Company background

NewTech Fitness Wristband (NTFW) is a family-owned business located in the Midwest part of the United States and has been in operation for five years. The company manufactures fitness wristbands that are sold to customers and to sporting goods retail stores. The wristbands can accurately track all-day stats like steps taken, distance traveled, calories burned, stairs climbed, active minutes, and sleep quality. Production and sales are seasonal for NTFW. Traditionally, the firm experiences higher demand for its products toward the end of the year.

John Carter was hired as the controller of NTFW one month ago. Carter's first task is to analyze the firm's inventory costing system. All the wristbands made by the company require the same quality direct materials and skilled direct labor. However, since direct labor is not a major component of manufacturing costs, direct materials and direct labor costs are combined into a single account, "Prime Costs." Carter learns that the company has been using an actual costing system for all five years that NTFW has been in existence. Under an actual costing system, prime costs are assigned to products as they are produced and manufacturing overhead costs are assigned to products at the end of an accounting period (i.e., quarterly) once the actual costs are known. Therefore, the actual costs incurred in each accounting period (quarter) are being assigned to that quarter's production.

As requested by the management of the company, Carter started his analysis by reviewing last year's income statement based on actual costing. The 2017 quarterly and annual income statements were prepared by the former controller of the company using information presented in Table A1. Table A1 shows actual fixed and variable operating costs, actual fixed and variable overhead costs, average sales price per unit, and unit sales. The actual overhead amounts shown in Table A1 were obtained from the accounting records of NTFW Company. Table A2 presents the quarterly and annual income statements based on actual costing for 2017.

The firm's management is reasonably satisfied with the results for the year as a whole, but is quite concerned with the results for Quarters I and II. Based on the quarterly losses incurred, management is considering shutting down operations during the first two quarters of the year, hoping to greatly improve the profits for the entire year. They feel that if the losses for Quarter I ($41,000) and Quarter II ($11,000) can be eliminated, the company's operating income for the year should go up by the $52,000 of losses that will be eliminated, increasing annual operating income from $565,000 to $617,000.

Carter is concerned with management's conclusion. He decides to show management a different view of the 2017 quarterly and annual results using two different costing systems-normal costing and standard costing. Due to the seasonality of sales and the difficulty in tracing actual factory overhead costs to units produced each quarter, Carter feels it would be far more meaningful to use one of these alternative costing systems. Both costing systems normalize (spread out) the overhead costs over the entire year by calculating predetermined overhead rates at the beginning of the year.

Normal costing and standard costing

Under a normal costing system, prime costs (direct materials and direct labor) are still assigned to products each quarter as the items are being produced, the same as an actual costing system. Overhead, however, is applied to products based on predetermined overhead rates when using a normal costing system. These rates are derived from the budgeted overhead and production numbers estimated at the beginning of the year.[1] Overhead is then applied to actual units produced each quarter based on the actual usage of the cost driver for production multiplied by the predetermined overhead rate. Since direct labor is not a major factor in production, Carter determines that machine hours is the most appropriate cost driver for the company. Each quarter the differences between actual overhead and overhead applied (that is, the amount of under/over applied overhead) are determined but are not closed at that time. Carter decides to show the under/over applied overhead amounts at the bottom of the quarterly and annual income statements, shown in Table A4, but they are not included in the calculation of operating income for each quarter. The periodic differences are accumulated for all four quarters, and the accumulated difference is closed to Cost of Goods Sold at year-end, and is only then included in the calculation of operating income.

At the end of each quarter, except the fourth quarter, the interim under/over applied overhead amounts are recorded as either a deferred debit (under applied overhead) or a deferred credit (over applied overhead) on the balance sheet. At the end of the year the balances in the deferred debit and deferred credit accounts are applied to annual income. Quarterly variances are not closed to income because variances can be either favorable or unfavorable and variances in one quarter could be offset by variances in the next quarter. Therefore, they are kept on the balance sheet as deferred debits or deferred credits during the year. At the end of the year, companies have to make a choice on which method to use to close the variance accounts to annual income. NTFW has chosen to write off the total under/over applied overhead to cost of goods sold because the amount is considered to be immaterial. The amount of under/over applied overhead amount at year end could be prorated between the work-in-process, finished goods, and cost of goods sold accounts, rather than simply closing the entire amount to cost of goods sold.[2]

Table A3 illustrates how Carter calculates the predetermined overhead rates for normal costing. Since Carter will be comparing results for normal and standard costing systems, he separates total overhead into its variable and fixed components, as is typically done under standard costing. Carter uses the former controller's estimates of annual variable ($400,000) and fixed ($200,000) overhead that were provided to him. The former controller based the budgeted variable and fixed overhead amounts on an estimated 40,000 units (80,000 machine hours) being produced in 2017. Carter then prepares quarterly and annual income statements for 2017 using normal costing, presented in Table A4.

Next, Carter decides to prepare quarterly and annual income statements using standard costing. Under standard costing, all inventoriable costs (direct materials, direct labor, and factory overhead) are applied to products based on predetermined standard rates. As illustrated in Table A5, the predetermined standard rate is the amount applied for each cost. It is calculated by multiplying the standard rate per unit of the cost driver by the standard quantity allowed of the cost driver for the units produced. Table A6 presents the quarterly and annual income statements under standard costing constructed using information from Tables A1 and A5.

The standards for the variable costs were determined based upon input from and analysis by engineers, statisticians, operating personnel and accounting staff. The budgeted fixed costs were based on 2016 results, adjusted for changes expected for 2017. The denominator level for production of 40,000 units, needed for determining the predetermined fixed overhead application rate, is the same as the number of units budgeted for 2017. The predetermined fixed application rate of $2.50 per standard machine hour is calculated in Table A5.

Standard costing allows management to conduct more in-depth variance analysis for each product cost. Total Under/Over Applied Variable Overhead can be broken down into a spending variance and an efficiency variance, while total Under/Over Applied Fixed Overhead can be broken into a spending variance and a production volume variance.

Just as with normal costing, variances are determined each quarter; however, they are not closed until year-end, when the accumulated amounts for each variance are closed to Cost of Goods Sold. Each quarterly variance is recorded as either a deferred debit (under applied overhead) or a deferred credit (over applied overhead) on the balance sheet. At the end of the year these deferred debits and credits are applied to the annual income. If the amount of the total under/over applied overhead is immaterial, which is the case for NTFW, the total under/over applied overhead amount is closed to cost of goods sold. If the amount is not immaterial, then NTFW would prorate the total under/over applied overhead variance between work-in-process, finished goods, and cost of goods sold.[3] The resulting quarterly and annual income statements based on standard costing for 2017 are shown in Table A6.

Management was certainly more pleased with the income in Quarters I and II when the quarterly income statements were created using normal and standard costing systems, and still quite happy with the overall results for the year. Management is intrigued that the results for normal and standard costing are quite similar and asks Carter to write a memo explaining the differences. Management also wants Carter to write a memo regarding the annual variable spending and efficiency variances as well as the annual fixed spending and production volume variances that were calculated under standard costing.

question :John Carter also prepared the quarterly and annual 2017 income statements based on normal costing and based on standard costing. Write a memo to management describing how these two costing systems differ. Discuss which of the two approaches would be more helpful in controlling operations during the year.