Review of Social, Economic & Business Studies, Vol.

9/10, 73-100

Activity-Based Variance Analysis: Another Approach to Overhead Costs Variance Analysis

lhan DALCI
Dr., Department of Business Administration, Faculty of Business and Economics, Eastern Mediterranean University

Veyis Naci TANI

Assoc. Prof. Dr., Faculty of Economics and Administrative Sciences, Cukurova University

Abstract Commercial success of the manufacturing companies depends on the decisions that their managers make. In other words, in order that manufacturing companies can compete in highly competitive environments, managers must make correct and sound decisions. In some cases, however, managerial decisions that are based on traditional approaches may not direct companies toward success. Therefore, management accountants sometimes should not use traditional approaches in order to reach the best possible information. Otherwise, they cannot make sound and correct decisions. Variance analysis, for example, is one of the areas in which the use of traditional approaches can be misleading for managerial purposes. The aim of this paper is to identify how traditional variance analysis leads managers to make wrong decisions, and how activity-based variance analysis can be used as an alternative approach to traditional variance analysis for overhead costs.

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Keywords: Variance analysis, activity-based variance analysis, overhead costs, activity-based costing, traditional costs accounting systems. Introduction Traditional variance analysis focuses on the number of units produced as the sole cost driver. In other words, costs are categorized as fixed or variable with respect to volume-based cost drivers in traditional variance analysis. Therefore, variable costs increase only as the number of units produced increases. The use of Activity-Based Costing (ABC) leads researchers to believe that there are some activities, costs of which change in proportion to some cost drivers other than production volume. For example, batch-level activities such as set up, material handling, receiving and inspection, and quality assurance are performed for the production of each batch of products rather than a single unit. This means, as one more batch of products is produced, one more set up or another batch level activity is required. In this case, the production of each batch leads to an increase in the set up costs. Therefore, whereas the costs of batch-level activities are fixed with respect to the sales volume, they are not fixed with respect to other cost drivers, such as number of set up activity. Under the traditional costing systems, however, costs are categorized as fixed or variable with respect to number of units produced. Thus, traditional variance analysis treats setup, inspection, material handling, and similar activity costs as fixed costs because they are fixed with respect to number of units sold. By contrast, ABC system does not treat these activities and their costs as fixed. This different treatment of the ABC system results in a difference in the variance analysis performed under both systems. Therefore the aim of this paper is to demonstrate that traditional approach to variance analysis may differ from activitybased variance analysis. Since costs of direct material and direct labor are treated in the same way under both traditional and

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activity-based costing systems, variance analysis for direct material and direct labor will not be covered in this paper. This paper will be divided into three sections. In the first section, traditional variance analysis for factory overhead costs will be explained. In the second section, activity-based costing will be examined, and in the last, activity-based variance analysis for factory overhead costs will be examined to show the underlying causes of the differences and conclude which way is more appropriate. 1. Traditional Variance Analysis of Factory Overhead Costs One of the functions that lead companies toward success is the control function. If managers do not conduct this function properly, they will not be able to see the root causes of the problems. As a result, managers cannot take corrective actions in order to correct the deficiencies that prevent their companies from reaching their goals. Any control system has three basic parts: a predetermined or standard performance level, a measure of actual performance, and comparison between actual and standard performance (Hilton, 2000:394). Standard cost represents a budget for the production of one unit of product. In other words, a standard cost represents the cost that should be and is predetermined in advance (Russell et. al., 2002:132). Standard cost is determined by management accountant to serve as benchmark in the control system. Once standard costs are established, they may be compared with the actual costs for the period and the difference or variance may be recorded. Variances may be divided into sub-components as part of any analysis; that is referred to as variance analysis (Russell et. al., 2002: 132). Variance analysis is an important mechanism in a control feedback reporting system. Variance analysis enables managers to see the causes of the variances between actual and standard costs. Whenever managers realize significant cost variances, they can investigate these variances in order to determine the root causes and take corrective actions if necessary.

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1.1. Establishment of Standards In order to determine the standards, management accountants have two approaches to use: analysis of historical cost data and task analysis (Hilton, 2000:395).These are explained as follow: Analysis of Historical Data: Management accountants can analyze the trend of historical cost data in order to make predictions for the future. In other words, managers can use historical cost data to determine what the future costs should be. Therefore, analysis of the behavior of the costs provides managers with the opportunity to budget the costs for the coming periods. However, management accountants should consider the possible trends in price levels and technological developments while making predictions for the future. For example, in determining the direct material price standards, management accountants must take the possible price increases into consideration. In addition to these, technological developments may provide companies with an opportunity to produce the products at lower costs. Therefore, managers should consider the effects of technological developments on production processes while making predictions of the costs for the coming periods. Task Analysis: Another way of setting standards, called task analysis, is the technique of analyzing the process of manufacturing a product to determine what it should cost (Hilton et. al, 2000: 678). The emphasis shifts from what it costed in the past to what it should cost in the future. In order to be successful with this technique, management accountants should work with engineers who are much more familiar with the production processes. They conduct studies together to determine how machinery should be used in the production process, and to determine the amount of resources such as direct materials which should be used in the production processes. In addition, time and motion studies can be conducted to determine how long each step performed by direct labors should take (Hilton et. al, 2000: 678). Thus, managers can make predictions about the direct labor costs. As explained above, in order to control the costs, management accountants determine standard costs and compare actual costs with standards in order to see whether actual costs are

