Cost Accounting and Variance Analysis for the CPA BAR Exam
Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
Cost accounting is one of the most calculation-heavy areas on BAR, and one of the easiest places to lose points that you understood perfectly well. Most of the damage comes from two habits: mixing up standard with actual, and memorizing eight variance formulas as eight separate things when six of them are the same formula wearing different labels.
This guide builds up in order. What counts as a product cost, how those costs move through inventory, how overhead gets allocated, how spoilage is handled, how absorption and variable costing differ, what activity-based costing is for, and then the full variance framework with worked examples.
In this guide
- How BAR tests this
- Product costs and period costs
- How costs flow through inventory
- Overhead allocation
- Spoilage
- Absorption vs variable costing
- Activity-based costing
- The variance framework
- Direct materials variances
- Direct labor variances
- Variable overhead variances
- Fixed overhead variances
- All eight variances
- Glossary
How does the BAR exam test cost accounting?
Cost and managerial accounting sits inside Area I, Business Analysis. The classification and costing-method material is tested at the application level. Variance analysis is tested a step higher, at the analysis level, which is why questions tend to hand you a scenario and make you decide which variance answers it rather than simply asking you to compute one.
| Representative task | Skill level |
|---|---|
| Calculate fixed, variable and mixed costs | Application |
| Use absorption, variable, activity-based, process and job order costing | Application |
| Derive the appropriate variance analysis method from a business scenario | Analysis |
| Interpret results through price, volume and mix analysis | Analysis |
The distinction between application and analysis is worth taking seriously when you plan your study time. Application means you can be asked to run the calculation. Analysis means you can be asked which calculation to run and what the answer implies about the business. Practising only the arithmetic prepares you for half the question.
What is the difference between a product cost and a period cost?
Product costs are direct materials, direct labor and manufacturing overhead. They sit in inventory on the balance sheet and become expense only when the unit is sold. Period costs are everything else and hit the income statement immediately.
| Product cost component | Example, laptop manufacturer |
|---|---|
| Direct materials | Glass and aluminium, traceable to each unit |
| Direct labor | Assembly wages, traceable to each unit |
| Manufacturing overhead | Factory rent, utilities, floor manager's salary. Indirect, not traceable to one unit |
Period costs are the non-manufacturing ones: marketing salaries, the accounting department, legal fees. On the income statement they sit below gross profit.
− Cost of goods sold, the product costs of units sold
= Gross profit
− General and administrative expenses, the period costs
= Net income
Worked example: Platinum Tech
Platinum Tech spends $1,000,000 producing 1,000 laptops, so $1,000 per unit, and sells 200 of them at $2,000 each.
Two separate events, and keeping them separate is the whole point. First, production. The $1,000,000 becomes inventory, not expense:
| Account | Debit | Credit |
|---|---|---|
| Finished goods inventory | $1,000,000 | |
| Cash or accounts payable | $1,000,000 |
Then, and only then, the sale of 200 units:
| Account | Debit | Credit |
|---|---|---|
| Cost of goods sold | $200,000 | |
| Finished goods inventory | $200,000 |
$800,000 stays in inventory. Add a $50,000 marketing salary as a period cost and the income statement reads: revenue $400,000, less COGS $200,000, gross profit $200,000, less G&A $50,000, net income $150,000.
Prime costs and conversion costs
| Term | Components | What it captures |
|---|---|---|
| Prime costs | Direct materials + direct labor | The most direct inputs |
| Conversion costs | Direct labor + manufacturing overhead | What it takes to turn materials into finished goods |
The trap, and the reason the two groups overlap. Direct labor appears in both, because it is both a direct input and part of the conversion effort. Students sometimes try to split it. Do not. And the bigger trap: expensing everything the factory spent this period. Only the cost riding on units that actually sold becomes expense. The rest is sitting on the balance sheet.
How do costs flow through the three inventory accounts?
| Account | What it holds | Costs leave when |
|---|---|---|
| Raw materials | Materials bought but not yet used | Materials are issued to production |
| Work in process | DM, DL and MOH on partly finished units | Units are completed |
| Finished goods | Completed units not yet sold | Units are sold, becoming COGS |
Worked example, continued
Platinum Tech buys $200,000 of raw materials, which sit in raw materials inventory. Production starts on 400 laptops, consuming $140,000 of those materials, $16,000 of direct labor and $8,000 of applied overhead. Work in process picks up $164,000.
