Transfer Pricing

Transfer price- is the value assigned to goods and services transferred between segments within the company.

➔ the amount charged by one segment of the organization for goods/services transferred/provided to another segment of the same
organization,.

Rationale and Need for a transfer price

1. To supply adequate information to motivate managers of the different segments of the organization to make good economic
decisions.
2. To supply transparent and useful information that may be used in evaluating the performance of business segments.
3. To properly distribute economic resources of the organization among the segments or responsibility centers.
4. To ensure that the autonomy of the various segments of the organization is protected and respected.

Factors Considered in Selecting a Transfer pricing Policy

Goal Congruence – a transfer price should permit a segment to operate as an independent entity and achieve its goals while functioning in
the best interests of the organization as a whole.

Segmental performance- the selling segment should not lose income by selling within the company.

Negotiation – the buying segment should not incur greater costs by buying within the company. Hence, if the product or service could be
purchased outside the company, the buying segment should be allowed to negotiate the transfer price.

Capacity – if the selling segment has excess capacity, it should be used to produce goods for transfer within the company. If there is no
excess capacity, the selling segment should not incur loss by selling to another segment within the same organization.

Cost structure – costs to be considered in a transfer price should be broken down into variable and fixed components, so that it would be
easier to identify relevant cost items.

Approaches used on setting transfer Price

1. Minimum transfer price- minimum amount that the selling segment would be willing to transfer the goods /services to another
segment.

Transfer price = Differential costs (variable costs) per unit + Lost contribution margin per unit on outside sales or opportunity cost

2. Market based transfer price – a transfer price equal to the prevailing market price encourages both the selling and the buying
segments to sell/buy internally. ( the price of the goods are sold on the open market.
3. Cost based transfer price

a. Variable cost transfer price – the transfer price is based only on variable or differential costs.

b. Full cost transfer price – includes actual manufacturing costs (variable and fixed) plus portions of marketing and administrative
costs.

c. Full absorption cost based transfer price – includes materials, labor and factory overhead

d. Cost plus mark-up – transfer pricing based on either variable costs of full absorption cost. The mark-up may be a lump sum
(pesos) or a markup percentage.

4. Negotiated transfer price – is appropriate when market prices are subject to rapid fluctuation. In negotiating a transfer price the
range is

Minimum transfer price –seller’s cost point of view; seller’s incremental cost plus opportunity cost. ( floor or lower limit)

Maximum transfer price – buyer’s point of view; the prevailing market price. (ceiling or upper limit)

5. Dual transfer price – the seller records the transfer price at the usual market price that would be paid by an outsider, while the
buyer (another segment within the firm) records the purchase at cost, usually the variable production cost.

Multinational Transfer pricing

The objective of international transfer pricing focuses on minimizing taxes, duties, and tariffs, foreign exchange risks along with enhancing
a company’s competitive position and improving its relation with foreign governments.
Illustrative Problem:

Patrick Enterprises is a diversified company of which one segment makes high quality fishing rods and another produces fishing reels.
Costs for a reel produced by the Reel Division are:

Fixed costs are allocated to all units produced based on estimated annual production.

● Estimated annual production: 400,000 reels

● Estimated sales to outside entities: 300,000 reels
● Estimated sales by the Reel Division to the Rod Division: 100,000 reels

The managers of the two divisions are currently negotiating a transfer price.

Required:

1. Determine a transfer price based on variable product cost.

2. Determine a transfer price based on total variable cost plus markup.
3. Determine a transfer price based on full production cost.
4. Determine a transfer price based on total cost per reel.
5. Assume that the Reel Division has no alternative use for the facilities that make the reels for internal transfer. Also assume that
the Rod Division can buy equivalent reels externally for P250. Calculate the upper and lower limits for which the transfer price
should be set.
6. Compute a transfer price that divides the “profit” between the two divisions equally.
7. In contrast to the assumption in 6, assume that the Reel Division can rent the facilities in which the 100,000 reels are produced
for P1,000,000. Determine the lower limit of the transfer price.

Exercise –Investment Center

Consider the following data for the two geographic divisions of Luzon Electric Company that operate as profit centers.

Northern Luzon Division Southern Luzon Division

Total Assets P1,000,000 P5,000,000
Current Liabilities 250,000 1,500,000
Operating Income 200,000 750,000
Required:

1. Calculate the ROI for each division.

2. Calculate the RI for each division using a required rate of return on investment of 12%
3. Luzon Electric has two sources of funds: long-term debt with a market value of P3,500,000 and an interest rate of 10% and equity
capital with a market value of P3,500,000 at a cost of 14%. Luzon income tax rate is 40%. Luzon applies the same weighted average cost
of capital to both divisions, since each division faces similar risks. Calculate the EVA for each division. Which of the measures calculated in
requirements 1,2 and 3 would you recommend Luzon Electric to use? Why?

Solutions:
1.
Northern Luzon Southern Luzon
Operating income P 200,000 P 750,000
/Total Assets P 1,000,000 P 5,000,000
ROI 20% P 15%

2. Residual Income
Northern Luzon Southern Luzon
Operating Income P 200,000 P 750,000
Less: Minimum required return
N (P1,000,000 x 12%) 120,000
S ( P5,000,000 x 12%) 600,000
Residual Income P 80,000 P 150,000

3. EVA
After-tax cost of debt financing (1-.40) x 10% = 6%
After –tax cost of equity financing = 14%

Weighted average cost of capital

WACC= (.06 x P3,500,000) + (.14 x P3,500,000)

3,500,000 + 3,500,000
= 210,000+ 490,000
7,000,0000
=10%

Northern Southern
After tax operating income
N (P200,000 x.60) P120,000
S ( P750,000 x.60) P 450,000
Less: Cost of Capital
N (P1,000,000-250,000) x .10 75,000
S (P5,000,000-1,500,000)x.10 350,000
EVA P 45,000 P 100,000

Sources amount % x Cost WACC

Debt P3,500,000 50% 6% 3%
Equity 3,500,000 50% 14% 7%
Total P7,000,00 100% 10%
BALANCED SCORECARD

Balanced scorecard consists of an integrated set of performance measures that are derived from and support a company’s strategy.

Strategy: a set of goals and specific action plans that if achieved, provide the desired competitive advantage.

Four perspectives of the Balanced Scorecard

1. Financial perspective –measures of profitability and market value among others, as indicators of how well the firm satisfies its owners
and shareholders. These financial measures show the impact of the firm’s policies and procedures on the firm’s current financial position
and therefore its current return to the shareholders

2. Customer perspective- focuses on how the organization should look to its customers for success.

Companies use the following performance measures when considering the customer perspective

a. Customer satisfaction - measures indicate whether the company is meeting customer’s expectations or even delighting them.
b. Customer retention or loyalty measures indicate how well a company is doing in keeping its customers.
c. Market share measures a company’s proportion of the total business in a particular market. Companies typically measure
market share in terms of peso sales, unit volume or number of customers.
d. Customer profitability refers to how much profit your customers make for you.

3. Internal business processes perspective measures the efficiency and effectiveness with which the firm produces the product or service.
Focuses on internal operations that will further both the customer’s perspective by creating value to the customer and by increasing
shareholder wealth.
4. Learning and growth perspective measures the firm’s ability to develop and utilize human resources to meet the strategic goals now
and into the future. Capabilities that an organization needs to create long term growth and improvements.

Key measures for evaluating manager’s performance would be employee satisfaction, employee retention and employee productivity.

a. Employee satisfaction recognizes that employee morale is important for improving productivity, quality, customer satisfaction,
and responsiveness to situations.
b. Employee retention recognizes that employees develop organization-specific capital and are a valuable nonfinancial asset to the
company.
c. Employee productivity recognizes the importance of output of employees.