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incurred as expected. If actual costs stray from standards, management accountants conduct variance analysis in order to see the causes of the strays. Direct materials and direct labor can easily be traced to products. Therefore, it is straightforward to determine standard costs for direct material and direct labor costs. However, it is not that easy to assign factory overhead costs to products. How much depreciation of equipment does it take to produce a product? How much electricity or machinery maintenance service does one unit of product require? Since all of these costs represent indirect portion of the production costs, it is difficult to set factory overhead standards for one unit of product. In this case, another approach for managing factory overhead costs should be used. In order to control overhead costs, the cost- management tool used by most companies is called a flexible budget (Hilton et. al, 2000: 722). In the coming section, flexible budgets and variance analysis under traditional costing systems will be explained. 1.2. Flexible Budgets A flexible budget calculates budgeted costs based on the actual output level in the budget period (Horngren et. al, 2003: 216). A flexible overhead budget is defined as a detailed plan for controlling overhead costs that is valid in the firms relevant range of activity (Hilton, 2000: 442). Static budget that is developed for a single planned output level, however, does not let management accountants to compute variances at actual output level because it is based on planned level of production. The following example can show how flexible budget provides much more useful information than a static budget does: It is assumed that, direct labor hour is used as sole cost driver for factory overhead costs and electricity cost that is variable factory overhead cost is incurred at a rate of $2 per direct labor hour. Two different budgets are shown below. The static budget is based on the predicted level of activity for the coming period, 4000 machine hour. This estimate is based on the planned production of 4000 units; each unit requires 1 direct labor hour. On the other

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hand, the flexible budget includes three different production activity levels: 3000, 4000, and 6000 direct labor hours.
Static Budget
Activity (direct labor hours).4000 Budgeted electricity cost$8000

Flexible Budget
Activity (direct labor hours)3000 4000 6000 Budgeted electricity cost...$6000 $8000 $12000

If 6000 units are actually produced during the period, with the usage of 6000 direct labor hours, and if $2000 electricity cost is incurred, a management accountant using the static budget will make the following analysis.
Actual Electricity Cost $2000 Budgeted electricity cost $8000 Cost Variance $6000 Favorable

As a result of the above analysis, the management accountant employing a static budget accepts favorable cost variance in the amount of $6000. The above analysis is based on a static budget which includes planned level of production activity of 4000 units. However, actual production in the period is 6000 units. Therefore, the use of static budget will mislead managers in making decisions. One practical way to overcome this difficulty is to flex the budget to what it would have been resulting the planned level of output to be 6000 rather than 1000 units. Flexing the budget simply means revising it to what it would have been had the planned level of output been some different figure (Atrill and McLaney, 2002:161). In this case, actual cost should be compared with the budgeted cost for 6000 units rather than 4000 units which represent the planned level of production. Therefore, actual electricity cost should be compared to budgeted cost that is $12000 1 as follows:
Actual Electricity Cost $2000 Budgeted Cost (flexible budget) $12000 Cost Variance $10000 Favorable

Traditional costing systems use single volume-based cost drivers to determine how costs behave. Variable costs are assumed to change only in proportion to a change in volume-based cost drivers such as number of machine hours run, number of direct labor hours, and
1

[ (6,000 units x 1 direct labor hour) x $2]

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number of units produced. Therefore, all of the costs that do not change with respect to volume-based cost drivers are accepted as fixed costs under traditional budgeting. In the following example it is assumed to be a flexible budget for the coming period at different activity levels. In this budget, it is also assumed that number of machine hours is used as the sole cost driver. Furthermore, the number of machine hours allowed (standard) for one unit is assumed to be 1.5 machine hours. The following flexible budget shows estimated variable and fixed factory overhead costs at production levels of 3000, 4500, and 5100 units. In this case, budgeted activity levels will be 4500 2 , 6750 3 , and 7650 4 machine hours for 3000, 4000, and 5000 units respectively.
Table 1. Monthly Flexible Overhead Budget Machine Hours 6750 $27000 11250 1350 900 $40500 $2400 10600 9600 5000 1300 1100 $30000 $70500

Budgeted Costs Variable Costs: Indirect Materials Indirect Labor Power (electricity) Heat Total Variable Fixed Costs Quality Assurance Setup Material handling Engineering Depreciation: Plant & Equipment Insurance & Property Taxes Total Fixed Cost Total overhead cost

4500 $18000 7500 900 600 $27000 $2400 10600 9600 5000 1300 1100 $30000 $57000

7650 $30600 12750 1530 1020 $45900 $2400 10600 9600 5000 1300 1100 $30000 $75900

As can be seen in the above budget, all of the costs that are fixed with respect to volume-based cost driver (machine hour) are
2 3