All 400 are completed, so the whole $164,000 moves to finished goods, or $410 per unit. Sell 100 of them and $41,000 moves from finished goods to COGS. The other $123,000 stays put.
How is manufacturing overhead allocated?
Overhead is awkward for three reasons at once. It is indirect, so it cannot be traced to a unit. It is not fully known until the period ends. And the production volume it will be spread across is itself an estimate. So companies set a rate in advance and apply it as they go.
Worked example
Expected overhead is $10,000. Expected production is 500 units at 2 direct labor hours each, so 1,000 estimated hours. The rate is $10 per direct labor hour.
At period end, only 760 hours were actually worked, so applied overhead is $7,600. Actual overhead turned out to be $11,000.
| Situation | Meaning | Adjustment |
|---|---|---|
| Under-applied | Actual overhead exceeded applied | Debit COGS, so COGS goes up |
| Over-applied | Applied overhead exceeded actual | Credit COGS, so COGS goes down |
Why it works that way. You applied $7,600 of overhead to units, but the factory really consumed $11,000. The units were undercosted by $3,400, so that amount has to be added back somewhere, and COGS is where it goes. Reason it out from the direction of the error and you will not need to memorize which way the entry runs.
One nuance worth knowing: closing the whole balance to COGS is the standard treatment when the amount is immaterial. A material balance is prorated across work in process, finished goods and COGS.
How is spoilage treated?
Normal spoilage is a cost of doing business, so it stays with the product. Abnormal spoilage is not, so it goes straight to expense.
| Type | Definition | Treatment | Example |
|---|---|---|---|
| Normal | Arises in the ordinary course of production | Product cost, stays in inventory | The occasional dropped pizza |
| Abnormal | Outside normal operations | Period cost, expensed immediately | Fire, storm damage |
Worked example: New York Pizza Company
The company makes 1,000 pizzas. Dropped pizzas account for $150 of normal spoilage. A lightning storm ruins ingredients, creating $700 of abnormal spoilage.
| Cost | Amount | Classification |
|---|---|---|
| Direct materials | $2,000 | Product |
| Direct labor | $1,000 | Product |
| Manufacturing overhead | $500 | Product |
| Normal spoilage | $150 | Product |
| G&A expenses | $400 | Period |
| Abnormal spoilage | $700 | Period |
| Inventory cost per pizza | $3.65 | $3,650 / 1,000 |
Total period costs are $400 plus $700, or $1,100.
The trap. Treating all spoilage alike. Ask whether a well-run version of this business would still have produced this loss. Dropped pizzas, yes, so it belongs to the cost of making pizzas. A lightning strike, no, so it is a loss of the period rather than a cost of the product.
How do absorption costing and variable costing differ?
One line item, and only one, is treated differently: fixed overhead. Absorption costing makes it a product cost. Variable costing makes it a period cost. Everything else about the two methods is the same.
| Absorption | Variable | |
|---|---|---|
| Also called | Full costing, traditional method | Contribution method |
| Fixed overhead | Product cost | Period cost |
| Income statement | Sales less COGS gives gross profit, less G&A gives operating income | Sales less variable costs gives contribution margin, less fixed costs gives operating income |
| Used for | External reporting under GAAP | Internal decision making |
| Scenario | Higher income under | Why |
|---|---|---|
| Produced more than sold | Absorption | Some fixed overhead stays parked in ending inventory |
| Produced less than sold | Variable | Absorption pulls prior-period fixed overhead out of inventory into COGS |
| Produced equals sold | Identical | No inventory build-up or draw-down |
The reasoning that makes this automatic. Under absorption costing, fixed overhead rides along with units. If units are still sitting in inventory at year end, so is their share of fixed overhead, which means it has not hit the income statement yet, which means income is higher. Build inventory and absorption wins. Draw inventory down and it loses. You never need to memorize the table.
What is activity-based costing?
ABC is an internal method that uses several activity-based cost pools and drivers instead of one company-wide allocation base. It exists because a single driver can lie to you.
