Chapter 11

Flexible Budgeting and the Management of Overhead and Support Activity Costs

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Flexible Budgets
Static budgets are prepared for a single, planned level of activity. Performance evaluation for overhead is difficult when actual activity differs from the planned level of activity.
Hmm! Comparing static budgets with actual costs is like comparing apples and oranges.

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

Consider the following example from the Cheese Company . . .

Static Budgets and Performance Reports

Static Budget Machine hours Variable costs Indirect labor Indirect materials Power Fixed costs Depreciation Insurance Total overhead costs 10,000 $ 40,000 30,000 5,000 12,000 2,000 $ 89,000 Actual Results 8,000 Variances 2,000 U

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

Static Budgets and Performance Reports

F = Favorable variance since actual costs Static Actual are less than budgeted costs.
Budget Machine hours Variable costs Indirect labor Indirect materials Power Fixed costs Depreciation Insurance Total overhead costs 10,000 $ 40,000 30,000 5,000 12,000 2,000 $ 89,000 Results 8,000 $ 34,000 25,500 3,800 12,000 2,000 $ 77,300 Variances 2,000 U $6,000 F 4,500 F 1,200 F 0 0 $11,700 F

Static Budgets and Performance Reports

Static Budget Machine hours Variable costs Indirect labor Indirect materials Power Fixed costs we done a good Depreciation Insurance 10,000 $ 40,000 30,000 5,000 Actual Results 8,000 $ 34,000 25,500 3,800 Variances 2,000 U $6,000 F 4,500 F 1,200 F 0 0 $11,700 F

Since cost variances are favorable, have job controlling costs? 12,000 12,000
2,000 $ 89,000 2,000 $ 77,300

Total overhead costs

Static Budgets and Performance Reports

I dont think I can answer this question using a static budget. I do know that actual activity is below budgeted activity which is unfavorable. But shouldnt variable costs be lower if actual activity is below budgeted activity?

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.

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.

Advantages of Flexible Budgets

Show revenues and expenses that should have occurred at the actual level of activity. May be prepared for any activity level in the relevant range. Reveal variances due to good cost control or lack of cost control. Improve performance evaluation.

Learning Objective 2

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Preparing a Flexible Budget

Preparing a Flexible Budget

Variable Cost Per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs 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 10,000 12,000

Preparing a Flexible Budget

Variable Cost Per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs 4.00 3.00 0.50 7.50 Total Fixed Cost Flexible Budgets 8,000 10,000 12,000 Hours Hours Hours

8,000 10,000 12,000 Variable costs are expressed as a constant amount per hour. $ 32,000 24,000 4,000 $ 60,000

$12,000 2,000

Preparing a Flexible Budget

Variable Cost Per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs 4.00 3.00 0.50 7.50 Total Fixed Cost Flexible Budgets 8,000 10,000 12,000 Hours Hours Hours 8,000 10,000 12,000

Fixed costs are expressed as a $ amount that does not total 32,000 24,000 change within the relevant 4,000 range $ 60,000 of activity.
$12,000 2,000

Preparing a Flexible Budget

Variable Cost Per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs 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 $ 12,000 2,000 $ 14,000 $ 74,000 10,000 12,000

Preparing a Flexible Budget

Variable Cost Per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost Fixed costs Depreciation Insurance Total fixed cost Total overhead costs 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 $ 12,000 2,000 $ 14,000 $ 74,000 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

Preparing a Flexible Budget

Variable Cost Per Hour Machine hours Variable costs Indirect labor Note: There is no Indirect material in the fixed costs. Power Total variable cost $ Fixed costs Depreciation Insurance Total fixed cost Total overhead costs 4.00 flex 3.00 0.50 7.50 Total Fixed Cost Flexible Budgets 8,000 10,000 12,000 Hours Hours Hours 8,000 $ 32,000 24,000 4,000 $ 60,000 $12,000 2,000 $ 12,000 2,000 $ 14,000 $ 74,000 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

