Illustrative Example Xander Barkley s XYX Company manufactures a single product. The standard cost card for one unit is as follows:

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1 Appendix 11A General Ledger Entries to Record Variances 11A-1 General Ledger Entries to Record Variances Although standard costs and variances can be computed and used by management without being formally entered into the accounting records, most organizations prefer to make formal entries. Formal entries tend to give variances a greater emphasis than informal, off-the-record computations, providing a clear signal of management s desire to keep costs within the limits that have been set. In addition, formal use of standard costs streamlines the bookkeeping process enormously. Inventories and cost of goods sold can be valued at their standard costs eliminating the need to keep track of the actual cost of each unit. Closing entries made at the end of the accounting period help adjust the financial statements to reflect actual costs. You may be saying, Why should I learn this? This is bookkeeping. I do not plan to be an accountant. I intend to be a senior manager with a staff of accountants who will report to me on all this. While we agree that there are nuances to recording and reporting transactions, as well as complexities best reserved for those intending to become specialists, every manager can benefit from knowing the basics of the accounting information system and how the information from transactions flows through the various accounts. The material on journalizing in this appendix will walk you through the basic logic. We explain matters that are usually skipped in other textbooks as unnecessary detail; however, you will be glad that we provide explanations for questions that you are usually expected to work through for yourself logically. You will learn where the information goes, how it is recorded, and how the variances are isolated by the accounting information system. We will illustrate the transactions recording process with the following example. Illustrative Example Xander Barkley s XYX Company manufactures a single product. The standard cost card for one unit is as follows: Inputs Direct materials Direct labour Variable manufacturing overhead Total standard cost per unit (1) Standard Quantity or Hours per Unit of Output (2) Standard Price or Rate per Unit of Input (3) Standard Cost per Unit of Output SQI SP SQI 3 SP 5.0 grams 1.5 hours 1.5 hours $ $ $40.00 Fixed overhead costs have been estimated to be $11,400 per month. Fixed overhead is applied using direct labour-hours. In the static budget for June, the company had projected 11A-1

2 11A-2 Appendix 11A to make 1,900 units. During June, 2,000 units were produced, 11 kg of materials were used, and the following costs were incurred: Materials purchased: 18 kg at $600 per kilogram $10,800 Direct labour: 4,000 hours at $19.50 per hour ,000 Variable manufacturing overhead costs incurred ,800 Fixed overhead costs incurred ,750 Required: 1. Compute all cost variances and indicate if a variance is favourable or unfavourable. 2. Prepare journal entries to record the variances and the flow of costs through the standard cost system. 3. Assume that 2,000 units produced in June were sold for a price of $60 per unit. Prepare an income statement (up to the gross margin) using the absorption costing format as shown in Chapter Prepare entries to close out the variances to the cost of goods sold. What is the actual gross margin for June? Computation of the Cost Variances Exhibit 11A 1 shows the calculation of all the variances. This was fully explained in the chapter and should be reviewed if necessary. The following points should be noted from the calculations. EXHIBIT 11A 1 Variance Calculations for XYX Company I J K L M N 1 XYX Company: Flexible Budget Cost Variances for June 2 AQ 3 AP AQ 3 SP SQ 3 SP 3 Standard Quantity Actual Quantity of Input at Actual Actual Quantity of Input at of Input Allowed for Actual Output Price Price variance Standard Price Quantity variance at Standard Price 4 18 kg 3 $600/kg 18 kg 3 $500/kg Direct Materials 5 $10, $9, $1, U 11 kg 3 $500/kg 10 kg 3 $500/kg 8 $ $5, U $5, ,000 h 3 $19.50/h 4,000 h 3 $20.00/h 3,000 h 3 $20.00/h Direct Labour 12 $78, Rate variance $80, Efficiency variance $60, $(2,000) $20, F U ,000 h 3 $5.00/h 3,000 h 3 $5.00/h Variable overhead 17 $20,800 Spending variance $20, Efficiency variance $15, $ $5, U U Actual Fixed Overhead Budget variance Budgeted Fixed Overhead Volume variance Applied Fixed Overhead 22 3,000 h 3 $4.00/h 23 $11,750 $11,400 $12, Fixed overhead $350 $(600) 25 U F

3 General Ledger Entries to Record Variances 11A-3 Direct materials The quantity of direct materials purchased does not equal the quantity of materials used, and thus the price variance is based on the purchased quantity of 18 kg, whereas the quantity variance is based on the amount used of 11 kg. The standard quantity of direct materials allowed for making 2,000 units is 10 kg, calculated as follows: SQ 5 SQI 3 Actual production volume 5 5 grams/unit 3 2,000 units 5 10 kg. Direct labour and variable overhead For direct labour, the standard quantity of hours allowed for 2,000 units is SQI 3 Actual volume hours/unit 3 2,000 units 5 3,000 hours. Since both variable overhead and applied fixed overhead are driven by the labour-hours, the standard quantity of the allocation base (direct labour-hours) allowed for the actual output of 2,000 units is also 3,000 hours. Fixed overhead With regard to fixed overhead cost, note that the predetermined fixed overhead allocation rate is $4 per labour-hour, calculated as follows: Budgeted fixed overhead cost Predetermined fixed overhead allocation rate 5 Denominator activity level The denominator activity level is the amount of labour-hours allowed for the planned (static budget) volume of $1,900 units. This is equal to SQI 3 Planned volume hours/ unit 3 1,900 units 5 2,850 hours. Thus, the predetermined rate is $11, ,850 hours 5 $4 per labour hour The quantity of the allocation base to which the rate is applied is the standard quantity of the base allowed for the actual output achieved of 2,000 units. This is 3,000 hours. Thus, applied fixed overhead is 3,000 3 $4 5 $12,000. And the volume variance is Budgeted fixed overhead cost 2 Applied fixed overhead cost 5 $11,400 2 $12,000 52$600 This is a favourable variance because the fixed overhead is overapplied relative to the budget. This occurs because the actual volume (2,000 units) was more than the planned volume (1,900 units). Overhead was applied to 3,000 hours instead of the denominator activity level of 2,850. The additional 150 hours to which the $4 rate was applied produces the $600 overapplication. Recording Variances To illustrate the general ledger entries needed to record standard cost variances, it will be helpful to remember that variances arise because transactional data differ from the standards. That is, actual prices deviate from standard prices and actual quantities deviate from the standard quantities allowed for the actual production volume. To isolate the variances, note the following: Liabilities (purchases and expenses) are recorded at the actual values; entries to accounts payable are recorded as AQ 3 AP. Inventoriable assets like raw materials added to or removed from inventory are recorded as AQ 3 SP. Resources (materials, labour, overhead) are applied to production (work in process) at standard quantities allowed for the actual production volume valued at standard prices: SQ 3 SP. Finished goods are transferred from work in process into finished goods inventory at the full standard cost, including applied fixed overhead: Q 3 SC. Cost of goods sold is also recorded at standard cost, including applied fixed overhead: Q 3 SC. The above protocols will enable the isolation of the variances and also enable closing entries to the variance accounts when adjusting standard costs to actual costs. The process explained below to isolate and record the variances for XYX Company will serve to LO6 CC27 A : Explain the cost flows in a standard costing system. Know LO6 Apply CC28 A : Prepare journal entries to record standard costs and variances.

