Flexible Budgets and Overhead Analysis

Chapter Eleven

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Static Budgets and Performance Reports

Hmm! Comparing static budgets with actual costs is like comparing apples and oranges.

Static budgets are prepared for a single, planned level of activity.

Performance evaluation is difficult when actual activity differs from the planned level of activity.
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Flexible Budgets
May be prepared for any activity level in the relevant range.
Show costs that should have been incurred at the actual level of activity, enabling apples to apples cost comparisons.

Reveal variances related to cost control.

Improve performance evaluation.

Lets look at CheeseCo.

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Static Budgets and Performance Reports

CheeseCo

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Static Budgets and Performance Reports

CheeseCo

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Static Budgets and Performance Reports

CheeseCo

U = Unfavorable variance CheeseCo was unable to achieve the budgeted level of activity.

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Static Budgets and Performance Reports

CheeseCo

F = Favorable variance that occurs when actual costs are less than budgeted costs.

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Static Budgets and Performance Reports

CheeseCo

Since cost variances are favorable, have we done a good job controlling costs?

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Static Budgets and Performance Reports

I dont think I can answer the question using a static budget.

Actual activity is below budgeted activity.

So, shouldnt variable costs be lower if actual activity is lower?

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Static Budgets and Performance Reports

The relevant question is . . .

How much of the favorable cost variance is due to lower activity, and how much is due to good cost control?

To answer the question, we must the budget to the actual level of activity.

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Preparing a Flexible Budget

To

a budget we need to know that:

Total variable costs change in direct proportion to changes in activity.

Total fixed costs remain unchanged within the relevant range.

Fixed

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Preparing a Flexible Budget

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Preparing a Flexible Budget

CheeseCo
Cost Formula per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs
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Total Fixed Cost

Flexible Budgets 8,000 10,000 12,000 Hours Hours Hours 8,000 10,000 12,000

4.00 3.00 0.50 7.50

Variable costs are expressed as a constant amount per hour.

$40,000 10,000 hours is $4.00 per hour.
$ 12,000 2,000

Fixed costs are expressed as a total amount.

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Preparing a Flexible Budget

CheeseCo
Cost Formula per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost $ 4.00 3.00 0.50 7.50 $ 12,000 2,000 Total Fixed Cost Flexible Budgets 8,000 10,000 12,000 Hours Hours Hours 8,000 $ 32,000 24,000 4,000 $ 60,000 10,000 12,000

Fixed costs $4.00 Depreciation Insurance Total fixed cost Total overhead costs
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per hour 8,000 hours = $32,000

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Preparing a Flexible Budget

CheeseCo
Cost Formula per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs
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Total Fixed Cost

Flexible Budgets 8,000 10,000 12,000 Hours Hours Hours 8,000 10,000 12,000

4.00 3.00 0.50 7.50 $ 12,000 2,000

$ 32,000 24,000 4,000 $ 60,000 $ 12,000 2,000 $ 14,000 $ 74,000

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Preparing a Flexible Budget

CheeseCo
Cost Formula per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs
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Total Fixed Cost

Flexible Budgets 8,000 10,000 12,000 Hours Hours Hours 8,000 10,000 $ 40,000 30,000 5,000 $ 75,000 $ 12,000 2,000 $ 14,000 $ 89,000 12,000

the relevant range.

$ 12,000 2,000

4.00 $ 32,000 3.00 24,000 Total fixed costs 0.50 4,000 do not change in 7.50 $ 60,000 $ 12,000 2,000 $ 14,000 $ 74,000

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Preparing a Flexible Budget

Cost Formula per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs
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Total Fixed Cost

Flexible Budgets 8,000 10,000 12,000 Hours Hours Hours 8,000 10,000 $ 40,000 30,000 5,000 $ 75,000 $ 12,000 2,000 $ 14,000 $ 89,000 12,000 $ 48,000 36,000 6,000 $ 90,000 $ 12,000 2,000 $ 14,000 $ 104,000

4.00 3.00 0.50 7.50 $ 12,000 2,000

$ 32,000 24,000 4,000 $ 60,000 $ 12,000 2,000 $ 14,000 $ 74,000

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Flexible Budget Performance Report

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Flexible Budget Performance Report

CheeseCo
Flexible budget Cost is prepared for the Formula per Hour same activity level (8,000 hours) as Machine hours actually achieved. Variable costs
Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs
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Total Fixed Cost

Flexible Budget 8,000

Actual Results 8,000 $ 34,000 25,500 3,800 $ 63,300

Variances 0

4.00 3.00 0.50 7.50 $ 12,000 2,000

$ 12,000 2,050 $ 14,050 $ 77,350

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Flexible Budget Performance Report

CheeseCo
Cost Formula per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs
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Total Fixed Cost

Flexible Budget 8,000

Actual Results 8,000 $ 34,000 25,500 3,800 $ 63,300 $ 12,000 2,050 $ 14,050 $ 77,350