3,000 units x 1.5 machine hours 4,500 units x 1.5 machine hours 4 5,100 units x 1.5 machine hours

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accepted as fixed. In other words, costs of quality assurance, setup, material handling, engineering, depreciation, and insurance & property are accepted as fixed costs in the traditional approach. Therefore, they are not expected to change at different activity levels. Other costs such as direct materials, direct labor, electricity, and heating costs are accepted as variable costs because they are assumed to change with respect to the number of machine hours run. 1.3. Variance Analysis The flexible overhead budget is the cost managers primary tool to control factory overhead costs. At the end of each accounting period, the cost manager benefits from the flexible budget in order to determine the amount of factory overhead costs that should have been incurred at the actual activity level. Then, the cost managers compare the actual factory overhead cost incurred with the budgeted overhead cost at an actual activity level determined in the flexible budget. The cost manager then calculates the overhead variances that will help him control factory overhead costs. Variance analysis for factory overhead cost is divided into two sections in which variable factory overhead and fixed overhead cost variances are examined separately. The analysis of variable and fixed overhead variances is explained as follows: 1.3.1. Variance Analysis for Variable Factory overhead Costs As only volume- based cost drivers are used under traditional variance analysis, costs that vary with respect to volume-based cost drivers such as number of machine hours are accepted as variable costs. The analysis of variable overhead variances is conducted in two sections as follows:

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1.3.1.1. Efficiency Variance Efficiency variance results from the use of more or less activity measure which is used as cost driver than the standard quantity, given the actual output. If machine hour is used as the cost driver, favorable or unfavorable efficiency variance will result from the use of more or less machine hour than the standard machine hours, given the actual output. Therefore, favorable or unfavorable variable overhead variance can be calculated with the help of following formula (Hilton et. al., 2000:731).
Variable-overhead efficiency variance = SVR (AH SH) (1)

Where, SVR = Standard variable-overhead rate AH = Actual machine hours SH = Standard machine hours If it is assumed that 3000 units are actually produced during the period, the total standard allowed number of machine hours is 4500 5 hours because standard activity level is 1.5 machine hours per unit. As it is seen in the flexible budget presented above, budgeted overhead cost for 4500 machine hours is $57000 6 . It is also assumed that actual factory overhead cost for the period is $62980 7 and actual number of machine hours is 4800 hours. The following is the variable overhead efficiency variance calculation using the above formulae:
Variable- overhead efficiency variance = $6 8 (4,800 4500) = $ 1800 unfavorable

From the figures, it is noticed that actual number of machine hours used (4800) exceeds the standard allowed number of machine hours (4500), given the actual production output. In this case,

5
6

Actual output x standard allowed machine hour per unit (3000 units x 1.5 hours) Budgeted variable overhead + Budgeted fixed overhead ($27000 + $30000) 7 Actual variable overhead + Actual fixed overhead ($30480 + $32500) 8 [($27000 4500) = ($40500 6750) = ($45900 7650)]

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actual number of machine hours used is more than the amount that should have been. 1.3.1.2. Spending Variance Spending variance emerges when actual cost of variable overhead is exceeding or falling behind the amount which is expected, after adjusting for the actual quantity of machine hours used. Spending variance may result from paying higher or lower price for the variable overhead items. For example, unfavorable variance could result from paying higher price than expected for indirect materials, or electricity. In addition, spending variance could arise as a result of using more or less than the expected amount of variable overhead items. For example, unfavorable spending could result from using more indirect materials than expected. In this case, spending variance can be calculated with the help of the following formula:
Variable-overhead spending variance = Actual variable overhead (AH x SVR) (2)

By using the data given above, spending variance can be calculated as follows:
Variable-overhead spending variance = $30480 (4800 x $6) = $1680 unfavorable

This variance is unfavorable because the actual variable-overhead cost exceeds the expected amount, after adjusting that expectation for the actual number of machine hours. This variance could be caused because of the factors explained above. 1.3.2. Variance Analysis for Fixed Factory Overhead Costs In order to analyze the performance of fixed-overhead costs, cost managers calculate two variances regarding the fixed-overhead: namely, fixed-overhead budget variance and fixed-overhead volume variance.

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1.3.2.1. Fixed-Overhead Budget Variance Fixed-overhead budget compares actual expenditures with budgeted fixed-overhead costs. Unfavorable or favorable fixedoverhead variance emerges from spending more or less on fixedoverhead items than the budgeted amounts. For example, company may pay more on the rent of the factory building because of the unexpected price increase made by the owner of the building. As a result, unfavorable variance emerges. The following formula shows how fixed-overhead budget variance is calculated:
Fixed-overhead budget variance =Actual fixed overhead Budgeted fixed overhead

(3)

By using the figures given in the previous sections, fixed-overhead budget variance could be calculated as follows:
Fixed-overhead budget variance = $32500 $30000 = $2500 unfavorable