4 11A-4 Appendix 11A illustrate these protocols. This will also give you one more opportunity to consider the calculation of variances from transactions processing data. This is a slightly different perspective from the one taken in the main body of Chapter 11. Direct Materials Variances THE PRICE VARIANCE XYX purchased 18 kg of material from its supplier at a price of $600 per kilogram for a total cost of $10,800. The company has incurred a liability to the supplier; it has acquired an asset that must be added to its inventory. There are three parts to this transaction. The first part, the liability to the supplier, is valued as AQ 3 AP and posted to accounts payable: Accounts payable (for buying 18 kg at $600/kg) Cr 10,800 The second part is adding the purchased materials to materials inventory. The amount purchased, AQ 5 18 kg, is entered into inventory at the standard price of SP 5 $500 per kilogram. In a standard costing system, all inventories are valued at standard prices. Thus, the entry for this part of the transaction is recorded as AQ 3 SP: Raw materials (18 kg at $500/kg) Dr $9,000 The discrepancy between the two entries made is due to the difference in the price per kilogram of materials (AP 2 SP) of $600 2 $500 5 $100 per kilogram. The price variance is 18 kg 3 $100/kg 5 $1,800 U. To journalize the price variance, an account to record the variance is created and this account is either debited or credited for the variance. A debit entry is needed to augment the inventory value against the liability recognized in accounts payable when the inventory value is less than the amount owing (i.e., the standard price is less than the actual price). This occurs when the variance is unfavourable. A favourable variance will require a credit entry to the variance account to augment the liability in accounts payable against the value of the inventory, since the company will owe the supplier less than the standard value of the inventory in the case where the actual price is less than the standard price. For XYX, the entry for the unfavourable price variance is as follows: Materials price variance [18 kg 3 ($600 2 $500 per kilogram), U] Dr $1,800 Combining the three pieces, we have the full set of entries for recording the purchase of materials: Raw materials (18 kg at $500/kg) Dr $9,000 Materials price variance (18 kg 3 $100/kg, U) Dr $1,800 Accounts payable (for buying 18 kg at $600/kg) Cr 10,800 Note that the price variance is recognized when purchases are made, rather than when materials are actually used in production. This permits the price variance to be isolated early, and it also permits the materials to be carried in the inventory account at standard

5 General Ledger Entries to Record Variances 11A-5 cost. This will be important to remember for later when we develop an income statement in a standard costing system. The Quantity Variance When direct materials are drawn from inventory and used in production, the quantity variance is isolated as follows. First, the quantity of raw materials removed from the inventory is AQ. And, since the inventory is valued at standard price, the quantity of the removed materials, AQ, is valued at standard price, SP, giving a value of AQ 3 SP. XYX removed 11 kg of materials valued at $500 per kilogram. Thus, we have the following: Raw materials (AQ 3 SP 5 11 kg 3 $500/kg) Cr $5,500 Second, the amount of raw materials applied to production is the standard quantity of the input allowed for the actual output volume of production, SQ. If inefficiencies occur when the resources are used in production, the only way to isolate the inefficiency in the use of a resource is to compare the application of the resource to production at the standard quantity allowed for the actual production volume being made, SQ, with AQ. Since the inventory account has been reduced by AQ, the actual quantity removed, the journalizing protocol allows the comparison between AQ and SQ the root of the quantity or inefficiency variance. To avoid confusing performance in the production activity with performance of the purchasing activity, standard price (SP) is used to value the resource quantities AQ and SQ. The entry to record the application of materials to production is as follows: Work in process (materials: SQ 3 SP 5 10 kg 3 $500/kg) Dr $5,000 This is a debit entry because the act of producing creates an asset work-in-process inventory. A comparison of the two entries reveals the quantity variance. This is $500. It is unfavourable because we removed (i.e., used) more materials than was allowed by the standard. A quantity variance account is created to record the discrepancy between the value of the resource used and the value of the resource applied. The appropriate entry to the variance account should be a debit, because, logically, we are short on the debit side by $500. This is a loose way of saying that unfavourable variances are recorded as debit entries to the variance accounts: Materials quantity variance ([11 kg 2 10 kg] 3 $500/kg) Dr $500 Collecting the three pieces together, we have the following: Work in process (materials: 10 kg at $500/kg) Dr $5,000 Materials quantity variance ([11 kg 2 10 kg] 3 $500/kg) Dr $500 Raw materials (11 kg at $500/kg) Cr $5,500 The above discussion is captured in Exhibit 11A 2. We have modified the variance diagram to include the appropriate journal entries. The entries to close the variance accounts to cost of goods sold are also shown in the exhibit. We will discuss these entries below in a separate section.