Variances 0 $ 2,000 U

4.00 3.00 0.50 7.50 $ 12,000 2,000

$ 32,000

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Quick Check

What is the variance for indirect material when the flexible budget for 8,000 hours is compared to the actual results? a. $1,500 U b. $1,500 F c. $4,500 U d. $4,500 F

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Flexible Budget Performance Report

CheeseCo
Cost Formula per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs
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Total Fixed Cost

Flexible Budget 8,000

Actual Results 8,000 $ 34,000 25,500 3,800 $ 63,300 $ 12,000 2,050 $ 14,050 $ 77,350

Variances 0 $ 2,000 U 1,500 U 200 F $ 3,300 U $ 0 50 U 50 U $ 3,350 U

4.00 3.00 0.50 7.50 $ 12,000 2,000

$ 32,000 24,000 4,000 $ 60,000 $ 12,000 2,000 $ 14,000 $ 74,000

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Flexible Budget Performance Report

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Static Budgets and Performance

How much of the $11,650 favorable variance is due to lower activity and how much is due to cost control?

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Flexible Budget Performance Report

Overhead Variance Analysis

Static Overhead Budget at 10,000 Hours $ 89,000

Lets place the flexible budget for 8,000 hours here.

Actual Overhead at 8,000 Hours $ 77,350

Difference between original static budget and actual overhead = $11,650 F.

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Flexible Budget Performance Report

Overhead Variance Analysis

Static Overhead Budget at 10,000 Hours $ 89,000 Flexible Overhead Budget at 8,000 Hours $ 74,000 Actual Overhead at 8,000 Hours $ 77,350

Activity This $15,000F variance is due to lower activity.

Cost control This $3,350U variance is due to poor cost control.

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The Measure of Activity A Critical Choice

Three important factors in selecting an activity base for an overhead flexible budget
Activity base and variable overhead should be causally related. Activity base should not be expressed in dollars or other currency. Activity base should be simple and easily understood.

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Variable Overhead Variances A Closer Look

If flexible budget is based on actual hours If flexible budget is based on standard hours

Only a spending variance can be computed.

Both spending and efficiency variances can be computed.

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Variable Overhead Variances Example

ColaCos actual production for the period required 3,200 standard machine hours. Actual variable overhead incurred for the period was $6,740. Actual machine hours worked were 3,300. The standard variable overhead cost per machine hour is $2.00. Compute the variable overhead spending variance first using actual hours. Then use standard hours allowed to calculate the variable overhead efficiency variance.
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Variable Overhead Variances

Actual Variable Overhead Incurred AH AR Flexible Budget for Variable Overhead at Actual Hours AH SR

Spending Variance

AH = Actual hours AR = Actual variable overhead rate SR = Standard variable overhead rate

Spending variance = AH(AR SR)

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Variable Overhead Variances Example

Actual Variable Overhead Incurred Flexible Budget for Variable Overhead at Actual Hours 3,300 hours $2.00 per hour = $6,600

$6,740

Spending Variance = $140 unfavorable

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Variable Overhead Variances A Closer Look

Spending Variance
Results from paying more or less than expected for overhead items and from excessive usage of overhead items.

Now, lets use the standard hours allowed, along with the actual hours, to compute the efficiency variance.

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Variable Overhead Variances

Actual Variable Overhead Incurred AH AR Flexible Budget for Variable Overhead at Actual Hours AH SR Flexible Budget for Variable Overhead at Standard Hours SH SR

Spending Variance

Efficiency Variance

Spending variance = AH(AR - SR) Efficiency variance = SR(AH - SH)

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Variable Overhead Variances Example

Actual Variable Overhead Incurred Flexible Budget for Variable Overhead at Actual Hours Flexible Budget for Variable Overhead at Standard Hours

3,300 hours $2.00 per hour $6,740

Spending variance $140 unfavorable

3,200 hours $2.00 per hour $6,400

$6,600

Efficiency variance $200 unfavorable

$340 unfavorable flexible budget total variance

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Variable Overhead Variances A Closer Look

Efficiency Variance
Controlled by managing the overhead cost driver.

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Quick Check Summary

Actual Variable Overhead Incurred Flexible Budget for Variable Overhead at Actual Hours 2,050 hours $5 per hour $10,250 Flexible Budget for Variable Overhead at Standard Hours 2,100 hours $5 per hour

$10,950
Spending variance $700 unfavorable

$10,500
Efficiency variance $250 favorable

$450 unfavorable flexible budget total variance

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Activity-based Costing and the Flexible Budget

It is unlikely that all variable overhead will be driven by a single activity.

Activity-based costing can be used when multiple activity bases drive variable overhead costs.