Two ways it lies. First, allocating everything on machine hours ignores costs like setup, testing and calibration that have nothing to do with how long a machine ran. Second, traditional costing buries support costs in period expense, so a product generating constant complaint calls and complicated shipping looks exactly as profitable as one that never causes trouble.
- Group costs into pools by activity. Production, packaging, shipping, customer support, and so on, with an estimated total cost for each.
- Pick a driver for each pool. Machine hours for one, number of shipments for another, complaint calls or setups for a third. The point is that each pool gets the driver that actually causes its cost.
- Compute a rate per pool and apply it. Pool cost divided by driver volume gives the rate, then assign cost to products by their actual driver usage.
ABC is for internal decisions only. Absorption costing is still what GAAP requires for external reporting, so a question asking what goes in the published financial statements is never answered with ABC.
How does variance analysis actually work?
Variance analysis compares what something should have cost against what it did cost, and splits the difference into two questions: did we pay more per unit of input than planned, and did we use more inputs than planned.
There are eight variances. Six of them are the same two formulas applied three times.
| Cost component | First variance | Second variance |
|---|---|---|
| Direct materials | Price | Efficiency |
| Direct labor | Price, also called rate | Efficiency |
| Variable overhead | Price | Efficiency |
| Fixed overhead | Spending | Production volume |
The one rule that holds the first six together. Price variances multiply by actual quantity. Efficiency variances multiply by standard price or rate. That is it. If you can remember which side is actual and which is standard, you can rebuild all six formulas without memorizing any of them.
Four things that are true of every variance:
- Standard means estimated, budgeted, what should have happened.
- For the first three categories, expected units produced is irrelevant. You multiply by actual output.
- Favorable means actual came out better than standard. Unfavorable means worse.
- Price and rate mean the same thing, and so do efficiency and usage. Textbooks differ, exams use both.
How do you calculate the direct materials variances?
Efficiency variance = (Actual quantity per unit − Standard quantity per unit) × Standard price × Units produced
Worked example: home manufacturer
| Standard | Actual | |
|---|---|---|
| Homes produced | 50 | 35 |
| Board feet per home | 6,000 | 6,500 |
| Cost per board foot | $2.00 | $1.75 |
The 50 budgeted homes are a distraction. Every calculation runs off the 35 actually built.
Efficiency: (6,500 − 6,000) × $2.00 × 35 = $35,000 unfavorable
Read the two together and there is a story: the company bought cheaper wood and then used more of it. That pairing turns up constantly in exam scenarios, and the analysis-level question is usually asking you to notice the connection rather than just report both numbers.
One variation to watch for. Some questions compute the materials price variance on the quantity purchased rather than the quantity used, which isolates the purchasing decision at the moment it happens. Read carefully which quantity you are given.
How do you calculate the direct labor variances?
Efficiency variance = (Actual hours per unit − Standard hours per unit) × Standard rate × Units produced
Worked example: same manufacturer
| Standard | Actual | |
|---|---|---|
| Homes produced | 50 | 35 |
| Labor hours per home | 400 | 375 |
| Cost per labor hour | $20.00 | $21.00 |
Efficiency: (375 − 400) × $20 × 35 = $17,500 favorable
Again the two variances point at each other. The company paid a higher hourly rate and got the work done in fewer hours, and the favorable efficiency variance is larger than the unfavorable rate variance. More experienced labor at a higher wage is the usual reading, and it was worth it here.
How do you calculate the variable overhead variances?
Identical structure to materials and labor. The only change is that the quantity is a cost driver rather than a physical input.
Efficiency variance = (Actual drivers per unit − Standard drivers per unit) × Standard rate × Units produced
With a standard of $1.50 per driver and 4 drivers per unit, an actual of $2.00 and 5 drivers, across 100 units:
Efficiency: (5 − 4) × $1.50 × 100 = $150 unfavorable
Why are the fixed overhead variances different?
Because fixed overhead does not move with volume. There is no meaningful "we used more of it per unit" question, so the efficiency variance has nothing to measure. Instead you ask whether total spend came in on budget, and whether you produced as many units as you assumed when you set the rate.