6 11A-6 Appendix 11A EXHIBIT 11A 2 Journal Entries to Record and Dispose Direct Materials Variances A B C D E F 1 Journal Entires for Direct Materials Variances 2 (1) (2) (3) 3 AQ 3 AP Price Variance AQ 3 SP Quantity Variance SQ 3 SP 4 Journal Entry Rule Cr Acc. Pay (purchased DM) AQ 3 (AP 2 SP) Dr Variance (U var) Cr Variance (F var) Dr DM inventory (purchases) Cr DM Inventory (usage) 5 18 kg 3 $600/kg 18 kg 3($600 2 $500) 18 kg 3 $500/kg 6 Cr Acc. Pay $10,800 5 $1,800 U Dr DM $9,000 (Purch.) 7 Entry 1 Dr Variance $1,800 (AQ 2 SQ) 3 SP Dr Variance (U var) Cr Variance (F var) Dr WIP (applied DM to WIP at standard cost) 8 11 kg 3 $500/kg (11 kg 2 10 kg) 3 $500/kg 10 kg 3 $500/kg 9 Cr DM $5,500 (Usage) 5 $500 U Dr WIP $5, Entry 2 Dr Variance $ Entry to Close the Entry to Close the DM Dr COGS and Cr Variance (U var) Dr COGS and Cr Variance (U var) 13 DM Price Variance Quantity Variance Dr Variance and Cr COGS (F var) Dr Variance and Cr COGS (F var) to COGS to COGS 14 Entry 3 Dr COGS $1,800 and Cr Var $1,800 (U var) Dr COGS $500 and Cr Var $500 (F var) 15 Direct Labour Variances Because direct labour cannot be inventoried, the isolation of the rate and the efficiency variances cannot be inferred just from the journal entries, as was possible with direct materials. For example, in columns 1 and 2 of Exhibit 11A 2, we have the debit and credit entries giving rise to the direct materials price variance. The fact that the materials can be inventoried enables the purchase of the resource to be separated from the use of that resource. The key is the time delay between acquisition and use. The inventory account acts as a fulcrum separating the price and the quantity variance. With direct labour, we cannot do this. There are two events with regard to direct labour: the act of hiring labour-hours and paying for them AH 3 AR, and the act of applying standard labour-hours to production and their standard value SH 3 SR. These are the first and third columns in Exhibit 11A 3. The entries that correspond to these two events are as follows: Work in process (labour: SH 3 SR 5 3,000 hours at $20 per hour..... Dr $60,000 (To record the application of direct labour to production) Wages payable (AH 3 AR 5 4,000 hours at $19.50 per hour) Cr $78,000 (To record the hiring and payment of direct labour) Note that, as with direct materials, direct labour costs enter into the work-in-process account at standard cost, both in terms of the rate and in terms of the hours allowed for the actual production of the period. The difference between the value of the direct labour hired (actual) and the direct labour applied (the flexible budget) is the flexible budget variance. The variance is unfavourable because actual expenditure exceeded the budget. Thus, a debit entry to the flexible budget variance account is necessary: Direct labour flexible budget variance (AH 3 AR 2 SH 3 SR 5 $78,000 2 $60,000, U) Dr $18,000

7 General Ledger Entries to Record Variances 11A-7 To isolate the rate and efficiency variances, ask why there is an $18,000 flexible budget variance. The flexible budget variance exists because there is a rate variance arising from the fact that AR fisr and/or there is an efficiency variance arising from the fact that AH fi SH. You can tell from the entries above that AR, SR, i.e., $19.50, $20; thus, the rate variance will be favourable. And since AH. SH, i.e., 4,000 hours. 3,000 hours, the efficiency variance will be unfavourable. The entries for isolating the variances and to close out the flexible budget variance are as follows: Labour efficiency variance ([AH 2 SH] 3 SR 5 1,000 hours 3 $20 per hour, U) Dr 20,000 Labour rate variance ([AR 2 SR] 3 AQ 5 $0.50 per hour 3 4,000 hours, F) Cr $ 2,000 Direct labour flexible budget variance Cr $18,000 Note that the entry to record and the entry to close out the flexible budget variance are usually omitted. We have presented these entries to emphasize that the role of the rate and the efficiency variances is to decompose the flexible budget variance and to show how these variances arise from comparing AR to SR and AH to SH. The discussion is summarized in Exhibit 11A 3. Note that since there is no asset account to accumulate the direct labour resource, when we acquire labour (Cr Wages payable), the corresponding debit is to the work in process, but the debit is at standard quantity and standard rate; thus, a flexible budgeted variance account is used to ensure the debits and credits match. EXHIBIT 11A 3 Journal Entries to Record Direct Labour Cost Variances A B C D E F 10 Journal Entries for Direct Labour Variances 11 (1) (2) (3) 12 AH 3 AR Rate Variance (RV) AH 3 SR Efficiency Variance (EV) SH 3 SR 13 Journal Entry Rule Cr Wages Payable (pay for direct labour) Note: Dr is made to WIP (SH 3 SR). AH 3 (AR 2 SR) Dr RV (U var) Cr RV (F var) AH 3 SR Is Not Journalized (AH 2 SH) 3 SR Dr EV (U var) Cr EV (F var) Dr WIP (applied DL to WIP at standard cost) 14 4,000 h 3 $19.50/h 4,000 h 3 $20.00/h 3,000 h 3 $20.00/h 15 Entry 1 Cr WG. Pay $78,000 (no jnl entry for this) Dr WIP $5, Entry 2 Cr Variance $2,000 Dr Variance $20, $78,000 $2,000 F $80, $20,000 U $60, Direct Labour Flexible Budget Variance (FBV) $18,000 U 19 Entry 1 Dr FBV $18,000 (U var) 20 Entry 2 Cr FBV $18,000 (close FBV account) Entry to Close the DL Rate Variance 23 to COGS Dr COGS and Cr RV (U var) Dr RV and Cr COGS (F var) Entry to Close the DL Efficiency Variance to COGS Dr COGS and Cr EV (U var) Dr EV and Cr COGS (F var) 24 Entry 3 Dr RV $2,000 and Cr COGS $2,000 (F var) Dr COGS $20,000 and Cr EV $20,000 (U var) 25 Variable Manufacturing Overhead Variances The approach to recording variable manufacturing overhead variances is similar to that for direct labour. It will be useful to review the discussion in Chapter 4, Systems Design: Job-Order Costing, on recording manufacturing overhead costs and the concept of a clearing account. As in Chapter 4, we will assume that costs that are paid when incurred are entered directly into the variable manufacturing overhead account. But, unlike in Chapter 4,

