Flexible Budgets and Overhead Analysis Chapter11 Flexible Budgets and Overhead Analysis

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.

Static Budgets and Performance Reports CheeseCo 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 Insurance 2,000 2,050 Total overhead costs 89,000 77,350

Static Budgets and Performance Reports CheeseCo 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 Power 5,000 3,800 1,200 Fixed costs Depreciation 12,000 Insurance 2,050 50 Total overhead costs 89,000 77,350 $11,650 U = Unfavorable variance CheeseCo was unable to achieve the budgeted level of activity.

Static Budgets and Performance Reports CheeseCo 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 Power 5,000 3,800 1,200 Fixed costs Depreciation 12,000 Insurance 2,050 50 Total overhead costs 89,000 77,350 $11,650 F = Favorable variance that occurs when actual costs are less than budgeted costs.

Static Budgets and Performance Reports CheeseCo 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 Power 5,000 3,800 1,200 Fixed costs Depreciation 12,000 Insurance 2,050 50 Total overhead costs 89,000 77,350 $11,650 Since cost variances are favorable, have we done a good job controlling costs?

Static Budgets and Performance Reports Actual activity is below budgeted activity which is unfavorable. So, shouldn’t variable costs be lower if actual activity is lower? I don’t think I can answer the question using a static budget.

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 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.

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.

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. Variable Fixed

Preparing a Flexible Budget Let’s prepare budgets for CheeseCo.

Preparing a Flexible Budget CheeseCo 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 are expressed as a constant amount per hour. $40,000 ÷ 10,000 hours is $4.00 per hour. 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 Fixed costs are expressed as a total amount. Depreciation $ 12,000 Insurance 2,000 Total fixed cost Total overhead costs

Preparing a Flexible Budget CheeseCo Cost Total Flexible Budgets Formula Fixed 8,000 10,000 12,000 Per Hour Hours Machine hours 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 Insurance 2,000 Total fixed cost Total overhead costs $4.00 per hour × 8,000 hours = $32,000

Preparing a Flexible Budget CheeseCo Cost Total Flexible Budgets Formula Fixed 8,000 10,000 12,000 Per Hour Hours Machine hours Variable costs 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 Insurance 2,000 Total fixed cost 14,000 Total overhead costs 74,000 89,000 104,000

Preparing a Flexible Budget CheeseCo Cost Total Flexible Budgets Formula Fixed 8,000 10,000 12,000 Per Hour Hours Machine hours Variable costs 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 Insurance 2,000 Total fixed cost 14,000 Total overhead costs 74,000 89,000 104,000 Total fixed costs do not change in the relevant range.

Flexible Budget Performance Report Let’s prepare a budget performance report for CheeseCo.

Flexible Budget Performance Report CheeseCo Flexible budget is prepared for the same activity level (8,000 hours) as actually achieved. Cost Total Formula Fixed Flexible Actual Per Hour Costs Budget Results Variances Machine hours 8,000 8,000 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 CheeseCo Cost Total Formula Fixed Flexible Actual Per Hour Costs Budget Results Variances Machine hours 8,000 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 Insurance 2,000 2,050 50 U Total fixed costs 14,000 14,050 Total overhead costs 74,000 77,350 $ 3,350 U

Flexible Budget Performance Report Remember the question: “How much of the total variance is due to activity and how much is due to cost control?”

Static Budgets and Performance How much of the $11,650 is due to activity and how much is due to cost control? 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 Power 5,000 3,800 1,200 Fixed costs Depreciation 12,000 Insurance 2,050 50 Total overhead costs 89,000 77,350 $11,650

Flexible Budget Performance Report Overhead Variance Analysis Let’s place the flexible budget for 8,000 hours here. Difference between original static budget and actual overhead = $11,650 F.

Flexible Budget Performance Report Overhead Variance Analysis Activity Cost control This $15,000F variance is due to lower activity. This $3,350U flexible budget variance is due to poor cost control.

Flexible Budget Performance Report There are two primary reasons for unfavorable variable overhead variances: 1. Spending too much for resources. 2. Using the resources inefficiently. What causes the cost control variance?

Overhead Rates and Overhead Analysis Recall that overhead costs are assigned to products and services using a predetermined overhead rate (POHR): Assigned Overhead = POHR × Standard Activity Overhead from the flexible budget for the denominator level of activity POHR = Denominator level of activity

Overhead Rates and Overhead Analysis – Example Let’s look at overhead rates in a budget for ColaCo.