EXAMPLE- BALANCED SCORECARD

The balanced scorecard for XYZ Inc. for the year 2021

Objectives Measures Initiatives Target Performance Actual Performances

Financial perspective
Increased Operating income Manage costs and unused P40,000,000 P42,000,000
shareholder value from productivity gain capacity
Increased Operating income Build strong customer P30,000,000 P68,400,000
shareholder value from growth relationships
Revenue growth Build strong customer 6% 6.48%
relationships
Customer
Perspective
Increase market Market share in Identify future needs of 6% 7%
share communication customers
networks segment
New customers Identify the target 5% 6%
customer segments
Increase customer Customer satisfaction Increase customer focus of 90% of customers 87% of customers
satisfaction survey sales organization give top two ratings give top two ratings
Internal Business
Process Perspective
Improve Percentage of Organize 75% 75%
manufacturing processes with R&D/manufacturing teams
capability advanced controls to implement advanced
controls
Improve Yield Identify root causes of 78% 79.3%
manufacturing problems and improve
quality and quality
productivity
Reduce delivery time Order delivery time Reengineer order delivery 30 days 30 days
to customers process
Meet specified On-time delivery Reengineer order delivery 92% 90%
delivery dates process
Learning and Growth
Perspectives
Develop process skill Percentage of Employee training 90% 92%
employees trained in programs
process and quality
management
 Empower workforce Percentage of Have supervisors act as 85% 90%
frontline workers coaches rather than
empowered to decision-makers
manage processes
Align employee and Employee satisfaction Employee participation 80% of employees 88% of employees
organization goals survey and suggestions programs give top two ratings give top two ratings
to build teamwork
Enhance information Percentage of Improve off-line data 80% 80%
system capabilities manipulating gathering
processes with
real-time feedback
Improve Number of major Organize 5 5
manufacturing improvements in R&D/manufacturing teams
processes process controls modify processes

Internal Business Process Performance

Three Important Performance Measures

1. Delivery cycle time –the amount of time when an order is received from a customer to when the completed order is shipped.

2. Throughput (Manufacturing Cycle)Time- the amount of time required to turn new materials into completed products.

It is composed of :

➔ Process time- the amount of time work is actually done on the product
➔ Inspection time – is the amount of time spent ensuring that the product is not defective
➔ Move time – is the time required to move materials or partially completed products from workstation to workstation
➔ Queue time- is the amount of time a product spends waiting to be worked on, to be moved, to be inspected, or to be shipped.

3. Manufacturing Cycle Efficiency (MCE) measures the proportion of production time spent on value-added activities.

If the MCE is less than 1, then non-value added is present in the production process. An MCE of .50 for example, would mean that half of
the total production time consisted of non–value activities.

➔ Value-added activities- those activities necessary to remain in business.

➔ Non-value-added activities – all activities other than those that are absolutely essential to remain in business.
➔ Non-value-added costs- are costs that are caused either by non-value-added activities or the inefficient performance of
value-added activities.
Illustrative: Measures of Internal Business Process Performance

ABC Company keeps careful track of the time relating to orders and their production. During the most recent quarter, the following
average times were recorded for each unit of order.

DAYS

Wait time 17.0

Inspection time 0.4

Process time 2.0

Move time 0.6

Queue time 5.0

Goods are shipped as soon as production is completed.

Required:

1. Compute the throughput time or velocity of production

Solution:

Throughput time = Process time + Inspection time + Move time + Queue time

= 2 days + .4 days + .6 days + 5.0 days

= 8 days

2. Compute the manufacturing cycle efficiency (MCE)

MCE = Value added time/ Throughput time

= 2.0 days/ 8.0 days
= .25
Thus, once put into production, a typical unit is actually worked on only 25% of the time.

3. What percentage of the production time is spent in non-value-added activities?

Since the MCE is 25%, the complement of this figure, or 75% of the total production time is
spent on non-value-added activities.

4. Compute the delivery cycle time.

Delivery cycle time = wait time + throughput time

= 17.0 days + 8.0 days

= 25.0 days
EXERCISES – Internal Business Process Performance

1. Which of the following represents value added time in the manufacturing cycle?
a. Inspection time b. Queue time c. Move time d. Process time

2. Throughput time consists of

a. process time
b. inspection time and move time
c. process time, inspection time, and move time
d. process time, inspection time, move time and queue time

3. Rain Corporation has provided the following data for one of its products:
Process time 3 days
Queue time 4 days
Inspection time 0.7 days
Move time 0.3 days
Wait time 9 days
Compute the manufacturing cycle efficiency.

Numbers 4 to 7 are based on the following information:

Wind Company has the following data:
Moving time 8 days
Inspection time 2 days
Processing time 10 days
Storage time 30 days

4. What is the amount of the value added time?

5. What is the total amount of nonvalue-added time?
6. What is the product’s cycle time?
7. What is the MCE?

Numbers 8 and 9 are based on the following information:

Moving time 10 days
Inspection time 5 days
Processing time 15 days
Storage time 20 days

8. What is the product’s cycle time?

9. What is the MCE?
10. MCE is computed as
a. Throughput time/Delivery cycle time
b. Process time/Delivery cycle time
c. Value added time/Throughput time
d. Value added time/Delivery cycle time

Managing Productivity and Marketing Effectiveness

Sustaining profitability and maintaining or improving market share requires effective marketing activities. Effectiveness in marketing,
however, demands proper consideration of factors such as selling price, sales volume, and productivity.

Productivity has become the wealth not only of the business but of nations as well.
Improvements in productivity is achieved when fewer workers, materials, machines, or other resources are used to manufacture and sell
the same or better products.

Among the benefits that higher productivity brings about to business firms are:
1. competitive advantage
2. higher –than average returns and
3. attainment of long-term success

★ Measuring Productivity
Productivity is the ratio of output to input.
➔ Productivity = Output/Input

To improve productivity, firms need to know the productivity levels of their operations.

A productivity measure is often compared to the performance of a prior period, another firm, the industry, or a benchmark in assessing a
firm’s productivity.

A measure of productivity can either be operational or financial productivity.

➔ Operational Productivity = Output units/Input units
➔ Financial Productivity = Peso output/Peso input

Productivity can be:

1. Partial Productivity
➔ Partial productivity measures the relationship between the output and one part of the required input used in producing
the output. The higher the ratio is the better. It is computed as follows:

Examples:
● Direct materials yield = Output/Input of materials
Workforce productivity:
● Output per labor hour = Output/Input of labor hours
● Output per person employed = Output/No. of labor force
● Process(activity) productivity = Output/Machine hours used
a . Partial operational productivity is the required physical amount of an input resource to produce one unit of output.
b. Partial financial productivity of an input resource is the number of units or the value of output manufactured for each peso spent on
the input resource.

2. Total Productivity
➔ shows the relationship between the output and the total cost of all input resources used to produce the output. It is a
financial productivity measure.
ILLUSTRATIVE PROBLEM: Productivity

In the fourth quarter of 2021 Star Company embarked on a major driver to improve productivity. The drive included redesigned products,
reengineered manufacturing processes, and productivity improvement courses. The drive was completed in the last quarter of 2022. The
controller’s office has gathered the following year-end data for the assessment of the drive.

2021 2022
Units manufactured and sold 15,000 18,000
Selling price of the product P40 P40
Materials used (pounds) 12,000 12,600
Cost per pound of material P8 P10
Labor-hours 6,000 5,000
Hourly wage rate P20 P25
Power (kwh) 1,000 2,000
Cost of power per kwh P2 P2
Required:

1. Compute the operational partial productivity ratios for each of the production factors for 2021 and 2022.

Operational Partial Productivity

2021 2022
Direct materials 15,000/12,000= 1.25 18,000/12,600=1.426
Direct labor 15,000/6,000 = 2.50 18,000/5,000 = 3.60
Power 15,000/1000 = 15 18,000/2,000 = 9

2. Compute the financial partial productivity ratios for each of the production factors for 2021 and 2022

Financial Partial productivity

2021 2022
Direct materials 15,000/P96,000=.15625 18,000/126,000 = .1429
Direct labor 15,000/P120,000 = .125 18,000/125,000 = . 144
Power 15,000/P2,000 = 7.50 18,000/P4,000 = 4.50

3. a. Total productivity in units

2021 15,000/P218,000 = .069

2022 18,000/ P255,000 = .071

Pesos

b. Total productivity in sales value

2021 P600,000/P218,000 = 2.752

2022 P720,000/P255,000 = 2.820

EXERCISE: MANAGING PRODUCTIVITY

Selected production data of Press Tool in 2022 and 2023 for manufacturing AA drill bits are made available to the analyst. The
manufacturing costs include total fixed factory overhead and other operating expenses of P300,000 per year and variable manufacturing
costs consisting of metal alloy (direct materials and direct labor hours).
Press Tool Company
Operating Data for AA
2022 2023 % Inc (Dec)
Units of AA manufactured and sold 8,000 9,600
Total sales @ P500 P 4,000,000 P 4,800,000 20%
Direct materials
2022 50,000 x P [Link] 1,200,000
2023 64,000 x P 25/lb 1,600,000 33%
Direct labor
2022 8,000 x P 40/hr 320,000
2023 8,000 x P 50/hr 400,000 25%
Fixed factory overhead and other operating 600,000 600,000
expenses
Operating income P1,880,000 P2,200,000 17%

Required:
1. Compute the partial operational productivity and financial productivity ratios for Press Tool Company in 2022 and 2023.