8 11A-8 Appendix 11A we are now going to assume that variable and fixed manufacturing overhead are accounted for in separate control accounts. This will make it easier to explain the logic of journalizing. Normally all of the manufacturing overhead is consolidated in a single control account. Indirect materials and indirect labour are entered into the manufacturing overhead account when the supplies are removed from inventory and labour is paid. Assume that for June, XYX Company paid a total of $10,000 for maintenance and utilities, and $10,800 for indirect labour. This is recorded as follows: Variable manufacturing overhead Dr $20,800 Accounts payable Cr $10,000 (To record the incurrence of non-labour variable manufacturing overhead costs paid when incurred) Wages payable Cr $10,800 (To record the use of indirect labour) Variable overhead is applied on the basis of direct labour-hours at the rate of $5/h. The quantity of the allocation base to which the rate is applied is the standard hours allowed for making 2,000 units. This is SH 5 3,000 hours. The applied variable overhead cost is SH 3 SR 5 3,000 3 $5 5 $15,000. The following entry records this: Work in process (VOH: SH 3 SR 5 3,000 hours 3 $5/hour)..... Dr $15,000 Variable manufacturing overhead Cr $15,000 At this point, you should see that there is a debit balance of $5,800 in the variable manufacturing overhead account. This is underapplied overhead and is also the variable overhead flexible budget variance. This variance is unfavourable. We record this as follows: Flexible budget variance (VMOH) Dr $5,800 Variable manufacturing overhead Cr $5,800 (Record the flexible budget variance and close the variable manufacturing overhead account) Why does this variance exist? Because the company spent more for the quantity of the allocation base it consumed: 4,000 hours were consumed and $20,800 in costs was incurred (implying an average actual variable overhead rate of $20,800/4,000 hours 5 $5.20/hour), whereas the 4,000 hours at $5 per hour should have cost $20,000. The $800 is the spending variance. It is unfavourable. Also, 4,000 hours were used to make 2,000 units instead of the 3,000 hours (1.5 hours/unit 3 2,000 units) allowed by the standards for the actual volume. This quantity difference is valued at 1,000 hours 3 $5/hour 5 $5,000. This is the efficiency variance. It is unfavourable. Now that we have the variances computed and evaluated, we can record the variances in the accounting system. The entries to record the variances are as follows: Variable overhead spending variance (AH 3 AR 2 AH 3 SR 5 $20, ,000 hours 3 $5/hour).. Dr $ 800 Variable overhead efficiency variance ([AH 2 SH] 3 SR 5 1,000 hours 3 $5/hour) Dr $5,000 Variable manufacturing overhead flexible budget variance Cr $5,800 (To record the variable overhead variances and clear the VMOH flexible budget variance account)

9 General Ledger Entries to Record Variances 11A-9 EXHIBIT 11A 4 Journal Entries to Record Variable Manufacturing Overhead Cost Variances A B C D E F 13 Journal Entries for Variable Overhead Variances 14 (1) (2) (3) 15 AH 3 AR Spending Variance (SV) AH 3 SR Efficiency Variance (EV) SH 3 SR Journal Entry Rule Dr VMOH Control AH 3 (AR 2 SR) (AH 2 SH) 3 SR Dr WIP Cr VMOH Cr Various Accts Dr Spending Var (U) AH 3 SR Is Not Dr Eff Var (U var) (applied VOH to WIP 16 (accumulate VOH expenses) Cr Spending Var (F) Journalized Cr Eff Var (F var) at standard cost) 17 4,000 h 3 $5.00/h 3,000 h 3 $5.00/h 18 Entry 1 Dr VMOH Cr Various Accts $20,800 Dr WIP Cr VMOH $15, Entry 2 Dr Variance $800 Dr Variance $5, $20,800 $800 U $20,000 $5,000 U $15, Variable Overhead Flexible Budget Variance (FBV) $5,800 U 22 Entry 1 Dr FBV Cr VMOH $5,800 (U Var) (clears VMOH) 23 Entry 2 Cr FBV $5,800 (close FBV account) Entry to Close the DL Rate Variance 26 to COGS Dr COGS and Cr Spending Var (U var) Dr Spending Var and Cr COGS (F var) Entry to Close the DL Efficiency Variance to COGS Dr COGS and Cr Efficiency Var (U var) Dr Efficiency Var and Cr COGS (F var) 27 Entry 3 Dr COGS $800 and Cr Var $800 (U var) Dr COGS $5,000 and Cr Var $5,000 (U var) 28 Note that the overhead account is cleared of the underapplied variable overhead when the flexible budget variance is isolated. And the flexible budget variance is cleared when the spending and efficiency variances are isolated. The spending and efficiency variance accounts will be cleared when the cost of goods sold account is adjusted from standard cost to actual cost. If there is no need to isolate the flexible budget variance, then this account will not be necessary and no entry is recorded for this variance. In that case, when the spending and efficiency variances are isolated with entries to the corresponding variance accounts, the respective opposite entries will be made directly to the variable overhead control account, which will clear that account. A summary of the above discussion is provided in Exhibit 11A 4. Column 1 records the accumulation of variable overhead expenses in the control account via debits. The corresponding credits are to various overhead item accounts. Column 3 shows the application of overhead to work in process and the corresponding credit to the overhead control account. At this juncture the flexible budget variance can be isolated as the balance in the overhead account, as explained above. Note that with direct materials, the inventory account enables the separation of the price and the quantity variances. The price and quantity variances are observable from the journal entries themselves. With variable overhead cost, there is no inventory account that enables the decomposition of the flexible budget variance. But there is an asset-like account, the clearing account: the overhead control account. The variable overhead account is used to track the incurrence of variable overhead costs (debits to the account) and the application of the overhead to production (credits to the account). The balance in the account is the over- or underapplied variable overhead and the flexible budget variance. The flexible budget variance is recorded in a separate account, and when this is done, the overhead account is cleared by the corresponding opposite entry. With direct labour, there is no inventory account and also there is no direct labour clearing account. Thus, work in process is debited directly when direct labour is acquired and applied to production. The flexible budget variance is isolated in a separate account and then decomposed into the rate and efficiency variances. The rate and efficiency variances must be calculated separately and then entered into the variance accounts, which will clear the flexible budget variance account. HELPFUL HINT

