Hilton • Maher • Selto

17Flexible Budgets, Overhead

Cost Management, and Activity-Based Budgeting

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.

17-3

A flexible budget is valid for a range of activity

A flexible budget is valid for a range of activity A static budget

is based on aparticular planned

level of activity

A static budget is based on a

particular planned level of activity

This range of activity isthe relevant range

This range of activity isthe relevant range

A flexible overhead budget is defined as a detailed plan for controlling overhead cost

valid in the firm’s relevant range of activity

A flexible overhead budget is defined as a detailed plan for controlling overhead cost

valid in the firm’s relevant range of activity

What Are Flexible Overhead Budgets?

17-4

Based on planned June production of 4,000 tents, at 1.5

machine hours per tent.

We cannot tell from this budget what it would cost to make

3,000 tents.

Based on planned June production of 4,000 tents, at 1.5

machine hours per tent.

We cannot tell from this budget what it would cost to make

3,000 tents.

Based ononly ONE

anticipatedactivity

level

Based ononly ONE

anticipatedactivity

level

Includes several possible activity levels

Static Budget Versus Flexible Budget

Exh.17-1

17-5

ActualElectricity Cost

ActualElectricity Cost

BudgetedElectricity Cost(static budget)

BudgetedElectricity Cost(static budget)

$1,050$1,050 $1,200$1,200

The manager is comparing the electricity cost incurred at the ACTUAL activity level (3,000 tents) with the budgeted electricity

cost at the PLANNED activity level (4,000 tents).

The manager is comparing the electricity cost incurred at the ACTUAL activity level (3,000 tents) with the budgeted electricity

cost at the PLANNED activity level (4,000 tents).

These activity levels are different, therefore we would expect the electricity cost to be different

These activity levels are different, therefore we would expect the electricity cost to be different

Advantages Of Flexible Budgets

Cost VarianceCost Variance

$150 Favorable$150 Favorable

17-6

ActualElectricity Cost

ActualElectricity Cost

BudgetedElectricity Cost(flexible budget)

BudgetedElectricity Cost(flexible budget)

Cost VarianceCost Variance

$1,050$1,050 $900$900 $150 Unfavorable$150 Unfavorable

The manager is comparing the electricity cost incurred at the ACTUAL activity level, 3,000 tents with the budgeted electricity

cost at the ACTUAL activity level, (3,000 tents x 1.5 machine hours) = 4,500 machine hours

The manager is comparing the electricity cost incurred at the ACTUAL activity level, 3,000 tents with the budgeted electricity

cost at the ACTUAL activity level, (3,000 tents x 1.5 machine hours) = 4,500 machine hours

Electrical cost was greater than it should have been, given the actual level of output

Electrical cost was greater than it should have been, given the actual level of output

Advantages Of Flexible Budgets

17-7

ProductUnits

Produced

Standard Machine

Hours Per Unit

Total Standard Allowed Machine

HoursTree Line Model 1,200 1.5 1,800River's Edge Model 900 1.8 1,620Valley Model 700 2 1,400

Total 2,800 4,820

ProductUnits

Produced

Standard Machine

Hours Per Unit

Total Standard Allowed Machine

HoursTree Line Model 1,200 1.5 1,800River's Edge Model 900 1.8 1,620Valley Model 700 2 1,400

Total 2,800 4,820

Output measures require different inputs

Output measures require different inputs

Output measures can be used if you only make one

product

Output measures can be used if you only make one

product

Flexible budget must be based on outputs that

can be compared

Flexible budget must be based on outputs that

can be compared

Activity Measure: Based On Input Or Output

17-8

1.5 standardallowed

machine hours per

tent

1.5 standardallowed

machine hours per

tent

Activity: Standard allowed machine hours 4,500 6,000 7,500

Budgeted electricity costs $900 $1,200 $1,500

Flexible budget (based on input)

Activity: Standard allowed machine hours 4,500 6,000 7,500

Budgeted electricity costs $900 $1,200 $1,500

Flexible budget (based on input)

Activity: tents manufactured 3,000 4,000 5,000Budgeted electricity costs $900 $1,200 $1,500