The fixed-overhead budget variance is unfavorable because more money is spent on fixed-overhead items than the budgeted amount. 1.3.2.2. Fixed-Overhead Volume Variance The production-volume variance is the difference between budgeted fixed overhead and fixed overhead allocated on the basis of actual output produced (Horngren et. al., 2003: 258). Production-volume variance arises when the actual level of cost allocation base for allocating fixed overhead costs differs from the budgeted level of the cost-allocation base chosen at the beginning of the period. Therefore, analysis of fixed-overhead volume variance identifies whether productive capacity is under or over utilized. In this case, unfavorable production-volume variance represents under allocated while favorable variance represents over allocated fixed overhead costs. Fixed-overhead volume variance can be calculated with the help of the following formula:

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Fixed-overhead volume variance = Budgeted fixed overhead Applied fixed overhead 9

(4)

By using the data given in the previous sections, fixed-overhead volume variance could be calculated as follows:
Fixed-overhead volume variance = $30000 $22500* = $7500 unfavorable
* $5** x 4500*** machine hours ** Budgeted overhead Planned activity level =$30000 6000 machine hours *** Actual number of units produced x Standard no. of machine hours per unit = 3000 units x 1.5 hours

In this case, unfavorable volume variance emerges because only 4500 machine hours are allowed although 6000 hours are planned. This means that capacity has been underutilized by 1500 machine hours. Traditional costing systems employ single volume-based cost drivers to determine how costs behave. In other words, variable costs are assumed to change only in proportion to a change in volume-based cost drivers such as number of machine hours run, and number of units produced. Therefore, all of the costs that do not change with respect to the volume-based cost drivers are accepted as fixed costs. However, from a different perspective, there are some costs that should be variable with respect to some cost drivers other than volume-based ones, as will be explained in the following section. 2. Activity-Based Costing Activity-based costing (ABC) is the extension of traditional volume-based costing that treats manufacturing overhead as a complex set of costs with multiple cost drivers (Mansuy, 2000:7; Drake et al., 2001: 444). Activity-based costing is the costing system that focuses on individual activities as the cost objects. An activity is an event, task or unit of work with a specified purpose; for example, designing products, starting up machines, operating
9

Predetermined fixed overhead rate x Standard allowed hours

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machines, moving and distributing products (Hicks, 1999: 41). Under activity-based costing system overhead costs are accumulated in activity-cost pools in proportion to the organizations resources that are consumed with each activity (Partridge and Perren, 1998:581). Then, overhead costs that are accumulated in activity-cost pools are allocated to products based on the appropriate cost drivers (McKenzie, 1999, 56; Cooper and Kaplan, 1988:21; Baxendale, 2001:63). A cost driver is a characteristic of an event or activity that results in the incurrence of costs (Hilton, 2000: 170; Brjesson, 1994: 83). Cost-driver base is a measurable cause, or driver, of performing an activity. For example, overhead costs accumulated in setup-cost pool can be allocated to products based on the number of setup activity performed for each product type because number of setups has the best cause-and-effect relationships with the incurrence of setup costs. Therefore, number of setups is the cost driver for setup-cost pool. The following section explicates how these activities and their costs are classified in an ABC system. 2.1. Hierarchy of Activities In this paper, activity-based costing has been studied just to understand that there exist some costs that are variable with respect to some cost drivers other than volume-based cost drivers such as number of units produced. In order to understand how costs vary in proportion to some cost drivers, rather than number of units produced, it should be understood how organizations resources are consumed by activities. Resource is anything that is a cost to business. Therefore, consumption of resources will lead to an increase in costs (McKenzie, 1999: 56). Different decisions to acquire any of the resources described above will cause different resources to be available to the organization. Decision about these resources will determine overall cost structure of the organization. All of the resources can be explained in the hierarchy as unit, batch, product, facility-level resources. These resources are consumed by the activities performed within the organization

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(Cooper and Kaplan, 1991:131). Activities, like resources, may be classified as one of the four types depending on the kind of decision to use resources: unit, batch, product, and facility-level activities (Drake et al., 2001: 444; MacArthur, 1993: 53; Tan, 1998). Unit-level resources and activities: Unit-level resources are used for each unit of product. In other words, as one more unit of product is produced, usage of unit-level resources increases. Materials used for production, components used for each unit and energy such as electricity is among the unit-level resources because these resources must be consumed for every unit of product produced. Unit-level activities, on the other hand, are performed for each unit of production. In other words, unit-level activities must be carried out every time a one more unit of product is produced. A decision to produce more units of products causes more unit-level activities. For example, machinery should be operated as more products are produced. Since unit-level activities are performed for each unit of production, they consume unit-level resources. For example, as one more unit is produced, more energy (which is unitlevel resource) is required. Batch-level resources and activities: Batch-level resources are used as a result of producing a group of similar products. For example, specialized labor of technicians and materials necessary to setup the equipment every time a batch of products is produced can be regarded as batch-level resources. Batch-level activities, on the other hand, are performed for each group or batch of similar products. A batch refers to a number of units of product that require the same setup, personnel, and equipment. For example, inspection, material-handling, moving, and setup activities are batch-level activities. These activities require the acquisition of batch-level resources. For example, every time machinery is setup, materials and other batch-level resources should be used. Therefore, number of setups can be a cost driver for setup-cost pool. Product-level resources and activities: Product-level resources are required as a result of the decision to produce a specific product line. Specialized equipment, software, and