10 11A-10 Appendix 11A Fixed Manufacturing Overhead Variances Similar to the case of variable overhead cost, any fixed cost that is paid when incurred is charged directly to the manufacturing overhead account. Accrued expenses are assumed to be for services and resources that are consumed uniformly over the year and thus are spread equally and recognized in each period. Assume that XYX Company paid $6,500 in rent and $3,500 in utilities. Also the company recognized $1,000 for prepaid insurance and $750 for accrued property taxes in June. These costs are journalized as follows: Fixed manufacturing overhead Dr $11,750 Accounts payable Cr $10,000 Prepaid insurance, factory Cr $750 Property taxes payable Cr $1,000 (To record the incurrence of manufacturing overhead cost) Fixed overhead is applied to products using the predetermined fixed overhead allocation rate. This rate is $4/hour, and the quantity of the allocation base to which the rate is applied is the standard number of hours allowed for 2,000 units. This is 1.5 hours/unit 3 2,000 units 5 3,000 hours. The applied fixed overhead is 3,000 hours 3 $4/hour 5 $12,000. The journal entry is as follows: Work in process (fixed overhead) Dr $12,000 Fixed manufacturing overhead Cr $12,000 (To record the application of fixed overhead to production) The $250 credit balance in the manufacturing overhead account is the flexible budget variance. The variance is favourable because the overhead is overapplied. Remember that the actual volume (and the actual quantity of the allocation base) are greater than the planned volume (and the denominator activity level). The journal entry for isolating the flexible budget variance is as follows: Fixed manufacturing overhead control Dr $250 Flexible budget variance Cr $250 (To clear FMOH control and isolate the flexible budget variance) The total variance, $250 F, is decomposed into the budget variance: Actual cost 2 Budgeted cost 5 $11,750 2 $11,400 5 $350 U And the volume variance is Budgeted cost 2 Applied cost 5 $11,400 2 $12,000 5 $600 F This reflects the difference between the budgeted hours of 2,850 and the 3,000 standard hours allowed for the actual volume of production of 2,000 units valued at the fixed overhead application rate of $4/hour. The entries to record the variances are as follows: Fixed manufacturing overhead flexible budget variance Dr $250 Fixed overhead budget variance (Actual cost 2 Budgeted cost 5 $11,750 2 $11,400 5 $350 U) Dr $350 Fixed overhead volume variance (Budgeted cost 2 Applied cost 5 $11,400 2 $12,000 5 $600 F) Cr $600 (To record the fixed overhead variances and clear the fixed manufacturing overhead flexible budget variance account)

11 General Ledger Entries to Record Variances 11A-11 EXHIBIT 11A 5 Journal Entries to Record the Fixed Manufacturing Overhead Variances A B C D E F 1 Journal Entries for Fixed Overhead Variances 2 (1) (2) (3) 3 Actual FOH Budget Variance (BV) Budgeted FOH Volume Variance (VV) SH 3 SR Dr FMOH Control Journal Entry Rule Cr Various Accts (BH 2 SH) 3 SR Dr WIP Cr FMOH (accumulate FOH Dr BV (U var) Budgeted FOH is Dr VV (U var) (applied FMOH to WIP 4 expenses) Cr BV (F var) not journalized Cr VV (F var) at standard cost) 5 $11,750 2,850 h 3 $4.00/h 3,000 h 3 $4.00/h 6 Entry 1 Dr FMOH Cr Various Accts $11,750 B FOH: $11,400 Dr WIP Cr FMOH $12,000 7 Entry 2 Dr Budget Var $350 Cr Volume Var $(600) 8 $11,750 $350 U $11,400 $(600) F $12,000 9 Fixed Overhead Flexible Budget Variance (FBV) $250 F 10 Entry 1 Dr FMOH Cr FBV $250 (F var) 11 Entry 2 Dr FBV $250 (close FBV account) Entry to Close the FOH Budget 14 Variance to COGS Dr COGS and Cr FOH BV (U var) Dr FOH BV and Cr COGS (F var) Entry to Close the FOH Volume Variance to COGS Dr COGS and Cr Vol Var (U var) Dr Vl Var and Cr COGS (F var) 15 Entry 3 Dr COGS $350 and Cr FOH BV $350 (U var) Dr Vol Var $600 and Cr COGS $600 (Fl var) 16 The logic of the journal entries is illustrated in Exhibit 11A 5 using the variance analysis diagram. Entries to Close the Variance Accounts XYX Company closes the variances to the cost of goods sold. An alternative way to close the variances is to prorate the variances between cost of goods sold, finished goods inventory, and work-in-process inventory. (We will not be illustrating the proration method in this book. Interested readers may consult any cost management textbook for more on this topic.) The following generic set of entries illustrates the method: Favourable variance: Variance account Dr $XXXX Cost of goods sold Cr $XXXX Unfavourable variance: Cost of goods sold Dr $YYYY Variance account Cr $YYYY