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Overhead Rates and Overhead Analysis

Recall that overhead costs are assigned to products and services using a predetermined overhead rate (POHR):
Assigned Overhead = POHR Standard Activity Overhead from the flexible budget for the denominator level of activity
Denominator level of activity

POHR

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Overhead Rates and Overhead Analysis

The predetermined overhead rate can be broken down into fixed and variable components.
The variable component is useful for preparing and analyzing variable overhead variances. The fixed component is useful for preparing and analyzing fixed overhead variances.

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Normal versus Standard Cost Systems

In a normal cost system, overhead is applied to work in process based on the actual number of hours worked in the period. In a standard cost system, overhead is applied to work in process based on the standard hours allowed for the output of the period.

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Fixed Overhead Variances

Actual Fixed Overhead Incurred Fixed Overhead Budget DH FR Fixed Overhead Applied SH FR

Budget Variance

Volume Variance

FR = Standard Fixed Overhead Rate SH = Standard Hours Allowed DH = Denominator Hours

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Overhead Rates and Overhead Analysis Example

ColaCo prepared this
Machine Hours 3,000 4,000 Total Variable Overhead $ 6,000 8,000

budget for overhead:

Variable Overhead Rate ? ? Total Fixed Overhead $ 9,000 9,000 Fixed Overhead Rate ? ?

Lets calculate overhead rates. ColaCo applies overhead based on machine-hour activity.
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Overhead Rates and Overhead Analysis Example

ColaCo prepared this
Machine Hours 3,000 4,000 Total Variable Overhead $ 6,000 8,000

budget for overhead:

Variable Overhead Rate $ 2.00 2.00 Total Fixed Overhead $ 9,000 9,000 Fixed Overhead Rate ? ?

Rate = Total Variable Overhead Machine Hours

This rate is constant at all levels of activity.

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Overhead Rates and Overhead Analysis Example

ColaCo prepared this
Machine Hours 3,000 4,000 Total Variable Overhead $ 6,000 8,000

budget for overhead:

Variable Overhead Rate $ 2.00 2.00 Total Fixed Overhead $ 9,000 9,000 Fixed Overhead Rate $ 3.00 2.25

Rate = Total Fixed Overhead Machine Hours

This rate decreases when activity increases.

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Overhead Rates and Overhead Analysis Example

ColaCo prepared this
Machine Hours 3,000 4,000 Total Variable Overhead $ 6,000 8,000

budget for overhead:

Variable Overhead Rate $ 2.00 2.00 Total Fixed Overhead $ 9,000 9,000 Fixed Overhead Rate $ 3.00 2.25

The total POHR is the sum of the fixed and variable rates for a given activity level.
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Fixed Overhead Variances Example

ColaCos actual production required 3,200 standard machine hours. Actual fixed overhead was $8,450. The predetermined overhead rate is based on 3,000 machine hours.

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Overhead Variances

Now lets turn our attention to calculating fixed overhead variances.

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Fixed Overhead Variances Example

Actual Fixed Overhead Incurred Fixed Overhead Budget Fixed Overhead Applied

$8,450

$9,000

Budget variance $550 favorable

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Fixed Overhead Variances A Closer Look

Budget Variance
Results from spending more or less than expected for fixed overhead items.

Now, lets use the standard hours allowed to compute the fixed overhead volume variance.

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Fixed Overhead Variances Example

Actual Fixed Overhead Incurred Fixed Overhead Budget Fixed Overhead Applied SH FR 3,200 hours $3.00 per hour $9,600

$8,450

$9,000

Budget variance $550 favorable

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Volume variance $600 favorable

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Volume Variance A Closer Look

Volume Variance
Results when standard hours allowed for actual output differs from the denominator activity.
Unfavorable when standard hours < denominator hours
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Favorable when standard hours > denominator hours

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Volume Variance A Closer Look

Volume Variance Does not measure overor under spending

Results when standard hours Itallowed for actual output differs results from treating fixed from the denominator activity. overhead as if it were a

variable cost.
Unfavorable when standard hours < denominator hours
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Favorable when standard hours > denominator hours

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Overhead Variances

Lets look at a graph showing fixed overhead variances. We will use ColaCos numbers from the previous example.
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Fixed Overhead Variances

Cost $9,000 budgeted fixed OH

Activity

3,000 Hours Expected Activity

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Fixed Overhead Variances

Cost $9,000 budgeted fixed OH
$550 Favorable Budget Variance

$8,450 actual fixed OH

Activity

3,000 Hours Expected Activity

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Fixed Overhead Variances

Cost
$600 Favorable Volume Variance 3,200 machine hours $3.00 fixed overhead rate

$9,600 applied fixed OH $9,000 budgeted fixed OH

{ $550 { Favorable
Budget Variance

$8,450 actual fixed OH

3,000 Hours Expected Activity

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Activity 3,200 Standard Hours

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Overhead Variances and Under- or Overapplied Overhead Cost

In a standard cost system:
Unfavorable variances are equivalent to underapplied overhead. Favorable variances are equivalent to overapplied overhead.

The sum of the overhead variances equals the under- or overapplied overhead cost for a period.
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End of Chapter 11

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