Variance Analysis and Activity-Based Costing

Learning Objective 7 Calculate variances in activity-based costing

• compare budgeted and actual overhead costs of activities

Activity-based costing (ABC) systems focus on individual activities as the fundamental cost objects. ABC systems classify the costs of various activities into a cost hierarchy—output unit-level costs, batch-level costs, product-sustaining costs, and facility-sustaining costs (see Chapter 5). In this section, we show how a company that has an ABC system and batch-level costs can benefit from variance analysis. Batch-level costs are the costs of activities related to a group of units of products or services rather than to each individual unit of product or service. We illustrate variance analysis for variable batch-level direct costs and fixed batch-level overhead costs.^*

Consider Lyco Brass Works, which manufactures many different types of faucets and brass fittings. Because of the wide range of products it produces, Lyco uses an activity-based costing system. In contrast, Webb uses a simple costing system because it makes only one type of jacket. One of Lyco’s products is Elegance, a decorative brass faucet for home spas.

Lyco produces Elegance in batches. It uses dedicated materials-handling labor to bring materials to the production floor, transport items in process from one work center to the next, and take the finished goods to the shipping area. Therefore, materials-handling labor costs for Elegance are direct costs of Elegance. Because the materials for a batch are moved together, materials-handling labor costs vary with the number of batches rather than with the number of units in a batch. Materials-handling labor costs are variable direct batch-level costs.

To manufacture a batch of Elegance, Lyco must set up machines and molds using highly skilled labor from a separate setup department. Setup costs are overhead costs. For simplicity, assume that setup costs are fixed costs of salaries paid to engineers and supervisors and the costs of leasing setup equipment. In the long run, number of setup-hours is the cost driver of setup costs.

Information regarding Elegance for 2020 follows:

Flexible Budget and Variance Analysis for Direct Materials-Handling Labor Costs

To prepare the flexible budget for the materials-handling labor costs, Lyco starts with the actual units of output produced, 151,200 units, and proceeds with the following steps.

1. Step 1: USING THE BUDGETED BATCH SIZE, CALCULATE THE NUMBER OF BATCHES THAT SHOULD HAVE BEEN USED TO PRODUCE THE ACTUAL OUTPUT. At the budgeted batch size of 150 units, Lyco should have produced the 151,200 units of output in 1,008 batches $(\text{151,200}\hspace{0.17em}\text{units}÷150\hspace{0.17em}\text{units per}$ batch).
2. Step 2: USING THE BUDGETED MATERIALS-HANDLING LABOR-HOURS PER BATCH, CALCULATE THE NUMBER OF MATERIALS-HANDLING LABOR-HOURS THAT SHOULD HAVE BEEN USED. At the budgeted 5 labor-hours per batch, 1,008 batches should have required 5,040 materials-handling labor-hours
3. Step 3: USING THE BUDGETED COST PER MATERIALS-HANDLING LABOR-HOUR, CALCULATE THE FLEXIBLE-BUDGET AMOUNT FOR MATERIALS-HANDLING LABOR-HOURS. The flexible-budget amount is 5,040 materials-handling labor-hours $\times \mathrm{\$}14\hspace{0.17em}\text{budgeted\hspace{0.17em}cost\hspace{0.17em}per\hspace{0.17em}materials‐handling\hspace{0.17em}labor\hspace{0.17em}hour}=\mathrm{\$}\text{70,560.}$

Note how the flexible-budget calculations for the materials-handling labor costs focus on batch-level quantities (materials-handling labor-hours per batch rather than per unit). If a cost had been a product-sustaining cost—such as product design cost—the flexible-budget quantity computations would focus at the product-sustaining level by, for example, evaluating the actual complexity of the product’s design relative to the budget.

The flexible-budget variance for the materials-handling labor costs can now be calculated as follows:

The unfavorable variance indicates that materials-handling labor costs were $11,655 higher than the flexible-budget target. We can get some insight into the possible reasons for this unfavorable outcome by examining the price and efficiency components of the flexible-budget variance. Exhibit 8-6 presents the variances in columnar form.

The unfavorable price variance for materials-handling labor indicates that the $14.50 actual cost per materials-handling labor-hour exceeds the $14.00 budgeted cost per materials-handling labor-hour. This variance could be the result of Lyco’s human resources manager negotiating wage rates less skillfully or of wage rates increasing unexpectedly due to a scarcity of labor.

The unfavorable efficiency variance indicates that the 5,670 actual materials-handling labor-hours exceeded the 5,040 budgeted materials-handling labor-hours for the actual output. Possible reasons for the unfavorable efficiency variance are as follows:

• Smaller actual batch sizes of 140 units, instead of the budgeted batch sizes of 150 units, resulted in Lyco producing the 151,200 units in 1,080 batches instead of $\text{1,008}\  (\text{151,200}÷150)$ batches
• The actual materials-handling labor-hours per batch (5.25 hours) were higher than the budgeted materials-handling labor-hours per batch (5 hours)

Reasons for smaller-than-budgeted batch sizes could include quality problems when batch sizes exceed 140 faucets and higher costs of carrying inventory.

Possible reasons for the larger actual materials-handling labor-hours per batch are:

• Inefficient layout of the Elegance production line
• Materials-handling labor having to wait at work centers for pickup or delivery of materials
• Unmotivated, inexperienced, and underskilled employees
• Very tight standards for materials-handling time

Identifying the reasons for the efficiency variance helps Lyco’s managers develop a plan for improving its materials-handling labor efficiency and take corrective action.

We now consider fixed setup overhead costs.