2. Compute the total productivity ratios in units and in pesos for 2022 and 2023.

Solution:
Press Tool Company
Partial Productivity
Direct Materials and Direct labor for AAA

Partial Operational Productivity

2022 2023
Direct materials 8,000/50,000 = 0.16 9,600/64,000 = 0.15
Direct labor 8,000/8,000 =1.00 9,600/8,000 = 1.20

Partial Financial Productivity

2022 2023
Direct materials 8,000/P1,200,000=0.0067 9,600/P1,600,000=0.006
Direct labor 8,000/ 320,000=0.0250 9,600/ 400,000=0.024

The partial operational productivity of Press Tool Company in 2022 indicates that the firm manufactured 0.16 unit of output for every
pound of direct materials used in production.
Using the productivity level in 2022 as the benchmark to assess productivity in 2023, the operating results show that the partial
operational productivity of the direct materials decreased to 0.15 or a 6.25% (.01/.16) decrease in productivity.

Partial productivity of direct labor, however, improved in 2023. The firm manufactured one unit for each direct labor hour in 2022 and
1.2 units in 2023, a 20% increase in productivity (1.20-1.00)/1.00= .20

2. Total productivity in units

2022 2023
8,000/P1,200,000=0.0067 9,600/P1,600,000=0.006
Managing Marketing Effectiveness

No entity can gain success without effective marketing activities that will enable it to accomplish the following:
➔ Earn the projected operating income
➔ Attend the desired and budgeted market share
➔ Adapt to market change

Summary of Variance Analysis to Assess Marketing Effectiveness

➔ Sales variance = Actual sales - Budgeted sales
➔ Sales price variance = (actual selling price–budgeted selling price )x actual units

Significance: Measures the impact of deviations of the actual selling prices from the master budgeted on contribution margin and
operating income.

➔ Sales Volume variance =( Actual units-budgeted units) x Budgeted contribution margin/unit

Significance : Measures the effect on contribution margin and operating income when the quantity sold for one or more products differs
from the quantity in the master

➔ Sales Mix variance for a product =( Actual sales mix % for the product – Budgeted sales mix % for the product) x Actual total units
of all products sold x Budgeted CM of the product

Significance: Measures the effect on contribution margin and operating income due to the deviation of the actual sales mix from the
budgeted sale mix.

➔ Sales quantity variance for a product = (actual units of all products sold – Budgeted sales units of all products) x Budgeted sales
mix % of the product x Budgeted contribution margin per unit of the product

Significance: Measures the effect on the contribution margin and operating income due to the deviation of the actual total sales units from
the budgeted total units.

➔ Market size variance = (Actual units of the market – Budgeted total units of the market) x Budgeted market share x
Weighted-average budgeted contribution margin per unit

Significance: Measures the effect of changes in the total market-size on the firm’s total contribution margin and operating income

➔ Market share variance= (Actual market share - Budgeted market share) x Actual total units of the industry x Weighted-average
budgeted contribution margin per unit

Significance: Measures the effect of changes in the firm’s market share on its total contribution margin and operating income.

Illustrative Problem:
ABC Company manufactures two products that sell to the same market. Its budget and operating results for 2022 are:

Budgeted Actual
Unit sales
Product A 30,000 35,000
Product B 60,000 65,000
Unit selling price
Product A P10 P12
Product B P25 P24
Unit contribution margin
Product A P4 P3
Product B P10 P12
Industry volume was estimated to be 1,500,000 units at the time the budget was prepared. Actual industry volume was 2,000,000 units.
Required:
1. Compute for the budgeted average unit contribution margin
Product A Product B
Contribution margin per unit P4 P 10
X Budgeted sales 30,000 60,000
Budgeted contribution margin P120,000 P600,000 P720,000
Divided by total budgeted sales 90,000
Budgeted average unit CM P 8

2. Compute for Sales Variance

Actual Sales
Product A (35,000 x P12) P 420,000
Product B (65,000 x P24) 1,560,000 P1,980,000
Less: Budgeted sales
Product A ( 30,000 x P10) 300,000
Product B (60,000 x P25) 1,500,000 1,800,000
Sales variance P 180,000 Fav

3. Compute for Sales price variance

Product A (P12-P10) x 35,000 P70,000 Favorable

Product B (P24-P25) x 65,000 65,000 unfavorable
Sales price variance P 5,000 favorable

4. Compute for Sales volume variance

Products Actual Budgeted Difference Budgeted CM Sales volume

quantity quantity Per unit Variance
A 35,000 - 30,000 5,000 x P4 P20,000 Fav
B 65,000 - 60,000 5,000 X P10 50,000 Fav
100,000 90,000 P 70,000 Fav

5. Compute for Sales Mix Variance

Products Actual Budgeted Difference Total Budgeted Sales mix

sales sales mix Actual contribution variance
mix Quantity margin per unit
A .35 - .3333 .0167 x 100,000 x P4 P 6,680 F
B .65 - .6667 .0167 x 100,000 x P10 16,700 U
P10,020U

6. Compute for Sales quantity variance

Products Total Total Difference Budgeted Budgeted Sales
Actual Budgeted sales mix CM per unit quantity
quantity quantity variance
A 100,000 - 90,000 10,000 x .3333 x P4 P13,332 F
-
B 100,000 - 90,000 10,000 x .6667 x P10 66,670 F
P80,002 F
7. Compute for market share variance

Actual market share (100,000/2,000,000) 5%

Budget market share ( 90,000/1,500,000) 6%
Difference 1%
x Actual units of the industry 2,000,000
20,000
X budgeted average unit contribution margin X P8
Market share variance P 160,000 UF

8. Compute for Market size variance

Actual total units of the market (industry) 2,000,000

Less: Budgeted total units of the Market 1,500.000
Difference 500,000
X Budgeted market share 6%
30,000
X Budgeted average unit contribution margin P8
Market size variance P240,000 Fav

EXERCISES –MARKETING EFFECTIVENESS

A.
ABC Company manufactures one product. Its budget and operating results for 2023 are:
Budgeted Actual
Unit sold 90,000 100,000
Unit contribution margin P8 P 10
Unit selling price P20 P21
Industry volume was estimated to be 1,500,000 units at the time the budget was prepared. The actual industry volume for the period was
2,000,000 units.
Required:
1. Compute the market size variance.
2. Compute the market share variance
3. Compute the sales quantity variance

1. Market size variance

Actual quantity 2,000,000
Less: Budgeted quantity 1,500,000
Difference 500,000
X Budgeted Market Share % X 6%
30,000
X Budgeted Contribution margin X P8
P 240,000 Favorable
2. Market share variance
Actual market share % (100,000/2,000,000) 5%
Less: Budgeted market share (90,000/1,500,000) 6%
Difference 1%
X Actual quantity x 2,000,000
20,000
X Budgeted contribution margin X P8
P 160,000 unfav
3. Sales quantity variance
Actual quantity 100,000
Less: Budgeted quantity 90,000
Difference 10,000
X Budgeted contribution margin X P8
P 80,000 Favorable
B.
XYZ Galore sells two chips to small machine tool manufacturers: AA and BB. Pertinent data for 2023:
Budgeted Actual
AA BB AA BB
Selling price per unit P 50 P160 P55 P155
Variable cost per chip 40 90 43 95
Contribution margin per chip P10 P 70 P12 P 60
Fixed cost per chip 6 30 5 25
Operating income P4 P40 P7 P35
Sales in units 1,200 400 1,000 1,000

Required:
1. What is AA’s sales quantity variance? P3,000 Fav.
2. What is BB’s sales mix variance? P35,000 Fav.
3. What is total sales volume variance? P40,000 Fav.

1. AA’s Sales quantity variance

Products Total Total Difference Budgeted Budgeted Sales
Actual Budgeted sales mix CM per unit quantity
quantity quantity variance
AA 2,000 - 1,600 400 x .75 x P 10 P3.000 F
-
BB 2,000 - 1,600 400 x .25 x P70 P7,000 F
P10,000 F
2. BB’s sales mix variance
Products Actual Budgeted Difference Total Budgeted Sales mix
sales sales mix Actual contribution variance
mix Quantity margin per
unit
AA .50 - .75 (.25 ) x 2,000 x P 10 P 5,000 UF
BB .50 - .25 .25 x 2,000 x P70 35,000 F
P30,000 F
3. Total Sales volume variance

Products Actual Budgeted Difference Budgeted CM Sales volume

quantity quantity Per unit Variance
AA 1,000 - 1,200 ( 200) x P10 P2,000 UF
BB 1,000 - 400 600 X P70 42,000 Fav
P 40,000 Fav

3. Total sales volume variance

AA (1,000-1,200 ) x P10 = P2,000 unfavorable
BB ( 1,000-400) x P70 = 42,000 favorable
P40,000 favorable
Quality
● refers to the organization’s ability to deliver its service commitments.