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specialized labor of engineers required to design the product can be shown as examples to product-level resources. Product-level activities, on the other hand, are performed to support particular product line, regardless of the number of units and number of batches in that product line. By contrast, batch-level and unit-level activities are performed for each batch of products and for each unit of production respectively. Engineering activity can be given as an example to product-level activity because an engineering activity is performed for the entire produce line, rather than for each batch or each unit. Product-level activities cause the consumption of product-level resources. For example, specialized labor of engineers is required to design the products. Facility-level resources and activities: Facility-level resources are necessary to provide a general capacity to produce the products. Land and factory building can be regarded as facilitylevel resources because these resources are required to provide general capacity for production. Facility-level activities are required in order to make the entire production process to occur. For example, operating the physical plant is facility-level activity because plant is necessary for the entire production process to be performed. Likewise, facility-level activities cause the consumption of facility-level resources. 2.2. The Importance of Activity-based Costing Once activities are classified, it can be identified how the activity consumes the resources. In other words, cost-driver base for each activity can be determined in order to identify how costs are incurred in the activity-cost pools. An increase or decrease in the cost-driver base leads to an increase or decrease in the level of an activity performed (Hilton et al., 2000:160). In turn, the level of an activity influences the consumption of resources and, consequently the costs. For example, number of design specifications can be regarded as a cost-driver base for the engineering activity because there is a direct cause-and-effect relationship between the number of design specifications and the incurrence of engineering costs.

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For another example, number of batches can be a cost-driver base for all batch-level activities because these activities are performed in direct proportion with the number of batches produced. From the explanations given above, it is understood that volume-based cost drivers such as number of units of products produced are not the sole cost-drivers that drive costs. In other words, some costs that are accepted as fixed under traditional costing system are variable with respect to some other cost drivers such as number of batches of products and number of design specifications. Since traditional costing systems are based on single volume-based cost driver, they provide less than adequate information for managerial decision-making. This means that traditional cost accounting systems do not supply reliable product cost information (Cokins, 2000:48). The activity-based approach has given accountants and managers a better understanding of what drives overhead costs (Innes, 1999:80-81). Therefore, an alternative approach to traditional variance analysis should be used in the existence of activities that are driven by cost drivers other than production volume. In this case, use of activity-based variance analysis can provide managers with better information because activity-based variance analysis uses multiple cost drivers as explained in the following section: 2.3. A New Approach: Activity-Based Variance Analysis for Factory Overhead Traditional costing systems, as previously stated, accept only volume based cost drivers as factors causing costs to change. Therefore, only those costs that vary according to volume-based cost drivers are accepted as variable factory overhead costs under traditional variance analysis. Other costs are classified as fixed costs. However, many costs that are accepted as fixed under traditional costing systems are, in fact, variable with respect to non-volume-based costs drivers. Therefore, flexible budget based on traditional assumptions will not give the most accurate information to cost managers. Instead, activity-based flexible budget will be used as an alternative budget to traditional one. The

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activity-based flexible budget will classify costs as unit, batch, product, and facility-level, in which case only facility-level costs are accepted as fixed. Others are accepted to be variable with respect to related cost drivers which give rise to the incurrence of them. Therefore in this part of the paper, employing ABC variance analysis, unit, batch, and product-level costs will be analyzed as variable factory overhead; and facility-level factory overhead costs will be analyzed as fixed. Variable-overhead efficiency and spending variances calculated under traditional analysis should be calculated using the ABC hierarchy approach. In this case, volumebased cost drivers will be used for unit-level; number of production runs will be used for batch-level; and other related cost drivers will be used for product-level costs as activity measures. The reason why different activity measures are used for different costs is that different costs are driven by different cost drivers. Since different activity measures are used under activity-based variance analysis, activity-based flexible budget will also include different activity measures. By using the same data, given in the traditional flexible budget in the preceding sections, activity-based flexible budget can be prepared as follows:

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Review of Social, Economic & Business Studies, Vol.9/10, 73-100 Table 2.Activity-Based Flexible Overhead Budget Budgeted Costs Variable Costs: Indirect Materials Indirect Labor Power (electricity) Heat Total Variable(unit level costs) Batch Level Costs (production runs) Quality Assurance Setup Material handling Total batch-level costs Product-level costs (design specfs) Engineering Total product-level costs Facility-level costs Depreciation: Plant & Equipment Insurance & Property Taxes Total Facility-level costs Total overhead cost 4500 $18000 7500 900 600 $27000 10 $2400 10600 9600 $22600 10 5000 5000 1300 1100 $2400 $57000 Level of Activity 6750 $27000 10 11250 1350 900 $40500 15 11 $2400 10600 9600 $33900 15 7500 12 7,500 1300 1100 $2400 $83400 7650 $30600 12750 1530 1020 $45900 17 $2400 10600 9600 $38420 18 9000 9000 1300 1100 $2400 $95720

