Journal Entries for Fixed Overhead Costs and Variances

We illustrate journal entries for fixed overhead costs for April 2020 using the Fixed Overhead Control account and the contra account Fixed Overhead Allocated (data from Exhibit 8-2).

Overall, $285,000 of fixed overhead costs were incurred during April, but only $230,000 were allocated to jackets. The difference of $55,000 is precisely the underallocated fixed overhead costs we introduced when studying normal costing in Chapter 4. The third entry illustrates how the fixed overhead spending variance of $9,000 and the fixed overhead production-volume variance of $46,000 together record this amount in a standard costing system.

At the end of the fiscal year, the fixed overhead spending variance is written off to the Cost of Goods Sold if it is immaterial in amount or prorated among Work-in-Process Control, Finished-Goods Control, and Cost of Goods Sold on the basis of the fixed overhead allocated to these accounts as described in Chapter 4. Some companies combine the write-off and proration methods—that is, they write off the portion of the variance that is due to inefficiency and could have been avoided and prorate the portion of the variance that is unavoidable. Assume that the balance in the Fixed Overhead Spending Variance account as of April 2020 is also the balance at the end of 2020 and is immaterial in amount. The following journal entry records the write-off to Cost of Goods Sold.

We now consider the production-volume variance. Assume that the balance in the Fixed Overhead Production-Volume Variance account as of April 2020 is also the balance at the end of 2020. Also assume that some of the jackets manufactured during 2020 are in work-in-process and finished-goods inventory at the end of the year. Many management accountants make a strong argument for writing off to Cost of Goods Sold and not prorating an unfavorable production-volume variance. Proponents of this argument contend that the unfavorable production-volume variance of $46,000 measures the cost of resources expended for 2,000 jackets that were not produced $(\$23\hspace{0.17em}\text{per jacket}\times \text{2,000}\hspace{0.17em}\text{jackets}=\$\text{46,000}).$ Prorating these costs would inappropriately allocate the fixed overhead costs incurred for the 2,000 jackets not produced to the jackets that were produced. The jackets produced already bear their representative share of fixed overhead costs of $23 per jacket. Therefore, this argument favors charging the unfavorable production-volume variance against the year’s revenues so that fixed costs of unused capacity are not carried in work-in-process inventory and finished-goods inventory.

There is, however, an alternative view. This view regards the denominator level as a “soft” rather than a “hard” measure of the fixed resources required to produce each jacket. Suppose that, either because of the design of the jacket or the functioning of the machines, it took more machine-hours than previously thought to manufacture each jacket. Consequently, Webb could make only 10,000 jackets rather than the planned 12,000 in April. In this case, the $276,000 of budgeted fixed overhead costs supports the production of the 10,000 jackets manufactured. Under this reasoning, prorating the fixed overhead production-volume variance would appropriately spread the fixed overhead costs among the Work-in-Process Control, Finished-Goods Control, and Cost of Goods Sold accounts.

What about a favorable production-volume variance? Suppose Webb manufactured 13,800 jackets in April 2020.

Because actual production exceeded the planned capacity level, clearly the fixed overhead costs of $276,000 supported the production of all 13,800 jackets and should therefore be allocated to them. Prorating the favorable production-volume variance achieves this outcome and reduces the amounts in the Work-in-Process Control, Finished-Goods Control, and Cost of Goods Sold accounts. Proration is also the more conservative approach in the sense that it results in a lower operating income than if the entire favorable production-volume variance were credited to Cost of Goods Sold.

Another argument for not always writing off variances is that such a policy might invite gaming behavior. If variances are always written off to Cost of Goods Sold, a company could set standards to either increase (for financial reporting purposes) or decrease (for tax purposes) its operating income. For example, Webb could generate a favorable production-volume variance by setting the denominator level used to allocate the firm’s fixed overhead costs low and thereby increase its operating income. Or the firm could do just the opposite if it wanted to decrease its operating income to lower its taxes. The proration method has the effect of approximating the allocation of fixed costs based on actual costs and actual output, so it is not susceptible to this type of manipulation.

There is no clear-cut or preferred approach for closing out the production-volume variance. The appropriate accounting procedure is a matter of judgment and depends on the circumstances of each case. Variations of the proration method may be desirable. For example, a company may choose to write off a portion of the production-volume variance and prorate the rest. The goal is to write off that part of the production-volume variance that represents the cost of capacity not used to support the production of output during the period. The rest of the production-volume variance is prorated to Work-in-Process Control, Finished-Goods Control, and Cost of Goods Sold.

If Webb were to write off the production-volume variance to Cost of Goods Sold, it would make the following journal entry.