12 11A-12 Appendix 11A The following schedule collects all the variances calculated for XYX Company: A B C D E F 1 XYX Company 2 Schedule of Variances, June 3 6 Materials price variance, U $ 1, Materials quantity variance, U Labour rate variance, F (2,000.00) 9 Labour efficiency variance, U 20, Variable overhead spending variance, U Variable overhead efficiency variance, U 5, Fixed overhead budget variance, U Fixed overhead volume variance, F (600.00) 14 Total variance, U $25, Rather than list every single closing entry, we will show two examples: 1. The entry to close out the materials price variance is as follows: Cost of goods sold Dr $1,800 Materials price variance Cr $1,800 (To close the materials price variance account to cost of goods sold) 2. The entry to close out the labour rate variance is as follows: Labour rate variance Dr $2,000 Cost of goods sold Cr $2,000 The remaining unfavourable and favourable variances can be closed to cost of goods sold by following the above template. The closing entries are also shown in Exhibits 11A 2 through 11A 5. The effect of the closing entries is that the variance account balances will all be reduced to zero and the cost of goods sold will be increased by the amount of each unfavourable variance (the impact of debiting the account) and reduced by the amount of each favourable variance (the impact of crediting the account). You can see from the above schedule, because the overall variance is $25,850 U, the net impact of closing all the variances to cost of goods sold is that it will be increased by this amount. Cost Flows in a Standard Costing System The flows of costs through the company s accounts are illustrated in Exhibit 11A 6. Note that entries into the various inventory accounts are made at standard cost not actual cost. The differences between actual and standard costs are entered into special accounts that accumulate the various standard cost variances. At XYX Company, these standard cost variance accounts are closed out to cost of goods sold at the end of the period. This is common practice at many companies. Unfavourable variances increase the cost of goods sold, and favourable variances decrease the cost of goods sold.

13 General Ledger Entries to Record Variances 11A-13 EXHIBIT 11A 6 Cost Flows in a Standard Costing System* A B C D E F G H I J K L M N O 3 Cost Flows in a Standard Costing System: XYX Company, June 4 Accounts Payable Raw Materials (RM) Work in Process 5 Pay for RM Add purch. Remove RM Apply RM to production 6 purchase to inventory from inventory SQ 3 SP 7 AQ 3 AP AQ 3 SP AQ 3 SP $5,000 Cost of goods 8 $10,800 Apply VOH to production manufactured 9 $10,000 Qty purch. Qty removed SH 3 SR $92, $9,000 $5,500 $15, RM Price Variance RM Quantity Variance Apply DL to production 12 AP fi SP AQ fi SQ SH 3 SR 13 Situation: AP, SP AP. SP Situation: AQ, SQ AQ. SQ $60, Variance (AP 2 SP) 3 AQ (AP 2 SP) 3 AQ Variance (AQ 2 SQ) 3 SP (AQ 2 SQ) 3 SP Apply FOH to production 15 Type: U F Type: U F SH 3 SR 16 $1,800 $500 $12, Variable Overhead Cost Wages payable 19 Incur costs Apply overhead Pay for direct and 20 for various to production indirect labour Direct Labour Flexible Budget Variance 21 activities SQ 3 SR AH 3 AR AR 3 AH fi SR 3 SH 22 $10,000 $15,000 $78,000 Situation: AR 3 AH. SR 3 SH AR 3 AH. SR 3 SH 23 $10,800 $10,800 Variance: AR 3 AH 2 SR 3 SH AR 3 AH 2 SR 3 SH 24 Underapplied Overapplied Type: U F 25 overhead $5,800 overhead $18, Account balance is also the flexible budget variance VOH Spending Variance VOH Efficiency Variance DL Rate Variance DL Efficiency Variance 29 AP fi SP AH fi SH AP fi SP AH fi SH 30 Situation: AP, SP AP. SP Situation: AH, SH AH. SH Situation: AP, SP AP. SP Situation: AH, SH AH. SH 31 Variance: (AP 2 SP) 3 AQ (AP 2 SP) 3 AQ Variance: (AH 2 SH) 3 SP (AH 2 SH) 3 SP Variance: (AP 2 SP) 3 AH (AP 2 SP) 3 AH Variance: (AH2SH) 3 SP (AH2SH) 3 SP 32 Type: U F Type: U F Type: U F Type: U F 33 $800 $5,000 $2,000 $20, Fixed Overhead Budget Variance Fixed Overhead Volume Variance 36 Fixed Overhead Cost Actual cost fi Budgeted cost Denominator level BH fi SH 37 Actual cost Applied FOH Situation: Actual 2 Actual 2 Situation: BH. SH BH, SH 38 $11,750 SQ 3 SR Budget, 0 Budget. 0 Variance: (BH2SH) 3 SP (BH2SH) 3 SP 39 $12,000 Type: U F Type: U F 40 Underapplied $250 Overapplied $350 $ Account balance is also the flexible budget variance. *Adapted from an exhibit suggested by Professor Rick French.