Flexible budget (based on output)Activity: tents manufactured 3,000 4,000 5,000Budgeted electricity costs $900 $1,200 $1,500

Flexible budget (based on output)

Usually not a meaningful measure in a multi-product firm becauseit would require us to add numbers of unlike products

Usually not a meaningful measure in a multi-product firm becauseit would require us to add numbers of unlike products

Output is measured in terms of the

standard allowed

input, given actual output

Output is measured in terms of the

standard allowed

input, given actual output

Flexible Budgets: Inputs Versus Outputs

17-9

If you recall, this is similar to the

Predetermined Cost-Driver Rate

discussed in Chapter 4.

If you recall, this is similar to the

Predetermined Cost-Driver Rate

discussed in Chapter 4.

Total Budgeted Monthly

Overhead Cost =

Budgeted Variable-

Overhead Cost per Activity Unit

×Total

Activity Units

+Budgeted Fixed-Overhead Cost

per Month.

EXAMPLEAssume that the company needs flexible budget numbers for three activity levels:

4,500 hours, 6,000 hours, and 7,500 hours.

Also, assume that the Predetermined Budgeted Variable-Overhead Cost per Activity Unit is $6 per hour. Budgeted Fixed-Overhead Cost for the month is

$30,000.

EXAMPLEAssume that the company needs flexible budget numbers for three activity levels:

4,500 hours, 6,000 hours, and 7,500 hours.

Also, assume that the Predetermined Budgeted Variable-Overhead Cost per Activity Unit is $6 per hour. Budgeted Fixed-Overhead Cost for the month is

$30,000. Flexible Budget?Flexible Budget?

Formula Flexible Budget

17-10

$57,000 $66,000 $75,000

= $6 ×4,500 6,000 7,500

+ $30,000

The flexed total budgeted monthly overhead for each activity level can now be used

effectively in planning and variance analysis.

The flexed total budgeted monthly overhead for each activity level can now be used

effectively in planning and variance analysis.

Formula Flexible Budget

Total Budgeted Monthly

Overhead Cost =

Budgeted Variable-

Overhead Cost per Activity Unit

×Total

Activity Units

+Budgeted Fixed-Overhead Cost

per Month

17-11

Manufacturing Overhead Work-in-Process Inventory

Actualoverhead

Appliedoverhead

Actualhours

Predeterminedoverhead

rate

X

Appliedoverhead

Actualhours

Predeterminedoverhead

rate

X

Overhead Application - Normal Costing

The Differencebetween Normal

Costing andStandard

Costing lies inthe quantity of

hours used

The Differencebetween Normal

Costing andStandard

Costing lies inthe quantity of

hours used

Exh.17-4

17-12

Manufacturing Overhead Work-in-Process Inventory

Actualoverhead

Appliedoverhead

Standardallowedhours

Predeterminedor standardoverhead

rate

X

Appliedoverhead

Standardallowedhours

Predeterminedor standardoverhead

rate

X

Overhead Application - Standard Costing

The Differencebetween Normal

Costing andStandard

Costing lies inthe quantity of

hours used

The Differencebetween Normal

Costing andStandard

Costing lies inthe quantity of

hours used

Exh.17-4

17-13

Both normal-costing and standard-costing systems use an overhead rate computed at the beginning of the accounting

period (predetermined overhead rate)

Both normal-costing and standard-costing systems use an overhead rate computed at the beginning of the accounting

period (predetermined overhead rate)

Budgeted Overhead

Planned Monthly Activity

Predetermined Overhead Rate

Variable $36,000 6,000 machine hours $6.00Fixed $30,000 6,000 machine hours $5.00

Total $66,000 6,000 machine hours $11.00

Budgeted Overhead

Planned Monthly Activity

Predetermined Overhead Rate

Variable $36,000 6,000 machine hours $6.00Fixed $30,000 6,000 machine hours $5.00

Total $66,000 6,000 machine hours $11.00

Computed annuallyComputed annually

Predetermined Overhead Rates

Exh.17-5

17-14

Choice Of Activity Measure

How should the cost manager select the activity measure for the flexible budget?