Spending variance = Standard total fixed OH − Actual total fixed OH
Production volume variance = (Standard units − Actual units) × Allocation rate
Worked example: frame manufacturer
| Budgeted | Actual | |
|---|---|---|
| Frames produced | 20,000 | 19,000 |
| Fixed overhead | $20,000 | $22,000 |
| Allocation rate | $1.00 | — |
Production volume: (20,000 − 19,000) × $1.00 = $1,000 unfavorable
Why producing less is unfavorable. The $1.00 rate was built on an assumption of 20,000 frames. Build only 19,000 and there are a thousand fewer units to carry the fixed cost, but the fixed cost does not shrink to match. It still has to go somewhere. Nothing was wasted and nobody did anything wrong, which is exactly why this variance confuses people. It is measuring capacity you paid for and did not use.
All eight variances in one place
| Variance | Formula | Multiply by |
|---|---|---|
| Direct materials | ||
| Price | (Actual price − standard price) × actual qty/unit × units produced | Actual quantity |
| Efficiency | (Actual qty/unit − standard qty/unit) × standard price × units produced | Standard price |
| Direct labor | ||
| Price | (Actual rate − standard rate) × actual hours/unit × units produced | Actual hours |
| Efficiency | (Actual hours/unit − standard hours/unit) × standard rate × units produced | Standard rate |
| Variable overhead | ||
| Price | (Actual OH/driver − standard OH/driver) × actual drivers/unit × units produced | Actual drivers |
| Efficiency | (Actual drivers/unit − standard drivers/unit) × standard rate × units produced | Standard rate |
| Fixed overhead | ||
| Spending | Standard total fixed OH − actual total fixed OH | Total dollars |
| Production volume | (Standard units − actual units) × allocation rate | Unit difference |
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Glossary
| Term | Definition |
|---|---|
| Product costs | DM, DL and MOH. Stay in inventory until the unit sells |
| Period costs | Non-manufacturing costs, expensed as incurred |
| Prime costs | Direct materials plus direct labor |
| Conversion costs | Direct labor plus manufacturing overhead |
| Raw materials | Materials bought but not yet issued to production |
| Work in process | Partly finished units carrying DM, DL and MOH |
| Finished goods | Completed units not yet sold |
| Under-applied overhead | Actual exceeded applied. Debit COGS |
| Over-applied overhead | Applied exceeded actual. Credit COGS |
| Normal spoilage | Expected in ordinary production. Product cost |
| Abnormal spoilage | Outside normal operations. Period cost |
| Absorption costing | GAAP method. Fixed overhead is a product cost |
| Variable costing | Internal method. Fixed overhead is a period cost |
| Contribution margin | Sales less variable costs |
| Activity-based costing | Internal method using multiple pools and drivers |
| Standard | The estimated figure that actual results are measured against |
| Favorable | Actual came out better than standard |
| Unfavorable | Actual came out worse than standard |
| Price or rate variance | Input cost against standard. Uses actual quantity |
| Efficiency or usage variance | Input usage against standard. Uses standard price |
Frequently asked questions
What is the difference between product costs and period costs?
Product costs are direct materials, direct labor and manufacturing overhead. They sit in inventory and become expense only when the unit is sold. Period costs are non-manufacturing costs and are expensed as incurred.
What is the one variance rule worth memorizing?
Price and rate variances multiply by actual quantity. Efficiency and usage variances multiply by standard price or rate. That single rule reconstructs six of the eight variance formulas.
How do absorption and variable costing differ?
Only in the treatment of fixed overhead. Absorption costing treats it as a product cost that rides along with inventory. Variable costing treats it as a period cost. When production exceeds sales, absorption reports higher income, because some fixed overhead is still sitting in ending inventory.
How is normal spoilage treated?
As a product cost, so it stays in inventory with the good units. Abnormal spoilage is expensed immediately as a period cost.
Is activity-based costing allowed under GAAP?
No. ABC is for internal decision making. Absorption costing is required for external financial statements.
Why is an unfavorable production volume variance not necessarily bad news?
Because nothing was wasted. It measures the fixed cost of capacity that was paid for and not used. Producing fewer units than assumed when the allocation rate was set leaves fewer units to absorb a fixed cost that does not shrink.
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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 95 on FAR. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.
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