Overhead Rates and Overhead Analysis – Example ColaCo prepared this budget for overhead: 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 ? Let’s calculate overhead rates. ColaCo applies overhead based on machine hour activity.

Overhead Rates and Overhead Analysis – Example ColaCo prepared this budget for overhead: Total Variable Fixed Machine Overhead Hours Rate 2,000 4,000 $ 2.00 9,000 ? 8,000 Rate = Total Variable Overhead ÷ Machine Hours This rate is constant at all levels of activity.

Overhead Rates and Overhead Analysis – Example ColaCo prepared this budget for overhead: Total Variable Fixed Machine Overhead Hours Rate 2,000 4,000 $ 2.00 9,000 4.50 8,000 2.25 Rate = Total Fixed Overhead ÷ Machine Hours This rate decreases when activity increases.

Overhead Rates and Overhead Analysis – Example ColaCo prepared this budget for overhead: Total Variable Fixed Machine Overhead Hours Rate 2,000 4,000 $ 2.00 9,000 4.50 8,000 2.25 The total POHR is the sum of the fixed and variable rates for a given activity level.

Overhead Variances Let’s use the overhead rates, to determine variable and fixed overhead variances.

Variable Overhead Variances – Example 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 Actual Flexible Budget Flexible Budget Variable for Variable for Variable Overhead Overhead at Overhead at Incurred Actual Hours Standard Hours AH × AR AH × SR SH × SR Spending Variance Efficiency Variance Spending variance = AH(AR - SR) Efficiency variance = SR(AH - SH)

Variable Overhead Variances – Example 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 $6,740 $6,600 $6,400 Spending variance $140 unfavorable Efficiency variance $200 unfavorable $340 unfavorable flexible budget total variance

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.

Now let’s turn our attention to fixed overhead. Overhead Variances Now let’s turn our attention to fixed overhead.

Overhead Rates and Overhead Analysis – Example ColaCo prepared this budget for overhead: Total Variable Fixed Machine Overhead Hours Rate 2,000 4,000 $ 2.00 9,000 4.50 8,000 2.25 What is ColaCo’s fixed overhead rate for an estimated activity of 3,000 machine hours?

Overhead Rates and Overhead Analysis – Example ColaCo prepared this budget for overhead: Total Variable Fixed Machine Overhead Hours Rate 2,000 4,000 $ 2.00 9,000 4.50 8,000 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

Fixed Overhead Variances – Example 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 Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied SH × FR Budget Variance Volume Variance FR = Standard Fixed Overhead Rate SH = Standard Hours Allowed

Fixed Overhead Variances – Example Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied SH × FR 3,200 hours × $3.00 per hour $8,450 $9,000 $9,600 Budget variance $550 favorable Volume variance $600 favorable

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.

Overhead Variances Let’s look at a graph showing fixed overhead variances. We will use ColaCo’s numbers from the previous example.

Fixed Overhead Variances Cost Fixed overhead applied to products Volume 3,000 Hours Expected Activity 3,200 Standard Hours

Fixed Overhead Variances 3,200 machine hours × $3.00 fixed overhead rate Cost $9,600 applied fixed OH $9,000 budgeted fixed OH $8,450 actual fixed OH Fixed overhead applied to products Volume 3,000 Hours Expected Activity 3,200 Standard Hours

Fixed Overhead Variances 3,200 machine hours × $3.00 fixed overhead rate Cost $600 Favorable Volume Variance $9,600 applied fixed OH { { $9,000 budgeted fixed OH { $8,450 actual fixed OH $8,450 actual fixed OH $550 Favorable Budget Variance Fixed overhead applied to products Volume 3,000 Hours Expected Activity 3,200 Standard Hours

Volume Variance – A Closer Look Results when standard hours allowed for actual output differs from the denominator activity. Unfavorable when standard hours < denominator hours Favorable when standard hours > denominator hours

Volume Variance – A Closer Look Does not measure over- or under spending Explainable by and controllable only through activity Volume Variance Results when standard hours allowed for actual output differs from the denominator activity. Unfavorable when standard hours < denominator hours Favorable when standard hours > denominator hours

Overhead Variances and Under- or Overapplied Overhead Cost In a standard cost system: Unfavorable variances are equivalent to underapplied overhead. Favorable variances are equivalent to overapplied overhead. The sum of the overhead variances equals the under- or overapplied overhead cost for a period.

I’m here to your budget. Are you ready to ante up? End of Chapter 11 I’m here to your budget. Are you ready to ante up?