Flexible Budgets and Overhead Analysis

Flexible Budgets and Overhead Analysis

Chapter

9

© The McGraw-Hill Companies, Inc., 2002Irwin/McGraw-Hill 2

Static Budgets and Performance Reports

Hmm! Comparingstatic budgets withactual costs is likecomparing apples

and oranges.

Let’s look at CheeseCo.

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.


Static ActualBudget Results Variances

Machine hours 10,000 8,000

Variable costs Indirect 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$


CheeseCo



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

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




U = Unfavorable variance CheeseCo was unable to achieve

the budgeted level of activity.

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 Power 5,000 3,800




CheeseCo

F = Favorable variance

Actual cost is less than budgeted cost.



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


CheeseCo



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




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

CheeseCo



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

Actual activity is belowbudgeted activity.

So, shouldn’t variable costsbe lower if actual activity

is lower?


The relevant question is . . .

“How much of the favorable cost variance isdue to lower activity, and how much is due to 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 to changes 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 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 costTotal overhead costs


Fixed costs areexpressed as atotal amount.

Variable costs are expressed as a constant amount per hour.

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

CheeseCo



Machine hours 8,000 10,000 12,000


Fixed costs Depreciation 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


Fixed costs Depreciation 12,000$ 12,000$ Insurance 2,000 2,000 Total fixed cost 14,000$ Total overhead costs 74,000$ ?

CheeseCo


Quick Check What should be the total overhead costs for the

Flexible Budget at 10,000 hours?

a. $92,500.

b. $74,000.

c. $89,000.

d. $94,000.


Quick Check What should be the total overhead costs for the

Flexible Budget at 12,000 hours?

a. $92,500.

b. $89,000.

c. $106,800.

d. $104,000.


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 labor 4.00$ 34,000$ Indirect material 3.00 25,500 Power 0.50 3,800 Total variable costs 7.50$ 63,300$ Fixed Expenses Depreciation 12,000$ 12,000$ Insurance 2,000 2,050 Total fixed costs 14,050$ Total overhead costs 77,350$


Flexible budget is prepared 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 labor 4.00$ 34,000$ Indirect material 3.00 25,500 Power 0.50 3,800 Total variable costs 7.50$ 63,300$ Fixed Expenses Depreciation 12,000$ 12,000$ Insurance 2,000 2,050 Total fixed costs 14,050$ Total overhead costs 77,350$


CheeseCo


Quick Check What is the variance for indirect labor when the

flexible budget for 8,000 hours is compared to the actual results?

a. $2,000 U

b. $2,000 F

c. $6,000 U

d. $6,000 F


Quick Check What is the variance for indirect materials 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


Quick Check What is the variance for depreciation when the

flexible budget for 8,000 hours is compared to the actual results?

a. $0

b. $1,000 F

c. $2,000 U

d. $2,000 F


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




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



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 place the flexible budget for

8,000 hours here.



This $15,000F variance is due 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 unfavorablevariable overhead variances:

1. Spending too much for resources.

2. Using the resources inefficiently.


Overhead Rates and Overhead Analysis

Overhead from theflexible budget for the

denominator level of activityPOHR =

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


Overhead Rates and Overhead Analysis – 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.

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 ratesfor a given activity level.



Overhead Variances

Let’s use the overhead rates, to determine variable and fixed overhead

variances.


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


Variable Overhead Variances

AH × SR

AH × AR

Spending variance = AH(AR - SR)

Efficiency variance = SR(AH - SH)

SH × SR

Spending Variance

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 unfavorable

Efficiency variance$200 unfavorable

$340 unfavorable flexible budget total variance$340 unfavorable flexible budget total variance


Quick Check Yoder Enterprises’ actual production for the

period required 2,100 standard direct labor hours. Actual variable overhead for the period was $10,950. Actual direct labor hours worked were 2,050. The predetermined variable overhead rate is $5 per direct labor hour. What was the spending variance?

a. $450 U

b. $450 F

c. $700 F

d. $700 U



period required 2,100 standard direct labor hours. Actual variable overhead for the period was $10,950. Actual direct labor hours worked were 2,050. The predetermined variable overhead rate is $5 per direct labor hour. What was the efficiency variance?

a. $450 U

b. $450 F

c. $250 F

d. $250 U


Variable Overhead Variances – A Closer 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 turn our attention

to fixed overhead.




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 required 3,200 standard machine hours. Actual fixed overhead

was $8,450.

Compute the fixed overhead budget and volume variances.

Fixed Overhead Variances – Example


Fixed Overhead Variances

Budget Variance

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 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



period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the budget variance?

a. $350 U

b. $350 F

c. $100 F

d. $100 U



period required 2,100 standard direct labor hours. Actual fixed overhead for the period was $14,800. The budgeted fixed overhead was $14,450. The predetermined fixed overhead rate was $7 per direct labor hour. What was the volume variance?

a. $250 U

b. $250 F

c. $100 F

d. $100 U


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 a graph showing fixed overhead

variances. We will use ColaCo’s

numbers from the previous example.



Volume

Cost

$9,000 budgeted fixed OH

3,000 Hours ExpectedActivity

Fixed overhead

applied to products


{


$8,450 actual fixed OH

Volume

Cost



Fixed overhead

applied to products

$550Favorable

Budget Variance

{ $8,450 actual fixed OH


{



3,200 machine hours × $3.00 fixed overhead rate

$600FavorableVolume

Variance

$9,600 applied fixed OH

3,200 Standard

Hours

Volume

Cost



Fixed overhead

applied to products

{


{



3,200 machine hours × $3.00 fixed overhead rate

$600FavorableVolume

Variance

$9,600 applied fixed OH

3,200 Standard

Hours

Volume

Cost



Fixed overhead

applied to products

{$550

FavorableBudget

Variance

{ $8,450 actual fixed OH


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


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

Occurs only because actualactivity differs from the

denominator activity


Overhead Variances and Under- or Overapplied Overhead Cost

Favorablevariances are equivalentto overapplied overhead.

Unfavorablevariances are equivalent

to underapplied overhead.

In a standardcost system:

The sum of the overhead variancesequals the under- or overapplied

overhead cost for a period.

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Flexible Budgets and Overhead Analysis