How should the cost manager select the activity measure for the flexible budget?

The variable overhead cost

and the activity measure

should move together

The variable overhead cost

and the activity measure

should move together

Direct labor time has traditionally been the most

popular activity measure in manufacturing firms

Direct labor time has traditionally been the most

popular activity measure in manufacturing firms

As automation increases, more

firms are switching to machine hours or process time

As automation increases, more

firms are switching to machine hours or process time

Dollar measures, such as direct-labor or

material costs can be misleading because they are subject to price-level changes

and other fluctuations

Dollar measures, such as direct-labor or

material costs can be misleading because they are subject to price-level changes

and other fluctuations

17-15

Koala manufactured 3,000 tree line tents X 1.5 machine hours per tent= standard allowed 4,500 machine hours

Koala manufactured 3,000 tree line tents X 1.5 machine hours per tent= standard allowed 4,500 machine hours

Actual machine hours for June = 4,800

Actual machine hours for June = 4,800

The total variable overhead variance for June =

Actual variable overhead $30,480Budget variable overhead $27,000

$ 3,480 F

The total variable overhead variance for June =

Actual variable overhead $30,480Budget variable overhead $27,000

$ 3,480 F

Overhead Cost Variances

For standard allowed 4,500 machine hours the budget overhead (from Exhibit 17-3) for June =

Variable overhead $27,000Fixed overhead $30,000

For standard allowed 4,500 machine hours the budget overhead (from Exhibit 17-3) for June =

Variable overhead $27,000Fixed overhead $30,000

From the cost accounting records, the actual overhead for June =Variable overhead $30,480Fixed overhead $32,500

$62,980

From the cost accounting records, the actual overhead for June =Variable overhead $30,480Fixed overhead $32,500

$62,980

17-16

The VARIABLE-OVERHEAD SPENDING VARIANCE is the difference betweenthe actual variable overhead cost and the product of the standardvariable -overhead rate and the actual hours of an activity base

(or cost driver)

The VARIABLE-OVERHEAD SPENDING VARIANCE is the difference betweenthe actual variable overhead cost and the product of the standardvariable -overhead rate and the actual hours of an activity base

(or cost driver)

Variable Overhead VariancesExh.17-6

???? ???? ???? ????4,800 machinehours

4,800 machinehours

$6.35 permachine hour

$6.35 permachine hour

4,800 machine hours

4,800 machine hours

$6.00 per machine hour

$6.00 per machine hour

Actual variable overheadActual variable overhead

Actual machine hours (AH)

Actual machine hours (AH)

Actual rate (AVR)

Actual rate (AVR)

Actual machine hours (AH)

Actual machine hours (AH)

Standard rate (SVR)

Standard rate (SVR)

Actual machine hours × the standard rate

Actual machine hours × the standard rate

$30,480$30,480 $28,800$28,800

$1,680 UnfavorableVariable-overheadspending variance

$1,680 UnfavorableVariable-overheadspending variance

17-17

$27,000$27,000$28,800$28,800

?? ?? ?? ??

The VARIABLE-OVERHEAD EFFICIENCY VARIANCE is the difference betweenthe actual and the standard hours of an activity base (or cost driver)

multiplied by the standard variable overhead rate

The VARIABLE-OVERHEAD EFFICIENCY VARIANCE is the difference betweenthe actual and the standard hours of an activity base (or cost driver)

multiplied by the standard variable overhead rate

Flexible budget:variable overhead

Flexible budget:variable overhead

Standard allowed machine hours (SH)

Standard allowed machine hours (SH)

Standard rate (SVR)

Standard rate (SVR)

Actual machine hours (AH)

Actual machine hours (AH)

Standard rate (SVR)

Standard rate (SVR)

Actual machine hours timesthe standard rate

Actual machine hours timesthe standard rate

Variable Overhead Variances

4,500 machinehours

4,500 machinehours

$6.00 permachine hour

$6.00 permachine hour

4,800 machine hours

4,800 machine hours

$6.00 per machine hour

$6.00 per machine hour

Exh.17-6

$1,800 UnfavorableVariable-overheadefficiency variance

$1,800 UnfavorableVariable-overheadefficiency variance

17-18

?? ?? ?? ??