As can be seen in the above flexible budget, only unit-level costs vary with respect to volume-based cost drivers (machine hours). In addition, batch, and product-level costs that are accepted as fixed cost under traditional variance analysis are variable with respect to cost drivers such as number of production runs and design specifications. However, facility-level costs are accepted as fixed
10 11

[ ( $18000 4500 machine hours) x 6750 machine hours ] [ 4500 units (3000 units 10 production runs) ] 12 [ ($5000 10 design specs) x 15 design specs ]

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under both traditional and activity-based costing systems. Therefore, variance analysis for variable unit-level costs will be the same under both traditional and activity-based variance analysis. However, batch-and product-level costs that are analyzed under the variance analysis for fixed costs should be analyzed as variable costs under activity-based variance analysis. Nevertheless, the analysis of facility-level costs under activity-based variance analysis will be the same as the analysis conducted for fixed costs under traditional variance analysis. In the following section, it is explicated how activity-based variance analysis should be conducted. 2.3.1. Variance Analysis for Unit-level Overhead Costs Since unit-level costs are accepted as variable with respect to volume-based cost drivers under both traditional and activity-based variance analysis, the calculation of variances for these costs is the same under the both systems. In addition, variance calculation of these costs has been explained in the previous section, it will not be covered again. 2.3.2. Variance Analysis for Batch-level Overhead Costs Since costs of batch-level activities are increasing in proportion to an increase in the number of production runs, number of production runs should be used as a measure for these activities. In this case, calculation of efficiency and spending variances for batch-level costs is performed as follows: 2.3.2.1. Efficiency Variance for Batch-level Overhead Costs Efficiency variance occurs when more or less of an activity measure is realized. It is used to measure cost driver activity and compare with the standard quantity allowed at actual output level. Therefore, favorable or unfavorable efficiency variance will occur when more or less production runs are used rather than the standard quantity (of production runs) at actual output level. In this

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case, following formula can be used to calculate efficiency variance for batch-level costs:
Efficiency variance for Batch-level costs = SVR (ANP SNP) (5)

Where, SVR = Standard variable-overhead rate ANP = Actual number of production runs SNP = Standard number of production runs As can be seen in the activity-based flexible budget prepared above, 10 production runs are planned for 3000 units. This means that standard allowed number of production runs can be employed as one production run for every 300 (3000units 10 setups) units. If it is assumed that 4500 units are actually produced during the period, total allowed number of production runs will be 15, as seen in the activity-based flexible budget. In the flexible budget prepared above, budgeted batch-level costs at 15 production runs are as follows:
Batch- level costs (cost driver: production runs) 15 Quality Assurance $ 3600 Setup 15900 Material handling 14400 Total variable batch-level costs .. $ 33900

Besides, it is assumed that actual number of batches (production runs) for the period is 18. Furthermore, actual batchlevel costs for the period are assumed to be as follows:

Batch- level costs (cost driver: production runs) 18 Quality Assurance $ 5000 Setup 20000 Material handling 18000 Total variable batch-level costs .. $ 43000

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By using these figures, efficiency variance for variable batch-level factory overhead costs can be calculated as follows:
Efficiency variance for Batch-level costs = SVR* (ANP SNP) = $2260* (18 15) = $6780 unfavorable * ($22600 10 production runs = $33900 15 production runs = $38420 17 Production runs)

In this case, unfavorable efficiency variance in the amount of $6780 emerges because actual number of production runs exceeds the standard allowed number of production runs at actual output level. Although 15 (4500units 300 13 units per batch) production runs are expected at actual production of 4500 units, actual number of production runs is 18. In this case, additional three production runs cause an extra cost of $6780. 2.3.2.2. Spending Variance for Batch-Level Overhead Costs Spending variance for batch-level overhead costs occurs when actual cost of batch-level activities is exceeding or falling behind the amount that is expected, after adjusting for the actual quantity of production runs. Therefore, favorable or unfavorable spending variance emerges from paying higher or lower than expected price on per unit of batch-level cost items. For example, if higher price than expected is paid for lubricant oil which is used for cleaning machinery while setting it up, unfavorable spending variance occurs. In this case, following formula can be used to calculate favorable or unfavorable spending variance:
Spending variance for batch-level cost = Actual Batch-level costs (ANP x SVR) (6)

In order to calculate spending variance, actual costs should be compared to budgeted cost at actual number of production runs. Detailed calculation of budgeted batch-level costs at actual number

13

(3000 units 10 production runs = 4500 units 15 productions runs = 5100 units 17 production runs)

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of production runs and calculation of spending variance are presented as follows:

Batch- level costs (Cost driver: production runs) 15 18 18 Budgeted costs Actual Costs (A) (B) (C) Quality Assurance$ 3600 $ 4320 14 $ 5000 Setup 15900 19080 20000 Material handling14400 17280 18000 $ 40680 $ 43000 Spending Variance (C B) $ 680 U 15 920 U 720 U $ 2320 U

