This chapter explains the concept of absorbed cost variances and the role they play with shop rates maintenance.
What is an absorbed cost variance?
An absorbed cost variance is the difference within a given date range between an absorbed cost and its associated actual costs.
Absorbed and actual costs are grouped on the income statement
Then you follow our general ledger setup guidelines (see chapter 3), the Cost of Sales section in your chart of accounts contains two account groups related to absorbed costs. Your Absorbed Labor account will be followed by its associated direct labor cost accounts and your Absorbed Mfg OH account will be followed by its associated manufacturing overhead cost accounts.
Absorbed accounts are contra accounts
The Absorbed Labor and Absorbed Mfg OH accounts are “contra” accounts. A contra account receives credit entries instead of the debit entries that are normally posted to cost of sales accounts. The objective is for the contra account balance to offset the balances of associated standard accounts to achieve a zero cost for direct labor and manufacturing overhead on the income statement.
Labor and overhead costs are absorbed into inventory
The purpose for zeroing out direct labor and manufacturing overhead costs is to absorb these costs through WIP into the inventory cost of finished items. The actual cost for labor and overhead are only realized on the income statement in the form of cost of goods sold when items are invoiced.
There is always a variance between absorbed and actual costs
Absorbed costs will not exactly offset actual costs because the hourly work center rates that determine absorbed costing are estimates that can never exactly match actual costs. Also, actual costs vary from period to period depending on payroll frequency (some months have an extra payroll run) and the erratic nature of overhead costs such as plant maintenance. Therefore a variance of some degree will always exist between absorbed and actual costs, which is normal and expected.
Overall accounting is always correct
So even though there are always variances between absorbed and actual costs, your overall accounting is always correct. If absorbed costs exceed actual costs, the excess amount is reflected in inventory with a slight reduction in overall cost of sales that will be offset later when items are sold. Conversely, if actual costs exceed absorbed costs, overall cost of sales will be slightly higher, but will be offset later when items are sold, and the value received to inventory will be slightly lower. In a pure accounting sense, your balance sheet and income statement are always correct and require no corrective intervention on your part.
Use variances as feedback for refining shop rates
The objective in WIP management is not to eliminate absorbed cost variances, which is not possible, but to keep them within an acceptable range. Keep in mind that “reasonably close” is the objective with manufacturing costing, so variances of 10-25% or so are not worrisome and can be minimized with ongoing refinement to your shop rates.
The variance amounts and percentages for direct labor and manufacturing overhead within a given date range are displayed in the Shop Rates screen. If you sense that your shop rates are over-absorbing or under-absorbing actual costs, it is your signal to adjust your shop rates. You should therefore review your shop rates at regular intervals, such as once per period, and make adjustments as needed.
Never attempt to adjust past costs
Never attempt to adjust past costs even when large variances have occurred. The overall accounting, no matter the severity of the variances, remains correct, and past labor and overhead costs have long ago been co-mingled with other costs and often absorbed into the cost of other items. DBA is not designed with any provision for past cost correction and attempts at corrections will cause myriad accounting problems.