The flexible budget amount for variable overhead $27,000 is the amount that will be applied to Work-in-Process for

product-costing purposes

The flexible budget amount for variable overhead $27,000 is the amount that will be applied to Work-in-Process for

product-costing purposes

Flexible budget:variable overhead

Flexible budget:variable overhead

Standard allowed machine hours (SH)

Standard allowed machine hours (SH)

Standard rate (SVR)

Standard rate (SVR)

Variable overhead appliedto work in process

Variable overhead appliedto work in process

$27,000$27,000

Standard allowed machine hours (SH)

Standard allowed machine hours (SH)

Standard rate (SVR)

Standard rate (SVR)

4,500 machinehours

4,500 machinehours

$6.00 permachine hour

$6.00 permachine hour

4,500 machinehours

4,500 machinehours

$6.00 permachine hour

$6.00 permachine hour

No differenceNo difference

Variable Overhead VariancesExh.17-6

$27,000$27,000

17-19

??The unfavorable variance resulting from using more

machine hours than the standard quantity, given actual output

The unfavorable variance resulting from using more

machine hours than the standard quantity, given actual output

The actual labor rate per hourdiffers from the standard rate

The actual labor rate per hourdiffers from the standard rate

Efficiency varianceEfficiency variance Spending varianceSpending variance

The variable overhead efficiency variance has nothing to do with

efficient or inefficient use of variable overhead items

The variable overhead efficiency variance has nothing to do with

efficient or inefficient use of variable overhead items

An unfavorable variance meansthat the total actual cost of

variable overhead is > expected, after adjusting for the actual

quantity of machine hours used

An unfavorable variance meansthat the total actual cost of

variable overhead is > expected, after adjusting for the actual

quantity of machine hours used

The spending variance is thereal control variance for variable

overhead

The spending variance is thereal control variance for variable

overhead

How To Interpret The Variable Overhead Variances

17-20

The FIXED-OVERHEAD BUDGET VARIANCE is the difference between actual fixed overhead and budgeted fixed overhead

The FIXED-OVERHEAD BUDGET VARIANCE is the difference between actual fixed overhead and budgeted fixed overhead

Fixed-overheadbudget variance

Actual Fixedoverhead

Budgeted fixedoverhead= -

Fixed-overheadbudget variance

Actual Fixedoverhead =

$32,500

Budgeted fixedoverhead =

$30,000

= -

Unfavorable variance of $2,500, because we spent

more than budgeted

Unfavorable variance of $2,500, because we spent

more than budgeted

Fixed Overhead Budget Variance

17-21

The FIXED-OVERHEAD VOLUME VARIANCE is the difference between budgeted fixed overhead and actual fixed overhead. Assume that the predetermined fixed overhead per machine

hour = $5 and that it is based on 4,500 machine hours.

The FIXED-OVERHEAD VOLUME VARIANCE is the difference between budgeted fixed overhead and actual fixed overhead. Assume that the predetermined fixed overhead per machine

hour = $5 and that it is based on 4,500 machine hours.

Fixed-overheadvolume variance

Budgeted fixedoverhead

Applied fixedoverhead= -

Applied fixedoverhead =

$22,500

Fixed-overheadvolume variance

Budgeted fixed overhead =

$30,000= -

Variance = $7,500 U, because we produced less than budgeted.Variance = $7,500 U, because we produced less than budgeted.

Fixed Overhead Volume Variance

17-22

Budget VarianceBudget VarianceVolume VarianceVolume Variance

The real control variance for

fixed overhead because it

compares actualexpenditures with

budgeted fixed overhead costs

The real control variance for

fixed overhead because it

compares actualexpenditures with

budgeted fixed overhead costs

Reconciles the two different purposes of the cost accounting system

Reconciles the two different purposes of the cost accounting system

For cost-management purposes, the cost-accounting system

recognizes that fixedoverhead does not

change as production activity varies

For cost-management purposes, the cost-accounting system

recognizes that fixedoverhead does not

change as production activity varies

For product-costing purposes, budgeted

fixed overhead is divided by planned activity to obtain a predetermined or standard fixed-overhead rate