Preparing a Flexible Budget

Variable Cost Per Hour Machine hours Total Fixed Cost Flexible Budgets 8,000 10,000 12,000 Hours Hours Hours 8,000 10,000 $ 40,000 30,000 5,000 Budgeted $ 75,000 $ 12,000 2,000 $ 14,000 $ 89,000 12,000 $ 48,000 36,000 6,000 fixed90,000 $ $ 12,000 2,000 $ 14,000 $ 104,000

Total budgeted Variable costs Indirect labor 4.00 $ 32,000 overhead cost Indirect material 3.00 24,000 Power 0.50 Budgeted variable Total 4,000 Total variable cost cost per $ overhead $ 7.50 activity60,000 activity unit Fixed costs Depreciation Insurance Total fixed cost Total overhead costs

units

overhead cost

$12,000 2,000

$ 12,000 2,000 $ 14,000 $ 74,000

Flexible Budget Performance Report

Flexible Budget Performance Report

Variable Cost Per Hour Machine hours Variable costs Indirect labor $ Indirect material Power Total variable costs $ Fixed Expenses Depreciation Insurance Total fixed costs Total overhead costs 4.00 3.00 0.50 7.50 $12,000 2,000 Total Fixed Costs Flexible Budget Actual Results 8,000 $ 34,000 25,500 3,800 $ 63,300 $ 12,000 2,000 $ 14,000 $ 77,300 Variances 0

Flexible Budget Performance Report

Variable Total Flexible budget is Cost Fixed prepared for the Per Hour Costs Machine hours Flexible Budget 8,000 Actual Results 8,000 $ 34,000 25,500 3,800 $ 63,300 $ 12,000 2,000 $ 14,000 $ 77,300 Variances 0

same activity level (8,000 hours) as Variable costs actually$achieved. Indirect labor 4.00
Indirect material Power Total variable costs $ Fixed Expenses Depreciation Insurance Total fixed costs Total overhead costs 3.00 0.50 7.50 $12,000 2,000

Flexible Budget Performance Report

Variable Cost Per Hour Machine hours Variable costs Indirect labor $ Indirect material Power Total variable costs $ Fixed Expenses Depreciation Insurance Total fixed costs Total overhead costs 4.00 3.00 0.50 7.50 $12,000 2,000 Total Fixed Costs Flexible Budget 8,000 $ 32,000 24,000 4,000 $ 60,000 $ 12,000 2,000 $ 14,000 $ 74,000 Actual Results 8,000 $ 34,000 25,500 3,800 $ 63,300 $ 12,000 2,000 $ 14,000 $ 77,300 Variances 0 $ 2,000 U 1,500 U 200 F $ 3,300 U 0 0 0 $ 3,300 U

Flexible Budget Performance Report

Indirect indirect Machine hours material have unfavorable variances Variable costs because costs Indirect labor actual4.00 $ Indirect material than the are more 3.00 Power flexible budget 0.50 costs.
Total variable costs $ Fixed Expenses Depreciation Insurance Total fixed costs Total overhead costs 7.50 Variable Total Cost Fixed laborHour Costs Per and Flexible Budget 8,000 $ 32,000 24,000 4,000 $ 60,000 $ 12,000 2,000 $ 14,000 $ 74,000 Actual Results 8,000 $ 34,000 25,500 3,800 $ 63,300 $ 12,000 2,000 $ 14,000 $ 77,300 Variances 0 $ 2,000 U 1,500 U 200 F $ 3,300 U 0 0 0 $ 3,300 U

$12,000 2,000

Flexible Budget Performance Report

Variable Cost Per Hour Machine hours Total Fixed Costs Flexible Budget 8,000 $ 32,000 24,000 4,000 $ 60,000 $ 12,000 2,000 $ 14,000 $ 74,000 Actual Results 8,000 $ 34,000 25,500 3,800 $ 63,300 $ 12,000 2,000 $ 14,000 $ 77,300 Variances 0 $ 2,000 U 1,500 U 200 F $ 3,300 U 0 0 0 $ 3,300 U

