Flexible Budgets and Overhead Analysis - · PDF fileFlexible Budgets and Overhead Analysis ......

Flexible Budgets andOverhead Analysis

Chapter

LEARNING OBJECTIVES

1. Prepare a flexible budget and explain theadvantages of the flexible budget approachover the static budget approach.

2. Prepare a performance report for both variableand fixed overhead costs using the flexiblebudget approach.

3. Use the flexible budget to prepare a variableoverhead performance report containing onlya spending variance.

After studying this chapter, you should be able to:

LEARNING OBJECTIVES

4. Use the flexible budget to prepare a variableoverhead performance report containing both aspending and an efficiency variance.

5. Explain the significance of the denominatoractivity figure in determining the standard costof a unit of product.

6. Apply overhead cost to units of product in astandard cost system.

7. Compute and interpret the fixed overheadbudget and volume variances.

After studying this chapter, you should be able to:

Static Budgets and PerformanceReports

Hmm! Comparingstatic budgets withactual costs is likecomparing apples

and oranges.

Static budgets areprepared for a single,

planned level ofactivity.

Performanceevaluation is difficultwhen actual activity

differs from theplanned level of

activity.Let’s look at CheeseCo.

Static ActualBudget Results Variances

Machine hours 10,000 8,000

Variable costs Indirect labour 40,000$ 34,000$ Indirect materials 30,000 25,500 Power 5,000 3,800

Fixed costs Amortization 12,000 12,000 Insurance 2,000 2,050

Total overhead costs 89,000$ 77,350$

CheeseCo

Machine hours 10,000 8,000 2,000 U

Variable costs Indirect labor 40,000$ 34,000$ $6,000 F Indirect materials 30,000 25,500 4,500 F Power 5,000 3,800 1,200 F

Fixed costs Depreciation 12,000 12,000 0 Insurance 2,000 2,050 50 U

Total overhead costs 89,000$ 77,350$ $11,650 F

Machine hours 10,000 8,000 2,000 U

Variable costs Indirect labour 40,000$ 34,000$ $6,000 F Indirect materials 30,000 25,500 4,500 F Power 5,000 3,800 1,200 F

Fixed costs Amortization 12,000 12,000 0 Insurance 2,000 2,050 50 U

U = Unfavourable varianceCheeseCo was unable to achieve

the budgeted level of activity.

CheeseCo

Machine hours 10,000 8,000 2,000 U

F = Favourable variance that occurs whenactual costs are less than budgeted costs.

CheeseCo

Machine hours 10,000 8,000 2,000 U

Since cost variances are favourable, havewe done a good job controlling costs?

CheeseCo

I don’t think Ican answer thequestion usinga static budget.

Actual activity is belowbudgeted activity which

is unfavourable.

So, shouldn’t variable costsbe lower if actual activity

is lower?

!The relevant question is . . .

“How much of the favourable cost varianceis due to lower activity, and how much is dueto good cost control?”

!To answer the question,we mustthe budget to theactual level of activity.

Flexible Budgets

Improve performance evaluation.

May be prepared for any activity level in the relevant range.

Show revenues and expensesthat should have occurred at theactual level of activity.

Reveal variances due to good costcontrol or lack of cost control.

Flexible Budgets

Central Concept

If you can tell me what your activity wasfor the period, I will tell you what your costs

and revenue should have been.

Preparing a Flexible Budget

To a budget we need to know that:"Total variable costs change

in direct proportion tochanges in activity.

"Total fixed costs remainunchanged within therelevant range. Fixed

Variable

Let’s prepare budgets for CheeseCo.

Cost Total Flexible BudgetsFormula Fixed 8,000 10,000 12,000Per Hour Cost Hours Hours Hours

Machine hours 8,000 10,000 12,000

Variable costs Indirect labour 4.00 32,000$ Indirect material 3.00 24,000 Power 0.50 4,000 Total variable cost 7.50$ 60,000$

Fixed costs Amortization 12,000$ Insurance 2,000 Total fixed costTotal overhead costs

Fixed costs areexpressed as atotal amount.

Variable costs are expressed asa constant amount per hour.

$40,000 ÷ 10,000 hours is$4.00 per hour.