Total Quality Management –an approach to continuous improvement that focuses on serving customers and uses frontline workers to
identify and solve problems systematically.

Quality involves conformance with specifications for products or services that meet or exceed customer requirements and expectations.
The quality of a product or service is one that meets customers’ expectations, In effect, quality is customer satisfaction.

A product or service is one that meets or exceeds customer expectations in the following domains:

1. Performance – how consistently and how well a product functions (product’s primary operating characteristics)
2. Features – indicates customer perception of quality (quality of design, differentiate functionality of similar products)
3. Reliability – the product or service will perform its intended function for a specified length of time.
4. Conformance –the degree to which the product or service design specifications are met.
5. Durability –indicates the operational life of a product (length of time a product functions)
6. Serviceability-how readily a product can be serviced back into an operational mode (ease of maintaining or repairing the product)
7. Aesthetics –the appearance of tangible products as well as the appearance of facilities
8. Perceived quality – directly related to the reputation of the firm that manufactures the product (suitability of the product for carrying
on its advertise function)
Quality costs include conformance and nonconformance costs.
Conformance costs are incurred to ensure that a product meets the minimum quality standard.
Nonconformance costs are the incremental costs incurred by a business when it fails to meet the
quality requirements for the product.

Cost of Quality

1. Prevention costs
These are costs incurred to avoid poor-quality goods and services. These include
➔ Systems development
➔ Quality engineering
➔ Quality circles
➔ Statistical process control activities
➔ Supervision of prevention activities
➔ Quality data gathering, analysis, and reporting
➔ Quality improvement projects
➔ Technical support provided to suppliers
2. Appraisal costs
These are costs incurred to determine the degree of conformance to quality requirements.
➔ Test and inspection of incoming materials
➔ Supervision of testing and inspection activities
➔ Test and inspection of in-process goods
➔ Finished product testing and inspection
➔ Maintenance of test equipment
➔ Field testing and appraisal at the customer site
3. Internal failure costs
These are costs that result from the identification of defects during the appraisal process.
➔ Rework
➔ Repairs
➔ Retooling changes
➔ Debugging of software errors
➔ Production downtime
➔ Retesting of reworked products
➔ Re-inspection of reworked products

4. External failure costs

These are costs incurred when poor quality goods or services are detected after delivery to customers.
➔ Warranty, repairs, and replacements
➔ Product recalls
➔ Lost sales resulting from a reputation for poor quality
 ➔ Liability arising from defective products
➔ Returns and allowances arising from quality problems.
➔ Cost of field servicing and handling complaints
➔ Repairs and replacements beyond the warranty period.
Prevention and appraisal costs are costs of conformance because they are incurred to ensure that products and services meet customers’
expectations.
Internal failure and external failure costs are costs of nonconformance because they are costs incurred and opportunity costs because of
the rejection of products or services.
The cost of quality is the sum of conformance and nonconformance costs.

ILLUSTRATIVE PROBLEM -Cost of Quality

Reporting quality costs
The purpose of reporting quality costs is to make management aware of the magnitude of quality costs and to provide a baseline against
which the impact of quality improvement activities could be measured.

The Black Company manufactures custom-designed milling machines and incurred the following costs of quality for 2022 and 2023:
2023 2022
Rework P 200,000 P 250,000
Quality Manual 40,000 50,000
Product design 300,000 270,000
Testing 80,000 60,000
Retesting 50,000 90,000
Product recalls 360,000 500,000
Field service 230,000 350,000
Disposal of defective units 90,000 85,000

The total sales in each of the two years were P6,000,000. The firm’s cost of goods sold is typically one-third of the net sales.
Required:
1. Prepare a cost-of-quality report that classifies the firm’s cost under the proper cost-of-quality category.
2. Calculate the ratio of each cost-of-quality category to sales in each of the two years. Comment on the trends in the cost of quality
between 2022 and 2023

Solution:
1.
Black Company
Cost of Quality Report
For 2022 and 2023
Cost of quality category Percent Percent
of total of total
sales sales
2023 2022
Prevention costs
Quality Manual P 40,000 P 50,000
Product design 300,000 P 340,000 5.67% 270,000 P320,000 5.33%
Appraisal costs
Testing 80,000 80,000 1.33% 60,000 60,000 1.00%
Internal failure costs
Rework 200,000 250,000
Retesting 50,000 90,000
Disposal of defective 90,000 340,000 5.67% 85,000 425,000 7.08%
units
External failure costs
Product recalls 360,000 500,000
Field service 230,000 590,000 9.83% 350,000 850,000 14.17%
Total costs of quality P1,350,000 22.50% P1,655,000 27.58%
EXERCISES –Cost of Quality
A. Classify the following items into types of cost of quality:
1. Warranty repairs External failure costs
2. Scrap Internal failure costs
3. Allowance granted due to blemish External failure costs
4. Contribution margin of lost sales External Failure Costs
5. Tuition for quality courses Prevention costs
6. Work in-process inspection Appraisal costs
7. Shipping costs for replacements External Failure costs
8. Recalls External failure costs
9. Inspection of reworks Internal failure cost
10. Tuning of testing equipment Prevention cost

B. The Gabriel Corporation manufactures and sells industrial grinders. The following table presents financial information pertaining to
quality in 2022 and 2023

2023 2022
Revenues P 12,500,000 P10,000,000
Line inspection 85,000 110,000
Scrap 200,000 250,000
Design Engineering 240,000 100,000
Cost of returned goods 145,000 60,000
Product-testing equipment 50,000 50,000
Customer support 30,000 40,000
Rework cost 135,000 160,000
Preventive equipment maintenance 90,000 35,000
Product liability claims 100,000 200,000
Incoming materials inspection 40,000 20,000
Breakdown maintenance 40,000 90,000
Product-testing labor 75,000 220,000
Training 120,000 45,000
Warranty repair 200,000 300,000
Supplier evaluation 50,000 20,000

Required:
1. Classify the cost item into the four costs of quality categories.
2. Calculate the ratio of each category to revenues in 2022 and 2023.

Cost of quality category Percent Percent

of total of total
sales sales
2023 2022
Sales P12,500,000 P10,000,000
Prevention costs
Design Engineering P 240,000 100,000
Preventive equipment 90,000 35,000
maintenance
Training 120,000 45,000
Supplier evaluation 50,000 P500,000 4% 20,000 200,000 2%
Appraisal costs
Line inspection 85,000 110,000
Product testing 50,000 50,000
equipment
Incoming materials 40,000 20,000
inspection
 Product-testing 75,000 250,000 2% 220,000 400,000 4%
labor

Internal failure costs

Scrap 200,000 250,000
Rework cost 135,000 160,000
Breakdown 40,000 375,000 3% 90,000 500,000 5%
maintenance

External failure costs

Cost of returned 60,000
goods 145,000
Customer support 30,000 40,000
Product liability 100,000 200,000
claims
Warranty repair 200,000 475,000 3.8% 300,000 600,000 6%
Total costs of quality P1,600,000 12.8% P1,700,000 17%

Standard Costing
The purpose of standard cost accounting is to control costs and promote efficiency. It is concerned with cost per unit and serves basically
the same purpose as a budget.

Standards are yardsticks that measure achievement or lack of achievement.

Standard costs are the scientifically predetermined costs of manufacturing a single unit or a number of units of product or of rendering
service during a specified period
of time.
Uses of standard costs
1. Cost control
2. Pricing decisions
3. Performance Appraisal
4. Cost awareness
5. Management by objectives
Comparison of Actual, Normal and Standard Costing

Actual Costing Normal Costing Standard Costing

Direct Materials Actual Actual Standard

Direct Labor Actual Actual Standard

Factory Overhead Actual Applied Standard

How are standards set

Setting Direct materials standard
The first step in developing material standards is to identify and list the specific direct materials used to manufacture the product.