14 11A-14 Appendix 11A Income Statement in a Standard Costing System The last tasks remaining are to present the income statement related to the standard costing system, and to reconcile the net income (gross margin in this illustration) stated at standard cost with the net income (gross margin) stated at actual costs. A company s policy for disposing the variances will impact the procedure for developing the standard cost net income and the subsequent reconciliation. At XYX, the policy is to write off the variances to the cost of goods sold. This topic is slightly more advanced and can be omitted. We present it to complete the discussion of variances and the flow of costs through the cost accounting system. The income statement showing the actual costs and the standard costs is presented in Exhibit 11A 7. Note that at XYX Company, the quantity of materials purchased in June is different from the quantity of materials used. This fact leads to a number of issues relating to the preparation of the income statement. EXHIBIT 11A 7 Income Statement for June A B C D E 1 XYX COMPANY 2 Income Statement for June 3 ACTUAL COST STANDARD COST VARIANCE 4 Revenue (2,000 $60) $120,000 $120,000 5 Cost of goods manufactured 6 Raw materials inventory, June 1 $ 0 $ 0 7 Add: Raw materials purchased $ 10,800 $ 9,000 8 Raw materials available $ 10,800 $ 9,000 9 Deduct: Raw materials inventory, June 30 $ 4,200 $ 3,500 $ 700* 10 Add: Raw materials quantity variance (U) $ Raw materials used or applied $ 6,600 $ 5,000 $ 1, Direct labour $ 78,000 $ 60,000 $18, Variable manufacturing overhead $ 20,800 $ 15,000 $ 5, Fixed manufacturing overhead $ 11,750 $ 12,000 $ (250) 15 Manufacturing costs in June $117,150 $ 92,000 $25, Add: Work in process, June 1 17 Deduct: Work in process, June Cost of goods manufactured $117,150 $ 92,000 $25, Cost of goods sold: 20 Finished goods inventory, June 1 $ 0 $ 0 21 Add: Cost of goods manufactured $117,150 $ 92, Goods available for sale $117,150 $92, Deduct: Finished goods inventory, June 30 $ 0 $ 0 24 Cost of goods sold, before adjustments $117,150 $ 92, Adjustments to cost of goods sold: 27 Add (deduct) unfavourable (favourable) variances* $ 700* $ 25, Cost of goods sold at actual cost $117,850 $117, Gross margin at actual cost $ 2,150 $ 2, *The cost of goods sold of $117,150 from the actual costing system does not include the $700 price variance of the 7 kg of materials in inventory at the end of June. Since the standard costing system at XYX writes off the entire amount of the variances to cost of goods sold, the cost of goods sold from the actual costing system must be restated to include the price variance deferred in inventory.

15 General Ledger Entries to Record Variances 11A-15 The value of materials available for use is based on 18 kg of inventory. The quantity of materials in inventory is 7 kg. This implies that 11 kg of materials was used, valued at $500/kg, giving $5,500. This is AQ 3 SP, but we know that the quantity of materials applied to production, SQ, is only 10 kg. The standard cost of 10 kg is $5,000. This is the amount for the cost of materials used that the standard costing income statement must indicate. To achieve this, we must adjust for the quantity variance of $500 when calculating the cost of materials used in the cost of goods manufactured. Without any adjustment for the quantity variance, in line 10, the value of direct materials used will be incorrectly shown as $5,500, and the cost of goods sold on the standard costing income statement will not be at standard cost. You can see this in the T-accounts in Exhibit 11A 6. On the actual costing income statement, there is no quantity variance recognized since we use AQ 3 AP as the value of the direct materials applied to production. The price variance for direct materials is $1,800 U, which can be inferred in line 7. However, due to the fact there is materials inventory, we cannot identify this amount in the variance column. Indeed, notice that the variance column does not identify the price and quantity variances to match the calculations made earlier for direct materials. This is not a mistake. The total materials variance in Exhibit 11A 7 is $700 1 $1,600 5 $2,300, just as before. The $700 is the price variance of units in inventory (7 kg 3 [$600 2 $500]/kg). The $1,600 in line 11 is the total materials variance associated with the materials removed from inventory and is made up of 11 kg 3 ($600 2 $500)/kg 5 $1,100 price variance and (11 kg 2 10 kg) 3 $500/kg 5 $500 quantity variance. Thus, the total price variance is the $700 for the 7 kg in the ending inventory (shown in line 9) plus the $1,100 for the 11 kg used in production (included in the $1,600, shown in line 11). The quantity variance is $500, also included in the $1,600 shown in line 11. In short, everything reconciles. The presence of ending inventory causes another complication when reconciling the actual costing net income to the standard costing net income. Given that XYX writes off all the variances to cost of goods sold, we know that when the standard costing net income is adjusted for all the variances (totalling $25,850 U), the result should be the actual costing net income. In Exhibit 11A 7, you can see that the actual cost of goods sold obtained following adjustments to the standard cost of goods sold is $117,850. But in line 24, the actual cost of goods sold from the actual costing system is $117,150. This discrepancy of $700 arises because the actual costing system will defer the price variance of the purchased units in ending inventory, unless this variance is fully written off to the cost of goods sold. In a true actual costing system, the price variance relating to the units in ending inventory will not flow to the cost of goods sold. But if you wish to reconcile the cost of goods sold between the actual costing system and the standard costing system, the unfavourable price variance associated with the purchase of materials in ending inventory must be added to the actual cost of goods sold. After the adjustments are complete, the gross margin is $2,150. Clearly, the presence of inventories in a standard costing system complicates financial reporting considerably. This is one of those situations where financial accounting and managerial accounting interact in an important way, and the accounting policy adopted by the company with regard to disposition of the variances plays a very important role in determining which figure will be reported as net income on the financial statements. Companies that write off the variances to the cost of goods sold do so in the belief that the end result will be not too different from anything that will result from more elaborate variance disposition policies. Even a simple policy like writing off to the cost of goods sold can cause pesky complications that must be attended to! A sharp pencil, alertness for detail, and logical analysis are essential to prevent reporting errors.