CheeseCo

Machine hours 8,000 10,000 12,000

Variable costs Indirect labour 4.00 32,000$ Indirect material 3.00 24,000 Power 0.50 4,000 Total variable cost 7.50$ 60,000$

Fixed costs Amortization 12,000$ Insurance 2,000 Total fixed costTotal overhead costs

$4.00 per hour × 8,000 hours = $32,000

CheeseCo

Machine hours 8,000 10,000 12,000

Variable costs Indirect labour 4.00 32,000$ 40,000$ 48,000$ Indirect material 3.00 24,000 30,000 36,000 Power 0.50 4,000 5,000 6,000 Total variable cost 7.50$ 60,000$ 75,000$ 90,000$

Fixed costs Amortization 12,000$ 12,000$ 12,000$ 12,000$ Insurance 2,000 2,000 2,000 2,000 Total fixed cost 14,000$ 14,000$ 14,000$ Total overhead costs 74,000$ 89,000$ 104,000$

CheeseCo

Machine hours 8,000 10,000 12,000

Variable costs Indirect labour 4.00 32,000$ 40,000$ 48,000$ Indirect material 3.00 24,000 30,000 36,000 Power 0.50 4,000 5,000 6,000 Total variable cost 7.50$ 60,000$ 75,000$ 90,000$

Fixed costs Amortization 12,000$ 12,000$ 12,000$ 12,000$ Insurance 2,000 2,000 2,000 2,000 Total fixed cost 14,000$ 14,000$ 14,000$ Total overhead costs 74,000$ 89,000$ 104,000$

Total fixed costsdo not change in

the relevant range.

CheeseCo

Let’s prepare a budget performance report for CheeseCo.

Flexible BudgetPerformance Report

Cost TotalFormula Fixed Flexible ActualPer Hour Costs Budget Results Variances

Machine hours 8,000 8,000 0

Variable costs Indirect labour 4.00$ 32,000$ 34,000$ Indirect material 3.00 24,000 25,500 Power 0.50 4,000 3,800 Total variable costs 7.50$ 60,000$ 63,300$ Fixed Expenses Amortization 12,000$ 12,000$ 12,000$ Insurance 2,000 2,000 2,050 Total fixed costs 14,000$ 14,050$ Total overhead costs 74,000$ 77,350$

Flexible budget isprepared for the

same activity level(8,000 hours) as

actually achieved.

CheeseCo

Cost TotalFormula Fixed Flexible ActualPer Hour Costs Budget Results Variances

Machine hours 8,000 8,000 0

Variable costs Indirect labour 4.00$ 32,000$ 34,000$ $ 2,000 U Indirect material 3.00 24,000 25,500 1,500 U Power 0.50 4,000 3,800 200 FTotal variable costs 7.50$ 60,000$ 63,300$ $ 3,300 UFixed Expenses Amortization 12,000$ 12,000$ 12,000$ 0 Insurance 2,000 2,000 2,050 50 UTotal fixed costs 14,000$ 14,050$ 50 UTotal overhead costs 74,000$ 77,350$ $ 3,350 U

CheeseCo

Remember the question:“How much of the totalvariance is due to activityand how much is due tocost control?”

Machine hours 10,000 8,000 2,000 U

Static Budgets and Performance How much of the $11,650 is due to activity

and how much is due to cost control?

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

Overhead Variance Analysis

Static ActualOverhead OverheadBudget at at

10,000 Hours 8,000 Hours

89,000$ 77,350$

Let’s placethe flexiblebudget for

8,000 hourshere.

This $15,000F variance isdue to lower activity.

Overhead Variance Analysis

Activity

This $3,350U flexiblebudget variance is dueto poor cost control.

Cost control

Static Flexible ActualOverhead Overhead OverheadBudget at Budget at at

10,000 Hours 8,000 Hours 8,000 Hours

89,000$ 74,000$ 77,350$

What causesthe cost

control variance?

There are two primaryreasons for unfavourablevariable overhead variances:

1. Spending too much for resources.

2. Using the resources inefficiently.

Overhead Rates and OverheadAnalysis

Overhead from theflexible budget for the

denominator level of activityPOHR =

Recall that overhead costs are assigned toproducts and services using a

predetermined overhead rate (POHR):

Assigned Overhead = POHR × Standard Activity

Denominator level of activity

Overhead Rates and OverheadAnalysis – Example

Let’s look at overhead

rates in a

budget for ColaCo.

ColaCo prepared this budget for overhead:

Total Variable Total FixedMachine Variable Overhead Fixed Overhead

Hours Overhead Rate Overhead Rate

2,000 4,000$ ? 9,000$ ?

4,000 8,000 ? 9,000 ?

ColaCo applies overhead basedon machine hour activity.

Let’s calculate overhead rates.

Rate = Total Variable Overhead ÷ Machine Hours

This rate is constant at all levels of activity.

2,000 4,000$ 2.00$ 9,000$ ?

