Chapter 1

(1)

Flexible Budgets and

Overhead Analysis

(2)

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.

Let’s look at CheeseCo.

(3)

Static Actual

Budget Results Variances

Machine hours 10,000 8,000 Variable costs

Ind irect labor $ 40,000 $ 34,000 Indirect materials 30,000 25,500 Power 5,000 3,800 Fixed costs

Depreciation 12,000 12,000 Insurance 2,000 2,050 Total overhead costs $ 89,000 $ 77,350

Static Budgets and Performance Reports

CheeseCo

(4)

Static Actual

Budget Results Variances

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

Static Actual

Budget Results Variances

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

Ind irect 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

Static Budgets and Performance Reports

U = Unfavorable variance

CheeseCo was unable to achieve the budgeted level of activity.

CheeseCo

(5)

Static Actual

Budget Results Variances

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

Static Actual

Budget Results Variances

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

Ind irect 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

Static Budgets and Performance Reports

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

CheeseCo

(6)

Static Actual

Budget Results Variances

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

Static Actual

Budget Results Variances

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

Ind irect 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

Static Budgets and Performance Reports

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

CheeseCo

(7)

Static Budgets and Performance Reports

I don’t think I can answer the

question using a static budget.

Actual activity is below budgeted activity which

is unfavorable.

So, shouldn’t variable costs be lower if actual activity

is lower?

(8)

 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.

Static Budgets and Performance

Reports

(9)

Flexible Budgets

Improve performance evaluation.

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

Show revenues and expenses that should have occurred at the actual level of activity.

Reveal variances due to good cost

control or lack of cost control.

(10)

Flexible Budgets

Central Concept

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

and revenue should have been.

(11)

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

Va ria ble

(12)

Preparing a Flexible Budget

Let’s prepare

budgets

for CheeseCo.

(13)

Cost Total Flexible Budgets

Formula Fixed 8,000 10,000 12,000

Per Hour Cost Hours Hours Hours

Machine hours 8,000 10,000 12,000 Variable costs

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

Depreciation $ 12,000

Insurance 2,000

Total fixed cost

Total overhead costs

Preparing a Flexible Budget

Fixed costs are expressed as a

total amount.

Variable costs are expressed as a constant amount per hour.

$40,000 ÷ 10,000 hours is

$4.00 per hour.

CheeseCo

(14)

Formula Fixed 8,000 10,000 12,000

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

Depreciation $ 12,000

Insurance 2,000

Total fixed cost

Total overhead costs

Preparing a Flexible Budget

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

CheeseCo

(15)

Preparing a Flexible Budget

Formula Fixed 8,000 10,000 12,000

Indirect labor 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

Depreciation $ 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

(16)

Preparing a Flexible Budget

Formula Fixed 8,000 10,000 12,000

Indirect labor 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

Depreciation $ 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 costs do not change in the relevant range.

CheeseCo

(17)

Let’s prepare a budget performance report for CheeseCo.

Flexible Budget

Performance Report

(18)

Cost Total

Formula Fixed Flexible Actual

Per Hour Costs Budget Results Variances

Machine hours 8,000 8,000 0

Variable costs

Indirect labor $ 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

Depreciation $ 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

Performance Report

Flexible budget is prepared for the same activity level

(8,000 hours) as actually achieved.

CheeseCo

(19)

Cost Total

Formula Fixed Flexible Actual

Per Hour Costs Budget Results Variances

Machine hours 8,000 8,000 0

Variable costs

Indirect labor $ 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 F Total variable costs $ 7.50 $ 60,000 $ 63,300 $ 3,300 U Fixed Expenses

Depreciation $ 12,000 $ 12,000 $ 12,000 0 Insurance 2,000 2,000 2,050 50 U

Total fixed costs $ 14,000 $ 14,050 50 U

Total overhead costs $ 74,000 $ 77,350 $ 3,350 U

Flexible Budget

Performance Report

CheeseCo

(20)

Remember the question:

“How much of the total variance is due to activity

and how much is due to cost control?”

Flexible Budget

Performance Report

(21)

Static Actual

Budget Results Variances

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

Ind irect 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

Static Budgets and Performance

How much of the $11,650 is due to activity

and how much is due to cost control?

(22)

Flexible Budget

Performance Report

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

Overhead Variance Analysis

Static Actual

Overhead Overhead

Budget at at

10,000 Hours 8,000 Hours

89,000

$ $ 77,350

Let’s place the flexible budget for 8,000 hours

here.

(23)

Flexible Budget

Performance Report

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

Overhead Variance Analysis

Activity

This $3,350U flexible budget variance is due

to poor cost control.

Cost control

Static Flexible Actual

Overhead Overhead Overhead

Budget at Budget at at

10,000 Hours 8,000 Hours 8,000 Hours 89,000

$ $ 74,000 $ 77,350

(24)

Flexible Budget

Performance Report

What causes the cost

control variance?

There are two primary reasons for unfavorable

variable overhead variances:

1. Spending too much for resources.

2. Using the resources

inefficiently.

(25)

Overhead Rates and Overhead Analysis

Overhead from the flexible budget for the

denominator level of activity POHR =

Recall that overhead costs are assigned to products and services using a

predetermined overhead rate (POHR):

Assigned Overhead = POHR × Standard Activity

Denominator level of activity

(26)

Overhead Rates and Overhead Analysis – Example

Let’s look at overhead rates in a

budget for ColaCo.

(27)

ColaCo prepared this budget for overhead:

Overhead Rates and Overhead Analysis – Example

Total Variable Total Fixed

Machine Variable Overhead Fixed Overhead

Hours Overhead Rate Overhead Rate

2,000

$ 4,000 ? $ 9,000 ?