For product-costing purposes, budgeted

fixed overhead is divided by planned activity to obtain a predetermined or standard fixed-overhead rate

Managerial Interpretation Of Fixed-Overhead Variances

17-23

(1) Actualfixed O/H

(1) Actualfixed O/H

(2) Budgetedfixed O/H

(2) Budgetedfixed O/H

(3)Fixed overhead applied

to work in process

(3)Fixed overhead applied

to work in process

Standard allowedmachine hours

Standard allowedmachine hours

Standard fixedoverhead rate

Standard fixedoverhead rate

XX

4,500 machine hrs

4,500 machine hrs

$5.00 permachine hr$5.00 per

machine hrXX

$30,000$32,500

Fixed-overheadbudget variance =

$2,500 U

Fixed-overheadvolume variance =

$7,500 U

$22,500

Fixed Overhead Budget And Volume Variances

Exh.17-8

17-24

Fixed overhead

$30,000

$22,500

0

Applied fixed overhead ($5.00 per standard

allowed machine hour)

Budgeted fixedoverhead

Machinehours

Volume variance$7,500

4,500 Standardallowed hours,

given actualoutput

6,000Plannedmonthlyactivity

Appliedfixed

overheadin June

Budgeted Versus Applied Fixed Overhead

Exh.17-9

17-25

4-, 3-, & 2-way Variance Analysis

Four-way analysis

Three-way analysis

Two-way analysis

Variable-overheadspendingvariance

Fixed-overheadbudget

variance

Variable-overheadefficiencyvariance

Fixed-overheadvolumevariance

$1,680 U $2,500 U $1,800 U $7,500 U

Combined spendingvariance

$4,180 U $1,800 U $7,500 U

$5,980 U

Combined budget variance

Underapplied overhead

$7,500 U

$62,980 actual overhead - overhead applied to WIP, 49,500 = $13,480

Exh.17-10

17-26

Using The Overhead Cost Performance Report In Cost Management

An Overhead Cost Performance ReportAn Overhead Cost Performance Report

Shows the fixed overhead budget variance ,along with

the actual and budgeted cost for each fixed overhead item.

Shows the fixed overhead budget variance ,along with

the actual and budgeted cost for each fixed overhead item.

Shows the variable overhead spending and efficiency variances, along with the

actual and budgeted cost for each variable overhead item.

Shows the variable overhead spending and efficiency variances, along with the

actual and budgeted cost for each variable overhead item.

The report would be used by management to exercise control over each of the overhead costs.

The report would be used by management to exercise control over each of the overhead costs.

17-27

Manufacturing OverheadManufacturing Overhead

Actual $62,980 $49,500 Applied

Credit:Indirect-material inventory Wages payable Utilities payableAccumulated depreciationPrepaid insurance and property taxesEngineering salaries payable

19,35032,6102,1701,3001,050

6,500

Debit:Work-in-process inventory

Applied overhead:$11.00 (predetermined overhead rate) X4,500 (standard allowedhours

$49,500

$13,480Debit:Cost of goods sold

$13,480

Using Standard Costs InProduct Costing

17-28

An activity-based flexible budget may provide more useful cost management information than a conventional flexible budget

An activity-based flexible budget may provide more useful cost management information than a conventional flexible budget

The traditional budgetThe traditional budget Activity-based flexible budgetActivity-based flexible budget

Costs are categorizedas variable based on

volume measures

Costs are categorizedas variable based on

volume measures

Machinehours

Machinehours

Directlaborhours

Directlaborhours

Costs are categorizedas variable based onseveral cost drivers

Costs are categorizedas variable based onseveral cost drivers

Cost that may seem fixed withrespect to a single volume-based cost driver may be variable with

respect to other non-volume related cost drivers

Cost that may seem fixed withrespect to a single volume-based cost driver may be variable with

respect to other non-volume related cost drivers

Activity-Based Flexible Budget

17-29

End of Chapter 17

I wish I could figure out how to ……..

my paycheck!