Four things that must be known about material input in standards development
1. Type of material needed
2. Quality of materials needed
3. Quantity needed
4. Price (cost) per unit
a. Standard quantity- quantity of direct materials that should go into the production of one finished unit.
b. Standard price –the unit price at which direct materials should be purchased.
Setting labor standards

a. Standard time -the number of direct labor hours that should go into the production of one finished unit.
 b. Standard labor rate –the standard rate of pay that an individual will receive based on the type of job being performed and the
experience that the person has had on the job.
Setting overhead standards
Factory overhead cost standards provide a means of allocating factory overhead. A standard cost system uses budgeted rates based on
standard hours or other cost drivers allowed for actual production.

Operating Performance Evaluation

Variance Analysis

One of the major purposes of using the standard cost system is to aid management in controlling the cost of production. Standards enable
management to make periodic comparisons of actual results with standard (or planned) results. Differences that arise between actual
results and planned results are called variances.

Variance analysis is a technique that can be used by management to measure performance, correct inefficiencies, and deal with
accountability functions.

Direct Material Variance Analysis

The difference between the actual cost and the standard cost of materials used is called a material cost variance. This variance is made up
of a price variance and a usage or quantity or efficiency variance.

The material price variance is caused by paying a higher or lower price than the standard price for materials

Material price variance

The materials usage variance is caused by using more or less than the standard amount
of materials to produce a product.

Material quantity variance or material usage variance

When the manufacturing process uses several different direct materials that are supposed to be combined in a standard proportion, the
material quantity variance may be broken down into:
a. Material mix variance
b. Materials yield variance

Materials Mix Variance Materials Yield Variance

Actual quantity x standard price (per Total Actual Input x Average

material) standard price Pxx

Less: Total Actual input x Average Less: Standard quantity x

standard price standard price (per material) xx

(Fav) Unfavorable (Fav) Unfavorable

Possible causes of material price variance
1. Fluctuations in market prices of materials.
2. Purchasing from distant suppliers, which results in additional transportation costs.
3. Failure to take cash discounts.
4. Purchasing of materials of inferior or substandard quality
5. Unfavorable contract terms

Possible causes of material quantity variance

1. Waste and loss of material in handling and processing
2. Substitution of defective or nonstandard materials.
3. Lack of proper tools or machines
4. Spoilage or production of excess scrap because of inexperienced workers of poor supervision.
5. Variation in yields from materials.
Direct labor variance analysis
Labor cost variance is the difference between actual labor cost and standard labor cost. The variance may be analyzed into labor rate
variance and labor usage or labor time or labor efficiency variance.
The labor rate variance is caused by paying a higher or lower rate of pay than standard to produce a product or complete a process

Labor rate variance

Labor Efficiency variance is caused by using more or less than the standard amount of labor hours to produce a product or complete
process.

Labor efficiency variance

If several different materials are used in the manufacturing process, the labor usag variance may be further analyzed into:

a. Labor efficiency variance b. Labor yield variance

Actual hours x standard rate Standard hours based on actual input

Less: Standard hours based on actual Less: Standard hours based on actual output x
input x standard labor rate standard labor rate

LEV LYV

Possible causes of labor rate variance

1. Inexperienced workers hired.
2. Change in labor rate
3. Use of an employee having a wage classification other than that assumed when the standard for a job was set.
4. Use of a greater number of higher-paid employees in the group than anticipated.

Possible causes of labor efficiency variance

1. Good or poor training of workers.
2. Poor materials or faulty equipment.
3. Good or poor supervision and scheduling of work.
4. Experience or lack of experience on the job.
5. Inefficient equipment
6. Machine breakdown
Factory overhead variances

To evaluate performance, predetermined standard costs are compared with actual cost incurred.

ONE FACTOR ANALYSIS

Actual factory overhead Pxx

Less: Standard factory overhead (Std hours x std. FOH rate) xx

Total factory overhead variance

Two Variance Method

1) Controllable variance is the difference between actual factory overhead and budgeted overhead on the basis of standard direct
labor hours allowed. A variance will occur if a company actually spends more or less than the direct number of hours allowed.

Actual factory overhead Pxx

Less: Budget allowed based on standard hours

Fixed overhead (at normal capacity) Pxx
Variable overhead( Std. hrs. x Variable OH rate xx
Controllable variance P xx

2) Capacity variance- the difference between budgeted overhead on the basis of standard labor hours allowed and standard factory
overhead applied to production.
Volume or capacity variance

Budget allowed based on standard hours Pxx

Less: Standard hours x standard overhead rate xx
Volume variance xx

❖ Standard hours = Equivalent production or Allowed hours based on actual production x standard hours per unit

Three Variance Method

1. Spending variance is the difference between actual factory overhead and budgeted factory overhead based on the basis of actual
direct labor hours worked.
Spending variance

Actual factory overhead

Less: Budget allowed at actual hours
Fixed overhead (normal capacity)
Variable overhead (actual hrs. x variable OH rate)
Spending variance
2. Variable Efficiency variance: a variance will occur if workers are more or less efficient than planned.

Budget allowed on actual hours

Less: Budget allowed on standard hours
Fixed (at normal capacity)
Variable( std. hrs. x variable OH rate)
Variable efficiency variance
 3. Volume (Production, Idle capacity) variance is also known as the denominator variance because the variance is the result of
production of activity level different from that used as denominator to calculate fixed factory overhead application rate.

Budget allowed on standard hours

Less: Standard hours x standard overhead rate
Volume variance

Four Variance Method

A. Variable overhead variance

Total variable manufacturing overhead variance is the difference between actual variable overhead and standard variable overhead
allowed on actual input. This may be broken down into:

Possible causes of variable overhead spending variance

1. Actual costs were different from those expected because of fluctuations in market prices or rates.
2. Increase in energy costs.
3. Waste in using supplies.
4. Avoidable machine breakdowns.
5. Wrong grade of indirect material and indirect labor.
6. Lack of operators or tools.
Possible causes of capacity or volume variance
1. Poor production scheduling.
2. Unusual machine breakdowns.
3. Storms or strikes.
4. Fluctuations over time
5. Decrease in customer demand
6. Excess plant capacity
7. Shortage of skilled workers

B. Fixed overhead variance

When budgeted factory overhead or the factory overhead rate is given in one figure only so that the budget allowances for capacities
other than normal cannot be reasonably determined, the fixed budget analysis is used. The budgeted factory overhead is used regardless
of the capacity attained and the standard number of hours. Variance analysis may be done as follows:
Illustrative Problem: Flexible Budgeting

Last month, the following events took place at ABC Company:

a. Produced and sold 50,000 plastic containers at a sales price of P10 each.

b. Standard variable cost per unit

Direct materials: 2 pounds @ P1 P 2.00
Direct labor: .10 hours @P15 1.50
Variable manufacturing overhead: .10 hours @ P5 .50
Total P 4.00

c. Fixed manufacturing overhead costs

Monthly budget for 40,000 containers or 4,000 hours, P80,000

d. Actual production costs

Direct materials purchased 200,000 pounds @P1.2 P 240,000

Direct materials used 110,000 pounds @ P1.2 132,000
Actual labor cost 84,000
Variable factory overhead 36,000
Fixed factory overhead 75,000

Required:

1. Compute the materials, labor, and overhead variances.

2. Journal entries to record the given information.

Solution:
Computations:

1. Standard quantity
Actual units produced x Std. Mat. required per unit =50,000 x 2 =100,000 lbs.

2. Standard hours
Actual units produced x hrs. required per unit = 50,000 x.10 = 5,000 hours

3. Factory overhead rate per hour

Variable Overhead rate per hour P 5.00
Fixed Overhead rate per hour ( P80,000/4,000 hours) 20.00
FOH rate per hour P 25.00

4. Standard cost per unit

Standard variable cost per unit P 4.00
Fixed overhead rate per unit ( P80,000/40,00o units) 2.00
Standard cost per unit P 6.00

Material Cost Variances

1) Direct material price variance

Actual materials purchased (Actual quantity x Actual price) P 240,000

Less: Actual quantity x standard price( 200,000 x P1) 200,000
Direct material price variance -unfavorable P 40,000

or
Direct Material price variance
Actual price P 1.20
Less: Standard price 1.00
Difference in price .20
X Actual quantity purchased 200,000
Material price variance-unfavorable P 40,000

2. Direct materials usage variance

Actual quantity used @ standard price (110,000 lbs. x P1) P 110,000

Less: Standard quantity @standard price (100,000 lbs. x P1) 100,000
Direct material usage variance- unfavorable P 10,000

or
Actual quantity used 110,000
Less: Standard quantity (50,000 units x 2 lbs.) 100,000
Difference in quantity 10,000
X standard price P 1.00
Direct material usage variance-unfavorable P 10,000

