Financial Reporting

The magnitude of the favorable/unfavorable production-volume variance under absorption costing is affected by the choice of the denominator level used to calculate the budgeted fixed manufacturing cost per unit. Assume the following actual operating information for Stassen in 2020:

Note that this is the same data used to calculate the income under variable and absorption costing for Stassen in Exhibit 9-1. As before, we assume that there are no price, spending, or efficiency variances in manufacturing costs.

Recall from Chapter 8 the equation used to calculate the production-volume variance:

The four different capacity-level concepts result in four different budgeted fixed manufacturing overhead cost rates. The different rates will result in different amounts of fixed manufacturing overhead costs allocated to the 8,000 units actually produced and in different production-volume variances. Using the budgeted fixed manufacturing costs of $1,080,000 (equal to actual fixed manufacturing costs) and the rates calculated in section Effect on Budgeted Fixed Manufacturing Cost Rate for different denominator levels, the production-volume variance computations are as follows:

How Stassen treats its production-volume variance at the end of the fiscal year will determine the effect this variance has on the company’s operating income. We now discuss the three alternative approaches Stassen can use to treat the production-volume variance. These approaches were first discussed in Chapter 4.

1. ADJUSTED ALLOCATION-RATE APPROACH. This approach restates all amounts in the general and subsidiary ledgers using recalculated actual cost rates. Given that actual fixed manufacturing costs are $1,080,000 and actual production is 8,000 units, the recalculated fixed manufacturing cost is $\text{\$}135\text{\hspace{0.17em}per unit (\$}1\text{,}080\text{,}000÷8\text{,}000\text{\hspace{0.17em}actual units).}$ Under the adjusted allocation-rate approach, the choice of the capacity level used to calculate the budgeted fixed manufacturing cost per unit has no impact on year-end financial statements. In effect, actual costing is adopted at the end of the fiscal year.
2. PRORATION APPROACH. This approach spreads the under- or overallocated overhead among ending balances in Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold. The proration restates the ending balances in these accounts to what they would have been if actual cost rates had been used rather than budgeted cost rates. Under this approach, the choice of the capacity level used to calculate the budgeted fixed manufacturing cost per unit also has no effect on the year-end financial statements.
3. WRITE-OFF VARIANCES TO COST OF GOODS SOLD APPROACH. Exhibit 9-7 shows how this approach affects Stassen’s operating income for 2020. Recall that the ending inventory on December 31, 2020, is 2,000 units. Using master-budget capacity utilization as the denominator level results in assigning the highest amount of fixed manufacturing cost per unit to the 2,000 units in ending inventory (see the line item “deduct ending inventory” in Exhibit 9-7). Accordingly, operating income is highest using master-budget capacity utilization. The differences in operating income for the four denominator-level concepts in Exhibit 9-7 are due to the different amounts of fixed manufacturing overhead being inventoried at the end of 2020:

In Exhibit 9-7, for example, the $54,000 difference $(\$\text{1,500,000}-\$\text{1,446,000})$ in operating income between master-budget capacity utilization and normal capacity utilization is due to the difference in fixed manufacturing overhead inventoried $(\$\text{270,000}-\$\text{216,000})\mathrm{.}$ 

To summarize, the common factor behind the increasing operating-income numbers in the columns from left to right in Exhibit 9-4 and Exhibit 9-7 is the increasing amount of fixed manufacturing costs incurred that is included in ending inventory. The amount of fixed manufacturing costs inventoried depends on two factors: the number of units in ending inventory and the rate at which fixed manufacturing costs are allocated to each unit. Exhibit 9-4 shows the effect on operating income of increasing the number of units in ending inventory (by increasing production). Exhibit 9-7 shows the effect on operating income of increasing the fixed manufacturing cost allocated per unit (by decreasing the denominator level used to calculate the rate).

Chapter 8  discusses the various issues managers and management accountants must consider when deciding whether to prorate the production-volume variance among inventories and cost of goods sold or to simply write off the variance to cost of goods sold. The objective is to write off the portion of the production-volume variance that represents the cost of capacity not used to support the production of output during the period. Determining this amount is almost always a matter of judgment.

For financial reporting, SFAS 151 provides greater clarity by requiring that the allocation of fixed manufacturing overheads to production be based on the normal capacity of the facilities. In this case, normal capacity refers to a range of production levels expected to be achieved over a number of periods or seasons under normal circumstances. With abnormally high production, fixed overhead allocated to each unit produced is decreased so that inventories are not measured above cost. When production is below the range of expected variation in output, the unallocated fixed overhead costs are recognized as an expense in the period in which they are incurred. The provisions of SFAS 151 need not be applied to immaterial items. Moreover, the rule does not require disclosure of the dollar amount of any adjustment necessary for compliance, that is, the amount of fixed overhead costs associated with unused productive capacity that is currently expensed to cost of goods sold, rather than included in the ending work-in-process and finished-goods inventories.