Total variable batch-level costs..$ 33900

As can be seen in the schedule above, total spending variance is unfavorable because actual cost ($43000) of batchlevel activities is higher than the budgeted cost ($40680) at 18 production runs. Unfavorable spending variance emerges from paying more than expected price for batch-level cost items. For example, $920 worth of unfavorable spending variance for setup activities may result from paying more than standard price for setup cost items. The unfavorable spending variance calculated above can also be calculated by using the formula which was presented above as follows:
Spending variance for batch-level cost = Actual Batch-level costs - (ANP x SVR) = $43000 - (18 x $2260) = $2320 U

2.3.3. Variance Analysis for Product-level Overhead Costs Although product-level costs are accepted as fixed under traditional variance analysis, they are accepted as variable cost under activity-based variance analysis. Nevertheless, these costs are not variable with respect to volume-based cost drivers. Therefore, product-level costs should neither be analyzed using the variance analysis for unit-level costs nor fixed costs. In this paper, product-level (engineering) costs are assumed to change with respect to number of design specifications. Therefore, the
14 15

[ ( $3600 15 ) x 18 ] Unfavorable variance

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efficiency and spending variances are calculated by using number of design specifications as an activity measure (cost-driver activity). In the previous sections, it is explained that 4500 units have actually been produced during the period. Also, budgeted number of design specifications is 15 at this level. The budgeted engineering costs at 15 design specifications, however, have nothing to do with the number of units produced. In other words, number of design specifications is changing with respect to factors other than production volume. For example, as product becomes more and more complex, more design specifications may be required. Then, more design specifications cause more engineering costs. For another example, as the company wants to improve the products quality, design quality should also be improved. In this case, more design specifications may be required to make the products quality better. Thus, more design specifications causes more engineering costs. In the activity-based flexible budget prepared above, there is different number of design specifications at different production levels. Of course, they do not differ because of different levels of production levels. In this paper, it is assumed that number of design specifications increases at different activity levels because of the planned increase in the quality-level of the design of the product. Under the actual circumstances, the budgeted number of design specifications is assumed to be 15 for the expected level of the quality of the products design. However, the actual number of design specifications and actual engineering costs for the period are assumed to be as follows:
Product-level costs (cost driver: design specs) Engineering.. Total variable product-level costs 17 $ 9000 $ 9000

In this case, actual number of design specifications (17) exceeds the budgeted number of design specifications (15). The budgeted engineering costs at 15 (expected number) design specifications are as follows (see activity-based flexible budget prepared in the previous section):

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Product-level costs (cost driver: design specs) Engineering Total variable product-level costs.

15 $ 7500 $ 7500

When actual and budgeted costs are compared, it is realized that actual costs exceeds budgeted costs by $1500 ($9000 - $7500). This unfavorable cost variance can be analyzed in detail under efficiency and spending variance analyses as follows: 2.3.3.1. Efficiency Variance for Product-level Overhead Costs As pinpointed before, efficiency variance occurs when more or less activity measure is used, which is used as cost driver activity, than the standard quantity. Therefore, favorable or unfavorable efficiency variance for product-level costs will occur when more or less design specifications than the standard quantity allowed are prepared. In this case, following formula can be used to calculate efficiency variance for product-level costs:
Efficiency variance for product-level costs = SVR (AND SND) (7)

Where, SVR = Standard variable-overhead rate AND = Actual number of design specifications SND = Standard number of design specifications As explained before, actual number of design specifications exceeds budgeted number. In this case, unfavorable efficiency variance will occur because actual number of design specifications exceeds budgeted number. The following figure shows how efficiency variance is calculated:
Efficiency variance for product-level costs = SVR (AND - SND) = $500* (17 - 15) = $1000 Unfavorable * [($5000 10 design specs) = ($7500 15 design specs) = ($5000 18 design specs)]

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2.3.3.2. Spending Variance for Product-level Overhead Costs Spending variance for product-level overhead costs occurs when actual cost of product-level activities exceeds or falls behind the amount expected, after adjusting for the actual quantity of design specifications. Therefore, favorable or unfavorable spending variance emerges from paying higher or lower than expected price on per unit of product-level cost items, or from using more or less than expected amount of product-level cost items. For example, if higher than expected price is paid to workers who prepares the design specifications, unfavorable spending variance will eventually emerge. On the other hand, if more than expected time is spent on design specifications, again unfavorable spending variance will occur. In this case, following formula can be used to calculate favorable or unfavorable spending variance:
Spending variance for product-level cost = Actual product-level costs (AND x SVR) (8)

In order to calculate spending variance, actual costs should be compared to budgeted cost at actual number of design specifications. Detailed calculation of budgeted product-level costs at actual number of design specifications and calculation of spending variance is presented as follows:
Product- level costs (Cost driver: design specs)