B. Labor Cost Variance

Actual labor cost (AH x AR = 6,000 hours x P14) P 84,000

Less: Standard labor costs ( SH x SR = 5,000 x P15) 75,000
Labor cost variance – Unfavorable P 9,000
❖ Standard hours (50,000x.10) = 5,000 hours

Direct Labor rate variance

Actual labor cost (AH x AR ) P 84,000
Less: Actual hours x standard rate (6,000 hours x P15) 90,000
Direct labor rate variance -favorable P( 6,000)
or
Actual labor rate per hour P 14
Less: Standard labor rate per hour 15
Difference in rate ( 1)
X Actual hours 6,000
Labor rate variance- favorable P(6,000)

Direct Labor Efficiency variance

Actual hours @ standard labor rate (6,000 x P15) P 90,000
Less: Standard hours @ standard rate ( 5,000 x P15) 75,000
Direct labor efficiency variance -unfavorable P 15,000
or
Actual hours 6,000
Less: Standard hours 5,000
Difference in hours 1,000
X standard labor rate per hour X P15
Direct labor efficiency variance-unfavorable P15,000

C. Factory overhead variance

Actual factory overhead (P36,000 + P75,000) P 111,000
Less: Standard hours x Standard FOH rate) = 5,000 x P25* 125,000
Total Factory overhead variance – favorable P( 14,000)

1) Two Variance Method

Controllable variance
Actual factory overhead P 111,000
Less: Budget Allowed on standard hours
Fixed factory overhead P 80,000
Variable factory overhead (5,000 hours x P5) 25,000 105,000
Controllable variance –unfavorable P 6,000

2) Volume Variance
Budget allowed on standard hours P 105,000
Less: Standard hours x standard FOH rate (Std. FOH Cost) 125,000
Volume variance –favorable P ( 20,000)

2) Three Variance Method

Spending Variance
Actual factory overhead P 111,000
Less: Budget allowed on actual hours
Fixed factory overhead P 80,000
Variable factory overhead (6,000 hours x P5) 30,000 110,000
Spending variance- unfavorable P 1,000

Variable Efficiency variance

Budget allowed on actual hours P 110,000
Less: Budget allowed on standard hours 105,000
Variable efficiency variance –unfavorable P 5,000

Volume Variance
Budget allowed on standard hours P 105,000
Less: Standard hours x standard FOH rate 125,000
Volume variance- favorable P( 20,000)

3) Four Variance method

Variable overhead spending variance
Actual variable factory overhead P 36,000
Less: Actual hours x Variable FOH rate (6,000 x P5) 30,000
Variable spending variance-unfavorable P 6,000

Variable overhead efficiency variance

Actual hours x variable FOH rate P 30,000
Less: Standard hours x Variable FOH rate (5,000 x P5) 25,000
Variable efficiency variance - unfavorable P 5,000

Fixed overhead spending variance

Actual fixed FOH P 75,000
Less: Fixed FOH at normal capacity 80,000
Fixed overhead spending variance-favorable P( 5,000)

Volume variance
Budgeted fixed overhead at normal capacity P 80,000
Less: Standard hours x Fixed FOH rate (5,000 x P20) 100,000
Volume variance-favorable P(20,000)

2. Journal Entries

Debit Credit
1. Direct materials inventory (200,000lbs x P1) 200,000
Material price variance 40,000
Accounts payable (200,000 x P1.2) 240,000
To record the purchase of 200,000 lbs. of
Materials at an actual cost of P1.20 per lb.
and to record the transfer to the Direct
Materials Inventory at the standard cost of
P1 per lb.

2. Work in process inventory 100,000

Materials efficiency variance 10,000
Direct materials inventory 110,000
To record the requisition of 110,000 lbs. of
materials at the standard cost of P1 per lb.
and to charge Work in Process Inventory
with the standard usage of 100,000 lbs. of
materials at the standard price

3. Work in process inventory (5,000 x P15) 75,000

Labor efficiency variance 15,000
Labor rate variance 6,000
Accrued payroll (6,000 x P14) 84,000
To charge Work in Process Inventory for the
standard cost of direct labor cost at P15 per
hour times 5,000 standard hours allowed
and to record the actual cost of P14 per hour
times the 6,000 hours actually worked.

4. Factory overhead control 111,000

Various credit accounts 111,000
To record actual overhead incurred

5. Work in process SH x SOR (5,000 hours x P25) 125,000

 Factory overhead applied 125,000
To record overhead applied to production

7. Factory overhead applied 125,000

Factory overhead controllable variance 6,000
Factory overhead volume variance 20,000
Factory overhead control 111,000

8. Finished goods inventory (50,000 x P6) 300,000

Work in process 300,000

9. Accounts receivable (50,000 x P10) 500,000

Sales 500,000

10. Cost of goods sold (50,000 x P6) 300,000

Finished goods 300,000
Illustrative Problem: Flexible Budgeting

Last month, the following events took place at ABC Company:

a. Produced and sold 50,000 plastic containers at a sales price of P10 each.

b. Standard variable cost per unit

Direct materials: 2 pounds @ P1 P 2.00
Direct labor: .10 hours @P15 1.50
Variable manufacturing overhead: .10 hours @ P5 .50
Total P 4.00

c. Fixed manufacturing overhead costs

Monthly budget for 40,000 containers or 4,000 hours, P80,000

d. Actual production costs

Direct materials purchased 200,000 pounds @P1.2 P 240,000

Direct materials used 110,000 pounds @ P1.2 132,000
Actual labor cost 84,000
Variable factory overhead 36,000
Fixed factory overhead 75,000

Required:

1. Compute the materials, labor, and overhead variances.

2. Journal entries to record the given information.

Solution:

Computations:

1. Standard quantity
Actual units produced x Std. Mat. required per unit =50,000 x 2 =100,000 lbs.

2. Standard hours
Actual units produced x hrs. required per unit = 50,000 x.10 = 5,000 hours

3. Factory overhead rate per hour

Variable Overhead rate per hour P 5.00
Fixed Overhead rate per hour ( P80,000/4,000 hours) 20.00
FOH rate per hour P 25.00
4. Standard cost per unit
Standard variable cost per unit P 4.00
Fixed overhead rate per unit ( P80,000/40,00o units) 2.00
Standard cost per unit P 6.00

Material Cost Variances

1) Direct material price variance

Actual materials purchased (Actual quantity x Actual price) P 240,000

Less: Actual quantity x standard price( 200,000 x P1) 200,000
Direct material price variance -unfavorable P 40,000

or
Direct Material price variance
Actual price P 1.20
Less: Standard price 1.00
Difference in price .20
X Actual quantity purchased 200,000
Material price variance-unfavorable P 40,000

2. Direct materials usage variance

Actual quantity used @ standard price (110,000 lbs. x P1) P 110,000

Less: Standard quantity @standard price (100,000 lbs. x P1) 100,000
Direct material usage variance- unfavorable P 10,000

or
Actual quantity used 110,000
Less: Standard quantity (50,000 units x 2 lbs.) 100,000
Difference in quantity 10,000
X standard price P 1.00
Direct material usage variance-unfavorable P 10,000

B. Labor Cost Variance

Actual labor cost (AH x AR = 6,000 hours x P14) P 84,000

Less: Standard labor costs ( SH x SR = 5,000 x P15) 75,000
Labor cost variance – Unfavorable P 9,000
❖ Standard hours (50,000x.10) = 5,000 hours

Direct Labor rate variance

Actual labor cost (AH x AR ) P 84,000
Less: Actual hours x standard rate (6,000 hours x P15) 90,000
Direct labor rate variance -favorable P( 6,000)

or
Actual labor rate per hour P 14
Less: Standard labor rate per hour 15
Difference in rate ( 1)
X Actual hours 6,000
Labor rate variance- favorable P(6,000)

Direct Labor Efficiency variance

Actual hours @ standard labor rate (6,000 x P15) P 90,000
Less: Standard hours @ standard rate ( 5,000 x P15) 75,000
Direct labor efficiency variance -unfavorable P 15,000
or
 Actual hours 6,000
Less: Standard hours 5,000
Difference in hours 1,000
X standard labor rate per hour X P15
Direct labor efficiency variance-unfavorable P15,000

C. Factory overhead variance

Actual factory overhead (P36,000 + P75,000) P 111,000
Less: Standard hours x Standard FOH rate) = 5,000 x P25* 125,000
Total Factory overhead variance – favorable P( 14,000)