16 11A-16 Appendix 11A LEARNING OBJECTIVES SUMMARY LO6 UNDERSTAND COST FLOWS IN A STANDARD COSTING ENVIRONMENT. Transactions processing and journalizing in a standard costing system are simpler than in actual costing systems. Purchases of inventory are entered into the system at standard prices, but suppliers are paid the actual value. When resources are applied to work in process, this is recorded at standard quantities and standard prices. The variances that result are entered into special accounts and at the end of the period are usually disposed to the cost of goods sold. APPLICATION COMPETENCY SUMMARY FOR APPENDIX 11A APPLICATION COMPETENCY DELIVERABLE SOURCE DOCUMENTS AND KEY INFORMATION STEPS KNOWLEDGE COMPETENCY Record the flow of costs in standard costing. LO6 CC28 A Key Information Account debits, credits, and balances Report/Document Updated account ledgers Various Accounts in the General Ledger Direct materials, direct labour, variable overhead, and work-in-process transactions Performance Report Price and quantity variances 1. Post entries to direct materials, accounts payable, wages payable, and work in process at standard costs. 2. Debit (credit) unfavourable (favourable) variances to the respective variance accounts. Cost flows in a standard costing system LO6 CC27 A 3. Close the variance accounts to the cost of goods sold account. BRIEF EXERCISE FOR APPENDIX 11A BRIEF EXERCISE 11A 1 Recording Variances in the General Ledger (LO6 CC27 A, 28 A ) Bliny Corporation makes a product with the following standard costs for direct material and direct labour: Direct material: 2.00 metres at $3.25 per metre $6.50 Direct labour: 0.40 hours at $12.50 per hour $5.00 During the most recent month, 5,000 units were produced. The costs associated with the month s production of this product were as follows: Material purchased: 12,000 metres at $3.45 per metre $41,400 Material used in production: 10,500 metres Direct labour: 1,980 hours at $12.20 per hour $24,156 The standard cost variances for direct material and direct labour have been computed as follows: Materials price variance: 12,000 metres at $0.20 per metre U Materials quantity variance: 500 metres at $3.25 per metre U Labour rate variance: 1,980 hours at $0.30 per hour F Labour efficiency variance: 20 hours at $12.50 per hour F $2,400 U $1,625 U $594 F $250 F

17 General Ledger Entries to Record Variances 11A-17 Required: 1. Prepare the general ledger entry to record the purchase of materials on account for the month. 2. Prepare the general ledger entry to record the use of materials for the month. 3. Prepare the general ledger entry to record the incurrence of direct labour cost for the month. EXERCISES FOR APPENDIX 11A EXERCISE 11A 1 Recording Material and Labour Variances in Journal Entries (LO3 CC15, 17; LO6 CC27 A, 28 A ) Genola Fashions, a U.S. company, began production of a new product on June 1. The company uses a standard costing system, establishing the following standards for one unit of the new product: Direct materials feet $5 per foot $35.00 Direct labour hours $8 per hour $12.80 During June, the following activity was recorded relative to the new product: a. Purchasing acquired 30,000 feet of material at a cost of $4.60 per foot. b. Production used 24,000 feet of the material to manufacture 3,000 units of the new product. c. Production reported 5,000 hours of labour time worked directly on the new product; the cost of this labour time was $43,000. Required: 1. For materials: a. Compute the direct materials price and quantity variances. b. Prepare journal entries to record the purchase of materials and the use of materials in production. 2. For direct labour: a. Compute the direct labour rate and efficiency variances. b. Prepare a journal entry to record the incurrence of direct labour cost for the month. 3. Post the entries you have prepared to the following T-accounts: Raw Materials Accounts Payable?? Bal.? 138,000 Materials Price Variance Wage Payable 43,000 Materials Quantity Variance Labour Rate Variance Work in Process Labour Efficiency Variance Materials used? Labour cost?

18 11A-18 Appendix 11A EXERCISE 11A 2 Computing Variances and Composing Journal Entries (LO3 CC15, 17; LO6 CC27 A, 28 A ) A company has the following standard costs: Direct materials: 7 kilograms at $4 per kilogram $28 Direct labour: 6 hours at $7 per hour $42 9,500 kilograms of materials and 8,500 hours of labour, costing $39,750 and $58,200, respectively, were used to produce 1,500 units. Required: 1. What amounts would be debited to work in process for materials and labour? 2. What would be the entry to record the materials quantity variance? That is, is it a debit or a credit, and of what amount? 3. Calculate the total direct labour cost variance. Identify and calculate the two components of this total labour variance. (Adapted CGA-Canada) EXERCISE 11A 3 Composing Variance Journal Entries (LO3 CC15, 16; LO6 CC27 A, 28 A ) Consider the following data compiled by Roachen Ltd. for 15,000 units of finished product: Actual material purchases on account (2,250 $6/unit) $13,500 Materials issued to production ,050 units Standard material cost per unit purchased $ 3.75 Standard quantity allowed for actual production ,200 units Required: Prepare journal entries to recognize price variances at the time of purchase, and quantity variances at the time of issue. (Adapted CGA-Canada) BUILDING YOUR SKILLS COMPREHENSIVE PROBLEM (LO3 CC15, 16, 17; LO6 CC27 A, 28 A ) The standard cost card for a product shows that 5 kg of direct materials and 10 hours of direct labour are required for each unit. Both fixed and variable manufacturing overhead are applied on the basis of direct labour-hours. The following information, in the form of journal entries, is available from the accounting records: Note that the following abbreviations are used: AP 5 accounts payable; VMOH 5 variable manufacturing overhead; FMOH 5 fixed manufacturing overhead; DM 5 direct materials; DL 5 direct labour; WIP 5 work in process Account Entry Description a. AP Cr $1,726,000 Record purchase of 95,000 kg of DM b. DM Dr $1,615,000 Record addition to DM inventory of 95,000 kg c. VMOH control Dr $403,620 Incur variable overhead d. FMOH control Dr $515,000 Incur fixed overhead e. DM Cr $1,355,682 Issue DM to production f. WIP Dr $1,360,000 Recognize the application of DM to production g. WIP Dr $2,240,000 Recognize the application of DL to production h. WIP Dr $400,000 Apply VMOH to production i. WIP Dr $608,000 Apply FMOH to production j. Budget variance Dr $2,000 Record the incurrence of fixed overhead budget variance k. Wages payable Cr $2,267,265 Record wages for direct labour used