Power has a favorable Variable costs variance because the Indirect labor $ 4.00 actual cost is Indirect material less than 3.00 Power 0.50 the flexible budget cost.
7.50 $12,000 2,000

Total variable costs $ Fixed Expenses Depreciation Insurance Total fixed costs Total overhead costs

Learning Objective 3

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Overhead Application in a Standard Costing System

Normal Costing Manufacturing Overhead Actual Applied overhead overhead: Actual hours x Predetermined overhead rate Difference lies in the quantity of hours used. Manufacturing Overhead Actual Applied overhead overhead: Standard allowed hours x Predetermined overhead rate Work-in-Process Inventory Applied overhead: Actual hours x Predetermined overhead rate

Standard Costing Work-in-Process Inventory Applied overhead: Standard allowed hours x Predetermined overhead rate

Overhead Application in a Standard Costing System

Budgeted Overhead Planned Monthly Activity Predetermined Overhead Rate

Variable . . . . $ 60,000 * . . . . . . . . . 8,000 machine hours . . . . . . . . $ 7.50 per process hour Fixed . . . . . . . 14,000 * . . . . . . . . . 8,000 machine hours . . . . . . . . 1.75 per process hour Total . . . . . . . $ 74,000 . . . . . . . . . 8,000 machine hours . . . . . . . . $ 9.25 per process hour
* From the flexible budget for planned activity of 8,000 machine hours

Learning Objective 4

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Choice of Activity Measure



Variable overhead and the activity measure should vary in a similar pattern. Identify variable overhead cost drivers.


Examples: machine hours, labor hours, process time.

Dollar measures should be avoided as they are subject to price-level changes.

Learning Objective 5

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost Management Using Overhead Cost Variances

Lets turn our attention to the computation of overhead cost variances. We will begin with variable overhead.

Variable Overhead Variances

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

Spending Variance
AH AR SVR SH

Efficiency Variance

= Actual Hours of Activity = Actual Variable Overhead Rate = Standard Variable Overhead Rate = Standard Hours Allowed

Variable Overhead Variances

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

Spending Variance

Efficiency Variance

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

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. Compute the variable overhead spending and efficiency variances.

Variable Overhead Variances Example

ColaCo prepared this
Total budgeted overhead cost Budgeted variable overhead cost per activity unit Total x activity units

budget for overhead:

= +
Budgeted fixed overhead cost

Total budgeted overhead cost

$2.00 per machine hour

Total machine hours

$9,000

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 Flexible Budget for Variable Overhead at Standard Hours 3,200 hours $2.00 per hour $6,400

$6,740

Spending variance $140 unfavorable

Efficiency variance $200 unfavorable

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 Flexible Budget for Variable Overhead at Standard Hours 3,200 hours $2.00 per hour $6,400

$6,740

The $140 unfavorable spending variance and the $200 unfavorable efficiency variance result in a $340 unfavorable flexible budget variance.

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.

Efficiency Variance
A function of the selected cost driver. It does not reflect overhead control.

Fixed Overhead

Now lets turn our attention to fixed overhead.

Fixed Overhead Variances

Actual Fixed Overhead Incurred Fixed Overhead Budget Fixed Overhead Applied SH PFOHR

Budget Variance

Volume Variance

PFOHR = Predetermined Fixed Overhead Rate SH = Standard Hours Allowed

Fixed Overhead
Recall that fixed overhead costs are applied to products and services using a predetermined fixed overhead rate (PFOHR):
Applied Fixed Overhead = PFOHR Standard Hours

PFOHR

Budgeted Fixed Overhead Planned Activity in Hours

Fixed Overhead Variances Example

ColaCo used the following predetermined fixed overhead rate:
PFOHR PFOHR PFOHR = = = Budgeted Fixed Overhead Planned Activity in Hours $9,000 3,000 machine hours $3.00 per machine hour

Fixed Overhead Variances Example

ColaCos 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

Actual Fixed Overhead Incurred Fixed Overhead Budget Fixed Overhead Applied 3,200 hours $3.00 per hour $8,450 $9,000 $9,600

Budget variance $550 favorable

Volume variance $600 (neither favorable nor unfavorable)

Fixed Overhead Variances

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

Fixed Overhead Variances A Closer Look

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

Volume Variance
Results from the inability to operate at the activity level planned for the period. Has no significance for cost control.