4,000 8,000 2.00 9,000 ?

2,000 4,000$ 2.00$ 9,000$ 4.50$

4,000 8,000 2.00 9,000 2.25

Rate = Total Fixed Overhead ÷ Machine Hours

This rate decreases when activity increases.

2,000 4,000$ 2.00$ 9,000$ 4.50$

4,000 8,000 2.00 9,000 2.25

The total POHR is the sum ofthe fixed and variable rates

for a given activity level.

Overhead Variances

Let’s use theoverhead rates, todetermine variableand fixed overhead

variances.

ColaCo’s actual production for the period required3,200 standard machine hours. Actual variableoverhead incurred for the period was $6,740.

Actual machine hours worked were 3,300.

Compute the variable overhead spending andefficiency variances.

Variable Overhead Variances –Example

Variable Overhead Variances

AH × SR AH × AR

Spending variance = AH(AR - SR)

Efficiency variance = SR(AH - SH)

SH × SR

SpendingVariance

EfficiencyVariance

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

3,300 hours 3,200 hours × × $2.00 per hour $2.00 per hour

Variable Overhead Variances –Example

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

$6,740 $6,600 $6,400

Spending variance$140 unfavourable

Efficiency variance$200 unfavourable

$340 unfavourable flexible budget total variance$340 unfavourable flexible budget total variance

Variable Overhead Variances – ACloser Look

Spending Variance Efficiency Variance

Results from paying moreor less than expected foroverhead items and from

excessive usage ofoverhead items.

Controlled bymanaging the

overhead cost driver.

Overhead Variances

Now let’s turnour attention

to fixedoverhead.

What is ColaCo’s fixed overhead rate for an estimated activity of 3,000 machine hours?

2,000 4,000$ 2.00$ 9,000$ 4.50$

4,000 8,000 2.00 9,000 2.25

What is ColaCo’s fixed overhead rate for an estimated activity of 3,000 machine hours? Fixed Overhead Rate

FR = $9,000 ÷ 3,000 machine hours FR = $3.00 per machine hour

2,000 4,000$ 2.00$ 9,000$ 4.50$

4,000 8,000 2.00 9,000 2.25

ColaCo’s actual production required3,200 standard machine hours. Actual

fixed overhead was $8,450.

Compute the fixed overhead budget andvolume variances.

Fixed Overhead Variances –Example

Fixed Overhead Variances

BudgetVariance

VolumeVariance

FR = Standard Fixed Overhead RateSH = Standard Hours Allowed

SH × FR

Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

3,200 hours × $3.00 per hour

Budget variance$550 favourable

Fixed Overhead Variances –Example

$8,450 $9,000 $9,600

Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

Volume variance$600 favourable

SH × FR

Fixed Overhead Variances –A Closer Look

Budget Variance Volume Variance

Results from paying moreor less than expected for

overhead items.

Results from operatingat an activity leveldifferent from the

denominator activity.

Overhead Variances

Let’s look at agraph showingfixed overhead

variances. We willuse ColaCo’s

numbers from theprevious example.

Volume

3,200Standard

3,000 HoursExpectedActivity

Fixed overhead

applied to products

$8,450 actual fixed OH

Volume

$9,600 applied fixed OH

$9,000 budgeted fixed OH

3,200Standard

Fixed overhead

applied to products

3,200 machine hours × $3.00 fixed overhead rate

FavourableVolumeVariance

{$550Favourable

BudgetVariance

$8,450 actual fixed OH$8,450 actual fixed OH

Volume

$9,600 applied fixed OH

$9,000 budgeted fixed OH

3,200Standard

Fixed overhead

applied to products

3,200 machine hours × $3.00 fixed overhead rate

Results when standard hoursallowed for actual output differsfrom the denominator activity.

Volume Variance – A Closer Look

VolumeVariance

Favourablewhen standard hours> denominator hours

Unfavourablewhen standard hours< denominator hours

Results when standard hoursallowed for actual output differsfrom the denominator activity.

Volume Variance – A Closer Look

VolumeVariance

Favorablewhen standard hours> denominator hours

Unfavorablewhen standard hours< denominator hours

Does not measure over- or under spending

Explainable by and controllable only through

activity

Overhead Variances and Under- orOverapplied Overhead Cost

The sum of the overhead variancesequals the under- or overapplied

overhead cost for a period.

Favourablevariances are equivalentto overapplied overhead.

Unfavourablevariances are equivalent

to underapplied overhead.

In a standardcost system:

End of Chapter 11

I’m here to yourbudget. Are you ready to

ante up?

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