Oliver's First Question - Under- vs. Over-applied Overhead

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The reason as to why there is under- or over-applied overhead is due to, what typically occurs, a difference between the actual overhead costs incurred and the estimated overhead that has been applied.

For instance, say in a clothing factory and for simplicity sake, the thread used to sew clothing is an example of an overhead cost as with mass production, it would not be economically feasible to calculate how much thread was used spread across multiple clothing styles.

Typically, managers want to be able to budget ahead of time as this allows for producing budgets and making decisions being made in a timely manner. As a result, they gear more towards trying to make an estimation of how much overhead will be used. Say in this example, the estimated amount of overhead for the whole fiscal period is $500. This $500 is the budgeted overhead and is applied to the credit account “MOH Allocated”.

At the end of the fiscal period, the company can then account for all of the actual overhead costs that have been incurred throughout the year. After accounting for all of the indirect costs for the year, say the actual amount of overhead is $600.

In this case, the actual amount exceeded what was estimated/budgeted, and thus the overhead costs are under allocated. This is similar to saying that the managers have underestimated the actual amount of overhead by estimating that only $500 would be used, but there ends up being $600 of thread being used (see 1).

In contrast, say if the actual overhead costs come out to be $450 when we had anticipated that the overhead costs to be $500 (which we have applied to MOH Applied because this was an estimation), then we over-applied overhead – we over-estimated how much overhead would be applied (see 2).

As stated earlier, the “MOH Allocated” account is a credit. To add onto this, we also have a “MOH Control” account that is a debit. All actual overhead costs that are incurred are applied to this account as once the actual costs are incurred, the balance in “MOH Allocated” gets netted out by the amount in the “MOH Control” account (you can think of this like closing off revenues and expenses into retained earnings at year end where you debit revenues and credit expenses to offset its amounts).

I have included an attachment to show the concept of under- (see 1) and over-applied (see 2) overhead with the use of T accounts.

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Hey guys good job so far at answering the questions, make sure all group members are contributing something to help each other out. You had great explainations however maybe try to incorporate some examples to further get the content across to Oliver. If you find a video or website that explains something really well feel free to post that as well!

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Since we initially estimate the overhead, there is no guarantee that it will be exact. Over or under applied overhead refers to the difference between manufacturing overhead cost applied and manufacturing overhead cost incurred. When the manufacturing overhead cost applied is greater than the actual manufacturing overhead costs incurred, we end up with overapplied overhead. When the manufacturing overhead cost applied is less than the actual manufacturing overhead cost incurred, we end up with underapplied overhead.

Activity Based Costing assigns a cost to each specific activity associated with creating a product, then determines the cost of the product by calculating the sum of these activities. Traditional based Costing uses an average rate to assign costs to a product. Management uses activity based costing because it allocates resources based on actual consumption therefore they find it more accurate. Although activity based costing seems like more work, it helps make better pricing and product mix decisions. For example, Chrysler uses activity based costing to reduce costs and eliminate inefficient activities.

A pro of Activity based costing is that it helps identify wasteful activities and products

A con of Activity based costing it that it is expensive and time-consuming to implement

A pro of traditional based costing is its easiness to apply

A con of traditional based costing is that it can lead to poor management decisions since an average rate is being used

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Hey guys here are my thoughts on Oliver's chapter 4 and 5 questions!

Chapter 4
Under normal costing we use budgeted overhead rates to try and forecast the future costs to help make decisions assess profitability.

When allocating overhead using the budgeted rate we basically have an estimate of the amount of indirect materials used in each specific job. But at year end, when we have the actual amount of overhead (specific indirect labour hours, Indirect materials used etc.), we want to compare and see how well we predicted the allocation of overhead. That is why when calculating Over/Under applied OH we take the Actual MOH costs- Allocated MOH, to find the difference between our OH forecast and the OH actual balance at year end. The difference is either the under/over applied OH.

That’s basically how I would sum up conceptually why we have under and over applied overhead for Oliver!

Chapter 5
Main Difference

-Each method (Traditional vs. ABC) provide different OH amounts.

-ABC uses multiple allocation rates, Traditional costing uses only one.

ABC

-Goal is to assign OH costs in a cost pool directly to a product.

-Detailed analysis of looking at a companies activity costs, seeing how those costs are individually allocated to the job and finding a rate to assign to each product.

Cons: Expensive and takes time.

Pros: Provides the company        with a cost benefit analysis of each product. Helps in making better managerial decisions and hopes to improve profitability, efficiency and quality of their production.

Traditional
-Uses averages to allocate OH costs to jobs, and doesn’t look at the actual OH costs incurred for the job.

-Companies should use this type of costing when their indirect costs are minimal in comparison to the total costs.

Cons: Can result in under and over costing.

Pros: Only using one allocation rate so it is faster and cheaper then ABC.

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Hi Oliver!
Because estimates are used to allocate OH in normal costing systems periodic adjustments must be made.
-Companies often need to allocate the cost of OH to cost objects before the actual cost has occurred. The costs applied (allocated) will never match the actual costs.
-We must reconcile the amount of OH Applied with OH Control (Actual)
In this system OH is allocated using an estimated rate (Est. OH/Est. Quantity of Base)
1. To allocate OH = estimated rate x actual quantity of base
2. We Cr. Overhead Applied with this estimated amount
3. When the actual cost occur we Dr. Overhead Control with the actual amount
4. When OH Control > OH Applied this results in under allocated OH
5. When OH Control < OH Applied this results in over allocated OH
6. We must then make adjustments for the over/under allocated OH

Hopefully this helps you better understand why there ends up being over or under applied OH

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My name is Gordon. I'm in my last semester at Carleton. I am on the Raven's Varsity soccer team - so come support us at MNP. I am looking forward to working with you all.

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Oliver came to my office today for some help... please watch the video and work together to help him!  Here is a summary of his questions:
CH 4: understanding conceptually why there ends up being over or under applied OH (walk through the process)
CH 5: Difference between traditional costing and activity based costing & examples of companies that would use ABC.

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I look forward to working with you all this semester. Thank you for everyone posting their introductions.  Remember that you can add different forms of media in here like videos, pictures, and links to websites that you found useful and relevant to the course matieral!

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Hi everyone!
My name is Lynn and I am currently in my third year in accounting. I just completed an eight month co-op term, so I am excited to be back to school and to work with all of you this semester!

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Hey guys!
My name is Melissa and I am a 3rd year accounting student. Looking forward to working with you all this semester!

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Hey guys,

My name is Daniel. I am a 4th year accounting student. This is the one 3rd year course I have yet to complete so I am excited to get started and looking forward to working with the rest of you guys!

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Hey Everyone,
My name is April, I am currently a 3rd year accounting student. I just transferred to Carleton from the accounting program at Algonquin. This is my first university course and I am looking forward to working with everyone this semester.

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Hey,
My name is Kim. I am a 4th year accounting student aswell. I'm looking forwarded to working with you all this semester.

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Hey guys,
My name is Stephen. I'm in 4th year accounting and I just completed my 4th co-op term at an accounting firm downtown, so it's been a while since I've been at school. Looking forward to getting back into the swing of things and helping out Oliver.

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Hey,
My name is Jay and I'm currently in my fourth year. I'm majoring in accounting with a minor in law. I'm excited to get started and work with everyone this year.

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Hi everyone,
My name is Nicole. I am a fourth year accounting student. I am taking this course because it is a requirement for my program and I also enjoy the flexibility which online courses offer. I look forward to working with everyone during this semester.