Fixed Overhead Variances

Cost $600 Volume Variance $550 Favorable Budget Variance
3,200 machine hours $3.00 fixed overhead rate

{ $9,000 budgeted fixed OH { $8,450

actual fixed OH

$9,600 applied fixed OH

3,000 Hours Planned Activity

Volume 3,200 Standard Hours

Learning Objective 6

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Overhead Cost Performance Report

Variable costs: Indirect material: Wax Plastic wrap Paper products Misc. supplies Indirect labor: Maintenance Janitorial Utilities: Electricity Natural gas Water Total variable cost

Fixed costs: Indirect labor: Inspection Production supervisor Set up Depreciation: Equipment Insurance Property taxes Total fixed cost Total overhead cost

Learning Objective 7

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

ActivityActivity-Based Flexible Budget

Variable Cost Per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost 4.00 3.00 0.50 7.50 Total Fixed Cost Flexible Budgets 8,000 10,000 12,000 Hours Hours Hours 8,000 $ 32,000 24,000 4,000 $ 60,000 $ 12,000 2,000 $ 14,000 $ 74,000 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

Fixed costs Depreciation $12,000 The Cheese Co. flexible Insurance 2,000 budget is based on a single Total fixed cost cost driver, machine hours Total overhead costs

ActivityActivity-Based Flexible Budget

Variable Cost Per Hour Machine hours Variable costs Indirect labor Indirect material Power Total variable cost 4.00 3.00 0.50 7.50 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 $ 40,000 30,000 5,000 $ 75,000 12,000 $ 48,000 36,000 6,000 $ 90,000

Fixed costs If different cost drivers are identified for the Depreciation $ different variable costs,12,000 $ 12,000 $ 12,000 $ 12,000 an activity-based flexible 2,000 Insurance 2,000 2,000 2,000 budget should be prepared $ 14,000 $ 14,000 $ 14,000 with different cost Total fixed cost Total overhead costs $ 74,000 $ 89,000 formulas based on the different drivers. $ 104,000

Learning Objective 8

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Standard Costs and Product Costing

Standard Costing Manufacturing Overhead Actual Applied overhead overhead: Standard allowed hours x Predetermined overhead rate Work-in-Process Inventory Applied overhead: Standard allowed hours x Predetermined overhead rate

Standard Costs and Product Costing

Disposition of Variances Manufacturing Overhead Cost of Goods Sold Actual Applied Balance (1) Balance (2) overhead overhead: Actual Applied Standard overhead overhead allowed hours greater than greater than x Applied Actual Predetermined overhead overhead overhead rate Balance (1) Balance (2) Balance (2) Balance (1)

Learning Objective 9

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

A General Model for Variance Analysis

Actual Quantity Actual Price Actual Quantity Standard Price Standard Quantity Standard Price

Price Variance
Materials price SP) AQ(AP - variance Labor rate variance AQ =Variable overhead Actual Quantity AP = spendingPrice Actual variance

Quantity Variance
Materials quantity variance SP(AQ - SQ) Labor efficiency variance SP = Standard Price Variable overhead SQ = Standard Quantity efficiency variance

A General Model for Variance Analysis

Actual Sales Volume Actual Sales Price Actual Sales Volume Budgeted Sales Price Budgeted Sales Volume Budgeted Sales Price

Sales Price Variance

ASV(ASP - BSP) ASV = Actual Sales Volume ASP = Actual Sales Price

Sales Volume Variance

BSP(ASV - BSV) BSP = Budgeted Sales Price BSV = Budgeted Sales Volume

End of Chapter 11
Im here to your budget. Are you ready to ante up?