15 17 17 Spending Variance Budgeted costs Actual Costs (C B) (A) (B) (C) Engineering . $ 7500 $8500 16 $9000 $500 Total variable product-level costs $ 7500 $ 8500 $ 9000 $500

As can be seen in the schedule above, total spending variance is unfavorable because actual cost ($9000) of productlevel activities is higher than the budgeted cost ($8500) at actual number of design
16

[ ($7500 15 design specs) x 17 design specs ]

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specifications. Unfavorable spending variance may emerge from paying more than expected price for product-level cost items. For example, $500 worth of unfavorable spending variance for engineering activities may result from paying more than standard price for engineering cost items. The unfavorable spending variance calculated above can also be calculated by using the formula which was presented above as follows:
Spending variance for product-level cost = Actual product-level costs (AND x SVR) = $9000 (17 x $500) = $500 Unfavorable

2.3.4. Variance Analysis for Facility-level Overhead Costs As explained in the previous sections, facility-level costs are accepted as fixed under both traditional and activity-based variance analysis. Therefore, the variance analysis for fixed overhead costs (facility-level costs) will be the same either under ABC or traditional applications. Because the calculation of these variances has been explained before, it will not be repeated in this section. Conclusion Traditional variance analysis focuses on the number of units sold as the sole cost driver. Therefore, under traditional variance analysis, variable costs increase only as the number of units produced increases. Nevertheless, traditional approach is consistent with the traditional product-costing systems, in which cost assignment is generally based on one or a few volume-based cost drivers. The use of ABC helps researchers realize that there are some activities, costs of which change in proportion to some cost drivers other than production volume. Traditional variance analysis treats setup, inspection, material handling, and similar activity costs as fixed costs because they are fixed with respect to number of units sold. By contrast, ABC system does not treat these activities and their costs as fixed. This different treatment of the

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ABC system results in a difference in the variance analysis performed under both systems. In this case, costs of batch and product-level activities that are accepted as fixed are analyzed in variance analysis for fixed costs under traditional variance analysis for factory overhead costs. On the other hand, these costs are treated as variable factory overhead costs under activity-based variance analysis. Thus, spending and efficiency variance calculated just for unit-level overhead costs should also be calculated for batch, and product-level overhead costs under activity-based variance analysis. Nevertheless, facility-level overhead costs are accepted as fixed under both traditional and activity-based variance analysis. Therefore, it can be stated that costs regarding the facility-level are analyzed as performed by the traditional variance analysis techniques. References ATRIL, P. and McLANEY, E., (2000), Management Accounting for Non-Specialists: Prentice Hall. BAXANDALE, S. J. (2001), Activity-Based Costing for The Small Business, Business Horizons, vol.44, No: 1, Jan/Feb., 61-70. BRJESSON, S. (1994), What Kind of Activity-Based Information Does Your Purpose Require? Two Case Studies, International Journal of Operations & Production Management, vol.14, No: 12, Jan., 79-99. COKINS, G. (2000), Overcoming the Obstacles to Implementing Activity-Based Costing, Bank Accounting and Finance, vol.14, 47- 54. COOPER, R. and KAPLAN, R. S. (1988), How Cost Accounting Distorts Product Costs. Management Accounting, April., 20-27. COOPER, R. and KAPLAN, R. S. (1991), Profit Priorities From Activity-Based Costing. Harward Business Review, MayJune., 130-135. DRAKE, A.; HAKA, S. F., and RAVENSCROFT, S. P. (2001), An ABC Simulation Focusing on Incentives and

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Innovation.Issues in Accounting Education, vol.16, Issue 3, Aug., 443-472. HICKS, D. T. (1999), Yes, ABC is For Small Business. Journal of Accountancy, vol.14, No:188, Aug., 41-46. HILTON, W. R. (2000), Managerial Accounting: McGraw-Hill, 4th Ed. HILTON, W. R., MAHER, M. W., and SELTO, F. H. (2000), Cost Management: McGraw-Hill, International edition. HORNGREN, C. T., DATAR, S. M, and FOSTER, G. (2003), Cost Accounting: Prentice Hall, 10th edition. INNES, J. (1999), The Use of Activity-Based Information: A Managerial Perspective, Management Accounting, vol.77, Issue 11, Dec., 81-83. MacARTHUR, J. B. (1993), Theory Of Constraints and ActivityBased Costing: Friends or Foes?. Journal of Cost Management, 50-56. MANSUY, J. E. (2000), Activity-Based Costing can Improve Project Bidding. Industrial Management, vol.42, No:1, Jan/Feb.,6-9. MCKENZIE, J. (1999), Activity-based Costing for Beginners. Management Accounting, vol.77, No:3, March., 56-57. PARTRIDGE, M. and PERREN, L. (1998), An Integrated Framework For Activity-Based Decision Making, Management Decision, 580-588. RUSSELL, D., PATEL, A., and WILKINSON, G. (2000), Cost Accounting: Prentice Hall. TANI, V. N. (1998), Costing Practices in Continuous Processors: A Comparison of two Case Studies. ODT Geliim Dergisi, Say: 4.

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