1) Two Variance Method

Controllable variance
Actual factory overhead P 111,000
Less: Budget Allowed on standard hours
Fixed factory overhead P 80,000
Variable factory overhead (5,000 hours x P5) 25,000 105,000
Controllable variance –unfavorable P 6,000

2) Volume Variance
Budget allowed on standard hours P 105,000
Less: Standard hours x standard FOH rate (Std. FOH Cost) 125,000
Volume variance –favorable P ( 20,000)

2) Three Variance Method

Spending Variance
Actual factory overhead P 111,000
Less: Budget allowed on actual hours
Fixed factory overhead P 80,000
Variable factory overhead (6,000 hours x P5) 30,000 110,000
Spending variance- unfavorable P 1,000

Variable Efficiency variance

Budget allowed on actual hours P 110,000
Less: Budget allowed on standard hours 105,000
Variable efficiency variance –unfavorable P 5,000

Volume Variance
Budget allowed on standard hours P 105,000
Less: Standard hours x standard FOH rate 125,000
Volume variance- favorable P( 20,000)

3) Four Variance method

Variable overhead spending variance

Actual variable factory overhead P 36,000
Less: Actual hours x Variable FOH rate (6,000 x P5) 30,000
Variable spending variance-unfavorable P 6,000

Variable overhead efficiency variance

Actual hours x variable FOH rate P 30,000
Less: Standard hours x Variable FOH rate (5,000 x P5) 25,000
Variable efficiency variance - unfavorable P 5,000
Fixed overhead spending variance
Actual fixed FOH P 75,000
Less: Fixed FOH at normal capacity 80,000
Fixed overhead spending variance-favorable P( 5,000)

Volume variance
Budgeted fixed overhead at normal capacity P 80,000
Less: Standard hours x Fixed FOH rate (5,000 x P20) 100,000
Volume variance-favorable P(20,000)

2. Journal Entries

Debit Credit
1. Direct materials inventory (200,000lbs x P1) 200,000
Material price variance 40,000
Accounts payable (200,000 x P1.2) 240,000
To record the purchase of 200,000 lbs. of
Materials at an actual cost of P1.20 per lb.
and to record the transfer to the Direct
Materials Inventory at the standard cost of
P1 per lb.

2. Work in process inventory 100,000

Materials efficiency variance 10,000
Direct materials inventory 110,000
To record the requisition of 110,000 lbs. of
materials at the standard cost of P1 per lb.
and to charge Work in Process Inventory
with the standard usage of 100,000 lbs. of
materials at the standard price

3. Work in process inventory (5,000 x P15) 75,000

Labor efficiency variance 15,000
Labor rate variance 6,000
Accrued payroll (6,000 x P14) 84,000
To charge Work in Process Inventory for the
standard cost of direct labor cost at P15 per
hour times 5,000 standard hours allowed
and to record the actual cost of P14 per hour
times the 6,000 hours actually worked.

4. Factory overhead control 111,000

Various credit accounts 111,000
To record actual overhead incurred

5. Work in process SH x SOR (5,000 hours x P25) 125,000

Factory overhead applied 125,000
To record overhead applied to production

7. Factory overhead applied 125,000

Factory overhead controllable variance 6,000
Factory overhead volume variance 20,000
Factory overhead control 111,000

8. Finished goods inventory (50,000 x P6) 300,000

Work in process 300,000
 9. Accounts receivable (50,000 x P10) 500,000
Sales 500,000

10. Cost of goods sold (50,000 x P6) 300,000

Finished goods 300,000

EXERCISES- STANDARD COSTING

A. ABC Company had budgeted 50,000 units of output using 50,000 units of raw materials at a total material cost of P100,000. Actual
output was 50,000 units of the product requiring 45,000 units of raw materials at a cost of P2.10 per unit.

Required: Compute the direct material price variance and material usage variance.
Solution:
Actual price P2.10
Less: Standard price (P100,000/50,000) 2.00
Difference .10
X Actual quantity used 45,000
Material price variance-unfavorable P4,500

Actual quantity 45,000

Less: Standard quantity 50,000
Difference ( 5,000)
X standard price P2.00
Material quantity variance- favorable P(10,000)

B. Nat Company uses a standard cost system. Information for raw materials for Product E for the month of October is as follows:
Standard unit price P 1.60
Actual purchase price per unit 1.55
Actual quantity purchased 2,000 units
Actual quantity used 1,900 units
Standard quantity allowed for actual production 1,800 units

Required: Compute the material price variance

Solution:
MPV = (Actual Price-Standard Price) x Actual quantity purchased
(P1.55-1.60) x2,000 = P100 favorable

C. Information on XYZ Company’s direct material costs is as follows:

Actual units of direct material used 20,000
Actual direct material cost P40,000
Standard price per unit of direct materials P2.10
Direct materials efficiency variance- favorable P3,000
What was XYZ’s direct material price variance?
Solution:
Actual price ( P40,000/20,000 units) P2.00
Less: Standard price 2.10
Difference P( .10)
X actual quantity used 20,000
Material price variance-favorable` P(2,000)

D. Information on CD Company’s direct material cost is as follows:

Standard unit price P 3.60
Actual quantity purchased 1,600
Standard quantity allowed for actual production 1,450
Materials purchase price variance-favorable P 240
What was the actual purchase price per unit, rounded to the nearest centavo?
Solution:
Actual price ? P 3.45
Less: Standard price 3.60
Difference ( .15)
X Actual quantity purchased 1,600
Material purchase price variance-favorable P ( 240)

E. B Company uses a standard cost system. Direct labor information for product AA for the month of October is as follows:
Standard price P 6.00 per hour
Actual rate paid P 6.10 per hour
Standard hours allowed for actual production 1,500 hours
Labor efficiency variance – unfavorable P 600

What are the actual hours worked?

Solution:
Actual hours? 1,600
Less: Standard hours 1,500
Difference 100
X standard labor rate P 6
Labor efficiency variance-unfavorable P 600

F. C Company’s direct labor costs for the month of July 2022 were as follows:
Actual direct labor hours 20,000
Standard direct labor hours 21,000
Direct labor rate variance –unfavorable P3,000
Total payroll P 126,000

What was C’s direct labor efficiency variance?

Solution:
Actual labor rate (P126,000/20,000 hours) P 6.30
Less: Standard rate ? 6.15
Difference (P3,000/20,000) .15
X actual hours 20,000
Labor rate variance-unfavorable P3,000

Labor efficiency variance

Actual hours 20,000
Less: standard hours 21,000
Difference (1,000)
X standard rate P 6.15
Labor efficiency variance-favorable P(6,150)

G. D Corporation’s direct labor costs for the month of March 2022 were as follows:
Standard direct labor hours 42,000
Actual direct labor hours 40,000
Direct labor rate variance-favorable P8,400
Standard direct labor rate per hour P 6.30

What was D’s total direct labor payroll for the month of March 2022?
Solution:
Actual rate ? P 6.09
Less: standard rate 6.30
Difference (P8,400/40,000 hours) ( .21)
X actual hours 40,000
Labor rate variance-favorable P(8,400)
Total direct labor payroll (40,000 hours x P6.09) P243,600
H. HH Company makes a single product which has the following standards:
Direct materials P 2.5 ounces at P20 per ounce
Direct labor 1.4 hours at P12.50 per hour
Variable manufacturing overhead 1.4 hours at ?

Variable manufacturing overhead is assigned on the basis of direct labor hours. The following data are available for October:
● 3,750 units of the compound were produced during the month.
● There was no beginning direct materials inventory.
● The ending direct materials inventory was 2,000 ounces.
● Direct materials purchased: 12,000 ounces for P225,000.
● Direct labor hours worked: 5,600 hours at a cost of P67,200.
● Variable manufacturing overhead costs incurred amounted to P18,200.
● Variable manufacturing overhead applied to products, P18,375/5,250=P3.50
Required:
1. Compute the direct materials price variance for October.
2. Compute the direct materials quantity variance for October.
3. Compute the direct labor efficiency variance for October.
4. Compute the variable overhead spending variance for October.
5. Compute the variable overhead efficiency variance for October.