4,000

8,000 ? 9,000 ?

ColaCo applies overhead based on machine hour activity.

Let’s calculate overhead rates.

(28)

Overhead Rates and Overhead Analysis – Example

Rate = Total Variable Overhead ÷ Machine Hours

ColaCo prepared this budget for overhead:

This rate is constant at all levels of activity.

Total Variable Total Fixed

Machine Variable Overhead Fixed Overhead

Hours Overhead Rate Overhead Rate

2,000

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

8,000 2.00 9,000 ?

(29)

Total Variable Total Fixed

Machine Variable Overhead Fixed Overhead

Hours Overhead Rate Overhead Rate

2,000

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

8,000 2.00 9,000 2.25

Overhead Rates and Overhead Analysis – Example

Rate = Total Fixed Overhead ÷ Machine Hours

ColaCo prepared this budget for overhead:

This rate decreases when activity increases.

(30)

Total Variable Total Fixed

Machine Variable Overhead Fixed Overhead

Hours Overhead Rate Overhead Rate

2,000

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

8,000 2.00 9,000 2.25

Overhead Rates and Overhead Analysis – Example

The total POHR is the sum of the fixed and variable rates

for a given activity level.

ColaCo prepared this budget for overhead:

(31)

Overhead Variances

Let’s use the

overhead rates, to determine variable and fixed overhead

variances.

(32)

ColaCo’s 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.

Compute the variable overhead spending and efficiency variances.

Variable Overhead Variances –

Example

(33)

Variable Overhead Variances

AH × SR

AH × AR

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

SH × SR

Spending

Variance Efficiency Variance

Actual Flexible Budget Flexible Budget Variable for Variable for Variable

Overhead Overhead at Overhead at

Incurred Actual Hours Standard Hours

(34)

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 unfavorable

Efficiency variance

$200 unfavorable

$340 unfavorable flexible budget total variance

(35)

Variable Overhead Variances – A Closer Look

Spending Variance Efficiency Variance

Results from paying more or less than expected for overhead items and from

excessive usage of overhead items.

Controlled by managing the

overhead cost driver.

(36)

Overhead Variances

Now let’s turn our attention

to fixed

overhead.

(37)

Overhead Rates and Overhead Analysis – Example

ColaCo prepared this budget for overhead:

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

Total Variable Total Fixed

Machine Variable Overhead Fixed Overhead

Hours Overhead Rate Overhead Rate

2,000

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

8,000 2.00 9,000 2.25

(38)

Overhead Rates and Overhead Analysis – Example

ColaCo prepared this budget for overhead:

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

Total Variable Total Fixed

Machine Variable Overhead Fixed Overhead

Hours Overhead Rate Overhead Rate

2,000

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

8,000 2.00 9,000 2.25

(39)

ColaCo’s actual production required 3,200

standard machine hours. Actual fixed overhead was $8,450.

Compute the fixed overhead budget and volume variances.

Fixed Overhead Variances –

Example

(40)

Fixed Overhead Variances

Budget

Variance Volume

Variance

FR = Standard Fixed Overhead Rate SH = Standard Hours Allowed

SH × FR

Actual Fixed Fixed Fixed

Overhead Overhead Overhead

Incurred Budget Applied

(41)

3,200 hours ×

$3.00 per hour

Budget variance

$550 favorable

Fixed Overhead Variances – Example

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

Actual Fixed Fixed Fixed

Overhead Overhead Overhead

Incurred Budget Applied

Volume variance

$600 favorable

SH × FR

(42)

Fixed Overhead Variances – A Closer Look

Budget Variance Volume Variance

Results from paying more or less than expected for

overhead items.

Results from operating at an activity level

different from the

denominator activity.

(43)

Overhead Variances

Let’s look at a graph showing fixed overhead variances. We will

use ColaCo’s

numbers from the

previous example.

(44)

Volume Cost

3,200 Standard 3,000 Hours

Expected

Fixed Overhead Variances

Fix ed ov erh ea d

ap plie d t o p rod uc ts

(45)

Fixed Overhead Variances

$8,450 actual fixed OH

Volume Cost

$9,600 applied fixed OH

$9,000 budgeted fixed OH

3,200 Standard 3,000 Hours

Expected Fix ed ov erh ea d

ap plie d t o p rod uc ts

3,200 machine hours × $3.00 fixed overhead rate

(46)

{

Favorable $600 Volume Variance

Fixed Overhead Variances

{

Favorable $550 Budget Variance

$8,450 actual fixed OH

Volume Cost

$9,600 applied fixed OH

$9,000 budgeted fixed OH

3,200 Standard 3,000 Hours

Expected Fix ed ov erh ea d

ap plie d t o p rod uc ts

3,200 machine hours × $3.00 fixed overhead rate

{

(47)

Results when standard hours allowed for actual output differs

from the denominator activity.

Volume Variance – A Closer Look

Volume Variance

Favorable

when standard hours

> denominator hours Unfavorable

when standard hours

< denominator hours

(48)

Results when standard hours allowed for actual output differs

from the denominator activity.

Volume Variance – A Closer Look

Volume Variance

Favorable

when standard hours

> denominator hours Unfavorable

when standard hours

< denominator hours

Does not measure over- or under spending

Explainable by and

controllable only through

activity

(49)

Overhead Variances and Under- or Overapplied Overhead Cost

The sum of the overhead variances equals the under- or overapplied

overhead cost for a period.

Favorable

variances are equivalent to overapplied overhead.

Unfavorable

variances are equivalent to underapplied overhead.

In a standard

cost system:

(50)