Solutions:
1. Material price variance
Actual price (P225,000/12,000) P18.75
Less: Standard price 20.00
Difference P( 1.25)
X Actual quantity purchased 12,000
MPV- favorable P(15,000)

2. Materials quantity variance

Actual quantity used (12,000-2,000) 10,000
Less: Standard quantity (3750 x 2.5 ounces) 9,375
Difference 625
X Standard price P 20.00
MQV-Unfavorable P12,500

3. Labor efficiency variance

Actual hours 5,600
Less: Standard hours (3,750 x 1.4 hrs.) 5,250
Difference 350
x Standard rate P12.50
LEV- Unfavorable P4,375

4. Variable overhead spending variance

Actual variable FOH P18,200
Less: Actual hours x Std. variable FOH rate (5,600 x P3.50) 19,600
VOH spending variance- Favorable P(1,400)

5. VOH efficiency variance

Actual hrs. x Std. var. FOH rate P19,600
Less: Standard hrs. x std. var. FOH rate (5,250 x P 3.50) 18,375
VOH efficiency variance-Unfavorable P 1,225
Or
AH-SH x Std. VFOR (5,600-5,250) x P3.50 =P1,225
I. ABC Mills, Inc. is a large producer of men’s and women’s clothing. The company uses standard costs for all of its products. The standard
costs and actual costs for a recent period are given below for one of the company’s product lines (per unit of product):
Standard cost Actual cost
Direct materials:
Standard: 4.0 yards at P3.60 per yard P 14.40
Actual: 4.4 yards at P3.35 per yard P 14.74
Direct labor:
Standard: 1.6 hours at P4.50 per hour 7.20
Actual: 1.4 hours at P4.85 per hour 6.79
Variable manufacturing overhead:
Standard: 1.6 hours at P1.80 per hour 2.88
Actual: 1.4 hours at P2.15 per hour 3.01

During the period, the company produced 4,800 units of product. A comparison of standard and actual costs for the period on a total
costs basis is shown below:

Actual costs (4,800 units at P24.54) P 117,792

Less: Standard costs ( 4,800 x P24.48) 117,504
Total cost variance- Unfavorable P 288

There was no inventory of materials on hand to start the period. During the period, 21,120 yards of materials were purchased, all of which
were used in production.

Required:
1. For direct materials: Compute the following:
a. Total materials cost variance
b. Price variance
c. Quantity variance
d. Prepare journal entries to record all activity relating to direct materials for
the period.

2. For direct labor: Compute the following:

a. Total labor cost variance
b. Rate variance
c. Efficiency variance
d. Prepare a journal entry to record the incurrence of direct labor for the period.

3. Compute the a) variable manufacturing overhead spending and b) efficiency

variances.

4. On seeing the P288 cost variance, the company’s president stated, “This variance of P288 is only .2% of the P117,504 standard cost for
the period. It’s obvious that our costs are well under control”. Do you agree? Explain

5. State possible causes of each variance that you have computed.

Solutions:
1a. Material cost variance
Actual material cost (AQ x AP) 21,120 x P3.35 P70,752
Less: Standard material cost (SQ SP) 19,200 xP3.60 69,120
Material cost variance –unfavorable P 1,632

1b) Material price variance

Actual price P 3.35
Less: Standard price 3.60
Difference ( .25)
X Actual quantity (4,800 x4.4 yards) X 21,120
Material price variance – favorable P (5,280)
 1c) Material quantity variance
Actual quantity 21,120
Less: Standard quantity (4,800 units x 4 yards per unit) 19,200
Difference 1,920
X standard price X 3.60
Material quantity variance- unfavorable P 6,912

1d. Journal entries

Debit Credit
Raw materials inventory (21,120 x P3.60) P 76,032
Materials price variance (21,120 x .25) P 5,280
Accounts payable (21,120 x P3.35) 70,752

Work in process (19,200 yards. x P3.60) 69,120

Materials quantity variance (1,920 x P3.60) 6,912
Raw materials inventory (21,120 x P3.60) 76,032

2a. Labor cost variance

Actual labor cost (AH x AR) 6,720 x P4.85 P32,592
Less: Standard labor cost ( SH x SR) 7,680 x P4.50 34,560
Labor cost variance –unfavorable P 1,968

2b) Labor rate variance

Actual labor rate P 4.85
Less: Standard labor rate 4.50
Difference .35
X actual hours (4,800 units x 1.4 hours per unit) X 6,720
Labor rate variance - unfavorable P 2,352

2c) Labor efficiency variance

Actual hours 6,720
Less: standard hours (4,800 units x 1.6 hrs. per unit) 7,680
Difference ( 960)
X standard labor rate X P4.50
Labor efficiency variance – favorable P(4,320)

2d) Journal entries

Debit Credit
Work in process (7,680 hrs. x P4.50) 34,560
Labor rate variance (6,720 hrs. x P.35) 2,352
Labor efficiency variance (960 hrs. X P4.50) P 4,320
Wages payable (6,720 hrs. x P4.85) 32,592

3a) Variable overhead spending variance

Actual variable overhead (AH x AVFOR(6,720 hrs. x P2.15 per hour P 14,448
Less: Actual hrs. x Std. variable OH rate (6,720 x P1.80 per hour) 12,096
VOH spending variance –unfavorable P 2,352

Or (AR-SR) X AH = (P2.15-P1.80) x 6,720= P2,352 unfavorable

3b) Variable overhead efficiency variances

Actual hours x variable OH rate P 12,096
Less: Standard hours x Std. variable OH rate( 7,680hrs. x P1.80 per hour) 13,824
VOH efficiency variance - favorable P( 1,728)
Or (AH-SH) x Std. VOH rate = (6,720-7,680) x P1.80= P (1,728) favorable

4. No. The total variance is made up of several quite large individual variances, some of which may warrant investigation. A summary of
variances is shown below:

Materials:
Price variance P 5,280 F
Quantity variance 6,912 U P 1,632 U
Labor:
Rate variance 2,352 U
Efficiency variance 4,320 F 1,968 F
Variable overhead
Spending variance 2,352 U
Efficiency variance 1,728 F 624 U
Total P 288 U

J. The following raw material quantities and prices at standard are estimated to produce 2,000 pounds of a finished product:
Material E 1,500 pounds P.30 P450
Material T 500 pounds .20 100
Material C 400 pounds .425 170
2,400 pounds P720

Actual quantities of raw materials used: (10,000 finished goods)

Material E 8,000 pounds P.32 P 2,560
Material T 2,400 pounds .18 432
Material C 2,800 pounds .45 1,260
13,200 pounds P 4,252

Required: Compute the mix and yield variances

Solution:
1. Mix variance
Actual Quantity at Standard Price
Material E (8,200 x P.30) P 2,400
Material T (2,400 x P. 20) 480
Material C (2,800 x.425) 1,190 P4,070
Less: Total actual input x Ave. standard price(13,200 x P.30) 3,960
Mix variance- unfavorable P 110

Average standard price (input)= P 720/2,400 = P.30

2. Material yield variance

Total actual input at average standard price P 3,960
Less: Total actual output at standard raw material cost (10,000 x P.36) 3,600
Yield variance-unfavorable P 360

Standard material cost =P 720/2,000= P.36

Illustrative Problem: Fixed Budget
When budgeted factory overhead or the factory overhead rate is given in one figure only so that budget allowances for capacities other
than normal cannot be reasonably determined, the fixed budget analysis is used. The budgeted factory overhead is used regardless of the
capacity attained and the standard number of hours.

The budgeted factory overhead based on 3,200 hours is P38,400. Two hours are allowed per unit of production. Actual units of
production are 1,500 requiring 2,950 hours. Factory overhead incurred amounts to P37,600.

Required: Compute the variances using the 2-way and 3-way methods.

Actual factory overhead P 37,600

Less: Standard hours x standard FOH rate (1,500 x 2 x P12) 36,000
Factory overhead variance – Unfavorable P 1,600

Analysis of variance
TWO WAY METHOD

1. Spending variance
Actual factory overhead P 37,600
Less: Budgeted factory overhead 38,400
Spending variance- favorable P( 800)

2. Volume variance
Budgeted factory overhead P 38,400
Less: Standard hours x standard overhead rate 36,000
Volume variance- unfavorable P 2,400
THREE WAY METHOD

1. Spending variance

Actual factory overhead P 37,600

Less: Budgeted factory overhead 38,400
Spending variance- favorable P ( 800)
2. Volume variance

Budgeted factory overhead P 38,400

Less: Actual hours x Standard FOH rate (2950 X P12) 35,400
Volume variance- unfavorable P 3,000
3. Efficiency variance

Actual hours x standard FOH rate P35,400

Less: Standard hours x Standard FOH rate 36,000
Efficiency variance- favorable P ( 600)